Arista Networks, Inc. — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015; filed November 5, 2015. Unaudited results. Unless noted, financial amounts below are in millions of dollars.
Business context and reporting period
Arista supplies cloud networking systems, including its EOS software and Ethernet switches, to large Internet companies, cloud service providers and enterprises. It reported one operating segment. Q3 revenue growth reflected higher shipments to existing customers, new customer additions and a larger installed base supporting service-contract growth. The company introduced CloudVision in June 2015, Macro Segmentation Services and new 10/25/40/50/100G switch series during the quarter.
Financial performance and liquidity
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Revenue | $217.5 | $155.5 | $592.1 | $410.6 |
| Product revenue | $193.3 | $141.5 | $527.6 | $374.3 |
| Service revenue | $24.2 | $14.0 | $64.6 | $36.3 |
| Gross profit / margin | $141.7 / 65.2% | $101.0 / 64.9% | $387.4 / 65.4% | $275.7 / 67.1% |
| Operating income / margin | $31.3 / 14.4% | $33.9 / 21.7% | $99.9 / 16.8% | $86.5 / 21.0% |
| Net income | $28.7 | $21.9 | $77.2 | $55.8 |
| Diluted EPS | $0.39 | $0.30 | $1.07 | $0.85 |
| Cash provided by operating activities | — | — | $84.0 | $98.7 |
Revenue increased 39.9% in Q3 and 44.2% year to date. Product revenue grew 36.7% and 40.9%, respectively; service revenue grew 72.8% and 78.0%. Q3 gross margin edged up year over year, while the nine-month margin declined. Management attributed the year-to-date decrease mainly to inventory obsolescence charges, higher warranty costs and investment in manufacturing and operations infrastructure. Operating expenses rose 64.6% in Q3 and 52.0% year to date; Q3 operating income consequently declined despite strong sales growth. Net income benefited from substantially lower income tax expense.
At September 30, cash and cash equivalents were $418.5 and marketable securities were $150.1, for total cash and securities of $568.6. Current assets were $921.1 and current liabilities $225.0. Total liabilities were $349.7. The company reported a $42.9 lease-financing obligation, including $1.3 current and $41.6 non-current; it reported no remaining notes payable. Deferred revenue totaled $190.7, current and non-current combined.
For the first nine months, operating cash flow was $84.0, down from $98.7. The cash-flow discussion cites higher receivables ($63.9 increase) and inventory ($31.9 increase), partly offset by deferred-revenue growth ($84.2). Investing activities provided $39.4, principally reflecting $58.2 of marketable-security maturities, against capital expenditures and other purchases. Financing activities provided $55.3, including $32.4 of excess tax benefits from equity compensation, $14.6 from option exercises and $9.4 from the employee stock purchase plan. Cash increased $178.5 from year-end 2014 to $418.5. Approximately $62.0 of cash and securities was held outside the U.S.; management said it had no current plans to repatriate those funds.
Material changes versus prior comparable periods
- Growth accelerated in both product and service revenue, with service revenue expanding faster from the increasing installed base.
- Gross margin improved 0.3 percentage points in Q3 but fell 1.7 points for the nine-month period.
- Operating margin contracted to 14.4% in Q3 from 21.7%; higher operating costs, notably R&D and litigation-related G&A, outweighed gross-profit growth. General and administrative expense rose 154.6% in Q3 and 137.8% year to date; management attributed the increase mainly to Cisco and OptumSoft litigation costs.
- Q3 effective tax rate fell to 6.1% from 32.3%; the nine-month rate was 20.8% versus 33.1%. A $5.8 benefit from the expiration of statutes of limitation on certain tax positions, plus related interest, contributed to the reduction.
- Nine-month operating cash flow declined by $14.7, while cash and securities remained substantial. Stock-based compensation was $32.3 for the nine months, compared with $19.6 a year earlier.
Outlook, risks, contingencies and unusual items
No quantified revenue, earnings or margin guidance is provided in the filing. Management expects continued investment in R&D, sales and marketing, and operating infrastructure; it cautioned that operating profit as a percentage of revenue could decline in the short to medium term. It believes existing cash and cash flow from operations will meet working-capital needs and growth plans for the foreseeable future. Results remain exposed to large-order timing, customer concentration, pricing and product mix, competition, supply constraints and inventory obsolescence.
Material litigation remains unresolved. Cisco alleges patent and copyright infringement and seeks damages and injunctive relief; its U.S. International Trade Commission cases could, if decided adversely, restrict imports of accused products. The OptumSoft dispute concerns claimed ownership and use of components of EOS. Arista said a loss was not probable but reasonably possible and that any potential loss or range could not be estimated. No liability was recorded for these matters. Litigation expense increased substantially. The filing also reports $4.5 of liabilities related to excess and obsolete component inventory commitments.
Management concluded disclosure controls and procedures were not effective as of September 30, 2015 because of a material weakness in review controls over cash-flow statement calculations and disclosures. The weakness had previously caused a $17.4 misclassification between operating and financing cash flows in the 2014 statement, which was corrected in amended financial statements. Remediation was ongoing; management nevertheless stated that the current quarter’s financial statements were fairly presented in all material respects.
Other notable items include a $4.0 million letter of credit associated with the headquarters lease and $36.6 of investments in privately held companies, which management describes as carrying risk of partial or total loss. The company also depends on two suppliers for essentially all electronic manufacturing services and has limited or sole-source suppliers for certain components.
Important facts for investors to verify
- Progress and outcomes in the Cisco and OptumSoft proceedings, including possible product restrictions, damages, royalties or changes to EOS.
- Whether the cash-flow control weakness is fully remediated and the results of the required internal-control assessment.
- Whether strong reported sales growth converts into operating cash flow, given the increases in receivables and inventory.
- Future gross margins, inventory-obsolescence and warranty charges, and the level of ongoing litigation expense.
- Customer concentration and order timing, as well as the company’s exposure to contract manufacturers and constrained component suppliers.