ARISTA NETWORKS, INC. 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. 17 -------------------------------------------------------------------------------- Table of Contents 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 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 in 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 collectively represented 40% of our revenue, and benefited from certain factors that are not expected to repeat in fiscal 2020. Consequently, the percentage of our revenue from these customers in fiscal 2020 is expected to decline, which will contribute to an expected year-over-year decline in our revenue for fiscal 2020. 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 The global coronavirus ("COVID-19") pandemic and related shelter in place, travel and social distancing restrictions imposed by governments around the world in an effort to contain or slow its spread have 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. We have prioritized the protection of our employees during this pandemic and, as a result, have closed our offices across the globe (including our corporate headquarters) limiting access to only those employees providing essential activities, instructed employees to work from home, and implemented travel restrictions. We continue to work closely with our contract 18 -------------------------------------------------------------------------------- Table of Contents manufacturers and supply chain partners who have experienced delays in component sourcing, workforce disruptions and governmental restrictions on the production and export of their products. Although we have worked diligently to drive improvements in these areas, including funding additional working capital and incremental purchase commitments, these delays have negatively impacted our ability to supply products to our customers on a timely basis. We expect to continue to invest in working capital as supply availability improves in order to address the risk of future COVID-19 related supply chain disruptions, but we cannot be certain that such disruptions will not occur. 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, the breadth and duration of governmental containment measures such as shelter in place, travel and social distancing restrictions as well as the reauthorization of or increase in such measures in the event of spikes in COVID-19 infection rates, and the impact on our customers, partners, contract manufacturers and supply chain, all of which are uncertain and cannot be predicted. However, any continued or renewed disruption in manufacturing and supply resulting from the COVID-19 pandemic or related containment measures would negatively impact our business. We also believe that any extended or renewed COVID-19 related economic disruption could have a negative impact on demand from our customers in future periods. While we have experienced some incremental improvement in demand from our cloud titan customers and some stabilization in sales activity in our campus and enterprise markets in the period, we continue to expect a year-over-year decline in total revenue for the year endingDecember 31, 2020 . Accordingly, current results and financial condition discussed herein may not be indicative of future operating results and trends. In response to potential future COVID-19 related disruptions to our business, we have continued to carefully review our investment and spending plans, cautiously reintroducing some incremental spending beginning in the third quarter as overall customer demand began to stabilize. 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. Acquisitions 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. In addition, onOctober 7, 2020 , we completed the acquisition ofAwake Security Inc. ("Awake Security"), a network detection and response ("NDR") platform provider headquartered inSanta Clara, California . With the acquisition of Awake Security, we are adding an NDR platform to our product portfolio that combines artificial intelligence (AI) with human expertise to autonomously hunt for and respond to insider and external threats. Results of Operations Three and Nine Months EndedSeptember 30, 2020 Compared to Three and Nine Months EndedSeptember 30, 2019 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) Three Months Ended September 30, Nine Months Ended September 30, 2020 2019 Change in 2020 2019 Change in $ $ $ % $ $ $ % Revenue Product$ 480,242 $ 555,066 $ (74,824) (13.5) %$ 1,312,561 $ 1,573,652 $ (261,091) (16.6) % Service 125,189 99,349 25,840 26.0 356,469 284,508 71,961 25.3 Total revenue 605,431 654,415 (48,984) (7.5) 1,669,030 1,858,160 (189,130) (10.2) Cost of revenue Product 199,465 218,220 (18,755) (8.6) 539,526 616,906 (77,380) (12.5) Service 21,004 18,921 2,083 11.0 62,202 53,219 8,983 16.9 Total cost of revenue 220,469 237,141 (16,672) (7.0) 601,728 670,125 (68,397) (10.2) Gross profit$ 384,962 $ 417,274 $ (32,312) (7.7) %$ 1,067,302 $ 1,188,035 $
(120,733) (10.2) %
Gross margin 63.6 % 63.8 % 63.9 % 63.9 %
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Revenue by Geography (in thousands, except percentages)
Three Months Ended September 30 ,
Nine Months Ended
2020 % of Total 2019 % of Total 2020 % of Total 2019 % of Total
Americas $ 452,693 74.8 % $ 532,318 81.4 % $ 1,289,182 77.2 % $ 1,418,325 76.3 %
Europe , Middle East
and Africa 89,588 14.8 75,439 11.5 226,189 13.6 298,768 16.1
Asia-Pacific 63,150 10.4 46,658 7.1 153,659 9.2 141,067 7.6
Total revenue $ 605,431 100.0 % $ 654,415 100.0 % $ 1,669,030 100.0 % $ 1,858,160 100.0 %
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 $74.8 million , or 13.5%, and $261.1 million , or
16.6%, for the three and nine months ended September 30, 2020 , respectively,
compared to the same periods in 2019. The decrease of $74.8 million was
primarily driven by reduced sales on a year-over-year basis to our larger
customers, combined with some COVID-19 related supply constraints in fiscal
2020. The decrease of $261.1 million was primarily the result of the recognition
of $116.8 million of deferred revenue related to customer acceptance of prior
period sales transactions in the nine months ended September 30, 2019 combined
with some reduction in sales to our larger customers in the period, and the
impact of COVID-19 related supply constraints. Service revenue increased $25.8
million , or 26.0%, and $72.0 million , or 25.3%, in the three and nine months
ended September 30, 2020 , compared to the same periods in 2019, as a result of
continued growth in support contracts as our customer installed base has
continued to expand. International revenues represented 25.2% and 22.8% of total
revenues in the three and nine months ended September 30, 2020 , respectively, an
increase from 18.6% and a decrease from 23.7% compared to the same periods in
the prior year. International revenues generally fluctuate based on the timing
of deployments by certain of our large end customers. In addition, the increase
in the current quarter was mainly due to an increase in demand in both our EMEA
and Asia-Pacific regions. We continued to experience competitive pricing
pressure on our products and services.
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.
Costs of providing PCS and other services primarily consist of personnel costs
for our global customer support organization.
Cost of revenue decreased $16.7 million , or 7.0%, and $68.4 million , or 10.2%,
for the three and nine months ended September 30, 2020 , respectively, compared
to the same periods in 2019. These decreases were primarily 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 and obsolete inventory
write-downs, including charges for excess and 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 remained consistent for the three and nine months ended September
30, 2020 , compared to the same periods in 2019. Gross margin in each period was
unfavorably impacted by incremental COVID-19 related supply chain costs combined
with some relatively fixed overhead costs on a lower revenue base.
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.
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Three Months Ended September 30, Nine Months Ended September 30,
2020 2019 Change in 2020 2019 Change in
$ $ $ % $ $ $ %
Operating expenses:
Research and development $ 128,049 $ 118,732 $ 9,317 7.8 %$ 352,747 $ 352,696 $ 51 - % Sales and marketing 53,372 55,279 (1,907) (3.4) 161,695 159,372 2,323 1.5 General and administrative 15,146 14,657 489 3.3 47,814 46,182 1,632 3.5 Total operating expenses$ 196,567 $ 188,668 $ 7,899 4.2 %$ 562,256 $ 558,250 $ 4,006 0.7 % 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. Research and development expenses increased$9.3 million , or 7.8% in the three months endedSeptember 30, 2020 compared to the same period in 2019. The increase was primarily due to an increase of$3.7 million in new product introduction costs in the current period combined with an increase of$5.6 million in personnel costs, which included an increase in stock-based compensation costs of$8.0 million , partially offset by a decrease in corporate bonus expense. For the nine months endedSeptember 30, 2020 , research and development expenses remained relatively constant compared to the same period in 2019, resulting from an increase of$5.6 million in personnel costs, an increase of$7.3 million in acquisition-related costs, and an offsetting decrease of$12.8 million in new product introduction costs in the nine months endedSeptember 30, 2020 . 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 continue to prudently manage our sales and marketing spend in fiscal 2020 with some targeted investment in strategic sales activities and, accordingly, expect a marginal increase in sales and marketing expenses in fiscal 2020 compared to fiscal 2019. Sales and marketing expenses decreased$1.9 million , or 3.4%, for the three months endedSeptember 30, 2020 compared to the same period in 2019. The decrease primarily resulted from COVID-19 related reductions in marketing and travel expenses, partially offset by increased salaries and stock-based compensation due to increased headcount. The increase of$2.3 million , or 1.5%, in the nine months endedSeptember 30, 2020 compared to the same period in 2019, was primarily driven by an increase in salaries and stock-based compensation due to increased headcount, and an increase of$3.7 million in acquisition-related expenses. This increase was partially offset by a reduction in travel expenses and other sales and marketing activities due to COVID-19. 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$0.5 million , or 3.3%, in the three months endedSeptember 30, 2020 , and$1.6 million , or 3.5%, in the nine months endedSeptember 30, 2020 compared to the same periods in 2019. The increase in each period was primarily due to acquisition-related expenses, partially offset by lower personnel costs. In addition, litigation-related costs decreased in the three and nine months endedSeptember 30, 2020 due to the settlement of our litigation with Optumsoft inDecember 2019 . Other Income, Net (in thousands, except percentages) Other income 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 that interest income from our fixed-income marketable securities will decline for the year endingDecember 31, 2020 as a result of lower interest rates in 2020 compared to 2019 and the sale of marketable securities in the three months endedSeptember 30 , 21 -------------------------------------------------------------------------------- Table of Contents 2020. In addition, we expect other income 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 returns on our cash and cash equivalents and marketable securities, and foreign currency exchange rate fluctuations. Three Months Ended September 30, Nine Months Ended September 30, 2020 2019 Change in 2020 2019 Change in $ $ $ % $ $ $ % Other income, net: Interest income$ 4,319 $ 13,446 $ (9,127) (67.9) %$ 24,649 $ 38,451 $ (13,802) (35.9) % Gain on sale of marketable securities 9,432 - 9,432 100.0 9,432 - 9,432 100.0 Gain on investments in privately-held companies - 4,277 (4,277) (100.0) - 5,427 (5,427) (100.0) Other income (expense), net (527) 1,446 (1,973) (136.4) (444) 1,435 (1,879) (130.9) Total other income, net$ 13,224 $ 19,169 $ (5,945) (31.0) %$ 33,637 $ 45,313 $ (11,676) (25.8) % The unfavorable change in Other income, net, during the three and nine months endedSeptember 30, 2020 as compared to the same periods in 2019 was primarily driven by a decrease in interest income from our fixed-income marketable securities caused by reduced interest rates. In addition, we recorded a gain on our investments in privately-held companies in the nine months endedSeptember 30, 2019 , which did not recur in the current period. The decrease in each period was partially offset by a realized gain of$9.4 million from the sale of our marketable securities in the three months endedSeptember 30, 2020 . Provision for Income Taxes (in thousands, except percentages) We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may also be subject toU.S. income tax. Generally, ourU.S. tax obligations are reduced by a credit for foreign income taxes paid on these foreign earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. Three Months Ended September 30, Nine Months Ended September 30, 2020 2019 Change in 2020 2019 Change in $ $ $ % $ $ $ %
Income before income
(18.6) % $ 538,683 $ 675,098 $ (136,415) (20.2) %
taxes
Provision for income 33,244 38,880 (5,636) (14.5) % 87,084 75,923 11,161 14.7 % taxes Effective tax rate 16.5 % 15.7 % 16.2 % 11.2 % For the three and nine months endedSeptember 30, 2020 , we recorded expenses of$33.2 million and$87.1 million for income taxes, respectively. For the three and nine months endedSeptember 30, 2019 , we recorded expenses of$38.9 million and$75.9 million , respectively. Income taxes for the three and nine months endedSeptember 30, 2020 were attributable to the overall decrease in worldwide earnings offset by lower tax benefits realized from stock-based compensation.
Liquidity and Capital Resources
Our principal sources of liquidity are cash, cash equivalents, marketable
securities, and cash generated from operations. As of
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
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Table of Contents 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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