10-Q 1 anet20190331-10q.htm FORM 10-Q Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2019
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission File Number: 001-36468
ARISTA NETWORKS, INC.
(Exact Name of Registrant as Specified in its Charter)
Delaware
 
20-1751121
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)
5453 Great America Parkway, Santa Clara, California
 
95054
(Address of principal executive offices)
 
(Zip Code)
(408) 547-5500
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o   
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
 
Accelerated filer  o
 
 
Non-accelerated filer  o
 
Smaller reporting company  o
 
 
 
 
Emerging growth company  o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.   o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  ý
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock, $0.0001 par value
ANET
New York Stock Exchange
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of April 26, 2019 was 76,622,544.



ARISTA NETWORKS, INC.
TABLE OF CONTENTS
 
 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 3.
 
Item 4.
 
Item 5.
 
Item 6.
 
 
 
 



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
ARISTA NETWORKS, INC.
Condensed Consolidated Balance Sheets
(Unaudited, in thousands, except par value)
 
 
March 31, 2019
 
December 31, 2018
ASSETS
 
 
 

CURRENT ASSETS:
 
 
 
 
Cash and cash equivalents
 
$
809,491

 
$
649,950

Marketable securities
 
1,341,427

 
1,306,197

Accounts receivable, net of rebates and allowances of $9,614 and $9,120, respectively
 
271,246

 
331,777

Inventories
 
347,153

 
264,557

Prepaid expenses and other current assets
 
131,657

 
162,321

Total current assets
 
2,900,974

 
2,714,802

Property and equipment, net
 
41,529

 
75,355

Acquisition-related intangible assets, net
 
55,111

 
58,610

Goodwill
 
53,684

 
53,684

Investments
 
31,486

 
30,336

Operating lease right-of-use assets
 
98,552

 

Deferred tax assets
 
126,045

 
126,492

Other assets
 
25,063

 
22,704

TOTAL ASSETS
 
$
3,332,444

 
$
3,081,983

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
CURRENT LIABILITIES:
 
 
 
 
Accounts payable
 
$
89,823

 
$
93,757

Accrued liabilities
 
104,228

 
123,254

Deferred revenue
 
304,729

 
358,586

Other current liabilities
 
44,413

 
30,907

Total current liabilities
 
543,193

 
606,504

Income taxes payable
 
37,925

 
36,167

Operating lease liabilities, non-current
 
93,616

 

Finance lease liabilities, non-current
 

 
35,431

Deferred revenue, non-current
 
231,742

 
228,641

Other long-term liabilities
 
25,601

 
31,851

TOTAL LIABILITIES
 
932,077

 
938,594

Commitments and contingencies (Note 7)
 

 


STOCKHOLDERS’ EQUITY:
 
 
 
 
Preferred stock, $0.0001 par value—100,000 shares authorized and no shares issued and outstanding as of March 31, 2019 and December 31, 2018
 

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of March 31, 2019 and December 31, 2018; 76,453 and 75,668 shares issued and outstanding as of March 31, 2019 and December 31, 2018
 
8

 
8

Additional paid-in capital
 
1,005,405

 
956,572

Retained earnings
 
1,395,534

 
1,190,803

Accumulated other comprehensive loss
 
(580)

 
(3,994
)
TOTAL STOCKHOLDERS’ EQUITY
 
2,400,367

 
2,143,389

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
3,332,444

 
$
3,081,983

The accompanying notes are an integral part of these condensed consolidated financial statements.

1


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Operations
(Unaudited, in thousands, except per share amounts)

 
 
Three Months Ended March 31,
 
 
2019
 
2018
Revenue:
 
 
 
 
Product
 
$
505,415

 
$
407,617

Service
 
90,009

 
64,872

Total revenue
 
595,424

 
472,489

Cost of revenue: 
 
 
 
 
Product
 
198,152

 
156,691

Service
 
16,702

 
12,879

Total cost of revenue
 
214,854

 
169,570

Gross profit
 
380,570

 
302,919

Operating expenses:
 
 
 
 
Research and development
 
119,669

 
102,362

Sales and marketing
 
51,053

 
42,140

General and administrative
 
15,506

 
19,679

Total operating expenses
 
186,228

 
164,181

Income from operations
 
194,342

 
138,738

Other income (expense), net:
 
 
 
 
Interest expense
 

 
(687
)
Other income, net
 
12,333

 
4,843

Total other income (expense), net
 
12,333

 
4,156

Income before income taxes
 
206,675

 
142,894

Provision for (benefit from) income taxes
 
5,646

 
(1,644
)
Net income
 
$
201,029

 
$
144,538

Net income attributable to common stockholders:
 
 
 
 
Basic
 
$
200,911

 
$
144,449

Diluted
 
$
200,918

 
$
144,456

Net income per share attributable to common stockholders:
 
 
 
 
Basic
 
$
2.65

 
$
1.95

Diluted
 
$
2.47

 
$
1.79

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
Basic
 
75,920

 
73,994

Diluted
 
81,201

 
80,721


The accompanying notes are an integral part of these condensed consolidated financial statements.



2


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited, in thousands)
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Net income
 
$
201,029

 
$
144,538

Other comprehensive income (loss), net of tax:
 
 
 
 
Foreign currency translation adjustments
 
235

 
353

Net change in unrealized gains (losses) on available-for-sale securities
 
3,179

 
(2,041
)
Other comprehensive income (loss)
 
3,414

 
(1,688
)
Comprehensive income
 
$
204,443

 
$
142,850


The accompanying notes are an integral part of these condensed consolidated financial statements.


3


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Stockholders' Equity
(Unaudited, in thousands)
 
 
Common Stock  
 
Additional
Paid-In Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
Stockholders’
Equity
 
 
Shares
 
Amount
 
Balance — December 31, 2018
 
75,668

 
$
8

 
$
956,572

 
$
1,190,803

 
$
(3,994
)
 
$
2,143,389

Cumulative-effect adjustment to beginning balance (1)
 

 

 

 
3,702

 

 
3,702

Net income
 

 

 

 
201,029

 

 
201,029

Other comprehensive income, net of tax
 

 

 

 

 
3,414

 
3,414

Stock-based compensation
 

 

 
24,291

 

 

 
24,291

Issuance of common stock in connection with employee equity incentive plans
 
791

 

 
26,323

 

 

 
26,323

Tax withholding paid for net share settlement of equity awards
 
(6
)
 

 
(1,850
)
 

 

 
(1,850
)
Vesting of early-exercised stock options
 

 

 
69

 

 

 
69

Balance — March 31, 2019
 
76,453

 
$
8

 
$
1,005,405

 
$
1,395,534

 
$
(580
)
 
$
2,400,367

_________________________________________
 
 
 
 
 
 
 
 
 
 
 
 
(1) On January 1, 2019, we adopted Accounting Standard Codification Topic 842 - Leases ("ASC 842"), which resulted in a cumulative-effect adjustment to the beginning balance of Retained Earnings for 2019. See Note 1 of the accompanying notes for further details. 

 
 
Common Stock  
 
Additional
Paid-In Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
Stockholders’
Equity
 
 
Shares
 
Amount
 
Balance — December 31, 2017
 
73,706

 
$
7

 
$
804,731

 
$
859,114

 
$
(1,938
)
 
$
1,661,914

Cumulative-effect adjustment to beginning balance
 

 

 

 
3,574

 

 
3,574

Net income
 

 

 

 
144,538

 

 
144,538

Other comprehensive loss, net of tax
 

 

 

 

 
(1,688
)
 
(1,688
)
Stock-based compensation
 

 

 
20,851

 

 

 
20,851

Issuance of common stock in connection with employee equity incentive plans
 
639

 
1

 
17,299

 

 

 
17,300

Tax withholding paid for net share settlement of equity awards
 
(7
)
 

 
(1,536
)
 

 

 
(1,536
)
Vesting of early-exercised stock options
 

 

 
86

 

 

 
86

Balance — March 31, 2018
 
74,338

 
$
8

 
$
841,431

 
$
1,007,226

 
$
(3,626
)
 
$
1,845,039



4


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands)
 
 
Three Months Ended March 31,
 
 
2019
 
2018
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income
 
$
201,029

 
$
144,538

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, amortization and other
 
8,362

 
5,697

Stock-based compensation
 
24,291

 
20,851

Deferred income taxes
 
(718
)
 
(3,541
)
Gain on investment in privately-held companies
 
(1,150
)
 

Accretion of investment discounts
 
(2,069
)
 
(30
)
Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
60,531

 
40,007

Inventories
 
(82,596
)
 
38,067

Prepaid expenses and other current assets
 
30,664

 
13,722

Other assets
 
1,214

 
(2,027
)
Accounts payable
 
(2,391
)
 
20,040

Accrued liabilities
 
(19,014
)
 
(48,140
)
Deferred revenue
 
(50,756
)
 
(42,686
)
Income taxes payable
 
2,040

 
3,478

Other liabilities
 
660

 
5,565

Net cash provided by operating activities
 
170,097

 
195,541

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Proceeds from maturities of marketable securities
 
302,264

 
90,448

Purchases of marketable securities
 
(332,247
)
 
(267,976
)
Purchases of property and equipment
 
(5,237
)
 
(6,336
)
Net cash used in investing activities
 
(35,220
)
 
(183,864
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Principal payments of lease financing obligations
 

 
(456
)
Proceeds from issuance of common stock under equity plans
 
26,323

 
17,300

Tax withholding paid on behalf of employees for net share settlement
 
(1,850
)
 
(1,536
)
Net cash provided by financing activities
 
24,473

 
15,308

Effect of exchange rate changes
 
195

 
(14
)
NET INCREASE IN CASH, CASH EQUIVALENTS AND RESTRICTED CASH
 
159,545

 
26,971

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —Beginning of period
 
654,164

 
864,697

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —End of period (1)
 
$
813,709

 
$
891,668

 
 
 
 
 
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION:
Right-of-use assets recognized upon the adoption of ASC 842 (2)
 
$
93,207

 
$

Right-of-use assets obtained in exchange for new operating lease liabilities
 
9,034

 

Property and equipment included in accounts payable and accrued liabilities
 
1,055

 
2,426

___________________________________________________
 
 
 
 
(1) See Note 4 of the accompanying notes for a reconciliation of the ending balance of cash, cash equivalents and restricted cash as shown in this condensed consolidated statements of cash flows.
(2) See Note 1 of the accompanying notes.
The accompanying notes are an integral part of these condensed consolidated financial statements.

5


ARISTA NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1.    Organization and Summary of Significant Accounting Policies
Organization
Arista Networks, Inc. (together with our subsidiaries, “we,” “our” or “us”) is a supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation enterprise. Our cloud networking solutions consist of our Extensible Operating System (“EOS”), a set of network applications and our 10/25/40/50/100 Gigabit Ethernet switching and routing platforms. We are incorporated in the state of Delaware. Our corporate headquarters are located in Santa Clara, California, and we have wholly-owned subsidiaries throughout the world, including North America, Europe, Asia and Australia.
Basis of Presentation and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements include the accounts of Arista Networks, Inc. and its wholly owned subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of the U.S. Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. In management’s opinion, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our financial information. The results for the three months ended March 31, 2019, are not necessarily indicative of the results expected for the full fiscal year. The condensed consolidated balance sheet as of December 31, 2018 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by GAAP for complete financial statements. All significant intercompany accounts and transactions have been eliminated.
Our condensed consolidated financial statements and related financial information in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and related footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on February 15, 2019.
Use of Estimates
The preparation of the accompanying condensed consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and accompanying notes. Those estimates and assumptions include, but are not limited to, revenue recognition and deferred revenue; allowance for doubtful accounts, sales rebates and return reserves; valuation of goodwill and acquisition-related intangible assets, accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; estimate of useful lives of long-lived assets including intangible assets; valuation of inventory and contract manufacturer/supplier liabilities; recognition and measurement of contingent liabilities; valuation of equity investments in privately-held companies; determination of fair value for stock-based awards; estimate of incremental borrowing rate for determining the present value of future lease payments; and valuation of warranty accruals. We evaluate our estimates and assumptions based on historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. Actual results could differ materially from those estimates.
Significant Accounting Policies
During the three months ended March 31, 2019, we adopted ASC 842 - Leases, as discussed in the section titled Recently Adopted Accounting Pronouncements of this Note 1. As a result, we added a new significant accounting policy "Leases" as described below. There have been no other significant changes to our accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 15, 2019.
Leases
Our initial application date of ASC 842 is January 1, 2019. For the periods prior to 2019, our leases were accounted for under the legacy guidance in ASC 840.
We determine if a contract contains a lease at inception. The lease term represents the non-cancellable period for which we have the right to use an underlying asset, which may include periods covered by certain options to extend and/or terminate the lease. Lease liabilities and corresponding right-of-use ("ROU") assets are recognized at the commencement date of a lease. Leases with an initial lease term of 12 months or less are not recorded on the balance sheet.

6


A lease liability is the present value of our future fixed lease payments. As none of our leases provides an implicit interest rate, we use our estimated incremental borrowing rate as of the lease commencement date to determine the present value of future lease payments. Our discount rates are determined and applied at a company level. An ROU asset is calculated as the lease liability, adjusted by unamortized initial direct costs, unamortized lease incentives received, cumulative deferred or prepaid lease payments, and accumulated impairment losses.
For fixed lease payments under operating leases, lease expense is recognized on a straight-lined basis over the lease term. For variable lease payments, lease expense is recognized when incurred. For operating leases that include both lease and non-lease components, we account for lease and non-lease components as a single lease component for all classes of underlying assets and, therefore, recognize non-lease payments as lease expense.  
Recently Adopted Accounting Pronouncements
Leases
In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standard Update ("ASU") No. 2016-02, Leases (“ASU 2016-02”), and in July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): Targeted Improvements (“ASU 2018-11”) (collectively referred to as "ASC 842"). Under the guidance, lessees are required to recognize assets and lease liabilities on the balance sheet for most leases including operating leases and provide enhanced disclosures. Companies are required to adopt this guidance using a modified retrospective approach and apply the transition provisions under the guidance at either 1) the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease, or 2) the beginning of the period of adoption (i.e. on the effective date). Under the transition method using the second application date, a company initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption.
We adopted the guidance on January 1, 2019 using the modified retrospective transition method and initially applied the transition provisions at January 1, 2019, which allows us to continue to apply the legacy guidance in ASC 840 for periods prior to 2019. We elected the package of transition practical expedients, which, among other things, allows us to keep the historical lease classifications and not have to reassess the lease classification for any existing leases as of the date of adoption. We also made the following accounting policy elections as allowed by ASC 842:
to apply the short-term lease exception, which allows us to keep leases with an initial term of twelve months or less off the balance sheet.
to account for each separate lease component of a contract and its associated non-lease components as a single lease component for all our leases.
As a result of the adoption, we recognized operating leases that were previously not recognized on the consolidated balance sheets. In addition, we derecognized the assets and the lease financing liabilities previously recorded for our headquarters building under a build-to-suit lease. Under ASC 842, this lease is recognized as an operating lease in our condensed consolidated financial statements beginning in the first quarter of 2019. The table below summarizes the impact of the adoption of ASC 842 on the condensed consolidated balance sheet as of January 1, 2019 (in thousands).
 
 
 
 
Adjustments for the Adoption of ASC 842
 
 
Balance Sheet Line Item
 
December 31,
2018
 
Derecognition of Build-to-Suit Lease
 
Recognition of Operating Leases (1)
 
January 1,
2019
Property and equipment, net
 
$
75,355

 
$
(32,806
)
 
$

 
$
42,549

Operating lease right-of-use assets
 

 

 
93,207

 
93,207

Deferred tax assets
 
126,492

 
(1,165
)
 

 
125,327

Other current liabilities
 
30,907

 
(2,242
)
 
12,391

 
41,056

Operating lease liabilities, non-current
 

 

 
88,230

 
88,230

Finance lease liabilities, non-current
 
35,431

 
(35,431
)
 

 

Other long-term liabilities
 
31,851

 

 
(7,414
)
 
24,437

Retained earnings
 
1,190,803

 
3,702

 

 
1,194,505

__________________
(1) Includes an operating lease for our corporate headquarters building under the build-to-suit arrangement, which was accounted for as a financing lease prior to 2019 and derecognized on January 1, 2019 upon the adoption of ASC 842.

7


Recent Accounting Pronouncements Not Yet Effective
Credit Losses of Financial Instruments 
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires a financial asset measured at amortized cost basis to be presented at the net amount expected to be collected. For trade receivables, we will be required to estimate lifetime expected credit losses. For available-for-sale debt securities, we will be required to recognize an allowance for credit losses rather than a reduction to the carrying value of the asset. This standard is effective for us for our first quarter of 2020. We are currently assessing the impact this guidance may have on our consolidated financial statements.
2.    Business Combinations
In the three months ended September 30, 2018, we acquired Mojo Networks, Inc. (“Mojo”) and Metamako Holding PTY LTD. (“Metamako”) in order to extend our cognitive cloud networking architecture and to improve our next generation platforms for low-latency applications. 
The total fair value of consideration transferred for these acquisitions was approximately $117.4 million, which consisted of $101.8 million in cash and $15.6 million for the fair value of 58,072 shares of our common stock issued. The following table summarizes our preliminary purchase price allocation of the two acquisitions, in aggregate, based on the estimated fair value of the assets acquired and liabilities assumed at their respective acquisition dates (in thousands):
 
 
Purchase Price Allocation
Cash and cash equivalents
 
$
4,953

Other tangible assets
 
23,709

Liabilities
 
(28,706
)
Intangible assets
 
63,720

Goodwill
 
53,684

Net assets acquired
 
$
117,360

We continue the process of identifying and evaluating pending escrow claims related to inventory, tax and other liabilities. Accordingly, the preliminary values reflected in the table above are subject to further measurement period adjustments.
The acquired intangible assets are amortized on a straight-line basis over their estimated useful lives as we believe this method most closely reflects the pattern in which the economic benefits of the assets will be consumed. The following table shows the valuation of the intangible assets acquired (in thousands) along with their estimated useful lives.
 
 
Acquisition Date Fair Value
 
Estimated Useful Life
Developed technology
 
$
52,510

 
5 years
Customer relationships
 
7,080

 
7 years
Trade name
 
2,470

 
3 years
Others
 
1,660

 
1 year
Total intangible assets acquired
 
$
63,720

 
 
The goodwill of $53.7 million is primarily attributable to the expected synergies created by incorporating the solutions of the acquired businesses into our technology platform, and the value of the assembled workforce. We operate under a single reportable segment. The goodwill is not deductible for income taxes purposes.
3.    Fair Value Measurements
Assets and liabilities recorded at fair value on a recurring basis in the accompanying condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. We use a fair value hierarchy to measure fair value, maximizing the use of observable inputs and minimizing the use of unobservable inputs. The three-tiers of the fair value hierarchy are as follows:
Level I - Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

8


Level II - Inputs are observable, unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities; and
Level III - Unobservable inputs that are supported by little or no market data for the related assets or liabilities and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.
We measure and report our cash equivalents, restricted cash, and available-for-sale marketable securities at fair value on a recurring basis. The following tables summarize the amortized costs, unrealized gains and losses and fair value of these financial assets by significant investment category and their level within the fair value hierarchy (in thousands):
 
 
March 31, 2019
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
Level I
 
Level II
 
Level III
Financial Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash Equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
 
$
445,647

 
$

 
$

 
$
445,647

 
$
445,647

 
$

 
$

Agency securities
 
22,200

 

 

 
22,200

 

 
22,200

 

U.S. government notes
 
4,993

 

 

 
4,993

 
4,993

 

 

 
 
472,840

 

 

 
472,840

 
450,640

 
22,200

 

Marketable Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial paper
 
48,514

 

 

 
48,514

 

 
48,514

 

Certificates of deposits (1)
 
5,000

 

 

 
5,000

 

 
5,000

 

U.S. government notes
 
386,734

 
397

 
(97
)
 
387,034

 
387,034

 

 

Corporate bonds
 
642,662

 
1,326

 
(279
)
 
643,709

 

 
643,709

 

Agency securities
 
256,913

 
407

 
(150
)
 
257,170

 

 
257,170

 

 
 
1,339,823

 
2,130

 
(526
)
 
1,341,427

 
387,034

 
954,393

 

Other Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds - restricted
 
4,218

 

 

 
4,218

 
4,218

 

 

Total Financial Assets
 
$
1,816,881

 
$
2,130

 
$
(526
)
 
$
1,818,485

 
$
841,892

 
$
976,593

 
$


 
 
December 31, 2018
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
Level I
 
Level II
 
Level III
Financial Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash Equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
 
$
322,080

 
$

 
$

 
$
322,080

 
$
322,080

 
$

 
$

Marketable Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial paper
 
59,479

 

 

 
59,479

 

 
59,479

 

Certificates of deposits (1)
 
5,000

 

 

 
5,000

 

 
5,000

 

U.S. government notes
 
308,946

 
118

 
(286
)
 
308,778

 
308,778

 

 

Corporate bonds
 
660,353

 
264

 
(1,399
)
 
659,218

 

 
659,218

 

Agency securities
 
273,993

 
240

 
(511
)
 
273,722

 

 
273,722

 

 
 
1,307,771

 
622

 
(2,196
)
 
1,306,197

 
308,778

 
997,419

 

Other Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds - restricted
 
4,214

 

 

 
4,214

 
4,214

 

 

Total Financial Assets
 
$
1,634,065

 
$
622

 
$
(2,196
)
 
$
1,632,491

 
$
635,072

 
$
997,419

 
$

______________________
(1) As of March 31, 2019 and December 31, 2018, all of our certificates of deposits were domestic deposits.

9


We did not realize any other-than-temporary losses on our marketable securities for the three months ended March 31, 2019 and 2018. As of March 31, 2019 and 2018, total unrealized losses of our marketable securities that had been in a continuous unrealized loss position were immaterial. We invest in marketable securities that have maximum maturities of up to two years and are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these marketable securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those marketable securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of these investments upon maturity or sale and therefore, we do not consider any of our marketable securities to be other-than-temporarily impaired as of March 31, 2019.
As of March 31, 2019, the contractual maturities of our investments did not exceed 24 months. The fair values of available-for-sale marketable securities, by remaining contractual maturity, are as follows (in thousands):
 
 
March 31, 2019
Due in 1 year or less
 
$
976,638

Due in 1 year through 2 years
 
364,789

Total marketable securities
 
$
1,341,427

The weighted-average remaining duration of our current marketable securities is approximately 0.8 years as of March 31, 2019. As we view these securities as available to support current operations, we classify securities with maturities beyond 12 months as current assets under the caption marketable securities in the accompanying unaudited condensed consolidated balance sheets.

4.    Financial Statements Details
Cash, Cash Equivalents and Restricted Cash
The following table is a reconciliation of cash, cash equivalents and restricted cash reported within the accompanying condensed consolidated balance sheets that sum to the total of the same such amounts shown in the accompanying condensed consolidated statements of cash flows (in thousands):
 
 
March 31, 2019
 
March 31, 2018
Cash and cash equivalents
 
$
809,491

 
$
886,160

Restricted cash included in other assets
 
4,218

 
5,508

Total cash, cash equivalents and restricted cash
 
$
813,709

 
$
891,668

Restricted cash included in other assets as of March 31, 2019 and March 31, 2018 primarily included $4.0 million pledged as collateral representing a security deposit required for a facility lease. In addition, March 31, 2018 included $1.1 million related to a letter of credit issued to a business partner. 
Accounts Receivable, Net
Accounts receivable, net consists of the following (in thousands):
 
 
March 31, 2019
 
December 31, 2018
Accounts receivable
 
$
280,860

 
$
340,897

Allowance for doubtful accounts
 
(373
)
 
(507
)
Product sales rebate and returns reserve
 
(9,241
)
 
(8,613
)
Accounts receivable, net
 
$
271,246

 
$
331,777

Inventories
Inventories consist of the following (in thousands):
 
 
March 31, 2019
 
December 31, 2018
Raw materials
 
$
102,836

 
$
76,795

Finished goods
 
244,317

 
187,762

Total inventories
 
$
347,153

 
$
264,557


10


Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consists of the following (in thousands):
 
 
March 31, 2019
 
December 31, 2018
Inventory deposit
 
$
19,555

 
$
14,639

Prepaid income taxes
 
35,920

 
38,636

Other current assets
 
63,436

 
95,730

Other prepaid expenses and deposits
 
12,746

 
13,316

Total prepaid expenses and other current assets
 
$
131,657

 
$
162,321

Property and Equipment, Net
Property and equipment, net consists of the following (in thousands):
 
 
March 31, 2019
 
December 31, 2018
Equipment and machinery
 
$
57,939

 
$
55,912

Computer hardware and software
 
31,371

 
30,566

Furniture and fixtures
 
3,711

 
3,697

Leasehold improvements 
 
31,089

 
36,447

Building
 

 
35,154

Construction-in-process
 
633

 
3,591

Property and equipment, gross
 
124,743

 
165,367

Less: accumulated depreciation
 
(83,214
)
 
(90,012
)
Property and equipment, net
 
$
41,529

 
$
75,355

On January 1, 2019, upon the adoption of ASC 842, we derecognized the building and certain leasehold improvements that were capitalized for our corporate headquarters building under a build-to-suit arrangement. See Note 1 and Note 6 for further details.
Depreciation expense was $4.7 million and $5.3 million for the three months ended March 31, 2019 and 2018, respectively.
Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
 
March 31, 2019
 
December 31, 2018
Accrued payroll related costs
 
$
45,117

 
$
70,755

Accrued manufacturing costs
 
25,968

 
31,336

Accrued product development costs
 
15,292

 
6,988

Accrued warranty costs
 
5,126

 
5,362

Accrued professional fees
 
8,652

 
5,678

Accrued taxes
 
889

 
839

Other
 
3,184

 
2,296

Total accrued liabilities
 
$
104,228

 
$
123,254


11


Warranty Accrual
The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Warranty accrual, beginning of period
 
$
5,362

 
$
7,415

Liabilities accrued for warranties issued during the period
 
932

 
1,557

Warranty costs incurred during the period
 
(1,168
)
 
(1,538
)
Warranty accrual, end of period
 
$
5,126

 
$
7,434

Contract Balances
The following table summarizes the activity related to our contract assets (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Contract assets, beginning balance
 
$
6,341

 
$

Contract assets, ending balance
 
5,699

 

The following table summarizes the activity related to our contract liabilities (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Contract liabilities, beginning balance
 
$
32,595

 
$
16,521

Less: Revenue recognized from beginning balance
 
(2,826
)
 
(1,694
)
Less: Beginning balance reclassified to deferred revenue
 
(1,259
)
 
(806
)
Add: Contract liabilities recognized
 
8,804

 
4,817

Contract liabilities, ending balance
 
$
37,314

 
$
18,838

As of March 31, 2019, $15.5 million of our contract liabilities was included in “Other current liabilities” with the remaining balance included in “Other long-term liabilities”.
Deferred Revenue and Performance Obligations
Deferred revenue is comprised mainly of unearned revenue related to multi-year PCS contracts, services and product deferrals related to acceptance clauses. The following table summarizes the activity related to our deferred revenue (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Deferred revenue, beginning balance (1)
 
$
587,227

 
$
498,740

Less: Revenue recognized from beginning balance
 
(190,597
)
 
(157,684
)
Add: Deferral of revenue in current period, excluding amounts recognized during the period
 
139,841

 
114,998

Deferred revenue, ending balance
 
$
536,471

 
$
456,054

______________________
 
 
 
 
(1) The beginning balance of the three months ended March 31, 2018 excludes $16.5 million that was reclassified to other current liabilities and other long-term liabilities at January 1, 2018 as a result of our adoption of ASC 606.
Revenue from Remaining Performance Obligations
Revenue from remaining performance obligations represents contracted revenue that has not yet been recognized, which includes contract liabilities and deferred revenue that will be recognized as revenue in future periods. As of March 31, 2019, approximately $575.2 million of revenue is expected to be recognized from remaining performance obligations. We expect to recognize revenue on approximately 88% of these remaining performance obligations over the next 2 years and 12% during the 3rd to the 5th year.

12


Other Income (Expense), Net
Other income (expense), net consists of the following (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Interest income
 
$
11,898

 
$
5,385

Interest expense
 

 
(687
)
Gain on investment in privately-held companies
 
1,150

 

Other expense, net
 
(715
)
 
(542
)
Total
 
$
12,333

 
$
4,156

Upon the adoption of ASC 842 on January 1, 2019, we derecognized the lease financing obligation associated with a build-to-suit lease, and therefore did not incur interest expense in the quarter ended March 31, 2019. See Note 1 for further details.

5.    Investments
Investments in Privately-Held Companies    
Our investments are in the equity of privately-held companies, which do not have readily determinable fair values. The following tables summarize activities related to our investments in privately-held companies during the three months ended March 31, 2019 and 2018 (in thousands):
 
 
Three Months Ended March 31, 2019
 
 
Cost of Investments
 
Cumulative Downward Adjustment/ Impairment
 
Cumulative Upward Adjustment
 
Carrying Amount
Balance of investments held at the beginning of the period
 
$
44,136

 
$
(15,000
)
 
$
1,200

 
$
30,336

Additions
 

 

 
1,150

 
1,150

Balance of investments held at the end of the period
 
$
44,136

 
$
(15,000
)
 
$
2,350

 
$
31,486

 
 
Three Months Ended March 31, 2018
 
 
Cost of Investments
 
Cumulative Downward Adjustment/ Impairment
 
Cumulative Upward Adjustment
 
Carrying Amount
Balance of investments held at the beginning of the period
 
$
36,136

 
$

 
$

 
$
36,136

Additions
 

 

 

 

Balance of investments held at the end of the period
 
$
36,136

 
$

 
$

 
$
36,136

As of March 31, 2019 and December 31, 2018, the carrying amount of the investments that have been remeasured to fair value as a result of impairment or observable transactions totaled $26.5 million and $22.3 million, respectively, and are classified within Level III of the fair value hierarchy.

6.    Leases
Operating Leases
We lease various offices and data centers in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2028. Some of our leases include options to extend the term of such leases for a period from three months to up to 10 years and/or options to early terminate the leases. As of March 31, 2019, we did not include any such options in determining the lease terms because we were not reasonably certain that we would exercise those options. Most of our leases require us to pay certain operating expenses in addition to base rent, such as taxes, repairs, and insurance and contain renewal and escalation clauses.

13


Build-to-Suit Lease
In August 2012, we executed a lease for a building then under construction in Santa Clara, California to serve as our headquarters. The lease term is 120 months and commenced in August 2013. Based on the terms of the lease agreement and due to our involvement in certain aspects of the construction, we were deemed the accounting owner of the building during the construction period in accordance with ASC 840. As a result, we recognized assets under construction and corresponding liabilities on the consolidated balance sheet. Upon completion of the construction in 2013, we concluded that we had forms of continued economic involvement in the facility, and therefore did not meet with the provisions for sale-leaseback accounting. Pursuant to ASC 840, we continued to carry the assets and liabilities capitalized during the construction period and accounted for the lease as a capital lease for the building and an operating lease for the underlying land.
Upon our adoption of ASC 842 on January 1, 2019 (see Note 1), we derecognized the assets and the lease financing liabilities recorded for the building. The build-to-suit lease was re-classified as an operating lease effective January 1, 2019 in accordance with ASC 842.
The following table summarizes the supplemental balance sheet information related to our operating leases as of March 31, 2019 (in thousands).
 
 
Financial Statement Classification
 
March 31, 2019
Right-of-use assets:
 
 
 
 
Operating lease right-of-use assets
 
Operating lease right-of-use assets
 
$
98,552

Lease liabilities:
 
 
 
 
Operating lease liabilities, current
 
Other current liabilities
 
14,139

Operating lease liabilities, non-current
 
Operating lease liabilities, non-current
 
93,616

Total operating lease liabilities
 
 
 
$
107,755

The following table summarizes our lease costs for the three months ended March 31, 2019 (in thousands).
 
 
Financial Statement Classification
 
Three Months Ended 
 March 31, 2019
Operating lease costs:
 
 
 
 
Fixed lease costs
 
Operating expenses
 
$
5,483

Variable lease costs
 
Operating expenses
 
1,464

Total operating lease costs
 
 
 
$
6,947

The operating lease costs in the table above include costs for long-term leases and short-term leases. Total short-term lease costs was immaterial. Fixed lease costs include expenses recognized for base rent payments on a straight-lined basis. Variable lease costs primarily include maintenance, utilities and operating expenses that are incremental to the fixed base rent payments, and are excluded from the calculation of ROU assets and operating lease liabilities. For the three months ended March 31, 2019, cash paid for amounts associated with our operating lease liabilities was approximately $4.4 million, which was classified as operating activities in the condensed consolidated statements of cash flows.
Prior to 2019, we recognized rent expense for our operating leases under the legacy guidance ASC 840. For the three months ended March 31, 2018, rent expense for all operating leases amounted to $2.8 million, and did not include maintenance, utilities and other operating expenses in accordance with ASC 840.

14


The following table shows our undiscounted future fixed payment obligations under our recognized operating leases and a reconciliation to the operating lease liabilities as of March 31, 2019 (in thousands).
 
 
March 31, 2019
Remainder of 2019
 
$
14,013

2020
 
20,012

2021
 
20,773

2022
 
21,134

2023
 
17,598

2024 and thereafter
 
35,870

Total future fixed operating lease payments
 
129,400

Less:
 
 
Imputed interest
 
(21,645
)
Total operating lease liabilities
 
$
107,755

 
 
March 31, 2019
Weighted-average remaining lease term — operating leases
 
6.4 years
Weighted-average discount rate — operating leases
 
5.1%

7.    Commitments and Contingencies
Leases
We lease various offices and data centers in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2028. See Note 6 for our future minimum payment obligations under our leases as of March 31, 2019.
Purchase Commitments
We outsource most of our manufacturing and supply chain management operations to third-party contract manufacturers, who procure components and assemble products on our behalf based on our forecasts in order to reduce manufacturing lead times and ensure adequate component supply. We issue purchase orders to our contract manufacturers for finished products and a significant portion of these orders consist of firm non-cancellable commitments. In addition, we purchase strategic component inventory from certain suppliers under purchase commitments that in some cases are non-cancellable, including integrated circuits, which are consigned to our contract manufacturers. As of March 31, 2019, we had non-cancellable purchase commitments of $253.8 million, of which $216.2 million was to our contract manufacturers and suppliers. In addition, we have provided deposits to secure our obligations to purchase inventory. We had $22.3 million and $17.4 million in deposits as of March 31, 2019 and December 31, 2018, respectively. These deposits are classified in “Prepaid expenses and other current assets” and “Other assets” in our accompanying unaudited condensed consolidated balance sheets.
Guarantees
We have entered into agreements with some of our direct customers and channel partners that contain indemnification provisions relating to potential situations where claims could be alleged that our products infringe the intellectual property rights of a third party. We have, at our option and expense, the ability to repair any infringement, replace product with a non-infringing equivalent-in-function product or refund our customers all or a portion of the value of the product. Other guarantees or indemnification agreements include guarantees of product and service performance and standby letters of credit for leased facilities and corporate credit cards. We have not recorded a liability related to these indemnification and guarantee provisions and our guarantee and indemnification arrangements have not had any significant impact on our consolidated financial statements to date.
Legal Proceedings
OptumSoft, Inc. Matters
On April 4, 2014, OptumSoft filed a lawsuit against us in the Superior Court of California, Santa Clara County titled OptumSoft, Inc. v. Arista Networks, Inc., in which it asserts (i) ownership of certain components of our EOS network operating system pursuant to the terms of a 2004 agreement between the companies; and (ii) breaches of certain confidentiality and use restrictions in that agreement. Under the terms of the 2004 agreement, OptumSoft provided us with a non-exclusive, irrevocable, royalty-free license to software delivered by OptumSoft comprising a software tool used to develop certain components of EOS

15


and a runtime library that is incorporated into EOS. The 2004 agreement places certain restrictions on our use and disclosure of the OptumSoft software and gives OptumSoft ownership of improvements, modifications and corrections to, and derivative works of, the OptumSoft software that we develop.
In its lawsuit, OptumSoft has asked the Court to order us to (i) give OptumSoft access to our software for evaluation by OptumSoft; (ii) cease all conduct constituting the alleged confidentiality and use restriction breaches; (iii) secure the return or deletion of OptumSoft’s alleged intellectual property provided to third parties, including our customers; (iv) assign ownership to OptumSoft of OptumSoft’s alleged intellectual property currently owned by us; and (v) pay OptumSoft’s alleged damages, attorney’s fees, and costs of the lawsuit. David Cheriton, one of our founders and a former member of our board of directors, who resigned from our board of directors on March 1, 2014 and has no continuing role with us, is a founder and, we believe, the largest stockholder and director of OptumSoft. The 2010 David R. Cheriton Irrevocable Trust dated July 28, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is one of our largest stockholders.
On April 14, 2014, we filed a cross-complaint against OptumSoft, in which we asserted our ownership of the software components at issue and our interpretation of the 2004 agreement. Among other things, we asserted that the language of the 2004 agreement and the parties’ long course of conduct support our ownership of the disputed software components. We asked the Court to declare our ownership of those software components, all similarly-situated software components developed in the future and all related intellectual property. We also asserted that, even if we are found not to own certain components, such components are licensed to us under the terms of the 2004 agreement. However, there can be no assurance that our assertions will ultimately prevail in litigation. On the same day, we also filed an answer to OptumSoft’s claims, as well as affirmative defenses based in part on OptumSoft’s failure to maintain the confidentiality of its claimed trade secrets, its authorization of the disclosures it asserts and its delay in claiming ownership of the software components at issue. We have also taken additional steps to respond to OptumSoft’s allegations that we improperly used and/or disclosed OptumSoft confidential information. While we believe we have meritorious defenses to these allegations, we believe we have (i) revised our software to remove the elements we understand to be the subject of the claims relating to improper use and disclosure of OptumSoft confidential information and made the revised software available to our customers and (ii) removed information from our website that OptumSoft asserted disclosed OptumSoft confidential information.
The parties tried Phase I of the case, relating to contract interpretation and application of the contract to certain claimed source code, in September 2015. On March 23, 2016, the Court issued a Final Statement of Decision Following Phase I Trial, in which it agreed with and adopted our interpretation of the 2004 agreement and held that we, and not OptumSoft, own all the software at issue in Phase I. The remaining issues that were not addressed in the Phase I trial are set to be tried in Phase II, including the application of the Court’s interpretation of the 2004 agreement to any other source code that OptumSoft claims to own and the trade secret misappropriation and confidentiality claims. The Phase II Trial is set for the first date the court is available after December 2, 2019.
We intend to vigorously defend against any claims brought against us by OptumSoft.  However, we cannot be certain that, if litigated, any claims by OptumSoft would be resolved in our favor.  For example, if it were determined that OptumSoft owned components of our EOS network operating system, we would be required to transfer ownership of those components and any related intellectual property to OptumSoft.  If OptumSoft were the owner of those components, it could make them available to our competitors, such as through a sale or license.  An adverse litigation ruling could result in a significant damages award against us and injunctive relief. In addition, OptumSoft could assert additional or different claims against us, including claims that our license from OptumSoft is invalid.
With respect to the legal proceedings described above, it is our belief that while a loss is not probable, it may be reasonably possible. Further, at this stage in the litigation, any possible loss or range of loss cannot be estimated.  However, the outcome of litigation is inherently uncertain. Therefore, if one or more of these legal matters were resolved against us in a reporting period for a material amount, our consolidated financial statements for that reporting period could be materially adversely affected.    
Other Matters
In the ordinary course of business, we are a party to other claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property.
We record a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. As of March 31, 2019, provisions recorded for contingent losses related to other claims and matters have not been significant. Based on currently available information, management does not believe that any additional liabilities relating to other unresolved matters are probable or that the amount of any resulting loss is estimable, and believes these other matters are not likely, individually and in the aggregate, to have a material adverse effect on our financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties and our view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on our financial position, results of operations or cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods.

16


8.    Equity Award Plan Activities
2014 Employee Stock Purchase Plan
Effective January 1, 2019, our board of directors authorized an increase of 756,679 shares to shares available for issuance under our 2014 Employee Stock Purchase Plan (the “ESPP”). Pursuant to the ESPP, the 2019 share increase was determined based the lesser of 1% of the total shares of common stock outstanding on December 31, 2018, 2,500,000 shares, or such amount as determined by our board of directors. During the three months ended March 31, 2019, we issued 45,743 shares at a weighted-average purchase price of $190.31 per share, respectively, under the ESPP. As of March 31, 2019, there remained 3,244,374 shares available for issuance under the ESPP.
Stock Option Activities
The following table summarizes the option activity under our stock plans and related information (in thousands, except years and per share amounts):
 
 
Options Outstanding 
 
 
 
 
 
 
Number of
Shares
Underlying
Outstanding Options
 
Weighted-
Average
Exercise
Price per Share
 
Weighted-
Average
Remaining
Contractual
Term (Years) of
Stock Options
 
Aggregate
Intrinsic
Value
of Stock
Options
Outstanding
Balance—December 31, 2018
 
5,899

 
$
37.09

 
5.2
 
$
1,027,741

Options granted
 
74

 
225.25

 
 
 
 
Options exercised
 
(613
)
 
28.71

 
 
 
 
Options canceled
 
(8
)
 
35.06

 
 
 
 
Balance—March 31, 2019
 
5,352

 
$
40.64

 
5.1
 
$
1,465,345

Vested and exercisable—March 31, 2019
 
2,762

 
$
26.11

 
4.5
 
$
796,325

Restricted Stock Unit (RSU) Activities
A summary of the RSU activity under our 2014 equity incentive plan (“2014 Plan”) and related information are presented below (in thousands, except years and per share amounts):
 
 
Number of
Shares
 
Weighted-
Average Grant
Date Fair Value Per Share
 
Weighted-Average
Remaining
Contractual Term (in years)
 
Aggregate Intrinsic Value
Unvested balance—December 31, 2018
 
1,308

 
$
150.60

 
1.5
 
$
275,638

       RSUs granted
 
41

 
226.29

 
 
 
 
       RSUs vested
 
(132
)
 
111.39

 
 
 
 
       RSUs forfeited/canceled
 
(18
)
 
175.69

 
 
 
 
Unvested balance—March 31, 2019
 
1,199

 
$
157.14

 
1.5
 
$
376,948

Shares Available for Grant
The following table presents the stock activity and the total number of shares available for grant under the 2014 Plan as of March 31, 2019 (in thousands):
 
 
Number of Shares
Balance—December 31, 2018
 
15,386

Options granted
 
(74
)
RSUs granted
 
(41
)
Options canceled
 
8

RSUs forfeited
 
18

Shares traded for taxes
 
6

Balance—March 31, 2019
 
15,303


17


Stock-Based Compensation Expense
Total stock-based compensation expense related to options, restricted stock units, restricted stock, and employee stock purchase rights granted were allocated as follows (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Cost of revenue
 
$
1,098

 
$
1,202

Research and development
 
13,131

 
10,945

Sales and marketing   
 
6,534

 
5,960

General and administrative
 
3,528

 
2,744

           Total stock-based compensation
 
$
24,291

 
$
20,851

As of March 31, 2019, unrecognized stock-based compensation expenses by award type and their expected weighted-average recognition periods are summarized in the following table (in thousands, except years).
 
 
March 31, 2019
 
 
Stock Option
 
RSU
 
ESPP
 
Restricted Stock
Unrecognized stock-based compensation expense
 
$
58,501

 
$
167,360

 
$
6,871

 
$
5,028

Weighted-average amortization period
 
3.8 years

 
3.2 years

 
1.0 years

 
3.5 years



18


9.    Net Income Per Share Available to Common Stock
The following table sets forth the computation of our basic and diluted net income per share available to common stock (in thousands, except per share amounts):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Numerator:
 
 
 
 
Basic:
 
 
 
 
Net income
 
$
201,029

 
$
144,538

Less: undistributed earnings allocated to participating securities
 
(118
)
 
(89
)
Net income available to common stockholders, basic
 
$
200,911

 
$
144,449

Diluted:
 
 
 
 
Net income attributable to common stockholders, basic
 
$
200,911

 
$
144,449

Add: undistributed earnings allocated to participating securities
 
7

 
7

Net income attributable to common stockholders, diluted
 
$
200,918

 
$
144,456

Denominator:
 
 
 
 
Basic:
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
75,920

 
73,994

Diluted:
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
75,920

 
73,994

Add weighted-average effect of dilutive securities:
 
 
 
 
Stock options and RSUs
 
5,279

 
6,670

Employee stock purchase plan
 
2

 
57

Weighted-average shares used in computing net income per share available to common stockholders, diluted
 
81,201

 
80,721

Net income per share attributable to common stockholders:
 
 
 
 
Basic
 
$
2.65

 
$
1.95

Diluted
 
$
2.47

 
$
1.79

The following weighted-average outstanding shares of common stock equivalents were excluded from the computation of diluted net income per share available to common stockholders for the periods presented because including them would have been anti-dilutive (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Stock options and RSUs to purchase common stock
 
162

 
22

Employee stock purchase plan
 
105

 
26

Total
 
267

 
48


10.    Income Taxes
 
 
Three Months Ended March 31,
 
 
2019
 
2018
 
 
 
 
 
 
 
(in thousands, except percentages)
Income before income taxes
 
$
206,675

 
$
142,894

Provision for (benefit from) income taxes
 
5,646

 
(1,644
)
Effective tax rate
 
2.7
%
 
(1.2
)%

19


The effective tax rates above reflect tax expense recorded on pre-tax income in the three months ended March 31, 2019 and an overall tax benefit recorded on pre-tax income in the three months ended March 31, 2018. The change in effective tax rate in the three months ended March 31, 2019, as compared to the same period in 2018, was primarily due to the overall increase in worldwide earnings, which proportionally exceeded the increase in excess tax benefits attributable to equity compensation.
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 be subject to U.S. income tax.
11.    Segment Information
We have determined that we operate as one reportable segment. The following table represents revenue based on the customer’s location, as determined by the customer’s shipping address (in thousands):
 
 
Three Months Ended March 31,
 
 
2019
 
2018
Americas
 
$
439,638

 
$
315,498

Europe, Middle East and Africa
 
111,269

 
121,886

Asia-Pacific
 
44,517

 
35,105

Total revenue
 
$
595,424

 
$
472,489

Long-lived assets, excluding intercompany receivables, investments in subsidiaries, privately-held equity investments and deferred tax assets, net by location are summarized as follows (in thousands):
 
 
March 31, 2019
 
December 31, 2018
United States
 
$
35,339

 
$
69,238

International
 
6,190

 
6,117

Total
 
$
41,529

 
$
75,355


12.    Subsequent Event
Stock Repurchase Program
Subsequent to March 31, 2019, our board of directors authorized a $1.0 billion stock repurchase program (the “Repurchase Program”). This authorization allows us to repurchase shares of our common stock opportunistically and will be funded from working capital. Repurchases may be made at management’s discretion from time to time on the open market, through privately negotiated transactions, transactions structured through investment banking institutions, block purchase techniques, trading plans under Rule 10b5-1 of the Securities Exchange Act of 1934, or a combination of the foregoing. The Repurchase Program, which expires in April 2022, does not obligate us to acquire any of our common stock, and may be suspended or discontinued by us at any time without prior notice.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 the SEC on February 15, 2019. 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.
Overview
We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale internet companies, cloud service providers and next-generation data centers and campuses for enterprise support. Our cloud networking solutions consist of our Extensible Operating System, or 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 and highly modular. 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

20


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 networks will continue to replace legacy network technologies, and that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of adoption. Cloud networks are subject to increasing performance requirements due to the growing number of connected devices, as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We expect to continue growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. Accordingly, 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.
We generate revenue primarily from sales of our switching 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.
To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. We expect that a substantial portion of our future sales will be follow-on sales to existing customers. It is also important that we are successful in markets other than cloud data center networking, such as the campus switching and WiFi networking markets. We intend to continue expanding our sales force and marketing 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 effectively. In order to support our strong growth, we have and may continue to accelerate our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations.
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 currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. 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 significant portion of our revenue. We have experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test, qualify and accept our products and other factors specific to our end customers. Due to these factors, we expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. For example, our sales to Microsoft as an end-user in the fiscal year ended December 31, 2018, representing 27% of our revenue during fiscal 2018, benefited from certain factors that may not repeat in fiscal 2019 or future fiscal years and the percentage of our revenue from Microsoft in fiscal 2019 is expected to decline. 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. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers.


21


Results of Operations
Three Months Ended March 31, 2019 Compared to Three Months Ended March 31, 2018
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
 
Three Months Ended March 31,
 
 
2019
 
2018
 
Change in
 
 
$
 
$
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
Product
 
$
505,415

 
$
407,617

 
$
97,798

 
24.0
%
Service
 
90,009

 
64,872

 
25,137

 
38.7

Total revenue
 
595,424

 
472,489

 
122,935

 
26.0

Cost of revenue
 
 
 
 
 
 
 
 
Product
 
198,152

 
156,691

 
41,461

 
26.5

Service
 
16,702

 
12,879

 
3,823

 
29.7

Total cost of revenue
 
214,854

 
169,570

 
45,284

 
26.7

Gross profit
 
$
380,570

 
$
302,919

 
$
77,651

 
25.6
%
Gross margin
 
63.9
%
 
64.1
%
 
 
 
 

Revenue by Geography (in thousands, except percentages)
 
 
Three Months Ended March 31,
 
 
2019
 
% of Total
 
2018
 
% of Total
Americas
 
$
439,638

 
73.8
%
 
$
315,498

 
66.8
%
Europe, Middle East and Africa
 
111,269

 
18.7

 
121,886

 
25.8

Asia-Pacific
 
44,517

 
7.5

 
35,105

 
7.4

Total revenue
 
$
595,424

 
100.0
%
 
$
472,489

 
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 and size of orders, the delivery and acceptance of products, and the impact of significant transactions.  In addition, while we expect our revenue to continue to grow in absolute dollars on a year-over-year basis, our revenue growth rates are expected to decline as our business scales.
Product revenue increased $97.8 million, or 24.0%, in the three months ended March 31, 2019, compared to the same period in 2018. The increase was primarily driven by sales to our existing customers as they continued to expand and upgrade their cloud networks. In addition, our newer switch products have continued to gain market acceptance, which has contributed to our revenue growth. Service revenue increased $25.1 million, or 38.7%, in the three months ended March 31, 2019, compared to the same period in 2018 as a result of continued growth in initial and renewal support contracts as our customer installed base has continued to expand. We continue to experience pricing pressure on our products and services due to competition, but demand for our products and growth in our installed base has more than offset this pricing pressure during the period. However, we have recently experienced a slowdown in demand from certain large end customers, and this slowdown could continue, which may impact our future revenue growth.
Cost of Revenue and Gross Margin
Cost of product 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 consists primarily of personnel costs for our global customer support organization. We expect our cost of revenue to continue to increase as our revenue increases.
Cost of revenue increased $45.3 million, or 26.7%, in the three months ended March 31, 2019 compared to the same period in 2018. The increase in cost of revenue was primarily due to the corresponding increases in product and service revenues.
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

22


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 decreased from 64.1% to 63.9% for the three months ended March 31, 2019 compared to the same period in 2018. The decrease in gross margin was primarily driven by a decrease in product margin due to increased product transition costs including some excess and obsolescence inventory-related charges, mostly offset by a favorable customer mix with lower discounts on smaller volume transactions. Service margin continued to improve due to a relatively fixed services cost base and growing service 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. We expect operating expenses to continue to increase in absolute dollars in the near term as we continue to invest in the growth of our business.
 
 
Three Months Ended March 31,
 
 
2019
 
2018
 
Change in
 
 
$
 
$
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
$
119,669

 
$
102,362

 
$
17,307

 
16.9
 %
Sales and marketing
 
51,053

 
42,140

 
8,913

 
21.2

General and administrative
 
15,506

 
19,679

 
(4,173
)
 
(21.2
)
Total operating expenses
 
$
186,228

 
$
164,181

 
$
22,047

 
13.4
 %
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 expect our research and development expenses to increase in absolute dollars as we continue to invest heavily in software development in order 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 $17.3 million, or 16.9% for the three months ended March 31, 2019 compared to the same period in 2018. The increase included a $10.4 million increase in personnel costs driven primarily by growth in headcount, including headcount additions from the two acquisitions we completed in the third quarter of 2018, a $3.2 million increase in research and development related facilities and IT costs, increased IT services and headcount growth, and a $2.9 million increase in new products compliance testing and certification services costs.
Sales and marketing.
Sales and marketing expenses consist primarily of personnel costs, marketing and promotional activities, and an allocated portion of facility and IT costs including depreciation. We expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our sales and marketing efforts worldwide.
Sales and marketing expenses increased $8.9 million, or 21.2%, for the three months ended March 31, 2019 compared to the same period in 2018. The increase included a $5.5 million increase in personnel costs driven primarily by increased headcount and a $1.5 million higher field demo costs.
General and administrative.
General and administrative expenses consist primarily of Cisco and OptumSoft litigation-related expenses, personnel costs, professional services fees, and an allocated portion of facility and IT costs including depreciation. 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 decreased $4.2 million, or 21.2%, for the three months ended March 31, 2019 compared to the same period in 2018. The decrease was primarily due to a $5.6 million decrease in litigation fees related to a reduced level of litigation activities as a result of the settlement of our litigation with Cisco in August 2018. This decrease was partially offset by a $1.2 million increase in other legal and professional fees, and a $1.1 million increase in personnel costs.

23


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, foreign currency transaction gains and losses, and interest expense on finance lease obligations. Upon adoption of ASC 842 on January 1, 2019, we derecognized the finance lease obligation associated with our build-to-suit lease, and therefore will not incur further interest expense as it relates to this obligation. See Note 1. Organization and Summary of Significant Accounting Policies of the Notes to Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q for further discussion. 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,
 
 
2019