Arista Networks, Inc. — Q3 2014 Form 10-Q
Reporting period: Three and nine months ended September 30, 2014, compared with the same periods in 2013. Arista supplies cloud networking solutions, including EOS software and Ethernet switches. It completed its IPO on June 6, 2014.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Revenue | $155.5 million | $101.6 million | $410.6 million | $246.5 million |
| Gross margin | 64.9% | 64.0% | 67.1% | 65.4% |
| Operating income | $33.9 million | $18.6 million | $86.5 million | $43.6 million |
| Net income | $21.9 million | $11.9 million | $55.8 million | $28.7 million |
| Diluted EPS | $0.30 | $0.20 | $0.85 | $0.49 |
- Revenue increased 53.0% in Q3 and 66.6% year to date. Management attributed growth mainly to switch sales, particularly to existing customers. Ports shipped rose 78.3% in Q3 and 79.3% year to date, while average selling price per port fell 15.5% and 9.0%, respectively, reflecting product mix and lower large-customer pricing.
- Operating expenses rose 44.6% in Q3 and 61.1% year to date, led by higher personnel, research and development, sales and marketing, and public-company costs. Operating margin was 21.7% in Q3 and 21.0% year to date, versus 18.3% and 17.7% a year earlier.
- Gross-margin improvement reflected scale and, year to date, lower warranty and inventory-obsolescence charges and a $2.2 million supplier settlement. Large-customer discounts, product mix, and higher manufacturing overhead partly offset the improvement.
- Cash and cash equivalents were $408.6 million at September 30, 2014, versus $113.7 million at year-end 2013. Nine-month operating cash flow was $98.7 million; investing cash outflow was $26.2 million; financing cash inflow was $222.5 million, primarily from the IPO.
- Current assets were $588.4 million and current liabilities $101.8 million. Convertible notes were no longer outstanding at quarter-end following IPO-related conversion and repayment. The company reported $42.8 million of non-current lease financing obligations; the filing also describes $1.1 million as the current portion.
Changes, outlook, and notable items
- The IPO generated approximately $238.9 million net proceeds. Approximately $96.5 million of notes and accrued interest converted into common stock; one noteholder was paid approximately $23.6 million. These transactions materially increased equity and cash and eliminated the convertible-note balance.
- Year-to-date revenue included $17.0 million net recognition of previously deferred product revenue; the comparable 2013 period had $7.4 million of net product deferrals. The company also recognized a $4.0 million fair-value gain on notes receivable; the borrower repaid the notes in October 2014 at twice outstanding principal, plus accrued interest.
- Management expects continued investment in research and development, sales and marketing, and infrastructure, and said operating profit could decline in the short to medium term. It believed cash and expected operating cash flows would cover working-capital needs and growth plans for at least 12 months. The filing provides no numerical revenue or earnings guidance.
- Key risks include dependence on a concentrated group of large customers, variable timing of large orders, price and product-mix pressure, and reliance on two electronic manufacturing services providers and limited or sole-source component suppliers. The ten largest end customers represented 43.0% of 2013 revenue; the largest represented 21.9%.
- OptumSoft litigation alleges ownership of certain EOS components and breaches of confidentiality and use restrictions. Arista disputes the claims; management said loss was not probable but reasonably possible and that a loss range could not be estimated. Trial was set for April 2016. A separate Net Navigation patent dispute was settled in June 2014.
- Management concluded disclosure controls were not effective at a reasonable level because of an unremediated material weakness in inventory controls. Prior errors involved freight capitalization and inventory purchase-price variances; remediation efforts were underway.
- Other watch items include the new Santa Clara headquarters lease, with minimum payments of approximately $2.6 million annually, and the expected release of IPO lock-up restrictions on employee and other shareholder shares after quarter-end.
Important facts for investors to verify
- Whether growth and margins remain resilient as average selling prices decline and large customers receive volume discounts.
- Current customer concentration, order timing, and revenue deferrals, since disclosed concentration percentages are primarily historical.
- Progress in remediating the inventory-control material weakness and whether controls become effective.
- Developments in the OptumSoft dispute, including potential effects on EOS intellectual property, product sales, costs, or customer confidence.
- Cash generation excluding IPO proceeds and the fair-value gain, alongside planned operating investments, lease commitments, and stock-based compensation.