Arista Networks, Inc. — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014; year-over-year comparisons are to the corresponding 2013 periods. Arista supplies cloud networking systems, including EOS software and Ethernet switches. It completed its IPO on June 6, 2014.
Financial performance and position
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $137.9 million | $83.5 million | $255.2 million | $144.8 million |
| Gross margin | 67.7% | 64.6% | 68.5% | 66.3% |
| Operating income | $30.7 million | $16.3 million | $52.6 million | $25.0 million |
| Operating margin | 22.2% | 19.5% | 20.7% | 17.3% |
| Net income | $21.6 million | $10.3 million | $33.9 million | $16.9 million |
| Diluted EPS attributable to common stockholders | $0.34 | $0.18 | $0.54 | $0.29 |
- Q2 revenue grew 65.2%; six-month revenue grew 76.2%. Management attributed most of the increase to switch product sales, primarily to existing customers. Q2 ports shipped rose 51.6%, partly offset by a 4.0% decline in average selling price per port.
- Gross-margin improvement reflected lower warranty and inventory-obsolescence charges than in 2013. For the first half, the comparison also benefited from a $2.2 million supplier settlement relating to a product defect; larger-customer volume discounts partly offset the improvement.
- Operating expenses rose 66.7% in Q2 and 71.9% for the first half, mainly from headcount, compensation, facilities and infrastructure, and public-company readiness costs. Stock-based compensation was $6.7 million in Q2 and $11.5 million for the first half.
- Six-month operating cash flow was $63.9 million, versus $8.7 million a year earlier. Investing cash outflow was $4.5 million, including $8.6 million of property and equipment purchases partly offset by release of $4.0 million restricted cash. Financing cash inflow was $224.1 million, primarily IPO proceeds.
- Cash and cash equivalents were $397.2 million at June 30, up from $113.7 million at year-end. Current assets were $562.7 million and current liabilities $97.7 million. The company reported no convertible notes payable at quarter-end; the balance sheet still included approximately $43.1 million of non-current lease-financing obligations.
Material changes and unusual items
- The IPO raised $238.7 million net of underwriting discounts and estimated issuance costs. Outstanding preferred shares converted to common stock, and approximately $96.5 million of notes and accrued interest converted into common shares. One noteholder was paid $23.6 million, including principal and interest.
- Q2 other income included a $4.0 million fair-value gain on notes receivable from a private company. After quarter-end, the borrower agreed to a merger expected to close in Q4 2014; Arista intended to extend the notes’ August 2014 maturity through closing.
- Revenue recognized from previously deferred large customer orders contributed to year-over-year growth: Q2 2014 included $5.5 million net recognition, compared with $7.6 million of net product deferrals in Q2 2013. For the six-month periods, the filing reports $13.9 million net recognition in 2014 versus $8.6 million of net deferrals in 2013.
Outlook, risks and contingencies
- The filing provides no specific revenue or earnings guidance. Management expected cash and operating cash flows to fund working capital and growth needs for at least 12 months, and expected 2014 capital expenditures of $17.3 million.
- Management plans continued investment in R&D, sales and marketing, international channels and operating infrastructure, and warned that operating profit could decline in the short to medium term. It also expects operating expenses to rise as the business expands.
- Revenue is exposed to large-customer order timing, discounts, product mix and deferred-revenue changes. Historically, the 10 largest end customers represented 43.0% of 2013 revenue, and Microsoft represented 21.9%; these are historical concentration figures, not Q2 2014 percentages.
- Supply is concentrated: two suppliers provided all electronic manufacturing services, and key components include limited- or sole-source items. The filing notes no guaranteed supply contracts with component suppliers.
- OptumSoft litigation disputes ownership and use of certain EOS-related software components. Management said a loss was not probable but was reasonably possible; it could not estimate a loss range. Potential consequences include damages, injunctions, or restrictions affecting products. Trial was set for April 2016. A separate Net Navigation patent dispute was settled June 30, 2014.
- Disclosure controls and procedures were deemed ineffective at a reasonable level of assurance because of an inventory-accounting material weakness. Errors involving freight capitalization and inventory purchase-price variances had been corrected; remediation was ongoing.
- The filing also discloses a possible Securities Act liability related to communications about a directed share program that was later terminated; any liability would depend on purchases and any successful claims.
Important facts for investors to verify
- Whether revenue growth and margin improvement persist after accounting for deferred large orders, customer discounts, and the prior-year warranty and inventory charges.
- Customer concentration and order timing in current periods, particularly because the filing’s cited concentration percentages are for 2013.
- Progress in remediating the inventory-control material weakness and whether controls are effective in later filings.
- Developments in the OptumSoft case and the private-company note transaction, including collection, maturity extension, and realized value of the notes.
- Actual capital spending and operating-profit trends against management’s stated investment plans and $17.3 million 2014 capital-expenditure expectation.
- Potential dilution from outstanding equity awards and shares becoming eligible for sale following IPO lock-up expirations.