Arista Networks (NYSE:ANET) released second-quarter 2016 results last Thursday after the market close. Despite initially plunging more than 4% on Friday morning, shares of the software-driven cloud networking specialist have more than recouped their early losses as the market digested the report. Let's take a closer look at how Arista closed the first half of the year and what to expect going forward.
Arista Networks' headline numbers
Quarterly revenue climbed 37.4% year over year, to $268.7 million and, based on generally accepted accounting principles (GAAP), translated to 62.1% growth in net income, to $38.9 million, or $0.53 per diluted share. On an adjusted (non-GAAP) basis, which adds perspective by excluding items like stock-based compensation and litigation expenses, gross margin came in at 64.1%, down from 65.8% in last year's second quarter. Adjusted net income rose 38.4%, to $53.7 million, or $0.74 per diluted share.
For perspective, Arista's guidance provided in May called for lower revenue between $259 million and $265 million, with adjusted gross margin of between 62% and 65%. And though we don't usually pay much attention to Wall Street's quarterly demands, analysts' consensus estimates predicted lower adjusted earnings of $0.68 per share and revenue of $262.4 million.
Arista CFO Ita Brennan stated the company is "pleased" with its performance in Q2, "which reflects strong adoption of new products and consistent operational execution."
"We are in the midst of a multi-year shift from legacy IT silos to cloud networking," added Arista Networks CEO Jayshree Ullal. "This quarter puts Arista at a billion-dollar run rate, which is a fitting validation of this trend, based on our innovative cloud-class, cloud-scale and cloud-converged offerings."
Arista's results: Digging deeper
Taking a closer look at Arista's top line, product revenue grew a healthy 35.4% year over year, to $235.6 million, while service revenue jumped 54.2%, to $33.1 million.
From a geographic standpoint, customers in the Americas represented around 75% of total revenue, down from 76% last quarter. Ullal also suggested during the subsequent conference call that Arista's international markets "progressed steadily" through the quarter, comprising around $68 million, or 25% of total revenue, up from 24% last quarter. It's important to note, however, in these early stages of growth that it won't be unusual to see the geographical revenue mix fluctuate slightly from quarter to quarter, namely depending on the timing of U.S. and international deployments.
Arista also now boasts around 4,000 cumulative customers, up from over 3,850 last quarter. And Arista confirmed because its data center purchases tend to be large, the company is focusing on nabbing "million-dollar customers" -- that is, in terms of customers, Arista is looking for quality over quantity.
Meanwhile, cash from operations came in at $54.9 million in Q2, and Arista generated free cash flow of $50.8 million, ending the quarter with cash, cash equivalents, and investments of $823.8 million.
On patent infringement and the ITC
Investors should also continue closely watching the status of -- and Arista's progress working around -- patent infringement litigation brought by archrival Cisco. In late June, the International Trade Commission issued a final determination in its investigation No. 337-TA-944 (the 944 case), concluding that Arista did violate three of five patents brought in the case by Cisco.
That said, Arista has already released a new EOS 4.16 containing software "design-arounds" to address the specific features it was found to be infringing.
"Our major customers are actively qualifying, or have already completed certification of the EOS 4.16 release," stated Ullal. "There should be no doubt about our commitment to our customers, and to our compliance with law and ITC orders."
Relatedly, Arista expects to receive an initial determination in a separate (945) case involving six other Cisco patents before the end of this year. It certainly won't be ideal if Arista is found to have infringed any of these six patents as well, but investors can be sure it will engineer similar workarounds if need be.
Finally, considering Arista's strong business fundamentals, "good" adoption of new products, and continued seamless execution of delivery and design-arounds as required by the ITC, Arista expects third-quarter revenue of $279 million to $285 million, adjusted gross margin of 62% to 65%, and adjusted operating margin of 26%. Note the latter two ranges exclude expected legal expenses of roughly $11 million. But either way, investors were only anticipating third-quarter revenue near the low end of Arista's expected range.
All things considered, from Arista's relative top- and bottom-line outperformance in the second quarter to its smooth implementation of IP workarounds in the face of a negative ITC decision and its encouraging forward guidance as new customers continue to pile on, I think this was as solid a quarter from Arista Networks as investors could have hoped. Assuming Arista can sustain its business momentum as it successfully battles to keep taking share from competitors in the fast-growing cloud networking market, I think shareholders should be happy with where it stands today.