Why Arista's Blowout Q2 Is Good News for Chip-Giant Broadcom

Within the data center and artificial intelligence (AI) trade, one of the most impressive earnings reports of Q2 came from Arista Networks (NYSE: ANET). The company showed a substantial surprise, exceeding expectations on sales and earnings per share (EPS).

However, when it comes to data centers, everything is connected. Arista Networks' latest results are a positive sign for Broadcom (NASDAQ: AVGO), a company it works closely with.

Below, we’ll dive into why Arista’s strong Q2 should be a welcome development for AVGO.

The Broadcom and Arista Connection: Understanding the Data Center Supply Chain

Arista primarily makes Ethernet-based routers and switches for data centers. Known as networking equipment, routers and switches direct the flow of information between different data center components. They allow computing chips, those that actually perform calculations and execute tasks, to communicate with each other.

As data centers must buy more advanced computing chips to increase their capabilities, they must also upgrade their networking equipment. However, routers and switches consist of various components, and Arista doesn’t design all of these. 

One key component in Arista’s routers and switches is networking chips. Who do they primarily buy those chips from? You guessed it: Broadcom. As Arista's switch and router sales see strong demand, Arista needs to buy Broadcom’s networking chips to meet it.

Let’s add some numbers around this to understand further why Arista’s Q2 is a particularly good sign for Broadcom.

Arista’s Product Revenue Leads the Way, Helping Broadcom Shares Spike

In Q2, Arista's sales increased by over 30%, significantly outpacing expectations for around 25% growth. In Q3, Arista forecasts $2.25 billion in sales, setting growth expectations at a solid 24%. 

However, Arista has two key segments of its business: product revenue and service revenue. Product revenue comprises sales of new switches and routers, while services include technical support, software updates, and hardware maintenance.

For Broadcom, Arista’s product segment is the key focus, as its networking chips go into Arista switches and routers. That is why it was a great sign to see Arista’s product segment growth significantly outpace its service segment growth.

This faster growth wasn’t by a small margin either; Arista’s product segment grew at 31.9%, nearly 1,000 basis points higher than its 22.7% services growth. This emphasizes that Arista’s strong Q2 was disproportionately driven by hardware sales, which directly fuels Broadcom’s networking chip business demand.

The price action on August 6, the day after Arista’s earnings release, provides further evidence of the significant relationship between Arista and Broadcom. In reaction to its strong Q2 results, Arista shares jumped more than 17%.

Following along, Broadcom also saw significant gains, with shares rising 3%. Meanwhile, the iShares Semiconductor ETF (NASDAQ: SOXX), a key indicator of sentiment for the semiconductor industry, fell by 0.8%.

These numbers illustrate that the gain in Broadcom wasn’t due to news that benefited the semiconductor industry as a whole. Instead, Arista’s strong results were likely the main driver of Broadcom shares moving higher, due to the specific relationship between the two.

For Broadcom investors, this shows that upside in Arista translates considerably to upside in Broadcom.

Looking Ahead: Arista and Broadcom’s Next-Gen Networking Chip, Tomahawk 6

In June, Broadcom announced that it had started shipping its new Tomahawk 6 networking chip. Broadcom’s Tomahawk line is one of the several families of networking chips that Arista uses in its products.

However, even though Tomahawk 6 has begun shipping, Broadcom doesn’t expect sales to ramp up immediately. In its Q2 earnings call, Broadcom said the Tomahawk 6 chips it had shipped at that point were “basic proof of concepts."

Importantly, Arista confirmed they have their hands on Tomahawk 6 in their earnings call. They said, “Tomahawk 6 is in our labs. Stay tuned for a new product next year.”

This shows that Arista is actively working to develop a product that contains Tomahawk 6. 

The release of such a product will be key to Broadcom generating meaningful Tomahawk 6 revenues. Overall, Arista’s statements provide added confidence that Tomahawk 6 can contribute upside to Broadcom’s business over the coming years as data centers upgrade to next-generation networking infrastructure.

This could be a key component that drives upside in Broadcom shares.

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The article "Why Arista's Blowout Q2 Is Good News for Chip-Giant Broadcom" first appeared on MarketBeat.