Arista Networks, Inc. — FY2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017. The filing also reports unaudited results for the quarter ended December 31, 2017 (Q4).
Business context
Arista supplies cloud networking solutions, including Ethernet switches and routers, its Extensible Operating System (EOS), and network applications. Revenue is primarily from product sales, with support services and renewals contributing a growing share. The company reported one operating segment and served more than 4,900 customers in approximately 80 countries. Microsoft, through channel partner World Wide Technology, represented 16% of FY2017 revenue.
Key financial results
| Metric | FY2017 | FY2016 | Change or context |
|---|---|---|---|
| Revenue | $1,646.2 million | $1,129.2 million | Up 45.8% |
| Product revenue | $1,432.8 million | $991.3 million | Up 44.5% |
| Service revenue | $213.4 million | $137.8 million | Up 54.8% |
| Gross profit / margin | $1,061.8 million / 64.5% | $723.1 million / 64.0% | Margin up 0.5 percentage points |
| Operating income / margin | $470.3 million / 28.6% | $243.4 million / 21.6% | Operating expenses grew more slowly than revenue |
| Net income / margin | $423.2 million / 25.7% | $184.2 million / 16.3% | Diluted EPS: $5.35 vs. $2.50 |
| Cash from operating activities | $631.6 million | $174.3 million | Increase included higher deferred revenue and other working-capital effects |
| Cash, equivalents and marketable securities | $1,535.6 million | $867.8 million | At December 31 |
| Total indebtedness | $39.6 million | $41.2 million | Primarily lease financing obligations |
| Working capital | $1,736.5 million | $1,066.6 million | At December 31 |
Q4 FY2017 revenue was $467.9 million, compared with $328.0 million in Q4 FY2016; net income was $103.8 million versus $58.8 million. Q4 figures are unaudited.
Material changes versus prior periods
- FY2017 growth was driven mainly by higher shipments to existing customers and increasing acceptance of newer switches; service growth reflected a larger installed base and support-contract renewals.
- Gross margin recovered to 64.5% from 64.0%, helped by service-margin improvement and customer mix, partly offset by higher excess and obsolete inventory charges. FY2015 gross margin was 64.9%.
- Research and development spending rose 27.8% to $349.6 million, but declined as a share of revenue to 21.2% from 24.2%. Total operating expenses increased 23.3% while revenue rose 45.8%.
- Inventory write-downs increased to $28.1 million from $12.1 million; charges for excess or obsolete supplier and contract-manufacturer commitments rose to $21.2 million from $6.2 million.
- Operating cash flow increased substantially year over year. The company attributed much of the increase to net income and a $142.3 million increase in deferred revenue; inventory growth used $69.7 million of cash.
Outlook, risks and unusual items
- Outlook: No quantified revenue or earnings guidance is provided in this 10-K. Management expects continued investment in R&D, sales and marketing, and operating infrastructure; operating expenses are expected to rise in absolute dollars in the near term. Management believes cash and operating cash flow should cover working-capital needs and growth plans for at least the next 12 months.
- Customer concentration and order timing: Large customers buy through purchase orders, not firm long-term commitments. Microsoft accounted for 16% of revenue in both 2017 and 2016. Management warns that large orders, qualification and acceptance timing, and customer budget cycles can make quarterly results volatile.
- Cisco litigation: USITC exclusion and cease-and-desist orders required product redesigns and changes to U.S. manufacturing, import and shipping workflows. Redesigned products were permitted to enter the U.S. subject to further proceedings. An enforcement matter relating to the 944 investigation remained pending; an administrative law judge had recommended a $307 million civil penalty if the Commission overturned the initial finding of no violation. The company said potential loss was reasonably possible but not estimable and had not accrued a probable loss. In the 945 matter, the USITC was considering whether redesigned products complied with its orders; customer qualification delays had affected business. The Federal Circuit affirmed the PTAB’s invalidity decision concerning the ’668 patent on February 14, 2018; related proceedings and orders were not thereby fully resolved.
- Other litigation: OptumSoft’s remaining claims concerning EOS software ownership and use remained unresolved. The court had ruled for Arista on ownership of software at issue in Phase I; the filing said potential loss on the remaining matters could not be estimated. The Tessera semiconductor investigation was settled and dismissed in December 2017.
- Tax and earnings quality: The 2017 effective tax rate was 10.9%, versus 24.0% in 2016, primarily reflecting $110.0 million of excess tax benefits from share-based awards and geographic earnings mix, partly offset by $51.8 million of provisional Tax Act charges. The tax accounting was not yet final. Stock-based compensation was $75.4 million in 2017.
- Supply and competition: Arista relies on three contract manufacturers and limited or sole-source component suppliers, including merchant-silicon vendors. Pricing pressure, product transitions, supply constraints, inventory exposure and competition from larger vendors and white-box suppliers could affect sales and margins.
- Liquidity and commitments: Current assets were $2,266.4 million and current liabilities $529.9 million. Contractual commitments totaled $283.8 million, including $147.9 million of supplier and manufacturer purchase commitments due within one year; these exclude $37.9 million of uncertain-tax-position and transition-tax liabilities whose payment timing could not be reliably estimated.
Most important facts for investors to verify
- Whether customers complete qualification and acceptance of litigation-related redesigned products, and how this affects deferred revenue, shipments and order timing.
- Developments and potential financial exposure in Cisco’s 944 enforcement action and 945 modification proceeding, including any restrictions on U.S. imports or sales.
- Revenue and receivable concentration, especially Microsoft’s 16% revenue contribution and the two customers representing 30% and 18% of year-end receivables.
- Inventory quality and purchase commitments, given the increase in inventory-related charges and $195.1 million of non-cancellable purchase commitments disclosed in the notes.
- The final Tax Act accounting and future tax rate, as well as the sustainability of unusually strong FY2017 operating cash flow and earnings growth.