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EX-32.1 - CEO AND CFO 906 CERTIFICATION - Arista Networks, Inc.ex321ceoandcfo906certifica.htm
EX-31.2 - CFO CERTIFICATION - Arista Networks, Inc.ex312cfocertificationq216.htm
EX-31.1 - CEO CERTIFICATION - Arista Networks, Inc.ex311ceocertificationq216.htm
EX-10.1 - SANMINA MANUFACTURING SERVICES AGREEMENT - Arista Networks, Inc.ex101-sanminamanufacturing.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________ 
FORM 10-Q
____________________________ 
(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2016
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 Number)
5453 Great America Parkway
Santa Clara, California 95054
(Address of principal executive offices)
(408) 547-5500
(Registrant’s telephone number, including area code)
 ________________ ___________
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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post 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, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
ý
Accelerated filer
o
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
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  x
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of July 29, 2016 was 69,243,826.
 






ARISTA NETWORKS, INC.
TABLE OF CONTENTS
 
 
Page
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 



PART I - FINANCIAL INFORMATION
Item 1. Financial Statements


ARISTA NETWORKS, INC.
Condensed Consolidated Balance Sheets
(Unaudited in thousands, except par value)
 
June 30,
2016
 
December 31,
2015
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
531,058

 
$
687,326

Marketable securities
292,760

 

Accounts receivable, net of allowances of $1,348 and $1,529, respectively
146,659

 
144,263

Inventories
118,130

 
92,129

Prepaid expenses and other current assets
53,447

 
50,610

Total current assets
1,142,054

 
974,328

Property and equipment, net
79,681

 
79,706

Investments
39,136

 
36,636

Deferred tax assets
55,305

 
48,429

Other assets
18,812

 
20,791

TOTAL ASSETS
$
1,334,988

 
$
1,159,890

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
60,097

 
$
43,966

Accrued liabilities
55,110

 
60,971

Deferred revenue
138,885

 
122,049

Other current liabilities
9,347

 
8,025

Total current liabilities
263,439

 
235,011

Income taxes payable
16,086

 
14,060

Lease financing obligations, non-current
40,438

 
41,210

Deferred revenue, non-current
91,439

 
74,759

Other long-term liabilities
6,754

 
6,698

TOTAL LIABILITIES
418,156

 
371,738

Commitments and contingencies (Note 5)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Preferred stock, $0.0001 par value—100,000 shares authorized, no shares issued and outstanding as of June 30, 2016 and December 31, 2015

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of June 30, 2016 and December 31, 2015; 69,195 and 68,132 shares issued and outstanding as of June 30, 2016 and December 31, 2015, respectively
7

 
7

Additional paid-in capital
592,465

 
537,904

Retained earnings
325,065

 
250,916

Accumulated other comprehensive loss
(705)

 
(675
)
TOTAL STOCKHOLDERS’ EQUITY
916,832

 
788,152

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,334,988

 
$
1,159,890

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

3


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Income
(Unaudited in thousands, except per share amounts)
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2016
 
2015
2016
 
2015
Revenue:
 
 
 
 
 
 
Product
$
235,616

 
$
174,072

$
448,091

 
$
334,213

Service
33,125

 
21,480

62,846

 
40,384

Total revenue
268,741

 
195,552

510,937

 
374,597

Cost of revenue:
 
 
 
 
 
 
Product
88,021

 
60,014

166,934

 
114,453

Service
9,269

 
7,648

17,462

 
14,500

Total cost of revenue
97,290

 
67,662

184,396

 
128,953

Total gross profit
171,451

 
127,890

326,541

 
245,644

Operating expenses:
 
 
 
 
 
 
Research and development
69,020

 
49,947

131,535

 
93,287

Sales and marketing
31,744

 
26,681

59,350

 
51,268

General and administrative
17,529

 
18,403

32,763

 
32,475

Total operating expenses
118,293

 
95,031

223,648

 
177,030

Income from operations
53,158

 
32,859

102,893

 
68,614

Other income (expense), net:
 
 
 
 
 
 
Interest expense
(732
)
 
(832
)
(1,483
)
 
(1,653
)
Other income (expense), net
416

 
417

753

 
(51
)
Total other income (expense), net
(316
)
 
(415
)
(730
)
 
(1,704
)
Income before provision for income taxes
52,842

 
32,444

102,163

 
66,910

Provision for income taxes
13,938

 
8,448

28,014

 
18,422

Net income
$
38,904

 
$
23,996

$
74,149

 
$
48,488

Net income attributable to common stockholders:
 
 
 
 
 
 
Basic
$
38,617

 
$
23,607

$
73,535

 
$
47,594

Diluted
$
38,635

 
$
23,638

$
73,573

 
$
47,667

Net income per share attributable to common stockholders:
 
 
 
 
 
 
Basic
$
0.57

 
$
0.36

$
1.08

 
$
0.73

Diluted
$
0.53

 
$
0.33

$
1.01

 
$
0.67

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
 
 
Basic
68,275

 
65,524

68,006

 
65,018

Diluted
72,817

 
71,215

72,523

 
70,919


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



4


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited in thousands)
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2016
 
2015
2016
 
2015
Net income
$
38,904

 
$
23,996

$
74,149

 
$
48,488

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
Foreign currency translation adjustments
(308)

 
113

(236)

 
(71)

Net change in unrealized gains (losses) on available-for sale securities
255

 
96

206

 
262

        Other comprehensive income (loss)
(53)

 
209

(30)

 
191

Comprehensive income
$
38,851

 
$
24,205

$
74,119

 
$
48,679


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



5


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited in thousands)
 
Six Months Ended
June 30,
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
74,149

 
$
48,488

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
9,662

 
6,246

Stock-based compensation
27,592

 
20,047

Deferred income taxes
(6,876
)
 
(2,266
)
Excess tax benefit on stock-based compensation
(15,967
)
 
(22,975
)
Amortization of investment premiums
385

 
883

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(2,396
)
 
(25,360
)
Inventories
(26,001
)
 
(22,297
)
Prepaid expenses and other current assets
(2,838
)
 
(20,747
)
Other assets
1,866

 
(3,257
)
Accounts payable
18,501

 
11,822

Accrued liabilities
(5,196
)
 
3,082

Deferred revenue
33,516

 
57,975

Income taxes payable
17,853

 
21,846

Other liabilities
1,779

 
(114
)
Net cash provided by operating activities
126,029

 
73,373

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of marketable securities
(292,938
)
 

Purchases of property and equipment
(12,042
)
 
(8,768
)
Purchases of intangible assets
(697
)
 
(705
)
Investment in privately-held companies
(2,500
)
 

Net cash used in investing activities
(308,177
)
 
(9,473
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Principal payments of lease financing obligations
(634
)
 
(514
)
Proceeds from issuance of common stock upon exercising options, net of repurchases
6,317

 
11,991

Minimum tax withholding paid on behalf of employees for net share settlement
(599
)
 

Proceeds from issuance of common stock under employee stock purchase plan
4,888

 
4,856

Excess tax benefit on stock-based compensation
15,967

 
22,975

Issuance costs from initial public offering

 
(261
)
Net cash provided by financing activities
25,939

 
39,047

Effect of exchange rate changes
(59
)
 
(20
)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(156,268
)
 
102,927

CASH AND CASH EQUIVALENTS—Beginning of period
687,326

 
240,031

CASH AND CASH EQUIVALENTS—End of period
$
531,058

 
$
342,958

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes, net of refunds
$
18,584

 
$
3,501

Cash paid for interest—lease financing obligation
$
1,469

 
$
1,509

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION:
 
 
 
Property and equipment included in accounts payable and accrued liabilities
$
1,408

 
$
619


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

6




ARISTA NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)

1.
Overview and Basis of Presentation
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 enterprises. Our cloud networking solutions consist of our Extensible Operating System, a set of network applications and our 10/25/40/50/100 Gigabit Ethernet switches. We were incorporated in October 2004 and reincorporated in the state of Delaware in March 2014. 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
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP" or "GAAP") and following 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 U.S. 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 and six months ended June 30, 2016, are not necessarily indicative of the results expected for the full fiscal year.
The condensed consolidated balance sheet as of December 31, 2015 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by generally accepted accounting principles for complete financial statements.
The accompanying unaudited condensed consolidated financial statements include the accounts of Arista Networks, Inc. and its wholly-owned subsidiaries and are prepared in accordance with GAAP. All significant intercompany accounts and transactions have been eliminated.
The accompanying unaudited condensed consolidated financial statements and related financial information 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, 2015, filed with the SEC on February 25, 2016.
Use of Estimates
The preparation of the accompanying unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the unaudited condensed 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 and sales return reserve; determination of fair value for stock-based awards; accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; valuation of inventory; valuation of warranty accruals; and the recognition and measurement of contingent liabilities. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ from these estimates, and those differences could be material to the unaudited condensed consolidated financial statements.
Significant Accounting Policies
There have been no material changes to our significant accounting policies as of and for the six months ended June 30, 2016, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.
Recent Accounting Pronouncements
In May 2014, the FASB issued ASU No. 2014-09, Revenue From Contracts With Customers (Topic 606), (as amended in June 2016, by ASU No. 2016-12-Revenue-Narrow-Scope Improvements and Practical Expedients), which outlines a single

7


comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The new standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires significantly expanded disclosures about revenue recognition.
In July 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, deferring the effective date of the new revenue standard by one year. In March 2016, the FASB issued ASU No. 2016-08, Revenue From Contracts With Customers-Principal versus Agent Considerations (Reporting Revenue Gross versus Net), and ASU No. 2016-10, Revenue From Contracts With Customers-Identifying Performance Obligations and Licensing. ASU No. 2016-08 clarifies the implementation guidance regarding principal versus agent identification and related considerations. Specifically, the guidance provides clarification around performance obligations for goods or services provided by another entity, assisting in determining whether the entity is the provider of the goods or services, the principal, or whether the entity is providing for the arrangement of the goods or services, the agent. ASU No. 2016-10 provides guidance around identifying whether promised goods or services are distinct and separately identifiable, whether promised goods or services are material or immaterial to the contract, and whether shipping and handling is considered an activity to fulfill a promise or an additional promised service. ASU No. 2016-10 also provides guidance around an entity's promise to grant a license providing a customer with either a right to use or a right to access the license, which then determines whether the obligation is satisfied at a point in time or over time, respectively.
In May 2016, the FASB issued ASU No. 2016-11, Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic 815): Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting (SEC Update)") ("ASU 2016-11"), which rescinds various standards codified as part of Topic 605, Revenue Recognition in relation to the future adoption of Topic 606. These rescissions include changes to topics pertaining to revenue and expense recognition including accounting for shipping and handling fees and costs and accounting for consideration given by a vendor to a customer.
The above standards are effective for fiscal years (and interim reporting periods within those years) beginning after December 15, 2017. The guidance is effective for us beginning in our first quarter of fiscal 2018. Early adoption would be permitted for all entities but not until the fiscal year beginning after December 15, 2016. The standard permits the use of either the retrospective or cumulative effect transition method. The retrospective method requires a retrospective approach to each prior reporting period presented with the option to elect certain practical expedients as defined within the guidance. The cumulative approach requires a retrospective approach with the cumulative effect of initially applying the guidance recognized at the date. of initial application and providing certain additional disclosures as defined per the guidance. We are currently reviewing the provisions of the standard and have not yet selected a transition method nor have we determined the effect of the standard on our consolidated financial statements.
In July 2015, the FASB issued ASU No, 2015-11, Inventory: Simplifying the Measurement of Inventory, which simplifies the measurement of inventory to be measured at the lower of cost or net realizable value. The guidance applies to inventory measured using First in First Out ("FIFO") or average cost. The guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The standard is effective for us for our first quarter of fiscal 2017. The guidance can be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. We are currently assessing the impact this guidance may have on our consolidated financial statements as well as the transition method that we will use to adopt the guidance.

In January 2016, the FASB issued ASU No, 2016-01, Financial Instruments-Recognition and Measurement of Financial Assets and Financial Liabilities, which enhances the reporting model for financial instruments to provide users of financial statements with more decision-useful information. The guidance will address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The standard is effective for us for our first quarter of fiscal 2018. The guidance may be early adopted under early application guidance. We are currently assessing the impact this guidance may have on our consolidated financial statements as well as the transition method that we will use to adopt the guidance.

In February 2016, the FASB issued ASU No, 2016-02, Leases, which addresses the classification and recognition of lease assets and liabilities formerly classified as operating leases under GAAP. The guidance will address certain aspects of recognition and measurement, and quantitative and qualitative aspects of presentation and disclosure. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The standard is effective for us for our first quarter of fiscal 2019. The guidance will be applied to the earliest period presented using a modified retrospective approach. The guidance includes practical expedients that relate to identification, classification, and initial direct costs associated with leases commencing prior to the effective date, and the ability to apply hindsight in evaluating lease options related to extensions, terminations or asset purchases. A practical expedient also exists to treat leases entered into prior effective date under existing

8


GAAP unless the lease has been modified. The guidance may be early adopted. We are currently assessing the impact this guidance may have on our consolidated financial statements as well as the transition method that we will use to adopt the guidance.

In March 2016, the FASB amended the existing accounting standards for stock-based compensation, ASU 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which impact several aspects of accounting for share-based payment transactions, including the income tax consequences, forfeitures, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The standard is effective for us for our first quarter of fiscal 2017. The guidance may be early adopted under early application guidance. If early adoption is elected, all amendments must be adopted in the same period. The manner of application varies by the various provisions of the guidance, with certain provisions applied on a retrospective or modified retrospective approach, while others are applied prospectively. We are currently assessing the impact this guidance may have on our consolidated financial statements as well as the transition method that we will use to adopt the guidance.

2.
Fair Value Measurements
        
Our assets and liabilities which require fair value measurement consist of cash and cash equivalents, marketable securities, accounts receivable, investments, accounts payable, and accrued liabilities. Cash equivalents, accounts receivable, accounts payable and accrued liabilities are stated at carrying amounts as reported in the condensed consolidated financial statements, which approximates fair value due to their short-term nature.

Assets and liabilities recorded at fair value on a recurring basis in the accompanying 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;

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 and available-for-sale marketable securities at fair value. The following table sets forth the fair value of our financial assets by level within the fair value hierarchy (in thousands):

 
June 30, 2016
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
Money market funds
$
311,311

 
$

 
$

 
$
311,311

Money market funds-restricted
4,041

 

 

 
4,041

Commercial Paper
17,975

 

 

 
17,975

U.S. government notes
125,424

 

 

 
125,424

Corporate bonds

 
149,361

 

 
149,361

Total financial assets
$
458,751

 
$
149,361

 
$


$
608,112

 
December 31, 2015
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
Money market funds
$
104,156

 
$

 
$

 
$
104,156

Money market funds-restricted
4,041

 

 

 
4,041

Total financial assets
$
108,197

 
$

 
$

 
$
108,197



9


3.    Balance Sheet Components
Marketable Securities
The following table summarizes the unrealized gains and losses and fair value of our short term available-for-sale securities (in thousands):
 
June 30, 2016
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
$
17,924

 
$
51

 
$

 
$
17,975

U.S. government notes
125,398

 
37

 
(11
)
 
125,424

Corporate bonds
149,231

 
235

 
(105
)
 
149,361

Total marketable securities
$
292,553

 
$
323

 
$
(116
)
 
$
292,760

As of June 30, 2016, there have been no other-than-temporary losses on our marketable securities. None of our marketable securities have been in continuous unrealized loss positions for greater than twelve months as of June 30, 2016. We had no marketable securities as of December 31, 2015.
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.
As of June 30, 2016, the contractual maturities of our investments did not exceed 24 months. The fair values of available-for-sale investments, by remaining contractual maturity, are as follows (in thousands):

 
 
June 30, 2016
Due in 1 year or less
 
$
201,798

Due in 1 year through 2 years
 
90,962

Total marketable securities
 
$
292,760

The weighted average remaining duration of our current marketable securities is approximately 0.8 years as of June 30, 2016. 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 consolidated balance sheets.
Accounts Receivable, net
Accounts receivable, net consists of the following (in thousands):
 
June 30,
2016
 
December 31,
2015
Accounts receivable
$
148,007

 
$
145,792

Allowance for doubtful accounts
(306
)
 
(963
)
Sales return reserve
(1,042
)
 
(566
)
Accounts receivable, net
$
146,659

 
$
144,263

Inventories
Inventories consist of the following (in thousands):
 
June 30,
2016
 
December 31,
2015
Raw materials
$
41,730

 
$
29,831

Finished goods
76,400

 
62,298

Total inventories
$
118,130

 
$
92,129


10


Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following (in thousands):
 
June 30,
2016
 
December 31,
2015
Prepaid income taxes
$
16,131

 
$
14,150

Other current assets
27,513

 
29,270

Other prepaid expenses and deposits
9,803

 
7,190

Total prepaid expenses and other current assets
$
53,447

 
$
50,610

Property and Equipment, net
    Property and equipment, net consists of the following (in thousands):
 
June 30,
2016
 
December 31,
2015
Equipment and machinery
$
36,062

 
$
29,101

Computer hardware and software
15,600

 
12,630

Furniture and fixtures
2,853

 
2,380

Leasehold improvements
29,466

 
24,372

Building
35,154

 
35,154

Construction-in-process
343

 
6,408

Property and equipment, gross
119,478

 
110,045

Less: accumulated depreciation
(39,797
)
 
(30,339
)
Property and equipment, net
$
79,681

 
$
79,706

Building consists of capitalized construction costs of our leased building in Santa Clara, California. Based on the terms of the lease agreement and due to our involvement in certain aspects of the construction, such as our financial involvement in structural elements of asset construction, making decisions related to tenant improvement costs and purchasing insurance not reimbursable by the buyer-lessor (the Landlord), we were deemed the owner of the building (for accounting purposes only) during the construction period. We continue to maintain involvement in the property post construction completion, and lack transferability of the risks and rewards of ownership, due to our required maintenance of a $4.0 million letter of credit, in addition to our ability and option to sublease our portion of the leased building for fees substantially higher than our base rate. Due to our continuing involvement in the property post construction and lack of transferability of related risks and rewards of ownership to the Landlord after construction completion, we account for the building as a financing obligation. See “Note 5 - Commitments and Contingencies". Accordingly, as of June 30, 2016 and December 31, 2015, we have recorded assets of $53.4 million, representing the total costs of the building and improvements incurred, including the costs paid by the Landlord. The building was completed in 2014.
Depreciation and amortization expense was $4.8 million, $3.3 million, $9.7 million, and $6.2 million for the three and six months ended June 30, 2016 and 2015, respectively.
Accrued Liabilities     
Accrued liabilities consist of the following (in thousands):
 
June 30,
2016
 
December 31,
2015
Accrued payroll related costs
$
30,878

 
$
39,479

Accrued warranty costs
4,841

 
4,718

Accrued manufacturing costs
6,920

 
6,397

Accrued professional fees
5,718

 
4,875

Accrued taxes
1,257

 
1,347

Other
5,496

 
4,155

Total accrued liabilities
$
55,110

 
$
60,971


11


Warranty Accrual
We offer a one-year warranty on all of our hardware products and a 90-day warranty against defects in the software embedded in the products. The accrued warranty liability is recorded in accrued liabilities in the accompanying consolidated balance sheets.
The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
Six Months Ended
June 30,
 
2016
 
2015
Warranty accrual, beginning of period
$
4,718

 
$
3,204

Liabilities accrued for warranties issued during the period
1,438

 
1,602

Warranty costs incurred during the period
(1,018
)
 
(834
)
Adjustments related to change in estimate
(297
)
 

Warranty accrual, end of period
$
4,841

 
$
3,972


12


4.    Investments
Investments in Privately-held Companies    
As of June 30, 2016 and December 31, 2015, we held non-marketable equity investments of approximately $36.1 million and $33.6 million, respectively, in privately-held companies which are accounted for under the cost method. During the quarter ended June 30, 2016 we made an additional investment of $2.5 million in one of these companies, which was accounted for under the cost method. There were no impairments recognized on our investments for the six months ended June 30, 2016.
Notes Receivable
As of June 30, 2016 and December 31, 2015, we have a $3.0 million promissory note with a privately-held company, which was recorded at cost. The interest rate on the promissory note is 8.0% per annum and is payable quarterly. All unpaid principal and accrued interest on the promissory note is due and payable on the earlier of August 26, 2017 or upon a default.

5.    Commitments and Contingencies
Operating Leases
We lease various operating spaces in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2024. There have been no material changes in our operating lease commitments under contractual obligation, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.
We recognize rent expense under these arrangements on a straight-line basis over the term of the lease. Rent expense for all operating leases amounted to $2.4 million, $1.2 million, $4.7 million, and $2.0 million for the three and six months ended June 30, 2016 and 2015, respectively.
Financing Obligation—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. The underlying building asset is depreciated over the building’s estimated useful life of 30 years. At the conclusion of the initial lease term, we will de-recognize both the net book values of the asset and the remaining financing obligation. There have been no material changes in our financing obligation commitments under contractual obligation, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.
As of June 30, 2016 and December 31, 2015, we have recorded assets of $53.4 million, representing the total costs of the building and improvements incurred, including the costs paid by the lessor (the legal owner of the building) and additional improvement costs paid by us, and a corresponding financing obligation of $41.9 million and $42.5 million, respectively. As of June 30, 2016, $1.5 million and $40.4 million were recorded as short-term and long-term financing obligations, respectively.
Land lease expense under our lease financing obligation included in rent expense above, amounted to $0.3 million and $0.6 million for both the three and six months ended June 30, 2016 and 2015, respectively.
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 product and a significant portion of these orders consist of firm non-cancelable commitments. In addition, we purchase strategic component inventory from certain suppliers under purchase commitments that in some cases are non-cancelable, including integrated circuits, which are consigned to our contract manufacturers. As of June 30, 2016, we had non-cancelable purchase commitments of $253.4 million up from $43.9 million as of December 31, 2015. This increase is primarily related to supply chain and production activities associated with our new U.S. operations and a planned increase in inventory levels in the third quarter of 2016.
We have provided restricted deposits to our third-party contract manufacturers and vendors to secure our obligations to purchase inventory. We had $2.3 million in restricted deposits as of June 30, 2016 and December 31, 2015. Restricted deposits are classified in other assets in our accompanying unaudited condensed consolidated balance sheets.

13


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 lease 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 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 copies of certain components of 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 dtd July 27, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is one of our largest stockholders.
OptumSoft has identified certain software components it claims to own, which are generally applicable tools and utility subroutines and not networking specific code. We cannot assure which software components OptumSoft may ultimately claim to own in the litigation or whether such claimed components are material.
On April 14, 2014, we filed a cross-complaint against OptumSoft, in which we assert our ownership of the software components at issue and our interpretation of the 2004 agreement. Among other things, we assert that the language of the 2004 agreement and the parties’ long course of conduct support our ownership of the disputed software components. We ask 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 assert that, even if we are found not to own any particular components at issue, 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 the case for Phase I of the proceedings, relating to contract interpretation and application of the contract to certain claimed source code, in September 2015. On December 16, 2015, the Court issued a Proposed Statement of Decision Following Phase 1 Trial, and on January 8, 2016, OptumSoft filed objections to that Proposed Statement of Decision. 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 of the software put 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. Phase II was previously scheduled to be tried in April 2016; that trial date has been vacated, however, and a new trial date has not yet been set.
We intend to vigorously defend against any action 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

14


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 at this time.  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.    
Cisco Systems, Inc. (“Cisco”) Matters    
On December 5, 2014, Cisco filed two complaints against us in District Court for the Northern District of California, which are proceeding as Case No. 4:14-cv-05343 (“’43 Case”) and Case No. 5:14-cv-05344 (“’44 Case”). In the ’43 Case, Cisco alleges that we infringe U.S. Patent Nos. 6,377,577; 6,741,592; 7,023,853; 7,061,875; 7,162,537; 7,200,145; 7,224,668; 7,290,164; 7,340,597; 7,460,492; 8,051,211; and 8,356,296 (respectively, “the ’577 patent,” “the ’592 patent,” “the ’853 patent,” “the 875 patent,” “the ’537 patent,” “the ’145 patent,” “the ’668 patent,” “the ’164 patent,” “the ’597 patent,” “the ’492 patent,” “the ’211 patent,” and “the ’296 patent”). Cisco seeks, as relief for our alleged infringement in the ’43 Case, lost profits and/or reasonable royalty damages in an unspecified amount, including treble damages, attorney’s fees, and associated costs. Cisco also seeks injunctive relief in the ’43 Case. On February 10, 2015, the court granted our unopposed motion to stay the ’43 Case until the proceedings before the United States International Trade Commission (“USITC”) pertaining to the same patents (as discussed below) become final. Trial has not been scheduled in the ’43 case.
In the ’44 Case, Cisco’s complaint alleges that we infringe U.S. Patent Nos. 7,047,526 and 7,953,886 (respectively, “the ’526 patent” and “the ’886 patent”), and further alleges that we infringe numerous copyrights pertaining to Cisco’s “Command Line Interface” or “CLI.” As relief for our alleged patent infringement in the ’44 Case, Cisco seeks lost profits and/or reasonable royalty damages in an unspecified amount including treble damages, attorney’s fees, and associated costs as well as injunctive relief. As relief for our alleged copyright infringement, Cisco seeks monetary damages for alleged lost profits, profits from our alleged infringement, statutory damages, attorney's fees and associated costs. On February 13, 2015, we answered the complaint in the ’44 Case, denying the patent and copyright infringement allegations and also raising numerous affirmative defenses. On March 6, 2015, Cisco filed an amended complaint against us the ’44 Case. In response, we moved to dismiss Cisco’s allegations of willful patent infringement and pre-suit indirect patent infringement. The Court granted the motion with leave to amend on July 2, 2015. On July 23, 2015, Cisco filed an amended complaint.
On January 25, 2016, we sought leave to file counterclaims against Cisco in the ’44 case for antitrust and unfair competition. That motion was denied by order dated February 18, 2016, which also granted Arista leave to file those claims as a separate action. On February 24, 2016, we filed a complaint containing our antitrust and unfair competition claims against Cisco in the District Court for the Northern District of California, which is proceeding as Case No. 5:16-cv-00923 (“’23 Case”). In the ’23 Case, Cisco filed a motion to stay the litigation, or in the alternative, to dismiss the complaint on April 13, 2016, and a hearing on Cisco’s motion has been set for August 18, 2016. Trial has not been scheduled in the ’23 case.
On May 17, 2016, the Patent and Trademark Appeals Board issued an order denying inter partes review on the ‘526 patent. On May 25, 2016, the Patent and Trademark Appeals Board issued an order initiating inter partes review on the ‘886 patent. In light of that order, in the ’44 case Cisco agreed to dismiss its claims as to the ‘886 patent with prejudice, and we dismissed our counterclaims as to the ‘886 patent without prejudice. Summary judgment cross-motions in the ’44 case will be heard on August 4, 2016 and trial has been set for November 21, 2016.
On December 19, 2014, Cisco filed two complaints against us in the USITC, alleging that Arista has violated Section 337 of the Tariff Act of 1930, as amended. The complaints have been instituted as ITC Inv. Nos. 337-TA-944 (“944 Investigation”) and 337-TA-945 (“945 Investigation”). In the 944 Investigation, Cisco initially alleged that certain Arista switching products infringe the ’592, ’537, ’145, ’164, ’597, and ’296 patents. Cisco has subsequently dropped the ’296 patent from the 944 Investigation. In the 945 Investigation, Cisco alleges that certain Arista switching products infringe the ’577, ’853, ’875, ’668, ’492, and ’211 patents. In both the 944 and 945 Investigations, Cisco seeks, among other things, a Limited Exclusion Order barring entry into the United States of accused switch products (including 7000 Series of switches) and components and software therein and a Cease and Desist Order against us restricting our activities with respect to our imported accused switch products and components and software therein. On February 11, 2015, we responded to the notices of investigation and complaints in the 944 and 945 Investigations by, among other things, denying the patent infringement allegations and raising numerous affirmative defenses.
The Administrative Law Judge assigned to the 944 Investigation issued a procedural schedule calling for, among other events: an evidentiary hearing on September 9-11 and 15-17, 2015; issuance of an initial determination regarding our alleged violations on January 27, 2016; and the Target Date for completion on May 27, 2016. On January 27, 2016 the Administrative

15


Law Judge issued a revised procedural schedule extending the date for issuance of an initial determination to February 2, 2016 and the Target Date to June 2, 2016. On February 26, 2016, the Commission issued a notice resetting the deadline for determining whether to review the initial determination to April 11, 2016 and the Target Date to June 9, 2016. The hearing has been completed and all post trial briefs have been submitted to the USITC. On February 2, 2016, the Administrative Law Judge issued his initial determination finding a violation of section 337 of the Tariff Act. More specifically, it was found that a violation has occurred in the importation into the United States, the sale for importation, or the sale within the United States after importation, of certain network devices, related software, and components thereof that the ALJ found infringe asserted claims 1, 2, 8-11, and 17-19 of the ’537 patent; asserted claims 6, 7, 20, and 21 of the ’592 patent; and asserted claims 5, 7, 45, and 46 of the ’145 patent. A violation of section 337 was not found with respect to any asserted claims of the ’597 and ’164 patents. On April 11, 2016, the Commission decided to review certain findings contained in the 944 initial determination. On June 23, 2016, the Commission issued its Final Determination, which found a violation with respect to the ’537, ’592, and ’145 patents, and found no violation with respect to the ’597 and ’164 patents. The Commission also issued a Limited Exclusion Order and a Cease and Desist Order pertaining to network devices, related software and components thereof that infringe one or more of claims 1, 2, 8-11, and 17-19 of the ’537 patent, claims 6, 7, 20, and 21 of the ’592 patent, and claims 5, 7, 45, and 46 of the ’145 patent. The Final Determination in the 944 Investigation is subject to Presidential review, which will be completed no later than August 22, 2016.
The Administrative Law Judge assigned to the 945 Investigation issued a procedural schedule calling for, among other events: an evidentiary hearing on November 9-20, 2015; issuance of an initial determination regarding our alleged violations on April 26, 2016; and the Target Date for completion on August 26, 2016. The evidentiary hearing was conducted in November 2015 and all post-hearing briefing has been completed. On March 29, 2016, the ALJ issued a revised procedural schedule extending the deadline for issuance of an initial determination to August 26, 2016, and the Target Date to December 26, 2016. On April 19, 2016, the Commission determined not to review this decision. We are awaiting the initial determination from the Administrative Law Judge. The initial determination will be subject to review by the Commission, which will then issue a Final Determination and any remedial orders on December 26, 2016. If the Final Determination finds a violation, it will be subject to Presidential review.
On April 1, 2015, we filed petitions for Inter Partes Review with the United States Patent Trial and Appeal Board (“PTAB”) seeking to invalidate Cisco’s ’597, ’211, and ’668 patents.  On April 10, 2015, we filed petitions for Inter Partes Review with the PTAB seeking to invalidate Cisco’s ’853 and ’577 patents.  On April 16, 2015, we filed additional petitions for Inter Partes Review with the PTAB seeking to invalidate Cisco’s ’853 and ’577 patents.  On August 11, 2015, we filed a second petition for Inter Partes Review of Cisco’s ’668 patent.  On October 6, 2015 we filed a second petition for Inter Partes Review of Cisco’s ’211 patent, which was denied on April 12, 2016.  On October 6, 2015, the PTAB granted our petition for Inter Partes Review of Cisco’s ’597 patent and our first petition for Inter Partes review of Cisco’s ’211 patents, but denied one of our petitions for Inter Partes Review of Cisco’s ’668 patent. On October 19, 2015 and October 22, 2015, the PTAB denied four petitions relating to the ’853 and ’577 patents. On November 18, 2015, we filed a request for rehearing on one of the denied petitions related to the ’577 patent, which was denied on February 29, 2016.  On December 9, 2015, we filed a petition for Inter Partes Review with the PTAB seeking to invalidate Cisco’s ’537 patent, and additional petitions for Inter Partes Review with the PTAB seeking to invalidate Cisco’s ’853, ’577, and ’668 patents.  On February 16, 2016, the PTAB denied our second petition for Inter Partes review of the ’668 patent. On March 17, 2016, we filed a request for rehearing on this decision, which was denied on March 29, 2016. On June 6, 2016, the PTAB instituted an Inter Partes Review proceeding for the ’853 patent. On June 11, 2016, the PTAB instituted Inter Partes Review proceedings for the ’577, ’668, and ’537 patents. On June 27, 2016, we filed a request for rehearing with respect to certain claims of the ’537 patent which the PTAB did not include in the instituted Inter Partes Review proceeding and are awaiting a ruling on that request. The PTAB must issue its final written decision on validity of the ’853 patent by June 6, 2017, and, for the ’577, ’668, and ’537 patents, by June 11, 2017.
We intend to vigorously defend against Cisco’s lawsuits, as summarized in the preceding paragraphs. However, we cannot be certain that any claims by Cisco would be resolved in our favor regardless of the merit of the claims. For example, an adverse litigation ruling could result in a significant damages award against us, could further result in the above described injunctive relief, could result in a requirement that we make substantial royalty payments to Cisco, and/or could require that we modify our products to the extent that we are found to infringe any valid claims asserted against us by Cisco. Any such adverse ruling could materially adversely affect our business, prospects, reputation, results of operation and financial condition.
In particular, with respect to the 944 Investigation, the USITC has issued a Limited Exclusion Order barring entry into the United States of our network devices (including 7000 Series of switches), related software and components thereof that infringe one or more of the claims of the ‘537, ‘592 and ‘145 patents specified above and a Cease and Desist Order restricting our activities with respect to such imported products. In the 945 Investigation, if our products are found to infringe any patents that are the subject of that investigation, such orders would likely be issued as well. If the Limited Exclusion Order and Cease and Desist Order are not disapproved by the US Trade Representative, we will need to remove features or develop technical design-arounds in order to take the products outside of the scope of any patent found to have been infringed and the subject of a violation. We may not be successful in developing technical design-arounds that do not infringe the patents or that are acceptable to our customers.

16


Our development efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. Moreover, we may seek to obtain clearance for any such technical design-arounds from U.S. Customs and Border Patrol (“CBP”), and we may be unable to do so in a timely manner, if at all. In the case that we attempt to change our manufacturing, importation processes and shipping workflows to comply with the Limited Exclusion Order or Cease and Desist Order, such changes may be extremely costly, time consuming and we may not be able to implement such changes successfully. Any failure to develop effective technical design-arounds, obtain timely clearance of such technical design-arounds or successfully change our manufacturing, importation processes or shipping workflows in a manner that is compliant with the Limited Exclusion Order or Cease and Desist Order may cause a disruption in our shipments and materially and adversely affect our business, prospects, reputation, results of operations and financial condition.
Cisco may also seek to enforce the Limited Exclusion Order and/or Cease and Desist Order issued in the 944 Investigation by filing for an enforcement action at the USITC.  The same would be true if such orders are issued in the 945 Investigation. In such a proceeding, we would need to demonstrate that our technical design-arounds render our products non-infringing or otherwise outside the scope of the Limited Exclusion Order or Cease and Desist Order.  If we are unable to do so then any product shipments after the effective date of the Limited Exclusion Order or Cease and Desist Order (whether from existing imported inventory or from products assembled from foreign sourced components) could be subject to significant civil penalties, potential seizure of that inventory which was found to have an ineffective technical design-around, and an order prohibiting the importation of further products until we implement additional technical design-arounds.
Additionally, the existence of this lawsuit could cause concern among our customers and partners and could adversely affect our business and results of operations. Whether or not we prevail in the lawsuit, we expect that the litigation will be expensive, time-consuming and a distraction to management in operating our business.
With respect to the various 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 at this time.  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. Based on currently available information, management does not believe that liability relating to these other unresolved matters is 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.


17


6.    Equity Award Plan Activities
Total stock-based compensation expense related to options, restricted stock awards, employee stock purchases, restricted stock units and stock purchase rights granted were allocated as follows (in thousands):
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2016
 
2015
2016
 
2015
Cost of revenue
$
868

 
$
784

$
1,661

 
$
1,420

Research and development
7,595

 
6,379

15,052

 
11,307

Sales and marketing
3,780

 
2,865

7,427

 
5,274

General and administrative
1,989

 
1,180

3,452

 
2,046

           Total stock-based compensation
$
14,232

 
$
11,208

$
27,592

 
$
20,047

Stock Option Activities
The following table summarizes the option and RSA (Restricted Stock Award) activity under our equity stock plans and related information:
 
 
Options and RSAs Outstanding 
 
 
 
 
 
 
Number of
Shares
Underlying
Outstanding Options and RSAs
 (in thousands)
 
Weighted-
Average
Exercise
Price per Share
 
Weighted-
Average
Remaining
Contractual
Term (Years) of
Stock Options
 
Aggregate
Intrinsic
Value
of Stock
Options
Outstanding
(in thousands)
Outstanding—December 31, 2015
 
11,630

 
$
24.49

 
7.6
 
$
620,802

Options granted
 
440

 
56.88

 
 
 
 
Options exercised
 
(825
)
 
7.71

 
 
 
 
Options canceled
 
(232
)
 
29.16

 
 
 
 
Outstanding—June 30, 2016
 
11,013

 
$
26.94

 
7.3
 
$
420,519

Vested and exercisable—June 30, 2016
 
4,021

 
$
13.25

 
6.4
 
$
207,297

Vested and expected to vest—June 30, 2016
 
10,449

 
$
26.29

 
7.3
 
$
405,623

As of June 30, 2016, the total unrecognized stock-based compensation expense related to unvested stock options, net of expected forfeitures, was $103.6 million, which is expected to be recognized over a weighted-average period of 4.0 years.
Restricted Stock Unit (RSU) Activities
A summary of the RSU activity under our stock plans during the reporting period and a summary of information related to RSUs expected to vest are presented below (in thousands, except per share and year 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, 2015
893

 
$
70.14

 
1.9
 
$
69,509

       RSUs granted
369

 
61.81

 
 
 
 
       RSUs vested
(130
)
 
69.02

 
 
 
 
       RSUs forfeited
(56
)
 
67.29

 
 
 
 
Unvested balance—June 30, 2016
1,076

 
$
67.57

 
1.9
 
$
69,302

Vested and expected to vest—June 30, 2016
1,006

 
$
67.60

 
1.8
 
$
64,766

As of June 30, 2016, there was $61.9 million of unrecognized stock-based compensation cost related to unvested RSUs, net of estimated forfeitures. This amount is expected to be recognized over a weighted-average period of 3.5 years.
Employee Stock Purchase Plan Activities
During the six months ended June 30, 2016, we issued 122,937 shares at an average purchase price of $39.76 under the 2014 Employee Stock Purchase Plan ("ESPP"). On February 17, 2015, the board authorized an increase to shares available for

18


future issuance under the ESPP. Per the ESPP, the increase is determined based on the lesser of 1% of total shares outstanding as of the first day of each fiscal year, or January 1, 2016, 2,500,000 shares or such amount as determined by our board of directors. The approved increase amounted to 681,315 shares. As of June 30, 2016, there remain 1,617,132 shares available for issuance under the ESPP. 
As of June 30, 2016, the total unrecognized stock-based compensation expense related to unvested ESPP options, net of expected forfeitures, was $2.1 million, which is expected to be recognized over a weighted-average period of 1.5 years.
Shares Available for Grant
The following table presents the stock activity and the total number of shares available for grant as of June 30, 2016 (in thousands):
 
 
 
 
 
Number of Shares
Balance—December 31, 2015
 
10,495

Authorized
 
2,044

Options granted
 
(440
)
RSUs granted
 
(369
)
Options canceled
 
232

Options repurchased
 
5

RSUs forfeited
 
56

Shares traded for taxes
 
9

Balance—June 30, 2016
 
12,032



19


7.
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
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
2016
 
2015
Numerator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Net income
$
38,904

 
$
23,996

 
$
74,149

 
$
48,488

Less: undistributed earnings allocated to participating securities
(287
)
 
(389
)
 
(614
)
 
(894
)
Net income available to common stockholders, basic
$
38,617

 
$
23,607

 
$
73,535

 
$
47,594

Diluted:
 
 
 
 
 
 
 
Net income attributable to common stockholders, basic
$
38,617

 
$
23,607

 
$
73,535

 
$
47,594

Add: undistributed earnings allocated to participating securities
18

 
31

 
38

 
73

Net income attributable to common stockholders, diluted
$
38,635

 
$
23,638

 
$
73,573

 
$
47,667

Denominator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
68,275

 
65,524

 
68,006

 
65,018

Diluted:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
68,275

 
65,524

 
68,006

 
65,018

Add weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and RSUs
4,488

 
5,497

 
4,466

 
5,708

Employee stock purchase plan
54

 
194

 
51

 
193

Weighted-average shares used in computing net income per share available to common stockholders, diluted
72,817

 
71,215

 
72,523

 
70,919

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
0.57

 
$
0.36

 
$
1.08

 
$
0.73

Diluted
$
0.53

 
$
0.33

 
$
1.01

 
$
0.67

The following 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
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
2016
 
2015
Stock options and RSUs to purchase common stock
3,211

 
2,370

 
3,487

 
2,138



20


8.
Income Taxes
Provision for income taxes was approximately $13.9 million and $8.4 million for the three months ended June 30, 2016 and 2015, and $28.0 million and $18.4 million for the six months ended June 30, 2016 and 2015, respectively. The change in the provision was a result of an increase in profit before income taxes and the change in effective tax rate based on current geographical distribution of the earnings.
We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, the U.S. tax obligation is reduced by a credit for foreign income taxes paid on these earnings avoiding double taxation.
We have been selected for examination by the Internal Revenue Service ("IRS") for our 2013 and 2014 tax years. It is difficult to determine when the examinations will be settled or their final outcomes in the foreseeable future. We believe that we have adequately provided reserves for any reasonably foreseeable adjustment to our tax returns and we do not anticipate a significant impact to our gross unrecognized benefits within the next 12 months related to these years.
Our gross unrecognized tax benefits as of June 30, 2016 were $23.5 million. If the gross unrecognized tax benefits as of June 30, 2016 were realized in future periods, this could result in a tax benefit of $14.7 million within our provision of income taxes. Because of the net operating loss and tax credit carryforwards, substantially all of our tax years remain open to tax examinations and we are unable to estimate the full range of possible adjustments to the balance of gross unrecognized tax benefits.
    
9.
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
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
2016
 
2015
United States
$
198,958

 
$
148,303

 
$
379,834

 
$
271,456

Other Americas
2,359

 
2,560

 
4,124

 
6,164

Europe, Middle East and Africa
42,644

 
24,782

 
86,383

 
64,872

Asia-Pacific
24,780

 
19,907

 
40,596

 
32,105

Total revenue
$
268,741

 
$
195,552

 
$
510,937

 
$
374,597

The following table presents our property, plant and equipment, net by geographic region for the periods presented (in thousands):
 
June 30,
2016
 
December 31,
2015
United States
$
70,646

 
$
70,719

International
9,035

 
8,987

Total
$
79,681

 
$
79,706



21


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 consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, our Annual Report on Form 10-K filed with the SEC on February 25, 2016. 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 for enterprise support. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our Ethernet switches. 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 allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.
We were founded in 2004 to address the limitations of legacy networking products and to create a cloud networking platform that is open and programmable. From 2004 to 2008, our activities were focused on the development of our software, which resulted in the commercial release of our first product, the 7100 Series switches based on our EOS software, in 2008. Since then, we have continued to introduce new products utilizing EOS, including our 7500 Series switch and our 7050 Series switch in 2010, the second generation of our 7500 Series switch, called the 7500E modular switch, in May 2013, our 7300 Series switch in November 2013, our 7280E in July 2014. In December 2014, we introduced our EOS+ software platform for networking programmability and automation, and in June 2015 we introduced CloudVision, a network-wide approach for workload orchestration and workflow automation. In September 2015, we introduced our Macro Segmentation Services, or MSS, to provide automated insertion of security and other in-line layer 4-7 services within any software driven cloud networking infrastructure. MSS has been endorsed by many of our technology alliance ecosystem partners with whom we are currently partnering with to deliver MSS platform support. In addition, during 2015, we introduced our first 10/25/40/50/100G switches with our 7060, 7260 and 7320 series switches. In January 2016, Arista unveiled NetDB, the network-wide, state-oriented database that enhances the core system database (SysDB) of Arista EOS.  NetDB builds upon the SysDB architecture by adding software infrastructure improvements, including state-sharing and replication mechanisms for centrally storing network state, increased software table capacities up to 1M routes, and the ability to stream state in realtime from EOS devices. This extends the benefits of the state-based system across the entire network. During March 2016, we introduced our 7500R series, building on the 7500E series and providing 100GbE density and large table sizes in a single chassis. At up to 115 Tbps capacity, the 7500R supports up to one million routes, subsuming switching and routing functions into a Universal Spine platform for cloud-scale networks. In June 2016, we introduced our Arista 7280R Universal Leaf Network Platform, a compact form factor capable of a broad set of leaf networking use-cases, including IP storage, routing and digital media.
We have experienced rapid revenue growth over the last several years, increasing our revenue at a compound annual growth rate of 56.4% from 2011 to 2015. As we have grown the functionality of our EOS software, expanded the range of our switching portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. To support our customers and revenue growth, we have expanded our international presence to include 23 foreign subsidiaries as of June 30, 2016, including Australia, Canada, France, Germany, India, Ireland, Japan, South Korea and the United Kingdom. Our revenue for the three and six months ended June 30, 2016 was $268.7 million and $510.9 million, respectively an increase of 37.4% and 36.4% compared to the same periods in 2015, respectively. We have been profitable and cash flow positive for each year since 2010.
We believe 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. We expect to continue rapidly 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. 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 intend to continue expanding our sales and marketing teams and programs and carrying out associated marketing activities in key geographies. 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. As a result, our levels of operating profit as a percentage of revenue could decline in the short to medium term. For a description of factors that may impact our future performance, see the disclosure in the section titled "Factors Affecting Our Performance" below.

22


Our Business Model
We derive revenue from sales of products and services. 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.
Since shipping our first products in 2008, our cumulative end-customer base has grown rapidly. Between December 31, 2011 and June 30, 2016, our cumulative end-customer base grew from approximately 1,100 to nearly 4,000. 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.
To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. 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 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 where our EOS software is installed on our products.  We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers. We have expanded our contract manufacturing capabilities to include an additional contract manufacturer in San Jose, California.
We market and sell our products through both our direct sales force and our channel partners, including distributors, value-added resellers, system integrators, original equipment manufacturer, or OEM partners and in conjunction with various technology partners. To facilitate channel coordination and increase productivity, we have created a partner program, the Arista Partner Program, to engage partners who provide value-added services and extend our reach into the marketplace. Authorized training partners provide technical training to our channel partners. Our partners commonly receive an order from an end customer prior to placing an order with us, and we confirm the identification of the end customer prior to accepting such orders. Our partners generally do not stock inventory received from us. Our sales organization is supported by systems engineers with deep technical expertise and responsibility for pre-sales technical support and engineering for our end customers. Each sales team is responsible for a geographic territory, has responsibility for a number of major direct end-customer accounts or has assigned accounts in a specific vertical market.
Factors Affecting Our Performance
We believe that our future success will depend on many factors, including our ability to expand sales to our existing customers as well as to add new end customers. While these areas present significant opportunity, they also present risks that we must manage to ensure successful results. See the section titled “Risk Factors.” Additionally, we face intense competition especially from larger, well-established companies, and we must continue to expand the capabilities of our cloud networking platform to succeed in our market. We are also currently engaged in lawsuits with Cisco, our largest competitor, whereby they claim that we have infringed their intellectual property rights.  We intend to vigorously defend against these Cisco lawsuits as summarized in the Legal Proceedings section below. However, we cannot be certain that any claims by Cisco would be resolved in our favor.  If we are unable to address these challenges, our business could be adversely affected.
Increasing Adoption of Cloud Networks. 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 believe that cloud networks will continue to replace legacy network technologies. Our business and results of operations will be significantly affected by the speed with which organizations implement cloud networks.
Expanding Sales to Existing Customer Base. We expect that a substantial portion of our future sales will be follow-on sales to existing end customers. As noted above, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our cloud networking solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing and expected infrastructure spend. We expect our business and results of operations will depend on our ability to sell additional products to our growing base of customers.
Adding New End Customers. We believe that the cloud networking market is still in the early stages of adoption. We intend to target new end customers by continuing to invest in our field sales force and extending our relationships with channel, technology and system-level partners. To date, we have primarily targeted end customers with the largest cloud data centers. A typical initial order involves the education of prospective customers about the technical merits and capabilities and potential cost savings of our products as compared to our competitors’ products. Our results of operations will depend on our ability to continue to add new customers. We believe that customer references have been, and will continue to be, an important factor in winning new business with special emphasis on four key verticals: the cloud titans, financial services, service and internet hosting providers and high tech enterprises.

23


Selling More Complex and Higher-Performance Configurations. Our results of operations have been, and we believe will continue to be, affected by our ability to sell more complex and higher-performance configurations of our products. Our ability to sustain our revenue growth will depend, in part, upon our continued sales of these more robust configurations, and quarterly results of operations can be significantly impacted by the mix of products and product configurations sold during the period.
Leveraging Channel Partners. We expect to continue to derive a growing portion of our sales through our channel partners as they develop new end customers and expand sales to our existing end customers. We plan to continue to invest in our network of channel partners to enable them to reach new end customers more effectively, increase sales to existing customers and provide services and support effectively. We believe that increasing channel leverage will extend and improve our engagement with a broad set of customers.
Investing in Research and Development for Growth. We believe that the market for cloud networking is still in the early stages of adoption and we intend to continue investing for long-term growth. We expect to continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products such as our 7280R platform and 7500R series, new releases and upgrades to our EOS software and new applications building upon our technology leadership. We believe one of our greatest strengths lies in the speed of our product development efforts. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these product development investments.
Customer Concentration and Timing of Large Orders. Historically, large purchases by a relatively limited number of end customers have accounted for a significant portion of our revenue. During the years ended December 31, 2015, 2014, and 2013, our largest end customer accounted for 12.0%, 14.9%, and 21.9% of our revenue, respectively. We have also experienced and continue to experience customer concentration on a quarterly basis. In addition, we have experienced increases in the size of our orders, including orders from existing customers, which could result in future increased customer concentration, depending on the timing of the fulfillment of those orders. We have also 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 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. 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.
Basis of Presentation
Revenue
We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also derive a portion of our revenue from sales of post contract support, or PCS, and to a lesser extent professional services. We generate PCS revenue from sales of technical support services contracts that are typically purchased in conjunction with our products and subsequent renewals of those contracts. We offer PCS services under renewable, fee-based contracts, which include 24-hour technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if available basis. 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 with unique terms and conditions that may require deferral of revenue. Additionally, we expect PCS revenue to increase in absolute dollars as we expand our installed base. Our ability to expand our installed base and increase our revenue is subject to numerous risks and uncertainties. See the section titled “Risk Factors.” We report revenue net of sales taxes.
Cost of Revenue
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. We expect our cost of product revenue to increase as our product revenue increases. Cost of providing PCS and other services consists primarily of personnel costs for our global customer support organization. We expect our cost of service revenue to increase as our PCS revenue increases.
Gross Margin
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, the average sales price of our offerings, manufacturing costs, including costs associated with the introduction of additional contract manufacturing capacity, merchant silicon costs and the mix of products sold. We expect our gross margins to fluctuate over time, depending on the factors described above and others. See the section titled “Risk Factors.”

24


Operating Expenses
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.
Research and Development Expenses
Research and development expenses consist primarily of personnel costs, with the remainder being prototype expenses, third-party engineering and contractor support costs, and an allocated portion of facility and IT costs and 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 expense research and development costs as incurred. 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.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of personnel costs and also include costs related to marketing and promotional activities, with the remainder being an allocated portion of facility and IT costs and depreciation. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales and marketing efforts worldwide and expand our relationships with current and future channel partners and end customers.
General and Administrative Expenses
General and administrative expenses consist primarily of personnel costs, legal and professional fees, and an allocated portion of facility and IT costs and depreciation. General and administrative personnel costs include those for our executive, finance, IT, human resources and legal functions. Our professional fees consist primarily of accounting, external legal and IT and other consulting costs. Refer to the discussion under “Legal Proceedings” subheading in Note 5. Commitments and Contingencies of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for information related to pending litigation.
Other Income (Expense), Net
Interest Expense   
Interest expense consists mostly of interest expense from our lease financing obligation.
Other Income (Expense)   
Other income (expense) consists mostly of foreign currency exchange gains and losses and interest income. Our foreign currency exchange gains and losses primarily relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates.
Provision for Income Taxes
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. Generally, our U.S. tax obligations are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations.
We account for income taxes under the liability approach for deferred income taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements but have not been reflected in our taxable income. Estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred income tax assets, which arise from temporary differences and carryforwards. We measure deferred income tax assets and liabilities using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that our deferred income tax assets will be realized based on the positive and negative evidence available. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more likely than not to realize.
We believe that we have adequately reserved for our uncertain tax positions, although we can provide no assurance that the final tax outcome of these matters will not be materially different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is

25


made and could have a material impact on our financial condition and results of operations. The provision for income taxes includes the effects of any reserves that we believe are appropriate, as well as the related net interest and penalties.

Results of Operations
The following table summarizes historical results of operations for the periods presented and as a percentage of revenue for those periods. We have derived the data for the three and six months ended June 30, 2016 and 2015 from our unaudited condensed consolidated financial statements (in thousands, except for percentage of revenue).    
 
Three Months Ended
June 30,
Six Months Ended
June 30,
 
2016
 
2015
2016
 
2015
Revenue:
 
 
 
 
 
 
Product
$
235,616

 
$
174,072

$
448,091

 
$
334,213

Service
33,125

 
21,480

62,846

 
40,384

Total revenue
268,741

 
195,552

510,937

 
374,597

Cost of revenue (1): 
 
 
 
 
 
 
Product
88,021

 
60,014

166,934

 
114,453

Service
9,269

 
7,648

17,462

 
14,500

Total cost of revenue
97,290

 
67,662

184,396

 
128,953

Gross profit
171,451

 
127,890

326,541

 
245,644

Operating expenses (1):
 
 
 
 
 
 
Research and development
69,020

 
49,947

131,535

 
93,287

Sales and marketing
31,744

 
26,681

59,350

 
51,268

General and administrative
17,529

 
18,403

32,763

 
32,475

Total operating expenses
118,293

 
95,031

223,648

 
177,030

Income from operations
53,158

 
32,859

102,893

 
68,614

Interest expense
(732
)
 
(832
)
(1,483
)
 
(1,653
)
Other income (expense), net
416

 
417

753

 
(51
)
Total other income (expense), net
(316
)
 
(415
)
(730
)
 
(1,704
)
Income before provision for income taxes
52,842

 
32,444

102,163

 
66,910

Provision for income taxes
13,938

 
8,448

28,014

 
18,422

Net income
$
38,904

 
$
23,996

$
74,149

 
$
48,488




26


 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
2016
 
2015
 
(as a percentage of revenue)
Revenue:
 
 
 
 
 
 
 
Product
87.7
 %
 
89.0
 %
 
87.7
 %
 
89.2
 %
Service
12.3

 
11.0

 
12.3

 
10.8

Total revenue
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue:
 
 
 
 
 
 
 
Product
32.8

 
30.7

 
32.7

 
30.6

Service
3.4

 
3.9

 
3.4

 
3.8

Total cost of revenue
36.2

 
34.6

 
36.1

 
34.4

Gross margin
63.8

 
65.4

 
63.9

 
65.6

Operating expenses:
 
 
 
 
 
 
 
Research and development
25.7

 
25.5

 
25.7

 
24.9

Sales and marketing
11.8

 
13.6

 
11.6

 
13.7

General and administrative
6.5

 
9.5

 
6.4

 
8.7

Total operating expenses
44.0

 
48.6

 
43.7

 
47.3

Income from operations
19.8

 
16.8

 
20.2

 
18.3

Interest expense
(0.3
)
 
(0.4
)
 
(0.3
)
 
(0.4
)
Other income (expense), net
0.2

 
0.2

 
0.1

 

Total other income (expense), net
(0.1
)
 
(0.2
)
 
(0.2
)
 
(0.4
)
Income before provision for income taxes
19.7

 
16.6

 
20.0

 
17.9

Provision for income taxes
5.2

 
4.3

 
5.5

 
5.0

Net income
14.5
 %
 
12.3
 %
 
14.5
 %
 
12.9
 %
________________________________________________________________________ 
(1) Includes stock-based compensation expense as follows:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
2016
 
2015
Cost of revenue
$
868

 
$
784

 
$
1,661

 
$
1,420

Research and development
7,595

 
6,379

 
15,052

 
11,307

Sales and marketing
3,780

 
2,865

 
7,427

 
5,274

General and administrative
1,989

 
1,180

 
3,452

 
2,046

           Total stock-based compensation
$
14,232

 
$
11,208

 
$
27,592

 
$
20,047



27


Three and Six Months Ended June 30, 2016 Compared to Three and Six Months Ended June 30, 2015
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
235,616

 
$
174,072

 
$
61,544

 
35.4%
 
$
448,091

 
$
334,213

 
$
113,878

 
34.1%
Service
33,125

 
21,480

 
11,645

 
54.2
 
62,846

 
40,384

 
22,462

 
55.6
Total revenue
268,741

 
195,552

 
73,189

 
37.4
 
510,937

 
374,597

 
136,340

 
36.4
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
88,021

 
60,014

 
28,007

 
46.7
 
166,934

 
114,453

 
52,481

 
45.9
Service
9,269

 
7,648

 
1,621

 
21.2
 
17,462

 
14,500

 
2,962

 
20.4
Total cost of revenue
97,290

 
67,662

 
29,628

 
43.8
 
184,396

 
128,953

 
55,443

 
43.0
Gross profit
$
171,451

 
$
127,890

 
$
43,561

 
34.1%
 
$
326,541

 
$
245,644

 
$
80,897

 
32.9%
Gross margin
63.8
%
 
65.4
%
 
 
 
 
 
63.9
%
 
65.6
%
 

 
 

Revenue by Geography (in thousands, except percentages)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
% of Total
 
2015
 
% of Total
 
2016
 
% of Total
 
2015
 
% of Total
Americas
$
201,317

 
74.9
%
 
$
150,863

 
77.1
%
 
$
383,958

 
75.1
%
 
$
277,620

 
74.1
%
Europe, Middle East and Africa
42,644

 
15.9

 
24,782

 
12.7

 
86,383

 
16.9

 
64,872

 
17.3

Asia-Pacific
24,780

 
9.2

 
19,907

 
10.2

 
40,596

 
8.0

 
32,105

 
8.6

Total revenue
$
268,741

 
100.0
%
 
$
195,552

 
100.0
%
 
$
510,937

 
100.0
%
 
$
374,597

 
100.0
%
Revenue
Revenue increased 37.4% in the three months ended June 30, 2016 and 36.4% in the six months ended June 30, 2016, compared to the same periods in 2015. We increased shipments to our existing customers as they continued to grow and expand their businesses, increasing their demand for our switch products and related accessories. The introduction of new products has contributed to our revenue growth, both with existing and new customers. Our overall customer count increased to almost 4,000 in the period as we expanded our market presence and geographical foot print. Service revenue increased 54.2% in the three months ended June 30, 2016 and 55.6% during the six months ended June 30, 2016 compared to the same periods in 2015, as a result of continued growth in initial and renewal support contracts as our customer installed base continues to expand. We also continued to experience fluctuations in product and service pricing due to competitive market pressures. However, these were more than offset by the increased demand drivers outlined above.
Cost of Revenue and Gross Margin
Cost of revenue increased $29.6 million in the three months ended June 30, 2016 and $55.4 million in the six months ended June 30, 2016, compared to the same periods in 2015. The increase in cost of revenue was primarily due to an increase in product shipment volume, an increase in costs to add capacity to our manufacturing and operations infrastructure, and to a lesser extent, an increase in expenses incurred to expand the infrastructure to support our growing customer installed base. Gross margin decreased from 65.4% to 63.8% for the three months ended June 30, 2016 compared to the same period in 2015, and from 65.6% to 63.9% for the six months ended June 30, 2016 compared to the same periods in 2015, respectively. The decrease during these periods was primarily the result of changes in customer mix and to a lesser extent product mix, as we expanded our business and increased the contribution of larger customers who typically receive higher discount levels. These unfavorable changes were partially offset by improved service margins as we scale our services business. We expect that our gross margins in the third quarter of 2016 will be relatively consistent with our recent quarters. While we do not have the ability to predict gross margins for periods beyond this time frame, we believe we may continue to experience some increase in product costs as we ramp our new contract manufacturer and related supply chain operations.

28


Operating Expenses (in thousands, except percentages)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
69,020

 
$
49,947

 
$
19,073

 
38.2%
 
$
131,535

 
$
93,287

 
$
38,248

 
41.0%
Sales and marketing
31,744

 
26,681

 
5,063

 
19.0
 
59,350

 
51,268

 
8,082

 
15.8
General and administrative
17,529

 
18,403

 
(874
)
 
(4.7)
 
32,763

 
32,475

 
288

 
0.9
Total operating expenses
$
118,293

 
$
95,031

 
$
23,262

 
24.5%
 
$
223,648

 
$
177,030

 
$
46,618

 
26.3%
Research and development
Research and development expenses increased $19.1 million, or 38.2%, for the three months ended June 30, 2016 compared to the same period in 2015. The increase was primarily due to an increase in personnel costs of $9.2 million, resulting from increases in headcount, stock-based compensation as well as additional bonus expense under our corporate bonus plan. Prototype spend, third-party engineering and consulting costs increased by $9.1 million related to the development of new products and some increased costs associated with litigation related changes in product design.
Research and development expenses increased $38.2 million, or 41.0%, for the six months ended June 30, 2016 compared to the same period in 2015. The increase was primarily due to an increase in personnel costs of $18.5 million, resulting from increases in headcount, stock-based compensation as well as additional bonus expense under our corporate bonus plan. Prototype spend, third-party engineering and consulting costs increased by $15.4 million related to the development of new products, and increased costs associated with litigation related changes in product design. Facilities and IT infrastructure costs increased $1.8 million due to expansion of our business and support center footprint and continued expansion and support of our research and development activities.
Sales and marketing
Sales and marketing expenses increased $5.1 million, or 19.0%, for the three months ended June 30, 2016 compared to the same period in 2015. The increase was primarily due to an increase in personnel costs of $4.4 million, resulting from increased headcount, additional sales incentive compensation due to higher sales volume, and additional corporate bonus expense.
Sales and marketing expenses increased $8.1 million, or 15.8%, for the six months ended June 30, 2016 compared to the same period in 2015. The increase was primarily due to an increase in personnel costs of $8.7 million, resulting from increased headcount, additional sales incentive compensation due to higher sales volume, and additional corporate bonus expense. This increase was partially offset by a decrease in product field demonstration costs of $1.4 million primarily related to significant costs incurred in the previous year as we experienced several product transitions to our next generation products.
General and administrative
General and administrative expenses decreased $0.9 million, or 4.7%, for the three months ended June 30, 2016 compared to the same period in 2015. This decrease was mostly due to a reduction in litigation expenses of $2.3 million related to the timing of litigation activities primarily related to the Cisco and OptumSoft legal matters outlined in Note 5 to the Consolidated Financial Statements. This decrease was largely offset by an increase in personnel costs of $1.5 million reflecting additional headcount, increased stock-based compensation charges, and additional bonus expenses under our corporate bonus program.
General and administrative expenses increased $0.3 million, or 0.9%, for the three months ended June 30, 2016 compared to the same period in 2015. The increase was due to an increase in personnel costs of $2.4 million reflecting additional headcount, increased stock-based compensation charges, and additional bonus expenses under our corporate bonus program. This increase was largely offset by a reduction of litigation expenses of $1.7 million primarily related to the timing of litigation activities in the Cisco and OptumSoft legal matters outlined in Note 5 to the Consolidated Financial Statements.

29


Other Income (Expense), Net (in thousands, except percentages)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Other income (expense), net:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   Interest expense
$
(732
)
 
$
(832
)
 
$
100

 
12.0%
 
$
(1,483
)
 
$
(1,653
)
 
$
170

 
10.3%
   Other income (expense), net
416

 
417

 
(1
)
 
0.2
 
753

 
(51
)
 
804

 
(1,576.5)
      Total other income (expense), net
$
(316
)
 
$
(415
)
 
$
99

 
23.9%
 
$
(730
)
 
$
(1,704
)
 
$
974

 
57.2%
Other income (expense), net
Other income (expense), net during the three and six months ended June 30, 2016 compared to the same periods in 2015 included an increase in interest income as we expanded our marketable securities portfolio during the current quarter. The increase in interest income in the three months ended June 30, 2016 was largely offset by an unfavorable change in foreign currency transaction losses.
Provision for Income Taxes (in thousands, except percentages)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Provision for income taxes
$
13,938

 
$
8,448

 
$
5,490

 
65.0%
 
$
28,014

 
$
18,422

 
$
9,592

 
52.1%
Effective tax rate
26.4
%
 
26.0
%
 
 
 
 
 
27.4
%
 
27.5
%
 
 
 
 
Provision for income taxes
Provision for income taxes was approximately $13.9 million and $8.4 million for the three months and $28.0 million and $18.4 million for the six months ended June 30, 2016 and 2015, respectively. The change in the provision was a result of an increase in profit before income taxes and the change in effective tax rate primarily due to the geographical distribution of the earnings.

30



Liquidity and Capital Resources
Our principal sources of liquidity are cash and cash equivalents, marketable securities, and cash generated from operations. As of June 30, 2016, cash and cash equivalents, and marketable securities were $823.8 million, of which approximately $91.1 million was held outside the U.S. in our foreign subsidiaries.  We have not repatriated nor do we currently have plans to repatriate these funds, but if we were to repatriate cash held outside of the U.S. for domestic cash operations, we would be required to accrue and pay U.S. income taxes to repatriate these funds less any previously paid foreign income taxes. We consider the undistributed earnings of our foreign subsidiaries as of June 30, 2016 to be indefinitely reinvested, and, accordingly, no U.S. income taxes have been provided thereon.
Our cash and cash equivalents, and marketable securities are held for working capital purposes. We expect to incur incremental working capital requirements of $100.0 million over the next quarter specifically related to new product transitions and the ramp of production and supply chain operations with our new contract manufacturer. In addition, we may incur incremental capital expenditures of up to $10.0 million in relation to these manufacturing efforts. We plan to continue to invest for long-term growth. We believe that our existing cash and cash equivalents together with cash flow from operations will be sufficient to meet our working capital requirements and our growth strategies for the foreseeable future. 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 and access to outsourcing our manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and costs incurred related to outstanding litigation claims. 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.

Cash Flows
 
June 30,
2016
 
December 31,
2015
 
(in thousands)
Cash and cash equivalents
$
531,058

 
$
687,326