Arista Networks, Inc. — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. Amounts are in U.S. dollars; financial statement amounts below are in millions unless noted. Arista supplies cloud networking products built around its EOS software and Ethernet switching and routing platforms.
Financial performance and position
| Metric | Q2 2017 | Q2 2016 | First half 2017 | First half 2016 |
|---|---|---|---|---|
| Revenue | $405.2 | $268.7 | $740.7 | $510.9 |
| Product revenue | $353.9 | $235.6 | $645.3 | $448.1 |
| Service revenue | $51.3 | $33.1 | $95.4 | $62.8 |
| Gross profit / margin | $259.8 / 64.1% | $171.5 / 63.8% | $474.0 / 64.0% | $326.5 / 63.9% |
| Operating income / margin | $116.6 / 28.8% | $53.2 / 19.8% | $190.1 / 25.7% | $102.9 / 20.2% |
| Net income | $102.7 | $38.9 | $185.6 | $74.1 |
| Diluted EPS | $1.30 | $0.53 | $2.37 | $1.01 |
- Cash flow: First-half operating cash flow was $242.1 million, versus $142.0 million a year earlier. Investing used $12.9 million and financing provided $26.0 million. Cash and cash equivalents increased by $255.6 million to $823.5 million.
- Liquidity: Cash, cash equivalents and marketable securities totaled approximately $1.125 billion at June 30, 2017, including $125.1 million held outside the U.S. Current assets were $1.949 billion and current liabilities were $610.8 million.
- Debt and obligations: The filing reports no conventional borrowing balance. Lease financing obligations totaled $40.4 million, including $38.7 million non-current; deferred revenue was $554.5 million in total. Non-cancelable purchase commitments were $152.4 million.
- Balance sheet: Total assets were $2.163 billion and stockholders’ equity was $1.358 billion. Inventory increased to $363.8 million from $236.5 million at year-end 2016.
Material changes and management commentary
- Q2 revenue grew 50.8% year over year; first-half revenue grew 45.0%. Management attributed growth chiefly to higher shipments to existing customers and market acceptance of newer products. Service revenue also rose with the expanding installed base and support-contract renewals.
- Operating income rose faster than revenue, and operating margin increased by 9.0 percentage points in Q2. Gross margin was broadly stable: improved service margins were partly offset by lower product margins from a somewhat higher mix of large customers receiving volume discounts.
- Operating expenses rose 21.0% in Q2 and 27.0% in the first half. Management cited hiring and investment in R&D and sales, as well as higher legal costs. Litigation-related expenses increased by $4.4 million in Q2 and $8.8 million in the first half versus comparable 2016 periods.
- First-half operating cash flow benefited from a $181.6 million increase in deferred revenue, while inventory growth used $127.3 million of cash. The filing says deferred revenue growth reflected product acceptance terms and continued growth in support contracts.
- The reported income tax provision was $14.4 million in Q2 and $5.2 million for the first half. The low first-half effective rate of 2.7% primarily reflected $47.9 million of excess tax benefits recognized in the provision following adoption of ASU 2016-09; the benefits are stock-award related and may make the tax rate variable.
Outlook, risks and contingencies
- The filing provides no numerical revenue or earnings guidance. Management expects continued investment in R&D, sales and marketing, and infrastructure, and expects operating expenses to rise in absolute dollars in the near term. It states that existing liquidity and operating cash flows should meet working-capital needs and growth plans for the foreseeable future.
- Management cautions that quarterly results can vary with large-customer order timing, product acceptance and revenue deferrals, pricing, product mix, and supply availability. Large purchases by a limited number of customers have historically represented a significant share of revenue; the filing does not state the current-quarter concentration.
- Cisco litigation and U.S. product restrictions: USITC exclusion and cease-and-desist orders in the 945 investigation were in effect, barring import and sale of covered infringing products in the U.S. The PTAB found relevant claims of the patents unpatentable, but the Commission declined to suspend the orders. Arista was redesigning products, working on customer qualification, and had requested CBP approval to import redesigned products. In a separate 944 enforcement proceeding, an administrative law judge found no violation, but recommended a $307 million civil penalty if the Commission reversed that finding; a final determination was pending. The company said potential losses from the legal matters were reasonably possible but could not be estimated.
- Other legal matters: Cisco appealed a favorable district-court judgment for Arista in a separate case. OptumSoft’s remaining claims concerning EOS ownership and alleged confidentiality/use restrictions remained unresolved; the court had ruled for Arista on ownership of software at issue in Phase I. Tessera’s USITC case against Broadcom and downstream respondents, including Arista, produced an initial determination finding a violation of one patent; the final determination was pending. Arista said Broadcom had agreed to defend it at no cost for claims based solely on Broadcom product functionality and characterized the loss likelihood at that stage as remote.
- Additional risks include customer and supplier concentration, dependence on third-party manufacturers and merchant-silicon suppliers, inventory and component availability, competitive pricing pressure, product qualification and redesign costs, and potential disruption to U.S. shipments. The company reported $36.1 million of cost-method investments in private companies, which it describes as inherently risky.
- Revenue-recognition standard Topic 606 was scheduled for adoption in Q1 2018. Management expected it to affect the amount and timing of revenue and disclosures and anticipated modified-retrospective adoption with a cumulative-effect adjustment; the impact was still under assessment.
Investor verification priorities
- Check the final outcomes of the 944 and 945 USITC matters, the status of any stays and CBP/USITC import approvals, and whether redesigns were accepted by customers.
- Track actual product shipments, customer qualification, and any penalties, damages, royalties or other material litigation developments; the filing does not estimate possible loss ranges.
- Assess the sustainability of revenue growth and margins against large-customer order timing, volume discounts, competition and product mix.
- Monitor inventory and purchase commitments alongside deferred revenue, cash conversion and revenue-recognition deferrals.
- Separate recurring tax performance from stock-based-compensation tax benefits when evaluating the unusually low first-half effective tax rate.