Arista Networks, Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. Unaudited consolidated results; dollar amounts below are in millions unless noted. Arista sells cloud networking switches, software and support services.
Financial performance
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Revenue | $290.3 | $217.5 | $801.2 | $592.1 |
| Gross profit / margin | $186.4 / 64.2% | $141.7 / 65.2% | $513.0 / 64.0% | $387.4 / 65.4% |
| Operating income / margin | $63.0 / 21.7% | $31.3 / 14.4% | $165.9 / 20.7% | $99.9 / 16.8% |
| Net income | $51.3 | $28.7 | $125.4 | $77.2 |
| Diluted EPS | $0.69 | $0.39 | $1.71 | $1.07 |
- Q3 product revenue was $254.2 million, up 31.5%; service revenue was $36.0 million, up 48.8%. Nine-month product and service revenue increased 33.1% and 53.1%, respectively.
- Operating cash flow for the first nine months was $78.7 million, versus $84.0 million a year earlier. Investing cash flow was negative $319.6 million, largely reflecting $342.5 million of marketable-security purchases. Financing cash flow was positive $54.2 million. Cash and equivalents ended at $500.5 million.
- Cash, cash equivalents and marketable securities totaled $800.1 million at September 30. Current assets were $1,324.2 million and current liabilities $355.1 million. The balance sheet reports $40.0 million of non-current lease financing obligations; no conventional debt balance is reported.
- Total assets were $1,519.1 million and stockholders’ equity $1,011.4 million. Deferred revenue totaled $284.8 million, current and non-current combined.
Changes and management commentary
- Revenue rose 33.4% in Q3 and 35.3% for the first nine months, driven mainly by higher shipments to existing customers and new products. The company reported more than 4,100 customers and over 10 million cumulative networking ports shipped.
- Gross margin declined 1.0 percentage point in Q3 and 1.4 points year to date. Management attributed the pressure to customer mix, including larger customers receiving higher discounts, and added manufacturing and operations capacity costs. Improved service margins partly offset these effects.
- Operating expenses increased 11.7% in Q3 and 20.7% year to date. R&D and sales and marketing spending increased; G&A fell as litigation expense was lower than in the comparison periods.
- The effective tax rate was 18.5% in Q3 versus 6.1% a year earlier, and 24.0% year to date versus 20.8%. Management cited earnings geography and changes in tax benefits.
Outlook, risks and contingencies
- No specific revenue or EPS guidance is provided. Management expects further product-cost increases in Q4 2016 as it invests in contract manufacturing and supply-chain operations; it also warned operating profit as a percentage of revenue could decline in the short to medium term as it invests in growth.
- Key operating risks include large-customer concentration and unpredictable order timing, competitive pricing and margin pressure, supply constraints, and execution of manufacturing expansion. The company had $226.2 million in non-cancelable purchase commitments and $64.9 million in inventory deposits at September 30.
- Cisco litigation: The USITC’s 2016 exclusion and cease-and-desist orders related to certain patents were in effect. Arista said it had redesigned affected products, sought U.S. Customs clearance to import them, and changed manufacturing and shipping workflows. Cisco filed an enforcement complaint alleging continued infringement; potential remedies include significant daily civil penalties. Related appeals and a separate USITC investigation remained unresolved.
- OptumSoft dispute: A March 2016 Phase I decision found Arista owned the software at issue in that phase. Other claims remained unresolved, and a Phase II trial date had not been set. The company said potential losses in the major legal matters were reasonably possible but could not be estimated.
- Management said existing cash and operating cash flow should meet working-capital and growth needs for the foreseeable future. Approximately $74.2 million of cash and securities was held outside the U.S.; the company said it did not currently plan to repatriate those funds.
- Disclosure controls were judged effective at a reasonable-assurance level; no material change in internal control over financial reporting was reported for the quarter.
Important facts for investors to verify
- Progress and financial impact of Cisco’s USITC enforcement action, appeals, and the pending investigation; confirm whether redesigned products received import clearance and avoid shipment disruption.
- Whether revenue growth remains supported by repeat customer demand, and how customer concentration, order timing and discounting affect future revenue and margins.
- Whether manufacturing expansion and supply commitments convert into sales without excess inventory, added costs or further gross-margin deterioration.
- Cash conversion: operating cash flow was below net income, with significant working-capital use, including increases in receivables, inventory and inventory deposits.
- Tax-rate variability, IRS examinations for 2013 and 2014, and the reported $20.2 million of gross unrecognized tax benefits.