Cloud networking provider Arista Networks Inc (NYSE:ANET) owes much of its success to the popularity of its data center switching products. The company's concentration in switching equipment has allowed it to achieve a trailing-12-month gross margin north of 65%, and a net profit margin over the same period of 14%, numbers that rival competitor Cisco Systems Inc.'s (NASDAQ:CSCO) financial model.
Yet Cisco isn't impressed with any similarities it shares with Arista. The networking giant's legal court challenges over infringement of intellectual property regarding data center switches is a cloud hanging over Arista's heady financial returns. To understand what the litigation might mean for Arista shareholders, let's review the facts and analyze the risks.
The property and the challenge
On Dec. 5 of last year, nearly six months to the day after Arista went public, Cisco filed two suits in the District Court of the Northern District of California, claiming patent infringements by Arista on 14 patents, as well as copyright violations of Cisco's "Command Line Interface," or CLI.
Cisco is seeking injunctive relief, as well unspecified lost profits and/or "reasonable royalty damages in an unspecified amount," according to Arista's most recently quarterly earnings filing with the SEC.
On Dec. 19, Cisco took its complaint to the United States International Trade Commission, or USITC, splitting up 12 of the 14 disputed patents in the California case into two suits, covering six patents each.
These suits seek to bar entry into the United States of Arista's "7000" family of switches. Additionally, Cisco seeks a "cease and desist" order in regard to Arista's activities related to the switches.
On Feb. 10, Arista responded by asking the Northern District Court of California to stay the first of the two cases under its jurisdiction until the USITC rulings conclude. It also began the process of contesting the second case.
In April, Arista filed petitions for "inter partes review" with the United States Patent Trial and Appeal Board, or PTAB, in an attempt to invalidate five Cisco patents common to both the California and USITC cases. Inter partes review is the formal process a company initiates with the PTAB to dispute the validity of a U.S. patent.
Now that there are three separate entities reviewing the disputed intellectual property between the two companies, the order of pending rulings is of immense interest to the companies and investors alike.
The two USITC cases may be the first to the finish line, with completion dates (before final review) set for April and August 2016.
In a positive development from Arista's perspective, the PTAB agreed in October to examine two of the patents submitted for the review. The PTAB's decision to determine the validity of a patent under this procedure in many cases signals a potential win for the petitioner. On the other hand, the PTAB has decided not to review a third patent out of the total of five Arista presented. The board will render a ruling on the two patents it has agreed to evaluate within 12 months from October.
Either of the two institutions may complete decisions in advance of the Northern District Court of California, especially considering the stay the California court issued on one of the two cases under its jurisdiction. Thus, although dates are fluid, we're likely to see some initial opinions handed down within calendar year 2016.
Arista's management appears confident that it can find technical workarounds to preserve the integrity of its products while keeping clear of new patent infringement, if the courts and patent board decide in favor of Cisco.
Yet in its quarterly SEC earnings filings this year, Arista has provided investors with a realistic understanding of possible, if unquantified, impacts to its business. Even in a workaround situation, there are two particular risks Arista investors should be apprised of.
First, if the USITC issues a "limited exclusion order" barring entry of the contested switch products into the U.S., Arista will most certainly be forced to modify its products, particularly the "7000" series. To this risk, the company states, "In the case that we attempt to modify our manufacturing and importation processes to comply with such orders, we may not be able to do so successfully or without substantial expense."
The second risk deals with customer relations and is worth quoting in its entirety:
Additionally, the existence of this lawsuit could cause concern among our customers and potential customers and could adversely affect our business and results of operations. An adverse litigation ruling could also result in a significant damages award against us and the injunctive relief described above. Many of our customers and channel partners require us to indemnify and defend them against third party infringement claims and pay damages in the case of adverse rulings. These claims could harm our relationships with our customers or channel partners and might deter them from doing business with us. In order to maintain our relationships with existing customers and secure business with new customers, we may be required from time to time to provide additional assurances beyond our standard terms.
The gist of both of these quotes, taken from Arista's most recently filed quarterly report on Nov. 6, is that even in what might be called a "middle case" scenario, in which Arista is forced into technical workarounds, the company may incur a not insignificant increase in its basic costs of doing business.
Arista is savoring its financial momentum at the moment. In the first three reported quarters of 2015, the company has increased revenue at a rate of 44% over 2014. Investors are certainly paying a premium for this growth -- the company trades at nearly 34 times forward one-year earnings. By comparison, Cisco, which is roughly 58 times larger than Arista by revenue, but as of late is growing sales only in the low single digits, trades at a one-year forward earnings multiple of 12.4. Arista would certainly be even more richly valued if not for the litigation.
If, as management appears to indicate, Arista's business won't come to a complete halt because of adverse rulings, there's still some near-term risk in the "ANET" symbol because of the high multiple investors are assigning the company in recognition of its rapid revenue expansion. Hostile court decisions that make it more expensive to retain customers and manufacture products have the potential to quickly upend the market's current valuation thesis.
This hypothetical added expense is likely more of a medium-term hurdle than a long-term problem, but until the cases are resolved, we can't say so with certainty. Ultimately, investors probably don't need to steer completely away from Arista. But until the present litigation is determined, shareholders should build positions in Arista Networks with a guiding principle of informed caution.
Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Arista Networks. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.