Arista Networks, Inc. — Q2 2015 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2015; filed August 6, 2015. Arista supplies cloud networking solutions built around its EOS software and Ethernet switches. In June, it introduced CloudVision for network-wide workload orchestration and workflow automation.
Financial results
| Metric | Q2 2015 | Q2 2014 | First half 2015 | First half 2014 |
|---|---|---|---|---|
| Revenue | $195.6 million | $137.9 million | $374.6 million | $255.2 million |
| Gross profit | $127.9 million | $93.4 million | $245.6 million | $174.7 million |
| Gross margin | 65.4% | 67.7% | 65.6% | 68.5% |
| Operating income | $32.9 million | $30.7 million | $68.6 million | $52.6 million |
| Net income | $24.0 million | $21.6 million | $48.5 million | $33.9 million |
| Diluted EPS | $0.33 | $0.34 | $0.67 | $0.54 |
| Cash from operations | Not separately provided for the quarter | $73.4 million | $63.9 million |
Q2 revenue rose 41.8% year over year; first-half revenue rose 46.8%. Product revenue was $174.1 million in Q2, up 37.7%; service revenue was $21.5 million, up 85.9%, mainly reflecting a larger installed base and more support contracts. For the first half, product and service revenue grew 43.5% and 81.3%, respectively.
Q2 gross margin declined 2.3 percentage points year over year, primarily from customer mix, larger customers’ discounts and investment in manufacturing and operating infrastructure. Operating expenses increased 51.5% in Q2, including a 158.3% increase in general and administrative expense; litigation fees accounted for $9.9 million of that increase. Operating margin fell to 16.8% from 22.2%. Net margin was 12.3%, versus 15.7%. Diluted EPS was lower year over year in Q2 despite higher net income; weighted-average diluted shares increased to 71.2 million from 44.1 million.
Balance sheet, liquidity and cash flow
- At June 30, cash and cash equivalents were $343.0 million and marketable securities were $208.8 million, totaling $551.8 million. Approximately $96.0 million was held outside the U.S.; the company said it had no current plan to repatriate those funds.
- Total current assets were $850.2 million and current liabilities were $202.5 million. Total liabilities were $325.3 million, including $43.1 million of lease financing obligations. The filing reports no notes payable outstanding at period-end.
- First-half operating cash flow was $73.4 million; investing cash outflow was $9.5 million, mainly property and equipment purchases; financing cash inflow was $39.0 million, mainly stock-based tax benefits, option exercises and employee stock purchases. Cash increased $102.9 million during the half.
- Operating cash flow included a $58.0 million increase in deferred revenue, while accounts receivable and inventory rose $25.8 million and $22.3 million, respectively. The filing attributes deferred revenue growth largely to support contracts and product revenue deferrals.
Outlook, commentary and key risks
- No numeric revenue or earnings guidance is provided in the supplied filing text. Management expects to continue investing in R&D, sales and marketing, and infrastructure; it cautions operating profit as a percentage of revenue could decline in the short to medium term and expects operating expenses to rise in absolute dollars.
- Management attributes growth to increased shipments to existing customers and new customer additions, while noting that large-customer order timing, discounting and product mix can cause significant quarterly variability. Larger customers typically receive higher discounts, contributing to margin pressure.
- Customer concentration, competitive pricing, dependence on a limited number of component suppliers and two contract manufacturers, and inventory forecasting are material business risks. The filing notes that two suppliers provided essentially all electronic manufacturing services and that some key components have limited or sole sources.
- Arista faces Cisco patent and copyright litigation, including two U.S. International Trade Commission investigations seeking orders that could restrict imports of accused switches. It also faces an OptumSoft dispute over ownership and use of EOS-related software. The company says a possible loss or range of loss in these matters cannot be estimated; adverse outcomes could involve damages, royalties, injunctions, product changes or sales restrictions.
- Disclosure controls were assessed as ineffective at June 30 because of a material weakness in cash-flow statement review controls. A 2014 cash-flow classification error had understated operating cash flow and overstated financing cash flow by $17.4 million; remediation was underway and not complete. Management stated the current-period statements were fairly presented in all material respects.
- Other notable items include $21.5 million of gross unrecognized tax benefits and $36.6 million of investments in privately held companies. Management considers existing cash and operating cash flow sufficient for foreseeable needs, while noting future capital requirements depend on growth, investment and litigation outcomes.
Most important facts for investors to verify
- Whether revenue growth continues without further deterioration in gross and operating margins, and how large-customer pricing and order timing affect results.
- Progress and outcomes in the Cisco investigations and OptumSoft litigation, including any changes to potential product availability, royalties or legal costs.
- Completion and effectiveness of remediation for the material weakness, and the consequences of the prior cash-flow classification error.
- Cash conversion and working-capital trends, particularly deferred revenue, receivables, inventory and the tax-related cash-flow effects.
- Exposure to concentrated manufacturing and component suppliers, and the value and recoverability of private-company investments and uncertain tax positions.