Arista Networks, Inc. — Q2 2019 Form 10-Q
Reporting period: Three and six months ended June 30, 2019. Unaudited results; financial amounts below are in U.S. dollars, millions except per-share data.
Business context
Arista supplies cloud networking solutions, including its EOS software and Ethernet switching and routing platforms. It generates most revenue from product sales, with support services providing a growing revenue stream. The company operates as one reportable segment.
Financial performance and liquidity
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Revenue | $608.3 | $519.8 | $1,203.7 | $992.3 |
| Gross profit / margin | $390.2 / 64.1% | $333.9 / 64.2% | $770.8 / 64.0% | $636.8 / 64.2% |
| Operating income (loss) | $206.8 | ($239.8) | $401.2 | ($101.1) |
| Net income (loss) | $189.3 | ($155.3) | $390.3 | ($10.7) |
| Diluted EPS | $2.33 | ($2.08) | $4.80 | ($0.14) |
| Operating cash flow | Not separately presented | Not separately presented | $366.5 | $326.1 |
- Q2 revenue grew 17.0% year over year; product revenue rose 15.4% and service revenue 26.7%. Six-month revenue increased 21.3%.
- Q2 operating margin was approximately 34.0%; six-month operating margin was approximately 33.3%.
- At June 30, cash and cash equivalents were $944.4 and marketable securities were $1,313.4, totaling approximately $2.26 billion. Total cash, cash equivalents and restricted cash were $948.6.
- Total liabilities were $915.7. The filing reports no funded debt; operating lease liabilities totaled $104.4, including $14.7 current and $89.7 non-current.
- Current assets were $3,028.5 and current liabilities $525.0. Deferred revenue was $502.2, including current and non-current portions.
- Six-month cash increased by $294.5. Investing cash use was $5.5 and financing cash use was $66.6, including $100.0 of share repurchases.
Changes versus the prior comparable period
- Profitability improved sharply from reported losses in 2018, chiefly because Q2 and six-month 2018 included a $405.0 legal-settlement charge related to Cisco. The settlement included a $400.0 payment and $5.0 in legal fees; the parties later completed a mutual release and settlement agreement.
- Revenue grew, while gross margin edged down from 64.2% to 64.1% for Q2 and 64.0% for the first half. Management attributed pressure to product transition costs and some excess and obsolete inventory charges, partly offset by customer mix; service margin improved.
- Research and development and sales and marketing expenses increased year over year as the company expanded headcount and investment. General and administrative expenses declined, partly due to lower litigation fees.
- Operating cash flow rose to $366.5 from $326.1 for the first half. The 2018 comparison included a $405.0 accrued settlement liability; 2019 cash flow was affected by lower deferred revenue and higher inventory.
- On January 1, 2019, Arista adopted ASC 842, recording operating lease assets and liabilities and reclassifying its headquarters build-to-suit lease. The adoption increased opening retained earnings by $3.7.
Outlook, management commentary and risks
- Management expects revenue to continue growing year over year in absolute dollars, while growth rates are expected to decline as the business scales. It expects operating expenses to increase in absolute dollars in the near term; the filing provides no specific numerical earnings or revenue guidance.
- Management reported a Q2 slowdown in demand from certain large end customers and warned it could continue. Large customer orders are variable in timing, and customer concentration and discounting can affect revenue and margins.
- Growth depends on continued sales to existing customers and expansion into campus switching and WiFi markets. The company also cited competitive pricing pressure, product-transition costs and reliance on third-party manufacturers and limited-source components.
- Non-cancellable purchase commitments were $230.9, including $208.8 to contract manufacturers and suppliers. Inventory increased to $314.2 from $264.6 at year-end, partly in preparation for product transitions.
- Arista reported approximately $545.7 of remaining performance obligations, expected to be recognized about 83% over the next two years and 17% in years three through five.
- The OptumSoft dispute remains unresolved. Arista said a loss was not probable but was reasonably possible; any possible loss or range could not be estimated. An adverse ruling could affect EOS-related intellectual property and cause damages or injunctive relief.
- A Ninth Circuit tax ruling prompted a change in the company’s tax position and a discrete $9.8 tax expense in Q2 2019. The reported effective tax rates were 14.2% for Q2 and 8.7% for the first half.
- The board authorized a $1.0 billion repurchase program in April 2019. Arista repurchased $100.0 of stock at an average $245.95 per share through June 30; approximately $900.0 remained authorized. The program is discretionary.
- Management said existing cash, marketable securities and operating cash generation should be sufficient for working capital and growth plans for at least the next 12 months.
Key facts for investors to verify
- Whether the slowdown among certain large customers continued after Q2, and how customer concentration affects future growth and pricing.
- Inventory quality and product-transition execution, including potential obsolescence charges and the ability to meet demand against substantial purchase commitments.
- Developments in the OptumSoft litigation, particularly potential exposure involving EOS and the inability to estimate a loss range.
- Gross-margin trends amid competition, customer discounts, supply costs and tariffs, and whether growth in services and newer products offsets pressure.
- Subsequent use of the repurchase authorization and its effects on liquidity and share count.
- Future tax expense following the change in the company’s treatment of stock-based compensation in its cost-sharing arrangement.