Arista Networks, Inc. — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017. Unaudited results are not necessarily indicative of full-year performance. Arista supplies cloud networking products built around its EOS software and Ethernet switching and routing platforms.
Financial performance and position
Amounts below are in millions of dollars except per-share data; comparisons are with the corresponding 2016 period.
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Revenue | $437.6 (+50.8%) | $290.3 | $1,178.3 (+47.1%) | $801.2 |
| Gross profit / margin | $280.6 / 64.1% | $186.4 / 64.2% | $754.6 / 64.0% | $513.0 / 64.0% |
| Operating income / margin | $140.8 / 32.2% | $63.0 / 21.7% | $330.9 / 28.1% | $165.9 / 20.7% |
| Net income / margin | $133.7 / 30.6% | $51.3 / 17.7% | $319.4 / 27.1% | $125.4 / 15.6% |
| Diluted EPS | $1.68 | $0.69 | $4.06 | $1.71 |
| Operating cash flow | Not presented by quarter | $448.0 | $108.7 |
Product revenue rose 49.6% in Q3 and 46.0% year to date, primarily from higher shipments to existing customers and adoption of newer switches. Service revenue grew 59.0% and 54.5%, respectively, as the installed base and support contracts expanded. Margins were broadly stable year to date; Q3 gross margin edged down 0.1 percentage point. Management attributed product-margin pressure to a higher mix of large customers receiving volume discounts and increased inventory-related costs, partly offset by improved service margins.
Operating expenses increased 13.3% in Q3 and 22.1% year to date, below revenue growth. Research and development spending rose 12.7% and 19.9%, respectively, as the company expanded headcount and product development. Sales and marketing expenses also increased with hiring and sales-support needs. Year-to-date general and administrative expense included $7.7 million of Cisco-litigation-related costs, including bond costs.
Liquidity and obligations: At September 30, cash and cash equivalents were $854.5 million and marketable securities were $488.6 million, totaling approximately $1.34 billion. Current assets were $2.08 billion versus current liabilities of $567.5 million. Total liabilities were $777.2 million, including $40.0 million of lease financing obligations; the filing reports no conventional borrowing balance. Cash increased $286.6 million during the first nine months. Operating cash flow benefited from a $192.2 million increase in deferred revenue and $40.5 million of cash from receivables, partly offset by a $96.7 million inventory increase and a $46.1 million decline in accounts payable. Investing cash outflow was $200.3 million, chiefly purchases of marketable securities. The filing says existing cash and operating cash flows should meet working-capital needs and growth plans for the foreseeable future.
Deferred revenue totaled $565.1 million, current and non-current, at quarter end. Inventory was $333.2 million, up from $236.5 million at December 31, 2016. Non-cancelable purchase commitments were $131.8 million.
Material changes, outlook, and notable items
- Growth was driven mainly by continued spending from existing customers, newer-product acceptance, and expansion of support contracts. Revenue mix shifted geographically: EMEA and Asia-Pacific grew faster than the Americas, although the Americas remained the largest region.
- The effective tax rate fell to 6.0% in Q3 and 4.1% year to date, primarily because adoption of ASU 2016-09 required excess stock-award tax benefits to be recognized in income tax expense. Those benefits were $23.8 million for Q3 and $71.7 million year to date; future tax rates may fluctuate with stock price and equity-award activity.
- Management expected operating expenses to continue rising in absolute dollars and anticipated continued work with customers to qualify U.S. product redesigns, which could affect Q4 business. The filing provides no numerical revenue or earnings guidance. Management also noted pricing pressure and variability in large-customer order timing.
- Cash and marketable securities included approximately $198.3 million held outside the United States. Management had no current plan to repatriate those funds and considered foreign earnings indefinitely reinvested.
- New revenue-recognition guidance (Topic 606) was scheduled for adoption in Q1 2018. Management expected it to affect the amount and timing of revenue and related disclosures, was assessing the impact, and anticipated a modified-retrospective transition. The filing also warns that the new standard will require deferral of incremental customer-contract commission costs.
Risks, contingencies, and unusual items
- Cisco disputes pose a significant operating risk. USITC exclusion and cease-and-desist orders cover certain products in the 944 and 945 investigations. Arista had redesigned products and obtained permission to import them, but further USITC proceedings could determine that the redesigns remain infringing. The 944 investigation was affirmed by the Federal Circuit and remanded for additional findings; its enforcement target date was September 4, 2018. A separate 945 modification proceeding was instituted in October 2017. Adverse outcomes could disrupt U.S. shipments, require further redesigns, trigger penalties, or harm customer acceptance.
- In the 944 enforcement matter, the administrative law judge initially found no violation but recommended a $307 million civil penalty if the Commission reversed that finding. The Commission remanded the matter for additional findings; this amount is a contingent potential penalty, not a recorded liability. Management said losses in the Cisco matters were reasonably possible but could not be estimated.
- Tessera: An administrative law judge found a violation involving a patent covering Broadcom semiconductor devices used in certain Arista products and recommended exclusion and cease-and-desist orders. A final Commission determination was targeted for December 1, 2017. Arista described loss at that stage as remote; Broadcom agreed to defend Arista at no cost for claims based solely on Broadcom product functionality.
- OptumSoft: The court ruled in Phase I that Arista owned the software at issue in that phase. Other issues remained unresolved, with no new Phase II trial date. Management said loss was not probable but reasonably possible and not estimable.
- Other notable exposures include customer concentration and unpredictable large orders, supply constraints and contract-manufacturer dependence, inventory obsolescence, competitive pricing, and customer qualification delays for redesigned products. The company had $36.1 million invested in private companies, which it described as inherently risky. No material off-balance-sheet arrangements were reported.
Investor verification priorities
- Track outcomes and timing of the Cisco 944 enforcement remand and 945 modification proceeding, including whether redesigned products remain eligible for U.S. import and sale.
- Check the final outcome of the Tessera Commission proceeding and any resulting product, supply, or import restrictions.
- Assess whether strong revenue and cash generation are sustainable, particularly given large-customer concentration, deferred-revenue growth, inventory buildup, and order variability.
- Monitor Q4 customer qualification and acceptance of redesigned products, related revenue deferrals, and effects on shipments and margins.
- Verify the effect of Topic 606 adoption on revenue timing, deferred revenue, commission-cost deferrals, and reported comparability.