Business context and reporting period
Arista Networks, Inc. filed this Form 10-K for the fiscal year ended December 31, 2016. It supplies Ethernet switching and routing platforms, its EOS operating system, networking applications and support services, primarily for cloud and data-center customers. The company reported one operating segment. Management described cloud networking as an early-stage market and emphasized continued growth investment.
Financial performance and liquidity
| Metric | FY 2016 | FY 2015 |
|---|---|---|
| Revenue | $1,129.2 million | $837.6 million |
| Product revenue | $991.3 million | $744.9 million |
| Service revenue | $137.8 million | $92.7 million |
| Gross profit / margin | $723.1 million / 64.0% | $543.6 million / 64.9% |
| Operating income / margin | $243.4 million / 21.6% | $149.3 million / 17.9% |
| Net income / net margin | $184.2 million / 16.3% | $121.1 million / 14.5% |
| Diluted earnings per share | $2.50 | $1.67 |
| Cash from operations | $131.4 million | $200.5 million |
Revenue grew 34.8% year over year; product revenue grew 33.1% and service revenue 48.7%. Fourth-quarter 2016 revenue was $328.0 million, versus $245.4 million in fourth-quarter 2015; quarterly net income was $58.8 million versus $43.9 million.
Operating cash flow was below net income, principally reflecting working-capital investment: accounts receivable increased $108.9 million and inventories increased $144.4 million. Capital expenditures were $21.4 million; operating cash flow less capital expenditures was approximately $110.0 million. Investing activities used $326.0 million, largely due to purchases of marketable securities.
At year-end, cash and cash equivalents were $567.9 million and current marketable securities were $299.9 million. Working capital was $1,066.6 million; current assets were $1,526.1 million against current liabilities of $459.6 million. Total liabilities were $621.2 million. Reported indebtedness was approximately $41.2 million, principally the building lease financing obligation; the filing reports no conventional borrowing facility. Deferred revenue totaled $372.9 million.
Material changes versus the prior comparable period
- Gross margin declined 0.9 percentage points to 64.0%. Management attributed the decrease to customer mix, including larger customers receiving higher discounts, and costs of expanded manufacturing and operations capacity; improved service margins partly offset these pressures.
- Operating margin increased to 21.6% from 17.9%, as revenue growth outpaced the increase in total operating expenses. Research and development expense rose 30.6% to $273.6 million.
- The effective tax rate increased to 24.0% from 17.1%; the filing cites higher state and foreign taxes and nondeductible items, partly offset by geographic earnings mix.
- Operating cash flow fell to $131.4 million from $200.5 million, while cash and cash equivalents decreased by $119.4 million. The company also held $299.9 million in marketable securities at year-end, compared with none at year-end 2015.
- Microsoft, purchased through channel partner World Wide Technology, accounted for 16.4% of 2016 revenue, compared with 12.0% in 2015.
Outlook, risks, contingencies and unusual items
- No specific full-year revenue or earnings guidance is provided. Management expects operating expenses to rise in absolute dollars as it invests in research and development, sales and marketing, and infrastructure. It expects first-quarter 2017 gross margin to face further product-cost pressure from expanded contract manufacturing and supply-chain operations.
- Customer concentration and order timing are significant risks: purchases are generally made on cancellable purchase orders rather than long-term commitments, and a limited number of large customers contribute materially to revenue. Competition and pricing pressure, product transitions, supply constraints, and dependence on a small number of key component suppliers and contract manufacturers may affect growth and margins.
- Cisco litigation and import restrictions: The USITC issued exclusion and cease-and-desist orders in one investigation. Although U.S. Customs and Border Protection had approved redesigned products for import in November 2016, it revoked that ruling on January 13, 2017. At the filing date, Arista said it could no longer import those products while CBP conducted a further proceeding. A separate USITC investigation had an administrative law judge’s initial violation finding under review. The company warned of possible shipment disruption, redesign and manufacturing costs, lost sales, royalties, damages, or penalties. The potential loss was described as reasonably possible but not estimable.
- Arista prevailed in a December 2016 jury verdict on Cisco copyright and patent claims in a separate case, but Cisco sought post-trial relief. An Arista antitrust case against Cisco remained pending.
- OptumSoft dispute: A court ruled for Arista on ownership of software considered in Phase I; remaining issues were unresolved. The company said a possible loss was not estimable.
- Management stated existing cash, cash equivalents and operating cash flow should be sufficient for working capital and growth plans for the foreseeable future. Approximately $111.7 million of cash was held outside the United States and treated as indefinitely reinvested. The company did not expect to pay dividends in the foreseeable future.
- Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting; management also concluded controls were effective at December 31, 2016.
Important facts for investors to verify
- Developments and operational effects of CBP’s review, USITC proceedings, and any resulting U.S. import or shipment restrictions.
- Whether customer concentration, particularly Microsoft’s 16.4% revenue share, changes and how large-order timing affects quarterly results.
- Whether inventory, receivables, supplier deposits and deferred revenue convert into cash as expected, given the 2016 working-capital build and lower operating cash flow.
- Whether higher manufacturing capacity costs, customer discounting and competition continue to pressure gross margin.
- Progress and financial impact of the remaining Cisco and OptumSoft matters; the filing states potential litigation losses were not estimable.