Arista Networks, Inc. — Q1 2016 Form 10-Q
Reporting period: Three months ended March 31, 2016; financial statements are unaudited. Comparisons are with Q1 2015 unless noted. Arista supplies cloud networking products built around its EOS software and Ethernet switches.
Financial performance and liquidity
| Metric | Q1 2016 | Q1 2015 | Change or context |
|---|---|---|---|
| Revenue | $242.2 million | $179.0 million | Up 35.3%; product revenue up 32.7%, service revenue up 57.2% |
| Gross profit / margin | $155.1 million / 64.0% | $117.8 million / 65.8% | Margin down 1.8 percentage points |
| Operating income / margin | $49.7 million / 20.5% | $35.8 million / 20.0% | Income up 39.1% |
| Net income | $35.2 million | $24.5 million | Net margin 14.6%, versus 13.6% |
| Diluted EPS | $0.48 | $0.34 | Up from prior-year quarter |
| Cash provided by operations | $71.1 million | $20.8 million | Higher, including increased deferred revenue and favorable working-capital movements |
| Cash and cash equivalents | $710.7 million | $687.3 million at Dec. 31, 2015 | Plus $51.6 million of marketable securities |
Operating expenses were $105.4 million, up 28.5%; research and development increased 44.2% to $62.5 million. Investing cash outflow was $60.3 million, including $51.6 million of marketable-security purchases and $8.6 million of property, equipment and intangible-asset purchases. Financing provided $12.4 million. Cash increased $23.3 million during the quarter.
Total liabilities were $360.1 million. The filing reports no conventional borrowing balance; lease financing obligations were $42.2 million, including $1.4 million current and $40.8 million non-current. Working capital was supported by cash, securities and operating cash generation. Approximately $55.1 million of cash and securities was held outside the U.S.; management said it had no current plan to repatriate those funds.
Material changes and management commentary
- Management attributed revenue growth mainly to greater shipments to existing customers, with additional growth from new customers and an expanding installed base. Service revenue benefited from initial and renewed support contracts.
- Gross margin declined primarily due to customer and product mix, higher discounts for larger customers, manufacturing-capacity expansion and inventory obsolescence charges; improved service margins partly offset these factors.
- Management expected Q2 2016 gross margin to be relatively consistent with recent quarters, while noting possible product-cost increases as a new contract manufacturer and supply chain ramp up. This was not full-year financial guidance.
- Management expected working-capital needs to rise by $50–$100 million over the next several quarters during the manufacturing transition, with a further $5–$10 million of related capital expenditures. It believed existing cash and operating cash flow would cover foreseeable needs.
- The company introduced NetDB in January 2016 and its 7500R series in March 2016. It planned continued investment in R&D, sales, marketing and operating infrastructure, and cautioned that operating-profit percentages could decline in the short to medium term.
Risks, contingencies and unusual items
- Cisco litigation: In the USITC 944 investigation, an administrative law judge found a Section 337 violation involving claims of three Cisco patents; the Commission decided to review specified issues on April 11, 2016. A separate USITC investigation remained pending. Potential outcomes include exclusion or cease-and-desist orders affecting imports, as well as damages, royalties, product redesign costs and shipment disruption. Arista stated that a possible loss was reasonably possible but that any loss range could not be estimated.
- OptumSoft dispute: On March 23, 2016, the court ruled for Arista on ownership of the software at issue in Phase I. Remaining issues had no new trial date. The company stated that a possible loss was reasonably possible but not estimable.
- Manufacturing and supply: The transition to an additional contract manufacturer carries execution, cost and working-capital risks. Non-cancelable purchase commitments totaled $57.3 million at March 31, 2016; key components may have limited sources.
- Customer and market concentration: Large orders and their timing can cause quarterly volatility. The filing reported that Microsoft, through a channel partner, represented 12.0% of 2015 revenue; it did not give a Q1 2016 largest-customer percentage in the provided text.
- Tax: The IRS was examining tax years 2013 and 2014. Gross unrecognized tax benefits were $22.5 million; the potential tax benefit if realized was $13.7 million.
- Other items: Stock-based compensation was $13.4 million, up from $8.8 million. Other income included transactional foreign-exchange gains, compared with losses in Q1 2015. Management reported effective disclosure controls and no material changes in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Subsequent outcomes of the Cisco USITC reviews and litigation, including any effect on product imports, shipments, customer indemnities or redesign requirements.
- Progress, costs and production scale-up at the new contract manufacturer, and whether the stated working-capital and capital-expenditure expectations change.
- Whether revenue growth remains supported by existing customers and service renewals, and how customer concentration and order timing evolve.
- Gross-margin trends, including the effects of customer discounts, product mix, obsolescence and manufacturing transition costs.
- Developments in the OptumSoft Phase II proceedings and the IRS examinations and uncertain tax positions.