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EX-10.1 - AMENDED SANMINA MANUFACTURING SERVICES AGREEMENT - Arista Networks, Inc.ex101secondamendedmsasanmi.htm
EX-32.1 - CEO AND CFO 906 CERTIFICATION - Arista Networks, Inc.ex321ceoandcfo906certifica.htm
EX-31.2 - CFO CERTIFICATION - Arista Networks, Inc.ex312cfocertificationq316.htm
EX-31.1 - CEO CERTIFICATION - Arista Networks, Inc.ex311ceocertificationq316.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 September 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 October 28, 2016 was 70,209,251.
 






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)
 
September 30,
2016
 
December 31,
2015
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
500,481

 
$
687,326

Marketable securities
299,667

 

Accounts receivable, net of allowances of $1,540 and $1,529, respectively
210,243

 
144,263

Inventories
162,128

 
92,129

Prepaid expenses and other current assets
151,659

 
50,610

Total current assets
1,324,178

 
974,328

Property and equipment, net
78,147

 
79,706

Investments
36,136

 
36,636

Deferred tax assets
62,221

 
48,429

Other assets
18,398

 
20,791

TOTAL ASSETS
$
1,519,080

 
$
1,159,890

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
77,048

 
$
43,966

Accrued liabilities
77,163

 
60,971

Deferred revenue
191,094

 
122,049

Other current liabilities
9,777

 
8,025

Total current liabilities
355,082

 
235,011

Income taxes payable
11,896

 
14,060

Lease financing obligations, non-current
40,041

 
41,210

Deferred revenue, non-current
93,741

 
74,759

Other long-term liabilities
6,900

 
6,698

TOTAL LIABILITIES
507,660

 
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 September 30, 2016 and December 31, 2015

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of September 30, 2016 and December 31, 2015; 70,133 and 68,132 shares issued and outstanding as of September 30, 2016 and December 31, 2015, respectively
7

 
7

Additional paid-in capital
636,074

 
537,904

Retained earnings
376,322

 
250,916

Accumulated other comprehensive loss
(983)

 
(675
)
TOTAL STOCKHOLDERS’ EQUITY
1,011,420

 
788,152

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
1,519,080

 
$
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
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Revenue:
 
 
 
 
 
 
 
Product
$
254,238

 
$
193,339

 
$
702,329

 
$
527,552

Service
36,023

 
24,209

 
98,869

 
64,593

Total revenue
290,261

 
217,548

 
801,198

 
592,145

Cost of revenue:
 
 
 
 
 
 
 
Product
94,777

 
67,990

 
261,711

 
182,443

Service
9,064

 
7,810

 
26,526

 
22,310

Total cost of revenue
103,841

 
75,800

 
288,237

 
204,753

Total gross profit
186,420

 
141,748

 
512,961

 
387,392

Operating expenses:
 
 
 
 
 
 
 
Research and development
70,648

 
58,748

 
202,183

 
152,035

Sales and marketing
33,216

 
26,508

 
92,566

 
77,776

General and administrative
19,535

 
25,195

 
52,298

 
57,670

Total operating expenses
123,399

 
110,451

 
347,047

 
287,481

Income from operations
63,021

 
31,297

 
165,914

 
99,911

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense
(735
)
 
(753
)
 
(2,218
)
 
(2,406
)
Other income (expense), net
639

 
13

 
1,392

 
(38
)
Total other income (expense), net
(96
)
 
(740
)
 
(826
)
 
(2,444
)
Income before provision for income taxes
62,925

 
30,557

 
165,088

 
97,467

Provision for income taxes
11,668

 
1,867

 
39,682

 
20,289

Net income
$
51,257

 
$
28,690

 
$
125,406

 
$
77,178

Net income attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
50,962

 
$
28,301

 
$
124,475

 
$
75,864

Diluted
$
50,980

 
$
28,329

 
$
124,531

 
$
75,967

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
0.74

 
$
0.42

 
$
1.82

 
$
1.16

Diluted
$
0.69

 
$
0.39

 
$
1.71

 
$
1.07

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
69,076

 
66,629

 
68,365

 
65,609

Diluted
73,453

 
71,887

 
72,811

 
71,232


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
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Net income
$
51,257

 
$
28,690

 
$
125,406

 
$
77,178

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
(165)

 
(249
)
 
(402)

 
(320
)
Net change in unrealized gains (losses) on available-for sale securities
(113)

 
(39
)
 
94

 
223

        Other comprehensive loss
(278)

 
(288)

 
(308)

 
(97)

Comprehensive income
$
50,979

 
$
28,402

 
$
125,098

 
$
77,081


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)
 
Nine Months Ended
September 30,
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
125,406

 
$
77,178

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
14,807

 
9,724

Stock-based compensation
42,708

 
32,325

Deferred income taxes
(13,720
)
 
(15,483
)
Excess tax benefit on stock-based compensation
(30,043
)
 
(32,381
)
Amortization of investment premiums
994

 
1,332

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(65,980
)
 
(63,248
)
Inventories
(69,998
)
 
(31,915
)
Prepaid expenses and other current assets
(98,050
)
 
(19,352
)
Other assets
3,208

 
(3,092
)
Accounts payable
35,510

 
(145
)
Accrued liabilities
15,913

 
18,102

Deferred revenue
88,027

 
84,238

Income taxes payable
27,275

 
24,759

Other liabilities
2,628

 
1,980

Net cash provided by operating activities
78,685

 
84,022

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Proceeds from maturity of marketable securities
41,917

 
58,200

Purchases of marketable securities
(342,484
)
 

Purchases of property and equipment
(15,787
)
 
(13,974
)
Investment in privately-held companies
(2,500
)
 

Change in restricted cash

 
(4,039
)
Purchases of intangible assets
(697
)
 
(743
)
Net cash (used in) provided by investing activities
(319,551
)
 
39,444

CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Principal payments of lease financing obligations
(960
)
 
(778
)
Proceeds from issuance of common stock upon exercising options, net of repurchases
15,556

 
14,562

Minimum tax withholding paid on behalf of employees for net share settlement
(811
)
 

Proceeds from issuance of common stock under employee stock purchase plan
10,326

 
9,366

Excess tax benefit on stock-based compensation
30,043

 
32,381

Issuance costs from initial public offering

 
(261
)
Net cash provided by financing activities
54,154

 
55,270

Effect of exchange rate changes
(133
)
 
(267
)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(186,845
)
 
178,469

CASH AND CASH EQUIVALENTS—Beginning of period
687,326

 
240,031

CASH AND CASH EQUIVALENTS—End of period
$
500,481

 
$
418,500

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid for income taxes, net of refunds
$
34,426

 
$
3,806

Cash paid for interest—lease financing obligation
$
2,196

 
$
2,257

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION:
 
 
 
Property and equipment included in accounts payable and accrued liabilities
$
1,313

 
$
916

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 nine months ended September 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 nine months ended September 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 plan to adopt the standards our first quarter of fiscal 2018. 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 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 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 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 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

8


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 August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Task Force), which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice in how certain transactions are presented and classified in the statement of cash flows. The guidance may be adopted early as of the beginning of an annual reporting period. The guidance will be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The standard is effective for us for our first quarter of fiscal 2018. We are currently assessing the impact this guidance may have on our consolidated financial statements.
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, which addresses recognition of current and deferred income taxes for intra-entity asset transfers when assets are sold to an outside party. Current GAAP prohibits the recognition of current and deferred income taxes until the asset has been sold to an outside party. This prohibition on recognition is considered an exception to the principle of comprehensive recognition of current and deferred income taxes in GAAP. The new guidance requires an entity to recognize the income tax consequences when the transfer occurs eliminating the exception. The guidance will be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The standard is effective for us for our first quarter of fiscal 2018, and may be early adopted under early application guidance. We are currently assessing the impact this guidance may have on our consolidated financial statements.

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):

9



 
September 30, 2016
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
Money market funds
$
304,926

 
$

 
$

 
$
304,926

Money market funds-restricted
4,041

 

 

 
4,041

Commercial Paper
11,997

 

 

 
11,997

U.S. government notes
139,499

 

 

 
139,499

Corporate bonds

 
148,171

 

 
148,171

Total financial assets
$
460,463

 
$
148,171

 
$


$
608,634

 
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


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):
 
September 30, 2016
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
$
11,941

 
$
56

 
$

 
$
11,997

U.S. government notes
139,509

 
22

 
(32
)
 
139,499

Corporate bonds
148,123

 
153

 
(105
)
 
148,171

Total marketable securities
$
299,573

 
$
231

 
$
(137
)
 
$
299,667

As of September 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 September 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 September 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):

 
 
September 30, 2016
Due in 1 year or less
 
$
171,170

Due in 1 year through 2 years
 
128,497

Total marketable securities
 
$
299,667

The weighted average remaining duration of our current marketable securities is approximately 0.8 years as of September 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.

10


Accounts Receivable, net
Accounts receivable, net consists of the following (in thousands):
 
September 30,
2016
 
December 31,
2015
Accounts receivable
$
211,783

 
$
145,792

Allowance for doubtful accounts
(291
)
 
(963
)
Sales return reserve
(1,249
)
 
(566
)
Accounts receivable, net
$
210,243

 
$
144,263

Inventories
Inventories consist of the following (in thousands):
 
September 30,
2016
 
December 31,
2015
Raw materials
$
64,610

 
$
29,831

Finished goods
97,518

 
62,298

Total inventories
$
162,128

 
$
92,129

Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following (in thousands):
 
September 30,
2016
 
December 31,
2015
Inventory deposit
$
62,576

 
$

Prepaid income taxes
22,817

 
14,150

Other current assets
55,363

 
29,270

Other prepaid expenses and deposits
10,903

 
7,190

Total prepaid expenses and other current assets
$
151,659

 
$
50,610

Property and Equipment, net
    Property and equipment, net consists of the following (in thousands):
 
September 30,
2016
 
December 31,
2015
Equipment and machinery
$
38,269

 
$
29,101

Computer hardware and software
16,840

 
12,630

Furniture and fixtures
2,865

 
2,380

Leasehold improvements
29,504

 
24,372

Building
35,154

 
35,154

Construction-in-process
304

 
6,408

Property and equipment, gross
122,936

 
110,045

Less: accumulated depreciation
(44,789
)
 
(30,339
)
Property and equipment, net
$
78,147

 
$
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 September 30, 2016 and December 31, 2015, we have recorded assets of $53.4 million,

11


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 $5.1 million and $3.4 million for the three months ended September 30, 2016 and 2015, respectively, and was $14.8 million, and $9.7 million for the nine months ended September 30, 2016 and 2015, respectively.
Accrued Liabilities     
Accrued liabilities consist of the following (in thousands):
 
September 30,
2016
 
December 31,
2015
Accrued compensation costs
$
41,695

 
$
39,479

Accrued warranty costs
5,597

 
4,718

Accrued manufacturing costs
14,558

 
6,397

Accrued professional fees
6,827

 
4,875

Accrued taxes
1,320

 
1,347

Other
7,166

 
4,155

Total accrued liabilities
$
77,163

 
$
60,971

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):
 
Nine Months Ended
September 30,
 
2016
 
2015
Warranty accrual, beginning of period
$
4,718

 
$
3,204

Liabilities accrued for warranties issued during the period
3,717

 
3,352

Warranty costs incurred during the period
(2,541
)
 
(1,765
)
Adjustments related to change in estimate
(297
)
 

Warranty accrual, end of period
$
5,597

 
$
4,791


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4.    Investments
Investments in Privately-held Companies    
As of September 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 prior 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 nine months ended September 30, 2016.

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 $2.3 million, $2.0 million, $7.0 million, and $4.7 million for the three and nine months ended September 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 September 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 $41.6 million and $42.5 million, respectively. As of September 30, 2016, $1.5 million and $40.0 million were recorded as short-term and long-term financing obligations, respectively.
Land lease expense related to our lease financing obligation is classified in rent expense in our unaudited condensed consolidated statements of income, and amounted to $0.3 million and $1.0 million for both the three and nine months ended September 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 September 30, 2016, we had non-cancelable purchase commitments of $226.2 million. In addition, we have provided deposits to secure our obligations to purchase inventory. We had $64.9 million and $2.3 million in deposits as of September 30, 2016 and December 31, 2015, respectively. These deposits are classified in other current and long term 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 access to our software for evaluation by OptumSoft; (ii) cease all conduct constituting the alleged confidentiality and use restriction breaches; (iii) secure the return or deletion of OptumSoft’s alleged intellectual property provided to third parties, including our customers; (iv) assign ownership to OptumSoft of OptumSoft’s alleged intellectual property currently owned by us; and (v) pay OptumSoft’s alleged damages, attorney’s fees, and costs of the lawsuit. David Cheriton, one of our founders and a former member of our board of directors, who resigned from our board of directors on March 1, 2014 and has no continuing role with us, is a founder and, we believe, the largest stockholder and director of OptumSoft. The 2010 David R. Cheriton Irrevocable Trust dtd July 28, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is one of our largest stockholders.
On April 14, 2014, we filed a cross-complaint against OptumSoft, in which we 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 certain components, such components are licensed to us under the terms of the 2004 agreement. However, there can be no assurance that our assertions will ultimately prevail in litigation. On the same day, we also filed an answer to OptumSoft’s claims, as well as affirmative defenses based in part on OptumSoft’s failure to maintain the confidentiality of its claimed trade secrets, its authorization of the disclosures it asserts and its delay in claiming ownership of the software components at issue. We have also taken additional steps to respond to OptumSoft’s allegations that we improperly used and/or disclosed OptumSoft confidential information. While we believe we have meritorious defenses to these allegations, we believe we have (i) revised our software to remove the elements we understand to be the subject of the claims relating to improper use and disclosure of OptumSoft confidential information and made the revised software available to our customers and (ii) removed information from our website that OptumSoft asserted disclosed OptumSoft confidential information.
The parties tried Phase I of the case, relating to contract interpretation and application of the contract to certain claimed source code, in September 2015. On 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 the software at issue in Phase I. The remaining issues that were not addressed in the Phase I trial are set to be tried in Phase II including the application of the Court’s interpretation of the 2004 agreement as set forth in the Final Statement of Decision Following Phase I Trial to any other source code that OptumSoft claims to own following a review. Phase II was previously scheduled to be tried in April 2016; however, that trial date has been vacated and a new trial date has not yet been set.
We intend to vigorously defend against any claims brought against us by OptumSoft.  However, we cannot be certain that, if litigated, any claims by OptumSoft would be resolved in our favor.  For example, if it were determined that OptumSoft owned components of our EOS network operating system, we would be required to transfer ownership of those components and any related intellectual property to OptumSoft.  If OptumSoft were the owner of those components, it could make them available to our competitors, such as through a sale or license.  An adverse litigation ruling could result in a significant damages award

14


against us and injunctive relief. In addition, OptumSoft could assert additional or different claims against us, including claims that our license from OptumSoft is invalid.
With respect to the legal proceedings described above, it is our belief that while a loss is not probable, it may be reasonably possible. Further, at this stage in the litigation, any possible loss or range of loss cannot be estimated.  However, the outcome of litigation is inherently uncertain. Therefore, if one or more of these legal matters were resolved against us in a reporting period for a material amount, our consolidated financial statements for that reporting period could be materially adversely affected.    
Cisco Systems, Inc. (“Cisco”) Matters    
We are currently involved in several litigation matters with Cisco Systems, Inc. These matters are summarized below.
Cisco Systems, Inc. v. Arista Networks, Inc. (Case No. 4:14-cv-05343) (“’43 Case”)
On December 5, 2014, Cisco filed a complaint against us in the District Court for the Northern District of California alleging 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) became final. Trial has not been scheduled in the ’43 Case.
Cisco Systems, Inc. v. Arista Networks, Inc. (Case No. 5:14-cv-05344) (“’44 Case”)    
On December 5, 2014, Cisco filed a complaint against us in the District Court for the Northern District of California alleging that we infringe numerous copyrights pertaining to Cisco’s “Command Line Interface” or “CLI” and U.S. Patent Nos.  7,047,526 and 7,953,886 (respectively, “the 526 patent” and “the 886 patent”). 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 raising numerous affirmative defenses. On March 6, 2015, Cisco filed an amended complaint against us in 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 May 25, 2016, the Patent and Trademark Appeals Board ("PTAB") issued an order initiating inter partes review of U.S. Patent No. 7,953,886 (“the ʼ886 patent). Following that order Cisco agreed to dismiss its claims as to the ʼ886 patent with prejudice, and we dismissed our counterclaims as to the ʼ886 patent without prejudice.
Summary judgment cross-motions in the ’44 Case were heard on August 4, 2016, and the Court denied all motions brought by both sides. A final pre-trial conference is set for November 3, 2016 and trial has been set for November 21, 2016.
Arista Networks, Inc. v. Cisco Systems, Inc. (Case No. 5:16-cv-00923) (“’23 Case”)
On February 24, 2016, we filed a complaint against Cisco in the District Court for the Northern District of California alleging antitrust violations and unfair competition. On April 13, 2016, Cisco filed a motion to stay the ’23 Case, or in the alternative, to dismiss the complaint. On August 23, 2016, the Court granted Cisco’s motion to stay until judgment has been entered on Cisco’s copyright claims in the ’44 Case, which the Court anticipated by December 22, 2016. Trial in the ’23 Case is set for August 3, 2018, and is not affected by the Court’s granting of the interim stay.
Certain Network Devices, Related Software, and Components Thereof (Inv. No. 337-TA-944) (“944 Investigation”)
On December 19, 2014, Cisco filed a complaint against us in the USITC alleging that we have violated Section 337 of the Tariff Act of 1930, as amended. The USITC instituted Cisco's complaint as Investigation No. 337-TA-944. Cisco initially alleged that certain of our switching products infringe the ’592, ’537, ’145, ’164, ’597, and ’296 patents. Cisco subsequently dropped the ’296 patent from the 944 Investigation. Cisco sought, among other things, a limited exclusion order barring entry into the United States of accused switch products (including our 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 complaint in the 944 Investigation by, among other things, denying the patent infringement allegations and raising numerous affirmative defenses.

15


The Administrative Law Judge ("ALJ") 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 a Target Date for completion of the investigation on May 27, 2016. On January 27, 2016, the ALJ issued a revised procedural schedule extending the date for issuance of an initial determination to February 2, 2016 and extending the Target Date to June 2, 2016.
On February 2, 2016, the ALJ issued his initial determination finding a violation of section 337 of the Tariff Act. More specifically, the ALJ 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. The ALJ did not find a violation of section 337 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 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. On August 22, 2016, the Presidential review period for the 944 investigation expired. The USITC orders are currently in effect.
Both we and Cisco filed petitions for review of the USITCs Final Determination to the U.S. Court of Appeals for the Federal Circuit (“Federal Circuit”). On August 26, 2016, the Federal Circuit consolidated the appeals and, on September 23, 2016, it issued an order setting an expedited briefing schedule. Under this schedule, we filed our opening brief on September 23, 2016; Cisco’s opening brief is due November 2, 2016; the USITC’s brief is due on December 2, 2016; our response/reply brief is due December 19, 2016; and Cisco’s reply brief is due January 2, 2017.
On August 26, 2016, Cisco filed an enforcement complaint under Section 337 of the Tariff Act of 1930, as amended, with the USITC. Cisco alleges that we are violating the cease and desist order issued in the 944 Investigation by engaging in the “marketing, distribution, offering for sale, selling, advertising, and/or aiding or abetting other entities in the sale and/or distribution of products that Cisco alleges continue to infringe claims 1-2, 8-11, and 17-19 of the ’537 patent”, despite the design changes we have made to those products. Cisco asks the USTIC to (1) enforce the cease and desist order; (2) modify the Commission’s limited exclusion order and/or cease and desist order “in any manner that would assist in the prevention of the unfair practices that were originally the basis for issuing such Order or assist in the detection of violations of such Order”; (3) impose the maximum statutory civil penalties for violation of the cease and desist order “including monetary sanctions for each day’s violation of the cease and desist order of the greater of $100,000.00 or twice the domestic value of the articles entered or sold, whichever is higher”; (4) bring a civil action in U.S. district court “requesting collection of such civil penalties and the issuance of a mandatory injunction preventing further violation of Cease and Desist Order”; and (5) impose “such other remedies and sanctions as are appropriate and within the Commission’s authority.” On September 28, 2016, the Commission instituted the enforcement proceeding. The proceeding has been assigned to Administrative Law Judge Shaw, who presided over the underlying investigation. On October 14, 2016, we responded to the complaint by, among other things, denying the patent infringement allegations and raising numerous affirmative defenses.
Certain Network Devices, Related Software, and Components Thereof (Inv. No. 337-TA-945) (“945 Investigation”)
On December 19, 2014, Cisco filed a complaint against us in the USITC alleging that we violated Section 337 of the Tariff Act of 1930, as amended. The USITC instituted Cisco’s complaint as Investigation No. 337-TA-945. Cisco alleges that certain of our switching products infringe the ’577, ’853, ’875, ’668, ’492, and ’211 patents. Cisco seeks, among other things, a limited exclusion order barring entry into the United States of accused switch products (including our 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 notice of investigation and complaint in the 945 Investigation by, among other things, denying the patent infringement allegations and raising numerous affirmative defenses.
The ALJ 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 a Target Date for completion on August 26, 2016. 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 extending the Target Date to December 26, 2016. On April 19, 2016, the Commission determined not to review this decision. On August 24, 2016, the ALJ issued a revised procedural schedule extending the deadline for issuance of an initial determination to November 7, 2016, and extending the Target Date to March 7, 2016. On September 7, 2016, the Commission determined not to review this decision. The Initial Determination will be subject to review by the Commission, which will then issue a Final Determination and any remedial orders by March 7, 2017. If the Final Determination finds a violation, it will be subject to Presidential review.

16


Inter Partes Reviews
We have filed petitions for Inter Partes Review (“IPR”) of the ‘597, ‘211, ‘668, ‘853, ‘537, ‘577, ‘886, and ‘526 patents. IPRs relating to the ‘597 (IPR No. 2015-00978) and ‘211 (IPR No. 2015-00975) patents were instituted in October 2015 and hearings on these IPRs were completed in July 2016. On September 28, 2016, the PTAB issued a final written decision finding claims 1, 14, 39-42, 71, 72, 84, and 85 of the ’597 patent unpatentable. The PTAB also found that claims 29, 63, 64, 73, and 86 of the ’597 patent had not been shown to be unpatentable. We filed a notice of appeal with respect to this decision regarding claims 29, 63, 64, 73, and 86 on October 11, 2016, and Cisco requested rehearing of the PTAB’s Final Written Decision on October 28, 2016. On October 5, 2016, the PTAB issued a final written decision finding claims 1 and 12 of the ’211 patent unpatentable. The PTAB also found that claims 2, 6-9, 13, 17-20 of the ’211 patent had not been shown to be unpatentable.
IPRs relating to the ‘668 (IPR No. 2016-00309), ‘577 (IPR No. 2016-00303), ‘853 (IPR No. 2016-0306), and ‘537 (IPR No. 2016-0308) patents were instituted in June 2016 and are set for hearing in March 2017. Final Written Decisions on these IPRs will be issued by June 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, in the 944 Investigation, the USITC has issued a limited exclusion order barring entry into the United States of our network devices (including our 7000 Series of switches), related software and components thereof that infringe one or more of the claims of the ʼ537, ʼ592, and ʼ145 patents specified above and a cease and desist order restricting our activities with respect to such imported products.
In response to the USITC’s findings in the 944 Investigation, we have made design changes to our products for sale in the United States to address the features that were found to infringe the ‘537, ’592, ’145 patents. Following the issuance of the final determination in the 944 Investigation, we submitted a Section 177 ruling request to U.S. Customs and Border Protection (“CBP”) seeking approval to import these redesigned products into the United States, and we are awaiting CBP’s decision. If the USITC finds that we infringe any patent in the 945 Investigation, the USITC is likely to issue remedial orders in that investigation as well. If such orders are not disapproved by the United States Trade Representative, we would need to further modify our products to take our products outside the scope of any patents we are found to have infringed in the 945 Investigation. We may not be successful in developing technical design-arounds that do not infringe the patents or that are acceptable to our customers. Our development efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. We may not be successful in our efforts to obtain clearance from CBP to import such modified products in a timely manner, or at all. While clearance from CBP will allow us to resume importation of our redesigned products into the United States, the USITC could still determine in the enforcement action that our redesigned products continue to infringe the ‘537, ‘592 or ‘145 patents. Any failure to effectively redesign our products to obtain timely clearance from CBP to import such redesigned products, or to address the USITC’s findings in a manner that is compliant with the limited exclusion order and cease and desist order may cause a disruption in our product shipments and materially and adversely affect our business, prospects, reputation, results of operations, and financial condition.
We have also made certain changes to our manufacturing, importation and shipping workflows to comply with the USITC’s remedial orders. These changes have included shifting manufacturing and integration of our products to be sold in the United States to U.S. facilities. Such changes may be extremely costly, time consuming, and we may not be able to implement such changes successfully. Any failure to successfully change our manufacturing and importation processes or shipping workflows in a manner that is compliant with the limited exclusion order and cease and desist order may cause a disruption in our product shipments and materially and adversely affect our business, prospects, reputation, results of operations, and financial condition.
For example, if the USITC determines that our redesigned products continue to infringe the ‘537, ‘592 or ‘145 patents, the USITC may impose the maximum statutory civil penalties for violation of the cease and desist order “including monetary sanctions for each day’s violation of the cease and desist order of the greater of $100,000.00 or twice the domestic value of the articles entered or sold, whichever is higher,” bring a civil action in U.S. district court “requesting collection of such civil penalties and the issuance of a mandatory injunction preventing further violation of Cease and Desist Order” or impose “such other remedies and sanctions as are appropriate and within the Commission’s authority.”
Additionally, the existence of Cisco's lawsuits against us 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.

17


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.  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.

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
September 30,
Nine Months Ended
September 30,
 
2016
 
2015
2016
 
2015
Cost of revenue
$
955

 
$
786

$
2,616

 
$
2,206

Research and development
8,010

 
7,037

23,062

 
18,344

Sales and marketing
3,947

 
2,864

11,374

 
8,138

General and administrative
2,204

 
1,591

5,656

 
3,637

           Total stock-based compensation
$
15,116

 
$
12,278

$
42,708

 
$
32,325

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
 
(1,583
)
 
9.85

 
 
 
 
Options canceled
 
(314
)
 
30.22

 
 
 
 
Outstanding—September 30, 2016
 
10,173

 
$
28.00

 
7.1
 
$
580,661

Vested and exercisable—September 30, 2016
 
3,685

 
$
14.38

 
6.3
 
$
260,514

Vested and expected to vest—September 30, 2016
 
9,658

 
$
27.39

 
7.1
 
$
557,170

As of September 30, 2016, the total unrecognized stock-based compensation expense related to unvested stock options, net of expected forfeitures, was $95.4 million, which is expected to be recognized over a weighted-average period of 3.9 years.

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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
440

 
63.80

 
 
 
 
       RSUs vested
(178
)
 
69.66

 
 
 
 
       RSUs forfeited
(72
)
 
67.06

 
 
 
 
Unvested balance—September 30, 2016
1,083

 
$
67.85

 
1.7
 
$
92,120

Vested and expected to vest—September 30, 2016
1,015

 
$
67.86

 
1.7
 
$
86,357

As of September 30, 2016, there was $61.4 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 3.3 years.
Employee Stock Purchase Plan Activities
During the nine months ended September 30, 2016, we issued 256,223 shares at a weighted average purchase price of $40.30 under the 2014 Employee Stock Purchase Plan ("ESPP"). On February 17, 2015, the board authorized an increase to shares available for 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 for 2016 amounted to 681,315 shares. As of September 30, 2016, there remain 1,483,846 shares available for issuance under the ESPP. 
As of September 30, 2016, the total unrecognized stock-based compensation expense related to unvested ESPP options, net of expected forfeitures, was $6.1 million, which is expected to be recognized over a weighted-average period of 1.8 years.
Shares Available for Grant
The following table presents the stock activity and the total number of shares available for grant as of September 30, 2016 (in thousands):
 
 
 
 
 
Number of Shares
Balance—December 31, 2015
 
10,495

Authorized
 
2,044

Options granted
 
(440
)
RSUs granted
 
(440
)
Options canceled
 
314

Options repurchased
 
5

RSUs forfeited
 
72

Shares traded for taxes
 
11

Balance—September 30, 2016
 
12,061



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
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Numerator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Net income
$
51,257

 
$
28,690

 
$
125,406

 
$
77,178

Less: undistributed earnings allocated to participating securities
(295
)
 
(389
)
 
(931
)
 
(1,314
)
Net income available to common stockholders, basic
$
50,962

 
$
28,301

 
$
124,475

 
$
75,864

Diluted:
 
 
 
 
 
 
 
Net income attributable to common stockholders, basic
$
50,962

 
$
28,301

 
$
124,475

 
$
75,864

Add: undistributed earnings allocated to participating securities
18

 
28

 
56

 
$
103

Net income attributable to common stockholders, diluted
$
50,980

 
$
28,329

 
$
124,531

 
$
75,967

Denominator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
69,076

 
66,629

 
68,365

 
65,609

Diluted:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
69,076

 
66,629

 
68,365

 
65,609

Add weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and RSUs
4,357

 
5,163

 
4,429

 
5,529

Employee stock purchase plan
20

 
95

 
17

 
94

Weighted-average shares used in computing net income per share available to common stockholders, diluted
73,453

 
71,887

 
72,811

 
71,232

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
0.74

 
$
0.42

 
$
1.82

 
$
1.16

Diluted
$
0.69

 
$
0.39

 
$
1.71

 
$
1.07

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
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Stock options and RSUs to purchase common stock
2,688

 
2,544

 
3,215

 
2,275



20


8.
Income Taxes
Provision for income taxes was approximately $11.7 million and $1.9 million for the three months ended September 30, 2016 and 2015, and $39.7 million and $20.3 million for the nine months ended September 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 September 30, 2016 were $20.2 million. If the gross unrecognized tax benefits as of September 30, 2016 were realized in future periods, this could result in a tax benefit of $11.4 million within our provision of income taxes.
    
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
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
United States
$
233,018

 
$
166,466

 
$
612,852

 
$
437,922

Other Americas
4,081

 
4,130

 
8,205

 
10,294

Europe, Middle East and Africa
37,728

 
29,457

 
124,111

 
94,329

Asia-Pacific
15,434

 
17,495

 
56,030

 
49,600

Total revenue
$
290,261

 
$
217,548

 
$
801,198

 
$
592,145

The following table presents our property, plant and equipment, net by geographic region for the periods presented (in thousands):
 
September 30,
2016
 
December 31,
2015
United States
$
70,095

 
$
70,719

International
8,052

 
8,987

Total
$
78,147

 
$
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, and 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, and 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, we 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. In August 2016, we introduced our next-generation CloudVision and EOS telemetry and analytics capabilities designed for modern cloud networks.
As of September 30, 2016, we have shipped more than 10 million cloud networking ports worldwide. 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 September 30, 2016, including Australia, Canada, France, Germany, India, Ireland, Japan, South Korea and the United Kingdom. Our revenue for the three and nine months ended September 30, 2016 was $290.3 million and $801.2 million, respectively an increase of 33.4% and 35.3% 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 September 30, 2016, our cumulative end-customer base grew from approximately 1,100 to over 4,100. 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 nine months ended September 30, 2016 and 2015 from our unaudited condensed consolidated financial statements (in thousands, except for percentages).    
 
Three Months Ended
September 30,
Nine Months Ended
September 30,
 
2016
 
2015
2016
 
2015
Revenue:
 
 
 
 
 
 
Product
$
254,238

 
$
193,339

$
702,329

 
$
527,552

Service
36,023

 
24,209

98,869

 
64,593

Total revenue
290,261

 
217,548

801,198

 
592,145

Cost of revenue (1): 
 
 
 
 
 
 
Product
94,777

 
67,990

261,711

 
182,443

Service
9,064

 
7,810

26,526

 
22,310

Total cost of revenue
103,841

 
75,800

288,237

 
204,753

Gross profit
186,420

 
141,748

512,961

 
387,392

Operating expenses (1):
 
 
 
 
 
 
Research and development
70,648

 
58,748

202,183

 
152,035

Sales and marketing
33,216

 
26,508

92,566

 
77,776

General and administrative
19,535

 
25,195

52,298

 
57,670

Total operating expenses
123,399

 
110,451

347,047

 
287,481

Income from operations
63,021

 
31,297

165,914

 
99,911

Interest expense
(735
)
 
(753
)
(2,218
)
 
(2,406
)
Other income (expense), net
639

 
13

1,392

 
(38
)
Total other income (expense), net
(96
)
 
(740
)
(826
)
 
(2,444
)
Income before provision for income taxes
62,925

 
30,557

165,088

 
97,467

Provision for income taxes
11,668

 
1,867

39,682

 
20,289

Net income
$
51,257

 
$
28,690

$
125,406

 
$
77,178




26


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
 
(as a percentage of revenue)
Revenue:
 
 
 
 
 
 
 
Product
87.6
 %
 
88.9
 %
 
87.7
 %
 
89.1
 %
Service
12.4

 
11.1

 
12.3

 
10.9

Total revenue
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue:
 
 
 
 
 
 
 
Product
32.7

 
31.2

 
32.7

 
30.8

Service
3.1

 
3.6

 
3.3

 
3.8

Total cost of revenue
35.8

 
34.8

 
36.0

 
34.6

Gross margin
64.2

 
65.2

 
64.0

 
65.4

Operating expenses:
 
 
 
 
 
 
 
Research and development
24.3

 
27.0

 
25.2

 
25.7

Sales and marketing
11.5

 
12.2

 
11.6

 
13.1

General and administrative
6.7

 
11.6

 
6.5

 
9.8

Total operating expenses
42.5

 
50.8

 
43.3

 
48.6

Income from operations
21.7

 
14.4

 
20.7

 
16.8

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

 

 
0.2

 

Total other income (expense), net

 
(0.3
)
 
(0.1
)
 
(0.4
)
Income before provision for income taxes
21.7

 
14.1

 
20.6

 
16.4

Provision for income taxes
4.0

 
0.9

 
5.0

 
3.4

Net income
17.7
 %
 
13.2
 %
 
15.6
 %
 
13.0
 %
________________________________________________________________________ 
(1) Includes stock-based compensation expense as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Cost of revenue
$
955

 
$
786

 
$
2,616

 
$
2,206

Research and development
8,010

 
7,037

 
23,062

 
18,344

Sales and marketing
3,947

 
2,864

 
11,374

 
8,138

General and administrative
2,204

 
1,591

 
5,656

 
3,637

           Total stock-based compensation
$
15,116

 
$
12,278

 
$
42,708

 
$
32,325



27


Three and Nine Months Ended September 30, 2016 Compared to Three and Nine Months Ended September 30, 2015
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
254,238

 
$
193,339

 
$
60,899

 
31.5%
 
$
702,329

 
$
527,552

 
$
174,777

 
33.1%
Service
36,023

 
24,209

 
11,814

 
48.8
 
98,869

 
64,593

 
34,276

 
53.1
Total revenue
290,261

 
217,548

 
72,713

 
33.4
 
801,198

 
592,145

 
209,053

 
35.3
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
94,777

 
67,990

 
26,787

 
39.4
 
261,711

 
182,443

 
79,268

 
43.4
Service
9,064

 
7,810

 
1,254

 
16.1
 
26,526

 
22,310

 
4,216

 
18.9
Total cost of revenue
103,841

 
75,800

 
28,041

 
37.0
 
288,237

 
204,753

 
83,484

 
40.8
Gross profit
$
186,420

 
$
141,748

 
$
44,672

 
31.5%
 
$
512,961

 
$
387,392

 
$
125,569

 
32.4%
Gross margin
64.2
%
 
65.2
%
 
 
 
 
 
64.0
%
 
65.4
%
 

 
 

Revenue by Geography (in thousands, except percentages)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
% of Total
 
2015
 
% of Total
 
2016
 
% of Total
 
2015
 
% of Total
Americas
$
237,099

 
81.7
%
 
$
170,596

 
78.5
%
 
$
621,057

 
77.5
%
 
$
448,216

 
75.7
%
Europe, Middle East and Africa
37,728

 
13.0

 
29,457

 
13.5

 
124,111

 
15.5

 
94,329

 
15.9

Asia-Pacific
15,434

 
5.3

 
17,495

 
8.0

 
56,030

 
7.0

 
49,600

 
8.4

Total revenue
$
290,261

 
100.0
%
 
$
217,548

 
100.0
%
 
$
801,198

 
100.0
%
 
$
592,145

 
100.0
%
Revenue
Revenue increased 33.4% in the three months ended September 30, 2016 and 35.3% in the nine months ended September 30, 2016, compared to the same periods in 2015. The increase in each period was primarily driven by increased shipments to our existing customers as they continue 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. As of September 30, 2016, we have shipped more than 10 million cumulative cloud networking ports worldwide and our overall customer count has exceeded 4,100. Service revenue increased 48.8% in the three months ended September 30, 2016 and 53.1% during the nine months ended September 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 $28.0 million in the three months ended September 30, 2016 and $83.5 million in the nine months ended September 30, 2016, compared to the same periods in 2015. The increase in cost of revenue was primarily due to an increase in product shipment volumes. In addition, we incurred some increased costs as we added capacity to our manufacturing and operations infrastructure. Gross margin decreased from 65.2% to 64.2% for the three months ended September 30, 2016 compared to the same period in 2015, and from 65.4% to 64.0% for the nine months ended September 30, 2016 compared to the same period in 2015, respectively. The decrease during these periods was primarily the result of changes in customer mix as we expanded our business including increased contributions from larger customers who typically receive higher discount levels, and increased costs associated with the expansion of manufacturing and operations capacity. These unfavorable changes were partially offset by improved service margins as we scale our services business. We expect our gross margins in the fourth quarter of 2016 will reflect some further increases in product costs as we continue to invest in new contract manufacturing and supply chain operations.

28


Operating Expenses (in thousands, except percentages)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
70,648

 
$
58,748

 
$
11,900

 
20.3%
 
$
202,183

 
$
152,035

 
$
50,148

 
33.0%
Sales and marketing
33,216

 
26,508

 
6,708

 
25.3
 
92,566

 
77,776

 
14,790

 
19.0
General and administrative
19,535

 
25,195

 
(5,660
)
 
(22.5)
 
52,298

 
57,670

 
(5,372
)
 
(9.3)
Total operating expenses
$
123,399

 
$
110,451

 
$
12,948

 
11.7%
 
$
347,047

 
$
287,481

 
$
59,566

 
20.7%
Research and development
Research and development expenses increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in each period was primarily due to an increase in third-party engineering, prototype and consulting costs, which grew $9.2 million and $24.2 million in the three months and nine months ended September 30, 2016, respectively as compared to the same periods in 2015. These increases related to additional outsourced development projects, increased internal development activity related to new products and increased costs associated with litigation-related changes in product design. Personnel costs increased by $3.9 million and $22.4 million in the three and nine ended September 30, 2016, respectively as compared to the same periods in 2015. These increases reflected additional headcount, increased stock-based compensation charges, and additional bonus expenses under our corporate bonus program. Facilities and IT infrastructure costs increased $2.4 million in the nine months ended September 30, 2016 compared to the same period in 2015, primarily due to the expansion and support of our research and development activities.
Sales and marketing
Sales and marketing expenses increased for the three and nine months ended September 30, 2016 compared to the same periods in 2015. The increase in each period was primarily due to an increase in personnel costs, which grew $6.6 million and $15.3 million in the three and nine months ended September 30, 2016, respectively as compared to the same periods in 2015. These increases reflected additional headcount, additional sales incentive compensation due to higher sales volumes, and additional bonus expenses under our corporate bonus program. The increase in the nine-month period was partially offset by a decrease in product field demonstration costs of $1.6 million primarily related to significant costs incurred in the previous year due to several product transitions to our next generation products.
General and administrative
General and administrative expenses decreased for the three and nine months ended September 30, 2016 compared to the same periods in 2015. The decrease in each period was primarily due to a reduction in litigation expenses of $6.8 million and $8.5 million in the three and nine months ended September 30, 2016 respectively as compared to the same periods in 2015. These decreases were primarily related to the timing of litigation activities associated with the Cisco and OptumSoft legal matters outlined in Note 5 to the Consolidated Financial Statements. This was partially offset by an increase in personnel costs of $0.8 million and $3.2 million in the three and nine months ended September 30, 2016 respectively as compared to the same periods in 2015. These increases reflected additional headcount, increased stock-based compensation charges, and additional bonus expenses under our corporate bonus program.
    

29


Other Income (Expense), Net (in thousands, except percentages)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Other income (expense), net:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   Interest expense
$
(735
)
 
$
(753
)
 
$
18

 
2.4%
 
$
(2,218
)
 
$
(2,406
)
 
$
188

 
7.8%
   Other income (expense), net
639

 
13

 
626

 
4,815.4
 
1,392

 
(38
)
 
1,430

 
3,763.2
      Total other income (expense), net
$
(96
)
 
$
(740
)
 
$
644

 
87.0%
 
$
(826
)
 
$
(2,444
)
 
$
1,618

 
66.2%
Other income (expense), net
Other income (expense), net improved during the three and nine months ended September 30, 2016 compared to the same periods in 2015 primarily due to a net increase in interest income as we expanded our marketable securities portfolio during the nine months ended September 30, 2016.
Provision for Income Taxes (in thousands, except percentages)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
Change in
 
2016
 
2015
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Provision for income taxes
$
11,668

 
$
1,867

 
$
9,801

 
525.0%
 
$
39,682

 
$
20,289