Arista Networks, Inc. — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017; filed May 5, 2017. Arista supplies cloud networking systems built around its EOS software and Ethernet switching and routing platforms. Unless noted, amounts below are in U.S. dollars.
Financial performance
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Revenue | $335.5 million | $242.2 million | +38.5% |
| Product revenue | $291.4 million | $212.5 million | +37.1% |
| Service revenue | $44.1 million | $29.7 million | +48.4% |
| Gross profit / gross margin | $214.2 million / 63.9% | $155.1 million / 64.0% | Margin down 0.1 percentage point |
| Operating expenses | $140.8 million | $105.4 million | +33.6% |
| Operating income / margin | $73.4 million / 21.9% | $49.7 million / 20.5% | Operating income +47.6% |
| Net income | $83.0 million | $35.2 million | +135.4% |
| Diluted EPS | $1.07 | $0.48 | +122.9% |
| Operating cash flow | $162.9 million | $77.1 million | +111.2% |
Net income included a $9.2 million income tax benefit, compared with a $14.1 million tax provision a year earlier. The filing attributes the tax swing primarily to $28.8 million of excess tax benefits from adopting share-based compensation accounting guidance; the reported profit and EPS growth therefore benefited materially from a discrete tax item.
Balance sheet and liquidity
- Cash and cash equivalents were $746.6 million at March 31, up from $567.9 million at year-end; marketable securities were $296.7 million. Combined, these totaled approximately $1.043 billion, including about $112.1 million held outside the United States.
- Current assets were $1.737 billion and current liabilities were $532.5 million. Deferred revenue totaled $497.2 million, including current and non-current balances.
- Total liabilities were $711.2 million. The filing reports no conventional borrowings; it reports a $40.8 million build-to-suit lease financing obligation, of which $39.1 million was non-current. The filing also describes non-cancelable purchase commitments of $362.6 million.
- Cash increased by $178.6 million during the quarter. Investing activities used $2.9 million net, and financing activities provided $18.5 million, primarily from employee equity-plan share issuance.
Material changes and management commentary
- Revenue growth was attributed mainly to higher shipments to existing customers and continued acceptance of newer products. Service growth reflected expansion of the installed base and initial and renewed support contracts.
- Operating expenses grew more slowly than revenue, but increased across all functions. Research and development rose 30.5%; general and administrative rose 45.4%, including $4.5 million of higher litigation expense, primarily related to Cisco matters.
- Operating cash flow benefited from a $124.2 million increase in deferred revenue and $44.1 million of cash collections, partly offset by $50.3 million of inventory growth. The deferred-revenue increase included product deferrals associated with contract acceptance terms and ongoing growth in support contracts.
- Revenue increased across the Americas and Asia-Pacific, while EMEA revenue declined slightly year over year. The United States generated $262.4 million, or about 78% of total revenue.
- Management expects to keep investing in R&D, sales and marketing, and infrastructure; it expects operating expenses to increase in absolute dollars in the near term. No specific revenue, earnings, or margin guidance is provided in the filing.
Risks, contingencies, and unusual items
- Cisco litigation and import restrictions: Existing USITC exclusion and cease-and-desist orders relate to certain patents and products. On May 4, 2017, the USITC issued additional orders in the 945 investigation concerning the ’577 and ’668 patents; the determination was subject to a 60-day Presidential review period, with a 5% bond required during that period for covered imports and sales. Arista said its proposed ’668 design-around was found to continue to infringe and that an alternative redesign would be needed. The company warns that redesign, approvals, supply-chain changes, or adverse enforcement outcomes could disrupt U.S. shipments and increase costs. A separate CBP ruling on April 7, 2017 approved certain redesigns related to the 944 investigation. Potential litigation losses were described as reasonably possible, but not probable, and not estimable.
- Other legal matters: In the OptumSoft dispute, the court’s Phase I decision favored Arista’s ownership interpretation for the software at issue in that phase; remaining issues had no new trial date. A separate Tessera USITC investigation involving Broadcom components and certain Arista products had an October 2017 target completion date. Plectrum filed a patent lawsuit in February 2017. The filing states that possible losses for the principal disputes could not be estimated.
- Concentration, competition, and execution: Management cautions that large purchases from a limited number of customers, order timing and acceptance terms, pricing pressure, competition, and sales-cycle variability can cause significant quarterly fluctuations. The filing cites Microsoft, through a channel partner, as 16% of revenue in 2016; Q1 2017 customer concentration is not specified here.
- Supply and commitments: Arista relies on third-party manufacturers and some limited- or sole-source suppliers. Purchase commitments and inventory needs may expose it to shortages, excess inventory, or obsolescence. USITC-related changes to manufacturing and shipping workflows may add cost and operational complexity.
- Tax and accounting: The effective tax rate was negative 12.5%, versus 28.5% a year earlier, largely because of share-based compensation tax benefits; management says the future rate may fluctuate. Arista expects to adopt the new customer revenue-recognition standard in Q1 2018 using the modified retrospective method and expects it to affect revenue timing, amounts, and disclosures; impact assessment was ongoing.
- Management stated that existing cash and operating cash flows should be sufficient for working capital and growth plans for the foreseeable future. It also noted that foreign cash was considered indefinitely reinvested and that repatriation could incur U.S. taxes.
Most important facts for investors to verify
- How much of the increase in net income and EPS reflects the one-time $28.8 million excess tax benefit, and what earnings or tax rate might look like without it.
- Whether the USITC and CBP proceedings, redesigns, bonds, or supply-chain changes constrain product imports or shipments, and the resulting litigation and compliance costs.
- Customer and product concentration, order timing, acceptance-related revenue deferrals, and the sustainability of demand from existing customers.
- Whether inventory growth, $362.6 million of non-cancelable purchase commitments, and deferred-revenue balances convert into shipments and cash without excess or obsolete inventory.
- The effect of the new revenue-recognition standard and ongoing tax examinations, including $29.9 million of gross unrecognized tax benefits disclosed at quarter-end.