Arista Networks, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. Unaudited results are compared with the three months ended March 31, 2017. Arista supplies cloud networking systems, including EOS software and Ethernet switching and routing platforms.
Financial results
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Revenue | $472.5 million | $335.5 million | +40.8% |
| Product revenue | $407.6 million | $291.4 million | +39.9% |
| Service revenue | $64.9 million | $44.1 million | +47.1% |
| Gross profit / margin | $302.9 million / 64.1% | $214.2 million / 63.9% | Margin +0.2 percentage points |
| Operating expenses | $164.2 million | $140.8 million | +16.6% |
| Operating income / margin | $138.7 million / 29.4% | $73.4 million / 21.9% | Margin +7.5 percentage points |
| Net income / net margin | $144.5 million / 30.6% | $83.0 million / 24.8% | +74.2% net income |
| Diluted earnings per share | $1.79 | $1.07 | +67.3% |
| Cash from operations | $195.5 million | $162.9 million | +$32.7 million |
- Growth was driven primarily by existing customers expanding their businesses and continued adoption of newer switch products; service revenue benefited from initial and renewal support contracts. Management said demand more than offset ongoing pricing pressure.
- Gross margin edged higher, supported by scale-related leverage in manufacturing overhead and service costs, partly offset by lower product margins from mix. Operating expenses grew more slowly than revenue; R&D rose 25.4%, sales and marketing 13.8%, while G&A fell 11.2%, largely due to lower litigation expense.
- Cash, cash equivalents and marketable securities totaled approximately $1.74 billion at March 31, 2018, including about $197.3 million held abroad. Cash and equivalents were $886.2 million; marketable securities were $851.9 million. Management said liquidity and operating cash flow should cover working capital and growth needs for at least 12 months.
- Current assets were $2.38 billion versus current liabilities of $457.8 million. Total liabilities were $735.0 million; these included $37.1 million of non-current lease financing obligations. The filing reports no conventional borrowings in the presented balance sheet. Operating cash flow exceeded net income, helped by collections, lower inventory and higher accounts payable; declines in accrued liabilities and deferred revenue partly offset those benefits.
- Investing cash outflow was $183.9 million, mainly reflecting net purchases of marketable securities. Financing cash inflow was $15.3 million, primarily from employee equity plans. Cash, cash equivalents and restricted cash increased $27.0 million during the quarter.
Material changes and accounting matters
- Revenue increased 40.8% year over year. EMEA revenue rose to $121.9 million from $42.7 million, increasing from 12.7% to 25.8% of total revenue; Americas revenue was $315.5 million, or 66.8% of total.
- Deferred revenue declined $42.7 million from year-end, excluding reclassifications required by ASC 606. Management attributed the decline mainly to customers certifying and accepting redesigned products related to the Cisco ITC matters. The company recognized $159.4 million of revenue that had been deferred at the beginning of the quarter.
- Arista adopted ASC 606 using the modified retrospective method on January 1, 2018. The adoption increased opening retained earnings by $3.5 million, primarily for previously expensed contract commission costs, and reclassified $16.5 million of deferred revenue related to prepaid subscriptions to other liabilities. Management said the standard’s impact on Q1 and expected 2018 results was not material.
- Tax benefit was $1.6 million, compared with $9.2 million in the prior-year quarter. The effective tax rate was negative 1.2%, versus negative 12.5%. The company had not completed its accounting for the Tax Act and was still evaluating GILTI treatment; estimates could change and materially affect tax expense.
Outlook, risks and contingencies
- Management expects revenue to continue growing year over year in absolute dollars, but expects growth rates to decline as the business scales. Revenue, margins and results may vary with large-customer order timing, acceptance and qualification, product and customer mix, discounts, and competitive pricing. Operating expenses are expected to increase in absolute dollars in the near term as Arista invests in R&D, sales and marketing, and infrastructure.
- Redesigned products tied to Cisco litigation remained subject to customer qualification and regulatory proceedings. A March 2018 recommended determination found the redesigns did not infringe one patent but did infringe another; on April 5, 2018, after quarter-end, the USITC suspended enforcement of remedial orders as to the latter patent following an appellate decision. A separate Cisco enforcement action remained pending, with a September 4, 2018 target date; an administrative law judge had recommended a possible $307 million penalty if the USITC overturned a finding of no violation. The company said the litigation loss was not probable, but reasonably possible, and that any loss or range could not be estimated.
- Other Cisco proceedings could result in import restrictions, penalties, damages, royalties, redesign costs, shipment disruption or customer delays. The company stated that it was vigorously defending the matters. OptumSoft’s dispute over ownership and use of certain EOS components also remained pending; the court had ruled for Arista on the Phase I contract interpretation issues, with Phase II scheduled to begin in March 2019. Management said a possible loss was reasonably possible but not estimable.
- At quarter-end, non-cancellable purchase commitments were $251.1 million, including $197.7 million to contract manufacturers and suppliers. New data-center and co-location leases added approximately $43.6 million of minimum future payments, mostly due in 2021–2028. The company also cited supply-chain and component availability, customer concentration, competition, product acceptance, and intellectual-property litigation as significant risks.
Investor verification priorities
- Track the final outcomes and financial exposure of the Cisco USITC enforcement and modification proceedings, and the effect of product redesigns on U.S. shipments and customer acceptance.
- Verify whether deferred product revenue tied to redesign certifications converts to recognized revenue, and monitor deferred revenue and customer acceptance trends.
- Assess the sustainability of revenue growth, gross margin and operating margin amid large-customer concentration, pricing pressure and product mix changes.
- Review operating cash flow quality, particularly the effects of working-capital movements and the quarter’s decline in accrued liabilities and deferred revenue.
- Monitor the completion of Tax Act and GILTI accounting assessments and any resulting changes to the effective tax rate or tax liabilities.
- Consider outstanding purchase commitments, new lease obligations and potential supply constraints alongside reported cash and marketable securities.