Arista Networks, Inc. — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Unaudited results; dollars below are U.S. dollars. Arista supplies cloud networking solutions, including EOS software and Ethernet switches.
Financial performance and liquidity
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $268.7 million | $195.6 million | $510.9 million | $374.6 million |
| Gross profit / margin | $171.5 million / 63.8% | $127.9 million / 65.4% | $326.5 million / 63.9% | $245.6 million / 65.6% |
| Operating income / margin | $53.2 million / 19.8% | $32.9 million / 16.8% | $102.9 million / 20.2% | $68.6 million / 18.3% |
| Net income / margin | $38.9 million / 14.5% | $24.0 million / 12.3% | $74.1 million / 14.5% | $48.5 million / 12.9% |
| Diluted EPS | $0.53 | $0.33 | $1.01 | $0.67 |
- Q2 product revenue was $235.6 million, up 35.4%; service revenue was $33.1 million, up 54.2%. For the first half, product revenue grew 34.1% and service revenue 55.6% year over year.
- Operating cash flow was $126.0 million for the first half, versus $73.4 million a year earlier. Operating cash flow benefited from net income and higher deferred revenue, payables, and income taxes payable; inventory growth used $26.0 million.
- Investing activities used $308.2 million, mainly reflecting $292.9 million of marketable-security purchases, not operating expenditure. Financing activities provided $25.9 million. Cash and equivalents fell by $156.3 million to $531.1 million.
- At June 30, cash, cash equivalents, and marketable securities totaled $823.8 million; current assets were $1.142 billion and current liabilities $263.4 million. Total liabilities were $418.2 million. The filing reports a $41.9 million building lease financing obligation, including $40.4 million long term; it does not report conventional borrowings in the presented balance sheet.
- Stock-based compensation was $27.6 million for the first half, versus $20.0 million in 2015.
Material changes versus prior period
- Revenue rose 37.4% in Q2 and 36.4% in the first half, driven by shipments to existing customers, new products, and an expanded customer base approaching 4,000.
- Gross margin declined 1.6 percentage points in Q2 and 1.7 points in the first half. Management attributed the decline mainly to customer mix, including greater sales to larger customers receiving higher discounts, and to a lesser extent product mix; improved service margins partly offset it.
- First-half R&D expense increased 41.0% to $131.5 million, reflecting headcount, compensation, product development, and litigation-related product design costs. Sales and marketing expense rose 15.8% to $59.4 million. G&A was broadly flat at $32.8 million.
- Inventory increased to $118.1 million from $92.1 million at year-end. Deferred revenue rose to $230.3 million, current and non-current combined, from $196.8 million.
- Non-cancelable purchase commitments increased to $253.4 million from $43.9 million at year-end, primarily for the new U.S. manufacturing operation and planned Q3 inventory buildup.
Outlook, risks, and unusual items
- Management said Q3 2016 gross margin should be relatively consistent with recent quarters, while noting possible additional product costs as the new contract manufacturer and supply-chain operations ramp. No numerical revenue or earnings guidance is provided in the filing text.
- Management expects approximately $100 million of incremental working-capital requirements in the next quarter for product transitions and the manufacturing ramp, and up to $10 million of incremental capital expenditures. It believes cash and operating cash flow are sufficient for foreseeable requirements.
- Management expects continued investment in R&D, sales, and infrastructure; operating profit as a percentage of revenue could decline in the short to medium term. Results may vary with large-customer order timing, customer and product mix, pricing, and supply-chain execution.
- Cisco litigation is a major contingency. In June, the USITC issued a limited exclusion order and cease-and-desist order covering products found to infringe specified claims of three Cisco patents. The order was subject to Presidential review through August 22, 2016. Arista warned that design-arounds or supply-chain changes could be costly or disrupt shipments. A separate USITC investigation remained pending, with a final determination then expected by December 26, 2016. The company said potential losses were reasonably possible but could not be estimated.
- OptumSoft litigation: a March 2016 Phase I decision found that Arista, not OptumSoft, owned the software put at issue in that phase. Remaining issues were unresolved, with no new Phase II trial date stated. Potential loss was not estimable.
- The IRS was examining tax years 2013 and 2014. Gross unrecognized tax benefits were $23.5 million; $14.7 million could benefit tax expense if realized. Management did not anticipate a significant impact to gross unrecognized benefits within 12 months.
- Management reported disclosure controls effective as of June 30, 2016, and no material change in internal control over financial reporting during the quarter.
Investor verification priorities
- Check the outcome and practical effect of Presidential review of the Cisco-related USITC exclusion and cease-and-desist orders, and the status of design-arounds, enforcement, and the other Cisco proceedings.
- Track whether the new U.S. contract manufacturer scales successfully, and whether the planned inventory buildup and $253.4 million of non-cancelable purchase commitments convert into demand without excess or obsolete inventory.
- Monitor gross-margin trends, customer concentration and discounting, and whether rapid revenue growth continues to translate into operating cash flow.
- Review the remaining OptumSoft claims and IRS examination developments; neither potential legal losses nor a full range of tax adjustments is quantified clearly in the filing.