You should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, and our Annual Report on Form 10-K filed with theSEC onFebruary 14, 2020 . This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. OverviewArista Networks pioneered software-driven, cognitive cloud networking for large-scale data center and campus environments. Our cloud networking solutions consist of our EOS, a set of network applications and our Ethernet switching and routing platforms. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable, highly modular and reliable. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services. We believe that cloud networking will continue to replace legacy network technologies across data center and campus environments. Our cloud networking platforms are well positioned to address the growing cloud networking market, and to address increasing performance requirements driven by the growing number of connected devices, as well as the need for constant connectivity and access to data and applications. We generate revenue primarily from sales of our switching and routing products which incorporate our EOS software. We generate the majority of our services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products. Our end customers span a range of industries and include large internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. As we have grown the 18
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functionality of our EOS software, expanded the range of our product portfolio and increased the size of our sales force, our revenue has grown rapidly. We have also been profitable and operating cash flow positive for each year since 2010. We believe our future success is dependent upon our ability to continue to develop market leading products and features that address the needs of our end customers and our ability to sell these products to new and existing customers, including an increase in sales in the enterprise data center switching, campus and WiFi networking markets. We intend to continue to invest in our sales activities in key geographies, as well as our relationships with channel, technology and system-level partners in order to reach new end customers more effectively, increase sales to existing customers, and provide services and support. In addition, we intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features, and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications. Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching and routing products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We work closely with third party contract manufacturers to manufacture our products. Our contract manufacturers deliver our products to our third party direct fulfillment facilities. We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers. Historically, large purchases by a relatively limited number of end customers have accounted for a significant portion of our revenue. We have experienced unpredictability in the timing of orders from these large end customers primarily due to changes in demand patterns specific to these customers, the time it takes these end customers to evaluate, test, qualify and accept our products, and the overall complexity of these large orders. We expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. For example, our sales to Microsoft and Facebook as end users in fiscal 2019 represented 23% and 17% of our revenue, respectively, and benefited from certain factors that are not expected to repeat in fiscal 2020. Consequently, the percentage of our revenue from Microsoft and Facebook in fiscal 2020 is expected to decline, which will likely negatively impact our revenue growth. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Recent Developments InDecember 2019 , a novel strain of coronavirus ("COVID-19") was identified inWuhan, China . This virus has spread globally, including tothe United States . InMarch 2020 , theWorld Health Organization declared COVID-19 a pandemic. Consequently, in an effort to contain COVID-19 or slow its spread, governments around the world have issued orders to isolate residents to their homes, practice social distancing when engaging in activities deemed "essential", close all business deemed not essential, and place restrictions on travel and mass gatherings. COVID-19 has negatively impacted the global economy, disrupted business, sales activities, supply chains and workforce participation, including our own, and created significant volatility and disruption of financial markets, and we expect that the global health crisis caused by COVID-19 will continue to negatively impact business activity for the foreseeable future. We have taken numerous steps, and will continue to take further actions, in our approach to address COVID-19. As a result, we have closed our offices across the globe (including our corporate headquarters) limiting access to only those employees providing essential activities, have instructed employees to work from home, and have implemented travel restrictions. We have also worked closely with our contract manufacturers and supply chain who have experienced delays in component sourcing, and production and export of their products, which negatively impacted our ability to supply products to our customers on a timely basis during the three months endedMarch 31, 2020 . The extent of the impact of COVID-19 on our operational and financial performance, including our ability to execute our business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and spread of the pandemic, restrictions on travel, transportation and other containment measures, our compliance with these measures and the impact on our customers, partners, contract manufacturers and supply chain, all of which are uncertain and cannot be predicted. However, any continued disruption in manufacturing and supply resulting from the COVID-19 pandemic or resulting restrictions would negatively impact our business. We also expect that COVID-19 related disruptions may have a negative impact on demand from our customers in future periods. While we expect to see some short-term strength in demand from our cloud titan customers, this may be more than offset by prolonged sales cycles with new prospects in the campus and enterprise markets, which could result in a year-over-year decline in revenues in the second quarter of 2020 and this may also continue into the third quarter or beyond. Accordingly, current results and financial condition discussed herein may not be indicative of future operating results and trends. In anticipation of further COVID-19 related disruptions to our business, we have undertaken a comprehensive review of our investment and spending plans and expect to reduce discretionary spending in future periods while maintaining an ongoing 19
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focus on key initiatives. Although management is actively monitoring the impact of COVID-19 on the Company's financial condition, liquidity, operations, suppliers, industry, and workforce, the full impact of the pandemic continues to evolve as of the date of this report. As such, the Company is unable to estimate the effects of COVID-19 on its future results of operations, financial condition, or liquidity. Acquisition OnFebruary 5, 2020 , we acquiredBig Switch Networks, Inc. ("Big Switch") a network monitoring and software-defined networking pioneer headquartered inSanta Clara, California . With the acquisition of Big Switch, we expect to expand our data center networking solutions and further strengthen our network monitoring and observability suite delivered through Arista's software platform CloudVision and DANZ (DataANalyZer) capabilities. Results of Operations Three Months EndedMarch 31, 2020 Compared to Three Months EndedMarch 31, 2019 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) Three Months Ended March 31, 2020 2019 Change in $ $ $ % Revenue Product$ 410,906 $ 505,415 $ (94,509 ) (18.7 )% Service 112,123 90,009 22,114 24.6 Total revenue 523,029 595,424 (72,395 ) (12.2 ) Cost of revenue Product 163,629 198,152 (34,523 ) (17.4 ) Service 21,149 16,702 4,447 26.6 Total cost of revenue 184,778 214,854 (30,076 ) (14.0 ) Gross profit$ 338,251 $ 380,570 $ (42,319 ) (11.1 )% Gross margin 64.7 % 63.9 %
Revenue by Geography (in thousands, except percentages)
Three Months Ended March 31, 2020 % of Total 2019 % of Total Americas$ 400,660 76.6 %$ 439,638 73.8 % Europe, Middle East and Africa 72,624 13.9 111,269 18.7 Asia-Pacific 49,745 9.5 44,517 7.5 Total revenue$ 523,029 100.0 %$ 595,424 100.0 % Revenue
We generate revenue primarily from sales of our products. We also derive a
portion of our revenue from sales of PCS, which is typically purchased in
conjunction with our products, and subsequent renewals of those contracts. We
expect our revenue may vary from period to period based on, among other things,
the timing, size, and complexity of orders, especially with respect to our large
end customers.
Product revenue decreased
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Cost of Revenue and Gross Margin Cost of revenue primarily consists of amounts paid for inventory to our third-party contract manufacturers and merchant silicon vendors, overhead costs in our manufacturing operations department, and other manufacturing-related costs associated with manufacturing our products and managing our inventory. Cost of providing PCS and other services primarily consists of personnel costs for our global customer support organization. Cost of revenue decreased$30.1 million , or 14.0% for the three months endedMarch 31, 2020 compared to the same period in 2019, which was driven by a corresponding decrease in revenue. Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, manufacturing-related costs including costs associated with supply chain sourcing activities, merchant silicon costs, the mix of products sold, and excess/obsolete inventory write-downs, including charges for excess/obsolete component inventory held by our contract manufacturers. We expect our gross margins to fluctuate over time, depending on the factors described above. Gross margin increased from 63.9% to 64.7% for the three months endedMarch 31, 2020 compared to the same period in 2019. The increase was primarily driven by a decrease in product transition costs including some excess and obsolete inventory-related charges, which was partially offset by a reduction in service margins due to a relatively fixed services cost base on lower revenues. Operating Expenses (in thousands, except percentages) Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. Three Months Ended March 31, 2020 2019 Change in $ $ $ % Operating expenses: Research and development$ 113,154 $ 119,669 $ (6,515 ) (5.4 )% Sales and marketing 57,086 51,053 6,033 11.8 General and administrative 18,349 15,506 2,843 18.3 Total operating expenses$ 188,589 $ 186,228 $ 2,361 1.3 % Research and development. Research and development expenses consist primarily of personnel costs, prototype expenses, third-party engineering and contractor support costs, and an allocated portion of facility and IT costs including depreciation. Our research and development efforts are focused on maintaining and developing additional functionality for our existing products and on new product development, including new releases and upgrades to our EOS software and applications. We plan to continue to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership. However, in light of the COVID-19 outbreak, we plan to tightly manage our spending in the coming year and as a result research and development expenses in 2020 may decrease from prior year levels. Research and development expenses decreased$6.5 million , or 5.4%, in the three months endedMarch 31, 2020 compared to the same period in 2019. The decrease in the three months endedMarch 31, 2020 was primarily due to$14.3 million decrease in new product introduction costs, including third party engineering and other product development costs. This decrease was partially offset by$5.9 million in severance and other acquisition-related expenses from the Big Switch acquisition, including facilities restructuring costs and retention bonuses, and$2.8 million in stock-based compensation driven by refresh grants to existing employees as well as grants to new employees acquired from Big Switch. Sales and marketing. Sales and marketing expenses consist primarily of personnel costs, marketing, trade shows, and other promotional activities, and an allocated portion of facility and IT costs, including depreciation. We intend to continue to prudently manage our sales and marketing spend in 2020 with some targeted investment in strategic sales activities and, accordingly, expect sales and marketing expenses to remain relatively flat for the remainder of the year as compared to 2019. Sales and marketing expenses increased$6.0 million , or 11.8%, for the three months endedMarch 31, 2020 compared to the same period in 2019. The increase in the three months endedMarch 31, 2020 included$3.7 million in severance and other 21
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acquisition-related expenses from the Big Switch acquisition, including retention bonuses, and$2.8 million in personnel-related costs mostly driven by an increase in headcount. General and administrative. General and administrative expenses consist primarily of personnel costs and professional services fees. General and administrative personnel costs include those for our executive, finance, human resources and legal functions. Our professional services fees are primarily due to external legal, accounting and tax services. General and administrative expenses increased$2.8 million , or 18.3%, in the three months endedMarch 31, 2020 compared to the same period in 2019. The increase for the three months endedMarch 31, 2020 was primarily related to$2.2 million in severance and other acquisition-related expenses from the Big Switch acquisition. Other Income (Expense), Net (in thousands, except percentages) Other income (expense) consists primarily of interest income from our cash, cash equivalents and marketable securities, gains and losses on our investments in privately-held companies, and foreign currency transaction gains and losses. We expect other income (expense) may fluctuate in the future as a result of the re-measurement of our private company equity investments upon the occurrence of observable price changes and/or impairments, changes in interest rates or returns on our cash and cash equivalents and marketable securities, and foreign currency exchange rate fluctuations. Three Months Ended March 31, 2020 2019 Change in $ $ $ % Other income (expense), net: Interest income$ 11,662 $ 11,898 $ (236 ) (2.0 )% Gain (loss) on investments in privately-held companies - 1,150 (1,150 ) (100.0 ) Other income (expense), net 495 (715 ) 1,210 (169.2 )
Total other income (expense), net
The change in other income (expense), net, during the three months ended
Three Months Ended March 31, 2020 2019 Change in $ $ $ % Income before income taxes$ 161,819 $ 206,675 $ (44,856 ) (21.7 )%
Provision for (benefit from) income taxes 23,388 5,646 17,742 314.2 % Effective tax rate
14.5 % 2.7 %
For the three months ended
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Liquidity and Capital Resources Our principal sources of liquidity are cash, cash equivalents, marketable securities, and cash generated from operations. As ofMarch 31, 2020 , our total balance of cash, cash equivalents and marketable securities was approximately$2.6 billion , of which approximately$397.9 million was held outside theU.S. in our foreign subsidiaries. Our cash, cash equivalents and marketable securities are held for working capital purposes. Our marketable securities investment portfolio is primarily invested in highly rated securities with the primary objective of minimizing the potential risk of principal loss. We plan to continue to invest for long-term growth. We believe that our existing balances of cash, cash equivalents and marketable securities together with cash generated from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced product and service offerings, our costs associated with supply chain activities, including access to outsourced manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and stock repurchases. If we require or elect to seek additional capital through debt or equity financing in the future, we may not be able to raise capital on terms acceptable to us or at all. If we are required and unable to raise additional capital when desired, our business, operating results and financial condition may be adversely affected.
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