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EX-32.1 - CEO AND CFO 906 CERTIFICATION - Arista Networks, Inc.ex321ceoandcfo906certifica.htm
EX-31.2 - CFO 302 CERTIFICATION - Arista Networks, Inc.ex312cfocertificationq317.htm
EX-31.1 - CEO 302 CERTIFICATION - Arista Networks, Inc.ex311ceocertificationq317.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, 2017
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, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth 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
 
 
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of October 27, 2017 was 73,100,644.
 






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,
2017
 
December 31,
2016
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
854,479

 
$
567,923

Marketable securities
488,635

 
299,910

Accounts receivable, net of allowances of $7,495 and $1,521, respectively
212,611

 
253,119

Inventories
333,157

 
236,490

Prepaid expenses and other current assets
186,657

 
168,684

Total current assets
2,075,539

 
1,526,126

Property and equipment, net
73,061

 
76,961

Investments
36,136

 
36,136

Deferred tax assets
95,697

 
70,960

Other assets
21,277

 
18,824

TOTAL ASSETS
$
2,301,710

 
$
1,729,007

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
32,893

 
$
79,457

Accrued liabilities
94,459

 
90,951

Deferred revenue
423,705

 
273,350

Other current liabilities
16,490

 
15,795

Total current liabilities
567,547

 
459,553

Income taxes payable
22,161

 
14,498

Lease financing obligations, non-current
38,199

 
39,593

Deferred revenue, non-current
141,440

 
99,585

Other long-term liabilities
7,811

 
7,958

TOTAL LIABILITIES
777,158

 
621,187

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, 2017 and December 31, 2016

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of September 30, 2017 and December 31, 2016; 73,067 and 70,811 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively
7

 
7

Additional paid-in capital
770,339

 
674,183

Retained earnings
755,281

 
435,105

Accumulated other comprehensive loss
(1,075)

 
(1,475
)
TOTAL STOCKHOLDERS’ EQUITY
1,524,552

 
1,107,820

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
2,301,710

 
$
1,729,007

    
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,
 
2017
 
2016
 
2017
 
2016
Revenue:
 
 
 
 
 
 
 
Product
$
380,344

 
$
254,238

 
$
1,025,615

 
$
702,329

Service
57,289

 
36,023

 
152,704

 
98,869

Total revenue
437,633

 
290,261

 
1,178,319

 
801,198

Cost of revenue:
 
 
 
 
 
 
 
Product
145,874

 
94,777

 
390,116

 
261,711

Service
11,142

 
9,064

 
33,599

 
26,526

Total cost of revenue
157,016

 
103,841

 
423,715

 
288,237

Total gross profit
280,617

 
186,420

 
754,604

 
512,961

Operating expenses:
 
 
 
 
 
 
 
Research and development
79,610

 
70,648

 
242,414

 
202,183

Sales and marketing
40,640

 
33,216

 
116,297

 
92,566

General and administrative
19,535

 
19,535

 
65,009

 
52,298

Total operating expenses
139,785

 
123,399

 
423,720

 
347,047

Income from operations
140,832

 
63,021

 
330,884

 
165,914

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense
(701
)
 
(735
)
 
(2,039
)
 
(2,218
)
Other income (expense), net
2,136

 
639

 
4,280

 
1,392

Total other income (expense), net
1,435

 
(96
)
 
2,241

 
(826
)
Income before provision for income taxes
142,267

 
62,925

 
333,125

 
165,088

Provision for income taxes
8,545

 
11,668

 
13,757

 
39,682

Net income
$
133,722

 
$
51,257

 
$
319,368

 
$
125,406

Net income attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
133,540

 
$
50,962

 
$
318,643

 
$
124,475

Diluted
$
133,555

 
$
50,980

 
$
318,704

 
$
124,531

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
1.84

 
$
0.74

 
$
4.43

 
$
1.82

Diluted
$
1.68

 
$
0.69

 
$
4.06

 
$
1.71

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
72,588

 
69,076

 
71,903

 
68,365

Diluted
79,322

 
73,453

 
78,528

 
72,811


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,
 
2017
 
2016
 
2017
 
2016
Net income
$
133,722

 
$
51,257

 
$
319,368

 
$
125,406

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
343

 
(165
)
 
500

 
(402
)
Net change in unrealized gains (losses) on available-for-sale securities
(165)

 
(113
)
 
(100
)
 
94

        Other comprehensive income (loss)
178

 
(278)

 
400

 
(308)

Comprehensive income
$
133,900

 
$
50,979

 
$
319,768

 
$
125,098


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,
 
2017
 
2016
Cash flows from operating activities
 
 
 
Net income
$
319,368

 
$
125,406

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
15,355

 
14,807

Stock-based compensation
54,991

 
42,708

Deferred income taxes
(22,743
)
 
(13,720
)
Amortization of investment premiums
1,106

 
994

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
40,508

 
(65,980
)
Inventories
(96,667
)
 
(69,998
)
Prepaid expenses and other current assets
(20,973
)
 
(98,050
)
Other assets
(1,560
)
 
3,208

Accounts payable
(46,075
)
 
35,510

Accrued liabilities
4,175

 
15,913

Deferred revenue
192,210

 
88,027

Income taxes payable
7,421

 
27,275

Other liabilities
847

 
2,628

Net cash provided by operating activities(1)
447,963

 
108,728

Cash flows from investing activities
 
 
 
Proceeds from marketable securities
135,483

 
41,917

Purchases of marketable securities
(325,414
)
 
(342,484
)
Purchases of property and equipment
(12,159
)
 
(16,484
)
Proceeds from repayment of notes receivable
3,000

 

Investment in privately-held companies

 
(2,500
)
Change in restricted cash
(1,257
)
 

Net cash used in investing activities
(200,347
)
 
(319,551
)
Cash flows from financing activities
 
 
 
Principal payments of lease financing obligations
(1,170
)
 
(960
)
Proceeds from issuance of common stock under equity plans
41,870

 
25,882

Minimum tax withholding paid on behalf of employees for net share settlement
(2,457
)
 
(811
)
Net cash provided by financing activities(1)   
38,243

 
24,111

Effect of exchange rate changes
697

 
(133
)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
286,556

 
(186,845
)
CASH AND CASH EQUIVALENTS—Beginning of period
567,923

 
687,326

CASH AND CASH EQUIVALENTS—End of period
$
854,479

 
$
500,481

Supplemental disclosures of non-cash investing activities:
 
 
 
Property and equipment included in accounts payable and accrued liabilities
$
468

 
$
1,313

(1)During our first fiscal quarter of 2017, we adopted Accounting Standards Update 2016-09, "Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting." Refer to Note 1 Recently Adopted Accounting Pronouncements for further details. This adoption resulted in a $30.0 million increase in net cash provided by operating activities and a corresponding $30.0 million decrease in net cash provided by financing activities for the nine months ended September 30, 2016.

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.
Organization and Summary of Significant Accounting Policies
Arista Networks, Inc. (together with our subsidiaries, “we,” “our” or “us”) is a supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation enterprise. Our cloud networking solutions consist of our Extensible Operating System (“EOS”), a set of network applications and our 10/25/40/50/100 Gigabit Ethernet switching and routing platforms. We were incorporated in October 2004 in the State of California under the name Arastra, Inc. In March 2008, we reincorporated in the State of Nevada and in October 2008 changed our name to Arista Networks, Inc. We 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 and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and the requirements of the U.S. Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. In management’s opinion, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our financial information. The results for the three and nine months ended September 30, 2017, are not necessarily indicative of the results expected for the full fiscal year. The condensed consolidated balance sheet as of December 31, 2016 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by GAAP for complete financial statements. Our unaudited condensed consolidated financial statements ("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.
Our 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, 2016, filed with the SEC on February 17, 2017.
Use of Estimates
The preparation of the accompanying consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and accompanying notes. Those estimates and assumptions include, but are not limited to, revenue recognition and deferred revenue; allowance for doubtful accounts 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; contract manufacturing liabilities; and recognition and measurement of contingent liabilities. We evaluate our estimates and assumptions based on historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. Actual results could differ materially from those estimates.
Recently Adopted Accounting Pronouncements
In March 2016, the Financial Accounting Standards Board (the “FASB”) amended the existing accounting standard for stock-based compensation, issuing Accounting Standards Update (“ASU”) 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which impacts 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. We adopted this standard during our first fiscal quarter of 2017. The impact of the adoption was as follows:    
Income tax accounting - The standard eliminates additional paid-in-capital (“APIC”) pools and requires excess tax benefits and tax deficiencies on share-based awards to be recognized in the income statement prospectively as discrete items upon exercise or vesting of such awards. The standard also requires excess tax benefits to be recognized regardless of whether the benefit reduces taxes payable. We adopted the guidance related to the timing of previously unrecognized excess tax benefits on a modified retrospective basis, which resulted in the recognition of a cumulative

7


effect adjustment of $1.8 million that increased retained earnings and increased our long-term deferred income tax as of January 1, 2017.
Earnings per share - Because excess benefits are no longer recognized in APIC, the assumed proceeds from applying the treasury stock method when calculating dilutive shares was amended to exclude the amount of excess tax benefits that would be recognized upon exercise or vesting of such awards. As a result, this reduces the assumed shares to be repurchased under the treasury stock method, thereby increasing the amount of dilutive shares used to compute earnings per share. We adopted the guidance related to the exclusion of excess tax benefits in calculating earnings per share on a prospective basis.
Forfeitures of stock options and awards - Under the new standard, we can make an accounting policy election to either estimate the number of share-based awards that are expected to vest, or account for forfeitures when they occur. We elected to account for forfeitures when they occur and adopted this change on a modified retrospective basis. As a result, we recorded the cumulative effect of the change as a $1.0 million decrease to retained earnings as of January 1, 2017.
Cash flow presentation of excess tax benefits - Prior to the new standard, we were required to present excess tax benefits on share-based awards as a cash inflow from financing activities with a corresponding cash outflow from operating activities. The new standard required that these excess tax benefits be classified with other income tax cash flows as an operating activity. We elected to adopt the guidance related to the presentation of excess tax benefits in our condensed consolidated statements of cash flows on a retrospective basis.

In April 2015, the FASB issued ASU 2015-05, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, providing guidance on fees paid in a cloud computing arrangement. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. We adopted this standard in our first quarter of fiscal 2017 on a prospective basis, and the adoption did not have a material impact on our consolidated financial statements.

In July 2015, the FASB issued ASU No, 2015-11, Inventory: Simplifying the Measurement of Inventory, which simplifies the measurement of inventory to be measured at the lower of cost or net realizable value. The guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. We adopted this standard in our first quarter of fiscal 2017 on a prospective basis, and the adoption did not have a material impact on our consolidated financial statements.
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, and in December 2016, by ASU No. 2016-20-Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers), which outlines a single 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

8


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.
The standards are expected to impact the amount and timing of revenue recognized and the related disclosures on our consolidated financial statements. The standard will also require that we defer all incremental commission costs to obtain a customer contract. We are currently evaluating the accounting, transition and disclosure requirements of the standard and are in the process of assessing the financial statement impact upon adoption. We will adopt ASU 2014-09 during the first quarter of 2018, and expect to adopt the guidance under the modified retrospective method which we anticipate will result in a cumulative effect adjustment as of the date of adoption.
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, and may be early adopted under early application guidance. While we are currently assessing the impact this guidance may have on our consolidated financial statements, we expect the adoption of this standard to increase the variability of other income (expense), net on our consolidated financial statements as a result of changes in the fair value of our marketable equity securities.
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 June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires a financial asset measured at amortized cost basis to be presented at the net amount expected to be collected. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses. This standard is effective for us for our first quarter of 2020. We are currently assessing the impact this guidance may have on our consolidated financial statements.
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. While we are currently assessing the impact this guidance may have on our consolidated financial statements, we do not expect the guidance to have a material impact 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. We are currently assessing the impact this guidance may have on our consolidated financial statements.

9



In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force which requires that amounts generally described as restricted cash or restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This standard is effective for us for our first quarter of fiscal 2018, and may be early adopted. We do not anticipate this standard will have a material impact on our consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718) Scope of Modification Accounting which addresses providing clarity to reduce diversity in practice, cost and complexity in the application of modification accounting when there is a change in terms or conditions of a share-based payment award. The guidance will be applied on a prospective basis to awards modified on or after the adoption date. This standard is effective for us for our first quarter of fiscal 2018, and may be early adopted. We do not anticipate this standard will have a material impact 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.

10


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):
 
September 30, 2017
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
Money market funds
$
319,584

 
$

 
$

 
$
319,584

Money market funds-restricted
5,502

 

 

 
5,502

Commercial paper
11,879

 

 

 
11,879

U.S. government notes
104,722

 

 

 
104,722

Corporate bonds

 
372,034

 

 
372,034

Total financial assets
$
441,687

 
$
372,034

 
$


$
813,721


 
December 31, 2016
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
Money market funds
$
305,182

 
$

 
$

 
$
305,182

Money market funds-restricted
4,245

 

 

 
4,245

Commercial paper
5,962

 

 

 
5,962

U.S. government notes
110,756

 

 

 
110,756

Corporate bonds

 
183,192

 

 
183,192

Total financial assets
$
426,145

 
$
183,192

 
$

 
$
609,337


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, 2017
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
$
11,879

 
$

 
$

 
$
11,879

U.S. government notes
104,955

 

 
(233
)
 
104,722

Corporate bonds
372,354

 
77

 
(397
)
 
372,034

Total marketable securities
$
489,188

 
$
77

 
$
(630
)
 
$
488,635


 
December 31, 2016
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
$
5,962

 
$

 
$

 
$
5,962

U.S. government notes
110,945

 
5

 
(194
)
 
110,756

Corporate bonds
183,455

 
109

 
(372
)
 
183,192

Total marketable securities
$
300,362

 
$
114

 
$
(566
)
 
$
299,910

As of September 30, 2017 and December 31, 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, 2017.

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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, 2017, 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, 2017
Due in 1 year or less
 
$
300,957

Due in 1 year through 2 years
 
187,678

Total marketable securities
 
$
488,635

The weighted average remaining duration of our current marketable securities is approximately 0.8 years as of September 30, 2017. As we view these securities as available to support current operations, we classify securities with maturities beyond 12 months as current assets under the caption marketable securities in the accompanying unaudited condensed consolidated balance sheets.
Accounts Receivable, net
Accounts receivable, net consists of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Accounts receivable
$
220,106

 
$
254,640

Allowance for doubtful accounts
(81
)
 
(204
)
Sales return reserve
(7,414
)
 
(1,317
)
Accounts receivable, net
$
212,611

 
$
253,119

Inventories
Inventories consist of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Raw materials
$
99,640

 
$
99,190

Finished goods
233,517

 
137,300

Total inventories
$
333,157

 
$
236,490


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Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Inventory deposit
$
31,957

 
$
60,315

Prepaid income taxes
14,583

 
17,383

Other current assets
126,190

 
79,140

Other prepaid expenses and deposits
13,927

 
11,846

Total prepaid expenses and other current assets
$
186,657

 
$
168,684

Property and Equipment, net
    Property and equipment, net consists of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Equipment and machinery
$
46,550

 
$
40,721

Computer hardware and software
21,527

 
17,420

Furniture and fixtures
2,993

 
2,879

Leasehold improvements
30,491

 
29,498

Building
35,154

 
35,154

Construction-in-process
135

 
421

Property and equipment, gross
136,850

 
126,093

Less: accumulated depreciation
(63,789
)
 
(49,132
)
Property and equipment, net
$
73,061

 
$
76,961

Depreciation and amortization expense was $5.2 million and $5.1 million, for the three months ended September 30, 2017 and 2016, respectively, and $15.0 million and $14.8 million for the nine months ended September 30, 2017 and 2016, respectively.
Accrued Liabilities     
Accrued liabilities consist of the following (in thousands):
 
September 30,
2017
 
December 31,
2016
Accrued compensation costs
$
44,477

 
$
52,854

Accrued warranty costs
8,286

 
6,744

Accrued manufacturing costs
25,592

 
14,824

Accrued professional fees
6,666

 
6,829

Accrued taxes
1,315

 
1,098

Other
8,123

 
8,602

Total accrued liabilities
$
94,459

 
$
90,951

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 unaudited condensed consolidated balance sheets.

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The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
Nine Months Ended September 30,
 
2017
 
2016
Warranty accrual, beginning of period
$
6,744

 
$
4,718

Liabilities accrued for warranties issued during the period
5,020

 
3,420

Warranty costs incurred during the period
(3,478
)
 
(2,541
)
Warranty accrual, end of period
$
8,286

 
$
5,597



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4.    Investments
Investments in Privately-held Companies    
As of September 30, 2017 and December 31, 2016, we held non-marketable equity investments of approximately $36.1 million in privately-held companies which are accounted for under the cost method. To date, we have not recognized any impairment losses on our investments.
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 2025. 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 $2.5 million and $2.3 million for the three months ended September 30, 2017 and 2016, respectively, and $7.5 million and $7.0 million for the nine months ended September 30, 2017 and 2016, respectively. 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, 2016.
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 operating lease commitments under contractual obligation, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.
As of September 30, 2017 and December 31, 2016, 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 $40.0 million and $41.2 million, respectively. As of September 30, 2017, $1.8 million and $38.2 million were recorded as short-term and long-term financing obligations, respectively.
Land lease expense related to our lease financing obligation is classified as rent expense in our unaudited condensed consolidated statements of income, and amounted to $0.3 million and $1.0 million for the three and nine months ended September 30, 2017, respectively, and $0.3 million and $1.0 million for the three and nine months ended September 30, 2016, 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, 2017, we had non-cancelable purchase commitments of $131.8 million. In addition, we have provided deposits to secure our obligations to purchase inventory. We had $34.7 million and $63.1 million in deposits as of September 30, 2017 and December 31, 2016, respectively. These deposits are classified in other current and long term assets in our accompanying unaudited condensed consolidated balance sheets.

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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

16


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.
As described below, on May 25, 2016, our petition for Inter Partes Review (“IPR”) of the ’886 patent was instituted by the United States Patent Trial and Appeal Board (“PTAB”). Cisco subsequently agreed to dismiss its claims as to the ‘886 patent with prejudice.
On December 14, 2016, following a two-week trial, the jury found that we had proven our copyright defense of scenes a faire and that Cisco had failed to prove infringement of the ’526 patent, and on that basis judgment was entered in our favor on all claims on December 19, 2016.
On January 17, 2017, Cisco filed a motion for judgment as a matter of law, challenging the sufficiency of the evidence in support of our scenes a faire defense. Cisco did not file any post-trial motion regarding the ’526 patent, nor did it file a motion for a new trial. We also filed a conditional motion for judgment as a matter of law and/or for a new trial on several grounds, which would be at issue only if the court granted Cisco’s motion. The hearing on both parties’ motions was held on April 27, 2017. On May 10, 2017, the court denied Cisco’s motion and denied our motions as moot.
Cisco filed a notice of appeal on June 6, 2017, and the parties are in the process of submitting their appeal briefs.
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 August 23, 2016, the Court granted Cisco’s motion to stay the ’23 Case until judgment was entered on Cisco’s copyright claims in the ’44 Case. On March 2, 2017, the Court lifted the stay and trial is set for August 3, 2018.
On March 23, 2017, Cisco filed a motion to dismiss our complaint in the ’23 Case. On October 10, 2017, the Court issued an order granting in part and denying in part Cisco’s motion to dismiss, with leave for us to amend to cure any deficiencies as to the claims that were dismissed.
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 violated 19 U.S.C. § 1337 (“Section 337”). 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

17


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 2, 2016, the Administrative Law Judge (“ALJ”) issued his initial determination finding a violation of Section 337. 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 infringed 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 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 will be in effect until the expiration of the ’537, ’592, and ’145 patents.
Both we and Cisco filed petitions for review of the USITC’s Final Determination to the U.S. Court of Appeals for the Federal Circuit (“Federal Circuit”). The appeal was fully briefed and oral argument was held on June 6, 2017. On September 27, 2017, the Federal Circuit affirmed the USITC’s Final Determination.
On August 26, 2016, Cisco filed an enforcement complaint under Section 337 with the USITC. Cisco alleges that we are violating the cease and desist and limited exclusion orders 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 USITC 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 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 ALJ Judge Shaw, who presided over the underlying investigation. The target date for the investigation was initially set for September 20, 2017. On June 20, 2017, the ALJ issued his initial determination finding that we did not violate the June 23, 2016 cease and desist order. The initial determination also recommended a civil penalty of $307 million if the Commission decided to overturn the finding of no violation. On July 3, 2017, the parties filed petitions for review of certain findings in the initial determination.
On August 4, 2017, the Commission issued an order remanding the investigation to the ALJ to make additional findings on certain issues and issue a remand initial determination. The Commission ordered the ALJ to set a schedule for completion of any necessary remand proceedings and a new target date for the enforcement action. On August 25, 2017 the ALJ issued an Initial Determination setting a June 4, 2018 deadline for the remand initial determination and September 4, 2018 as the new target date for the enforcement action. The ALJ also set a briefing schedule and a February 1, 2018 hearing. On September 18, 2017, the Commission determined not to review the Initial Determination setting the target date.
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. 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) related software, and components thereof and a cease and desist order against us restricting our activities with respect to our imported accused switch products, related software, and components thereof.
On December 9, 2016, the ALJ issued her initial determination finding a violation of Section 337. 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, 7, 9, 10, and 15 of the ’577 patent and asserted claims 1, 2, 4, 5, 7, 8, 10, 13, 19, 56, and 64 of the ’668 patent. The ALJ did not find a violation of Section 337 with respect to asserted claim 2 of the ’577 patent or any asserted claims of the ’853, ’492, ’875, and ’211 patents. On December 29, 2016, we, Cisco and the Office of Unfair Import Investigation (“OUII”) filed petitions for review of certain findings contained in the initial determination. On March 1, 2017, the Commission issued a notice that it was reviewing the final initial determination in part on certain issues.

18


On May 4, 2017, the Commission issued its Final Determination, which found a violation with respect to the ’577 and ’668 patents, and found no violation with respect to the ’211, ’853, ’875 and ’492 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, 7, 9, 10, and 15 of the ’577 patent and 1, 2, 4, 5, 7, 8, 10, 13, 18, 56, and 64 of the ’668 patent. The 60-day Presidential review period for the 945 Investigation expired on July 4, 2017. During the 60-day Presidential review period, the USITC Orders permitted Arista to continue importing and selling products covered by the orders so long as we paid a 5% bond. Because the United States Trade Representative did not disapprove the USITC’s final determination, the limited exclusion order and cease and desist order are now in full effect.
On May 25, 2017 and June 1, 2017, the PTAB issued final written decisions finding all claims of the ’577 and ’668 patents that we were found to have infringed in the 945 Investigation unpatentable. On June 1, 2017 and June 2, 2017, we filed emergency petitions to suspend the remedial orders in the 945 Investigation. On July 20, 2017, the Commission issued a notice denying our petition to suspend the remedial orders. On July 21, 2017, we filed a motion to stay the remedial orders in the 945 Investigation pending disposition of the relevant appeals and sought expedited consideration of our motion. On September 11, 2017, the Commission denied our motion to stay.
On June 30, 2017, Cisco filed a petition for review of the USITC’s Final Determination to the Federal Circuit regarding the ’853, ’492, ’875 and ’211 patents. On July 21, 2017, we filed a petition for review of the Final Determination to the Federal Circuit.
On August 25, 2017 we filed a motion with the U.S. Court of Appeals for the Federal Circuit requesting that the Federal Circuit stay the remedial orders pending the completion of the appeal of the 945 Investigation. On September 22, 2017, the Federal Circuit issued an order denying our motion to stay, but ordered that our redesigned products be allowed to enter the country “unless and until Commission proceedings are initiated and completed to produce an enforceable determination that such a redesign is barred” by a Commission remedial order.
On September 27, 2017, Cisco filed a petition with the USITC requesting that the Commission institute a modification proceeding to determine whether our redesigned products infringe the patent claims underlying the remedial orders in the 945 Investigation. On October 27, 2017, the Commission instituted the modification proceeding. The USITC has assigned Mary Joan McNamara as the ALJ to oversee the proceeding. The Commission has set a deadline of five months for the ALJ to issue a recommended determination on what, if any, modifications to the remedial orders issued in the 945 Investigation are appropriate. This deadline may be extended by one month upon a showing of good cause. The recommended determination will be subject to review by the Commission after which the Commission will issue a final determination. The Commission has not set a target date for the final determination. On November 1, 2017, Cisco filed a request for an expedited “limited recommended determination” on certain issues relating to the ’577 patent. Cisco’s request seeks completion of briefing by December 11, 2017 and a recommended determination “as soon as practicable” after that.
Inter Partes Reviews
We have filed petitions for Inter Partes Review 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. 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. Both parties have appealed the final written decisions on the ’211 and ’537 patent IPRs.
The IPR relating to the ’886 patent was instituted on May 25, 2016. Following that decision, 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.
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 hearings were held on March 7, 2017. On May 25, 2017, the PTAB issued final written decisions finding claims 1, 7-10, 12-16, 18-22, 25, and 28-31 of ’577 patent unpatentable, and that claim 2 of the ’577 patent, claim 63 of the ’853 patent, and claims 1, 10, 19, and 21 of the ’537 patent had not been shown to be unpatentable. On June 1, 2017, the PTAB issued a final written decision finding claims 1-10, 12-13, 15-28, 30-31, 33-36, 55-64, 66-67, and 69-72 of the ’668 patent unpatentable. We filed a Notice of Appeal concerning the ’577 patent on July 21, 2017, and Notices of Appeal concerning the ‘853 and ’537 patents on July 26, 2017. Cisco cross-appealed concerning the ’577 patent on July 26, 2017 and filed a Notice of Appeal concerning the ’668 patent on August 1, 2017. For the appeals of the IPRs on the ’668 and ’577 patents, the Federal Circuit granted our motion for an expedited briefing schedule, and the briefing will be completed in November 2017.
* * * * *

19


We intend to vigorously defend against each of the Cisco lawsuits, as summarized in the preceding paragraphs. However, we cannot be certain that any claims by Cisco will be resolved in our favor regardless of the merit of the claims. Any adverse litigation ruling could result in injunctive relief, including the above described injunctive relief, could lead to significant penalties assessed or damages awarded against us or a requirement that we make substantial royalty payments to Cisco, and/or could require that we modify our products.
For example, in the 944 Investigation, the USITC 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 ’537, ʼ592, and ʼ145 patents specified above and a cease and desist order restricting our activities with respect to such imported products. In the 945 Investigation, the USITC issued a limited exclusion order barring entry into the United States of our network devices, related software, and components thereof that infringe one or more of the claims of the ’577 and ’668 patents specified above and a cease and desist order restricting our activities with respect to such imported products.
To comply with these orders, we have sought to develop technical redesigns that no longer infringe the patents that are the subject of the orders. In any efforts to develop these technical redesigns for our products, we may be unable to do so in a manner that does not continue to infringe the patents or that is acceptable to our customers. Our redesign efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. Moreover, our ability to import redesigned products into the United States is based on rulings from U.S. Customs and Border Protection (“CBP”) and the Federal Circuit. While these favorable rulings currently allow us to import our redesigned products into the United States, the USITC could determine in an enforcement action or modification proceeding that our redesigned products continue to infringe the patents that are the subject of any USITC orders. In addition, the Federal Circuit or CBP could decide to withdraw or alter their rulings based on a change in circumstances. Any failure to effectively redesign our products, obtain customer acceptance of those redesigned products, retain authorization to import those redesigned products, or address the USITC findings in a manner that complies with the USITC orders, may cause a disruption to our product shipments, a rejection or return of our redesigned products by (or a delay or loss of sales to) customers, subject us to penalties or damage awards, and materially and adversely affect our business, revenues, prospects, reputation, results of operations, and financial condition.
Specifically, 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, and ’145 patents. Following the issuance of the final determination in the 944 Investigation, we submitted a Section 177 ruling request to CBP seeking approval to import these redesigned products into the United States. On November 18, 2016, we received a 177 ruling from CBP finding that our redesigned products did not infringe the relevant claims of the ʼ537, ’592, and ʼ145 patents, and approving the importation of those redesigned products into the United States. On January 13, 2017, at the request of Cisco and without our input, CBP issued a letter to us revoking its prior November 18 ruling. CBP subsequently conducted an inter partes proceeding between Arista and Cisco to determine whether our redesigned products infringe and whether to approve them for importation into the United States. On April 7, 2017, following the inter partes proceeding, CBP again ruled that our redesigned products do not infringe the relevant claims of the ’537, ’592, and ’145 patents and again approved those redesigns for importation into the United States. On September 12, 2017, Cisco filed a second request with CBP seeking to revoke our approval to import our redesigns relating to the 944 Investigation. We have opposed Cisco’s request, and CBP has not yet ruled on Cisco’s request.
Similarly, on May 4, 2017, the USITC issued a limited exclusion order and cease and desist order in the 945 Investigation with respect to the ’668 and ’577 patents. We have made design changes to our products for sale in the United States to address the features that were found to infringe the ’577 and ’668 patents. We are making ongoing modifications to our products to also ensure that they continue to meet customer requirements, and we are working with our customers to qualify those modified products for use in our customers’ networks. In particular, the ’577 patent was directed to a feature that is implemented in the merchant silicon chips that we purchase from third-party suppliers. Because we do not design, build or manufacture these merchant silicon chips, we are limited in further modifications that we can make to our products for this patent. We are deploying these additional modifications for a subset of our products, and for all of our products we will remove the features found to infringe until the ’577 patent expires on June 30, 2018. These redesign and qualification efforts could be extremely costly and time consuming for us and our customers as well as disruptive to our other development activities and distracting to management. We may not be able to complete, and our customers may not be able to qualify these redesigned products in a timely fashion, if at all. For example, some of our customers continue to test and qualify our redesigned products which address the ’577 and ’668 patents to ensure that they meet their network requirements. This could result in an inability to ship those redesigned products to our customers, a delay or cancellation of purchases by, some customers until those further modifications are completed and/or qualified or a rejection or return of our redesigned products or a delay or loss of sales to some customers, any of which could materially and adversely affect our business, revenues, deferred revenue balances, prospects, reputation, results of operations or financial condition.
Because the USITC did not suspend its orders in the 945 Investigation, despite a PTAB finding that every relevant claim of the ’668 and ’577 patents is unpatentable, we were previously barred from importing our redesigned products into the United States until we received approval from CBP. On July 21, 2017, we submitted a Part 177 request to CBP seeking approval to import our redesigned products into the United States. Following the Federal Circuit’s order on September 22,

20


2017, allowing us to import our redesigned products, we withdrew our request. On October 12, 2017, CBP, over Cisco’s objection, terminated the Part 177 proceedings, and confirmed that it will permit entry of our redesigns pursuant to the Federal Circuit’s September 22, 2017 order.
In either the 944 or 945 Investigations, if the USITC determines that our redesigned products infringe patents that are the subject of USITC remedial orders, those products will be barred from import into the United States, or sale after importation. In addition, 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 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.” In the 944 Investigation, the ALJ recommended a civil penalty of $307 million if the Commission were to reverse ALJ’s finding of no violation. Any such finding by the USITC could materially and adversely affect our business, prospects, reputation, results of operations and financial condition.
An adverse finding in an enforcement action or modification proceeding would take effect immediately upon USITC’s issuance of the final determination, without any Presidential review period. To address such a finding, we would have to further redesign our products to make them non-infringing, and until we made such changes we would not be able to import or ship our products to customers. In such a situation, we may not be able to do so in a manner that does not continue to infringe the patents or that is acceptable to customers. We may not be able to complete, and our customers may not be able to qualify, such redesigned products in a timely fashion, if at all, following the issuance of an adverse final determination, leading to an inability to sell or ship products to customers. Our redesign efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. For example, in the enforcement action for the 944 Investigation, although the ALJ issued an initial determination finding that our redesigned products did not violate the June 23, 2016 cease and desist order, if the ALJ modifies the initial determination during the remand proceeding, or if the Commission finds a violation in its final determination on September 4, 2018, we will no longer be able to import or ship our products in the U.S. until we make further changes to address those findings, which could materially and adversely affect our business, revenues, prospects, reputation, results of operations or financial condition. We would also need to obtain USITC or CBP approval to resume importation of such redesigned products into the United States. In addition, the USITC would not provide a service and support exception for our previously redesigned products, and customers may be required to upgrade to new products to obtain service and support. If we are unable to obtain such approvals or provide such service and support exception, our business, prospects, reputation, results of operations or financial condition could be materially and adversely affected.
In the 945 Investigation, while the USITC orders are based upon patent claims that the PTAB has found to be invalid, these orders will remain in effect unless and until the PTAB decisions are affirmed on appeal and the PTO cancels the patents. If the Commission finds a violation in its final determination for the modification proceeding, we will no longer be able to import or ship our products in the U.S. until we make further changes to address those findings and/or until the PTAB decisions are so affirmed and the PTO cancels the patents, which could materially and adversely affect our business, revenues, prospects, reputation, results of operations or financial condition. We would also need to obtain USITC or CBP approval to resume importation of any such redesigned products into the United States. In addition, the USITC would not provide a service and support exception for our previously redesigned products, and customers may be required to upgrade to new products to obtain service and support. If we are unable to obtain such approvals or provide such service and support exception, our business, revenues, prospects, reputation, results of operations or financial condition could be materially and adversely affected. In addition, even if the PTAB decisions are affirmed on appeal, and the patent claims are canceled, if we are found to have violated the USITC’s orders while those orders remain in effect, we may be subject to penalties.
To comply with the USITC’s remedial orders, we have also made certain changes to our manufacturing, importation and shipping workflows. 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.
In connection with these changes, to the extent that we are required to make further modifications to our supply chain to obtain alternative U.S. sources for subcomponents, we may be unable to obtain a sufficient quantity of these components on commercially reasonable terms or in a timely manner, if at all, which could delay or halt entirely production of our products or require us to make further modifications to our products to incorporate new components that are available in the United States. Any of these events could result in lost sales, reduced gross margins or damage to our end-customer relationships, which would materially and adversely impact our business, financial condition, results of operations and prospects.

21


Additionally, the existence of Ciscoʼs lawsuits against us could cause concern among our customers and partners and could adversely affect our business and results of operations. Many of our customers and partners require us to indemnify and defend them against third party infringement claims and pay damages in the case of adverse rulings. These claims could harm our relationships with our customers or channel partners, cause them to delay or defer purchasing decisions or deter them from doing business with us. From time to time, we may also be required to provide additional assurances beyond our standard terms. Whether or not we prevail in the lawsuit, we expect that the litigation will be expensive, time-consuming and a distraction to management in operating our business.
With respect to the various legal proceedings described above, it is our belief that while a loss is not probable, it may be reasonably possible. Further, at this stage in the litigation, any possible loss or range of loss cannot be estimated.  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.
In the Matter of Certain Semiconductor Devices, Semiconductor Device Packages, and Products Containing Same (U.S. International Trade Commission Investigation No. 337-TA-1010) (the “1010 Investigation”)
On May 23, 2016, Tessera Technologies, Inc., Tessera, Inc., and Invensas Corp. (“Tessera”) filed a complaint in the USITC alleging that Broadcom Limited, Broadcom Corporation, Avago Technologies Limited, and Avago Technologies U.S. Inc. (“Broadcom”) and certain of Broadcom's customers violated 19 U.S.C. § 1337 (“Section 337”). On June 20, 2016, the USITC instituted Tessera’s complaint as Investigation No. 337-TA-1010.
Tessera alleges that certain Broadcom semiconductor devices infringe U.S. Patent Nos. 6,856,007; 6,849,946; and 6,133,136. Tessera further alleges that Broadcom’s downstream customers, Arista Networks, Inc.; ARRIS International plc; ARRIS Group, Inc.; ARRIS Technology, Inc.; ARRIS Enterprises LLC; ARRIS Solutions, Inc.; Pace Ltd.; Pace Americas, LLC; Pace USA; LLC, ASUSteK Computer Inc.; ASUS Computer International; Comcast Cable Communications, LLC; Comcast Cable Communications Management, LLC; Comcast Business Communications, LLC; HTC Corporation; HTC America, Inc.; NETGEAR, Inc.; Technicolor S.A.; Technicolor USA, Inc.; and Technicolor Connected Home USA LLC (“Downstream Respondents”) are violating Section 337 by importing, selling after importation, or selling for importation products that incorporate the accused Broadcom semiconductor devices. The accused Company products include certain models of our switching products.
Tessera seeks the following relief: (1) a permanent limited exclusion order excluding from importation into the U.S. all of Broadcom’s semiconductor devices and semiconductor device packages, as well as Downstream Respondents’ products containing Broadcom’s semiconductor devices that infringe one or more of the three patents-in-suit and (2) a permanent cease and desist order prohibiting Broadcom and the Downstream Respondents and related companies from importing, marketing, advertising, demonstrating, warehousing inventory for distribution, offering for sale, selling, qualifying for use in the products of others, distributing, or using the accused Broadcom semiconductor devices and Downstream Respondents’ products containing Respondents’ semiconductor devices and semiconductor device packages that infringe one or more of the three patents subject to the USITC Investigation.
An evidentiary hearing was held from March 27-31, 2017. On June 30, 2017, the ALJ issued an initial determination that found a violation with respect to the ’946 patent and no violation with respect the ’136 and ’007 patents. The ALJ recommended that the Commission issue limited exclusion and cease and desist orders and recommended a 100% bond for imports during the Presidential review period. The Commission has indicated it will review the initial determination, and the target date for the final determination is December 1, 2017.
To the extent claims made by Tessera in the USITC Investigation against us are based solely on functionality residing in Broadcom’s products, Broadcom has agreed to defend us at no cost to us.
* * * * *
An adverse final determination from the Commission could result in issuance of remedial orders that could prevent Broadcom, Arista, and the other Downstream Respondents from selling infringing products for import into the United States, importing infringing products into the United States, or selling infringing products after importation into the United States. This could include both the infringing semiconductor devices as well as downstream products, including our Ethernet switches, that incorporate those devices. During the 60-day Presidential review period following the final determination, Broadcom, Arista, and the other Downstream Respondents could continue to import and sell infringing products by paying a bond. The ALJ’s recommended bond is 100% of the entered value of the product. Following the end of the Presidential review period, if the U.S. Trade Representative chooses not to disapprove the final determination, the remedial orders would go into full effect.
If the USITC orders go into full effect, to continue importing and selling products found to be infringing, Broadcom and its manufacturers would need to develop redesigned products that do not infringe, and we would have to integrate these devices into its own products, or Broadcom and/or the Downstream Respondents would need to obtain a license from Tessera. It may not be possible to do this in a timely fashion, if at all. Because the asserted patents are directed towards technology used

22


in the manufacture of the semiconductor devices not manufactured or designed by us, we would be dependent on Broadcom and its manufacturers to create such redesigned products.
Before Broadcom, Arista, or the other Downstream Respondents could import redesigned products into the United States, the products would have to be approved by CBP or the USITC. We may not be successful in any efforts to obtain such approvals in a timely manner, or at all. While a favorable ruling from CBP would allow Broadcom, Arista, and the other Downstream Respondents to resume importation of our redesigned products into the United States, the USITC could ultimately determine in an enforcement action that such redesigned products continue to infringe the patents that are the subject of the USITC orders.
Any failure to effectively redesign these products and obtain timely clearance from CBP or USITC to import such redesigned products or to obtain a license from Tessera may cause a disruption to our product shipments and materially and adversely affect our business, revenues, prospects, reputation, results of operations, and financial condition. However, it is our belief that at this stage of the legal proceedings, the likelihood of a loss is remote.
Other Matters
In the ordinary course of business, we are a party to other claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property. We record a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. As of September 30, 2017, provisions recorded for contingent losses related to other claims and matters have not been significant. Based on currently available information, management does not believe that any additional liabilities relating to other unresolved matters are probable or that the amount of any resulting loss is estimable, and believes these other matters are not likely, individually and in the aggregate, to have a material adverse effect on our financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties and our view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on our financial position, results of operations or cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods.


23


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,
 
2017
 
2016
2017
 
2016
Cost of revenue
$
1,113

 
$
955

$
3,224

 
$
2,616

Research and development
11,048

 
8,010

30,977

 
23,062

Sales and marketing
5,115

 
3,947

12,651

 
11,374

General and administrative
2,876

 
2,204

8,139

 
5,656

           Total stock-based compensation
$
20,152

 
$
15,116

$
54,991

 
$
42,708

Stock Option Activities
On February 6, 2017, the board authorized an increase to shares available for future issuance under the 2014 Equity Incentive Plan (“EIP”). Per the EIP, the increase is determined based on the lesser of 3% of total shares outstanding as of the first day of each fiscal year, 12,500,000 shares, or such amount as determined by our board of directors. The approved increase for 2017 amounted to 2,124,333 shares. As of September 30, 2017, there remain 13.4 million shares available for issuance under the EIP.
The following table summarizes the option activity under our equity stock plans and related information:
 
 
Options Outstanding 
 
 
 
 
 
 
Number of
Shares
Underlying
Outstanding Options (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, 2016
 
9,509

 
$
28.79

 
6.9
 
$
646,394

Options granted
 
170

 
96.61

 
 
 
 
Options exercised
 
(1,730
)
 
16.97

 
 
 
 
Options canceled
 
(322
)
 
32.89

 
 
 
 
Outstanding—September 30, 2017
 
7,627

 
$
32.81

 
6.4
 
$
1,195,859

Vested and exercisable—September 30, 2017
 
3,035

 
$
19.91

 
5.7
 
$
515,111

Vested and expected to vest—September 30, 2017
 
7,627

 
$
32.81

 
6.4
 
$
1,195,859

As of September 30, 2017, the total unrecognized stock-based compensation expense related to unvested stock options was $75.0 million, which is expected to be recognized over a weighted-average period of 3.6 years.
Restricted Stock Unit (RSU) Activities
A summary of the RSU activity under our stock plans during the reporting period and a summary of information related to RSUs expected to vest are presented below (in thousands, except per share and year amounts):
 
Number of
Shares
 
Weighted-
Average Grant
Date Fair Value Per Share
 
Weighted-Average
Remaining
Contractual Term (in years)
 
Aggregate Intrinsic Value
Unvested balance—December 31, 2016
1,375

 
$
74.23

 
1.8
 
$
133,081

       RSUs granted
666

 
137.26

 
 
 
 
       RSUs vested
(339
)
 
75.63

 
 
 
 
       RSUs forfeited
(60
)
 
77.21

 
 
 
 
Unvested and expected to vest balance—September 30, 2017
1,642

 
$
99.41

 
1.8
 
$
311,368

As of September 30, 2017, there was $152.4 million of unrecognized stock-based compensation cost related to unvested RSUs. This amount is expected to be recognized over a weighted-average period of 3.3 years.

24


Equity Incentive Plan Shares Available for Grant
The following table presents EIP stock activity and the total number of shares available for future grant as of September 30, 2017 (in thousands):
 
 
 
 
 
Number of Shares
Balance at December 31, 2016
 
11,754

Authorized
 
2,124

Options granted
 
(170
)
RSUs granted
 
(666
)
Options canceled
 
322

Options repurchased
 
2

RSUs forfeited
 
60

Shares traded for taxes
 
17

Balance at September 30, 2017
 
13,443

Employee Stock Purchase Plan Activities
During the nine months ended September 30, 2017, we issued 204,918 shares at a weighted average purchase price of $61.15 under the 2014 Employee Stock Purchase Plan ("ESPP"). On February 6, 2017, 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, 2,500,000 shares, or such amount as determined by our board of directors. The approved increase for 2017 amounted to 708,111 shares. As of September 30, 2017, there remain 1,987,039 shares available for issuance under the ESPP. 
As of September 30, 2017, the total unrecognized stock-based compensation expense related to unvested ESPP options was $2.8 million, which is expected to be recognized over a weighted-average period of 1.4 years.

25


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,
 
2017
 
2016
 
2017
 
2016
Numerator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Net income
$
133,722

 
$
51,257

 
$
319,368

 
$
125,406

Less: undistributed earnings allocated to participating securities
(182
)
 
(295
)
 
(725
)
 
(931
)
Net income available to common stockholders, basic
$
133,540

 
$
50,962

 
$
318,643

 
$
124,475

Diluted:
 
 
 
 
 
 
 
Net income attributable to common stockholders, basic
$
133,540

 
$
50,962

 
$
318,643

 
$
124,475

Add: undistributed earnings allocated to participating securities
15

 
18

 
61

 
56

Net income attributable to common stockholders, diluted
$
133,555

 
$
50,980

 
$
318,704

 
$
124,531

Denominator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
72,588

 
69,076

 
71,903

 
68,365

Diluted:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
72,588

 
69,076

 
71,903

 
68,365

Add weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and RSUs
6,636

 
4,357

 
6,528

 
4,429

Employee stock purchase plan
98

 
20

 
97

 
17

Weighted-average shares used in computing net income per share available to common stockholders, diluted
79,322

 
73,453

 
78,528

 
72,811

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
1.84

 
$
0.74

 
$
4.43

 
$
1.82

Diluted
$
1.68

 
$
0.69

 
$
4.06

 
$
1.71

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,
 
2017
 
2016
 
2017
 
2016
Stock options and RSUs to purchase common stock
14

 
2,688

 
73

 
3,215



26


8.
Income Taxes
We had a provision for income taxes of $8.5 million and $13.8 million in the three and nine months ended September 30, 2017, respectively as compared to an income tax provision of $11.7 million and $39.7 million in the three and nine months ended September 30, 2016, respectively. For the three and nine months ended September 30, 2017, the change in our income taxes as compared to the same periods in 2016 was primarily due to the recognition of excess tax benefits of $23.8 million and $71.7 million as a component of the provision for income taxes resulting from the adoption of ASU 2016-09, offset by an increase in the tax provision driven by higher profits before 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. 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 2014 tax year and the subsequent years remain open for audit. It is difficult to determine when the examinations will ultimately be settled. We believe that we have adequately provided reserves for any reasonably foreseeable adjustment to our tax returns. It is likely that within the next 12 months that either the IRS examination for tax year 2014 will be settled or the statute of limitations will run for jurisdictions in which we have unrecognized tax benefits recorded. The settlement or statute lapse would result in a reduction of the unrecognized tax benefit recorded. The reduction may range from no change up to approximately $2.2 million.
Our gross unrecognized tax benefits as of September 30, 2017 were $34.4 million. If the gross unrecognized tax benefits as of September 30, 2017 were realized in future periods, this could result in a tax benefit of $21.3 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,
 
2017
 
2016
 
2017
 
2016
United States
$
306,637

 
$
233,018

 
$
869,383

 
$
612,852

Other Americas
2,681

 
4,081

 
8,818

 
8,205

Europe, Middle East and Africa
79,143

 
37,728

 
199,244

 
124,111

Asia-Pacific
49,172

 
15,434

 
100,874

 
56,030

Total revenue
$
437,633

 
$
290,261

 
$
1,178,319

 
$
801,198

The following table presents our property, plant and equipment, net by geographic region for the periods presented (in thousands):
 
September 30,
2017
 
December 31,
2016
United States
$
66,914

 
$
69,352

International
6,147

 
7,609

Total
$
73,061

 
$
76,961



27


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
You should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, and our Annual Report on Form 10-K filed with the SEC on February 17, 2017. 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 switching and routing platforms. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.
We believe that cloud networks will continue to replace legacy network technologies, and that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of adoption. Cloud networks are subject to increasing performance requirements due to the growing number of connected devices, as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We expect to continue growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. Accordingly, we intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features, and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications.
We generate revenue primarily from sales of our switching products which incorporate our EOS software. We generate the majority of our services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. As we have grown the functionality of our EOS software, expanded the range of our product portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. We have also been profitable and cash flow positive for each year since 2010.
To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. We expect that a substantial portion of our future sales will be follow-on sales to existing customers. We intend to continue expanding our sales force and marketing activities in key geographies, as well as our relationships with channel, technology and system-level partners in order to reach new end customers more effectively, increase sales to existing customers, and provide services and support effectively. In order to support our strong growth, we have and may continue to accelerate our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations.
Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching and routing products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. We work closely with third party contract manufacturers to manufacture our products. Our contract manufacturers deliver our products to our third party direct fulfillment facilities.  We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers.
Historically, large purchases by a relatively limited number of end customers have accounted for significant portion of our revenue. We have experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test, qualify and accept our products and 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.
Furthermore, to comply with the limited exclusion order and cease and desist order in the 945 Investigation as described above in Note 5, entitled Commitments and Contingencies, we have made design changes to our products for sale in the United States

28


to address the features that were found to infringe the patent claims underlying the remedial orders in the 945 Investigation . We have also worked closely with our customers on the qualification and testing of our redesigned products.  The timing of completion of these qualification activities, some of which have extended beyond the current quarter, has impacted our business with these customers in these quarters. We will continue to work with these customers to complete these procedures and improve these design changes with further product modifications in order to meet customer requirements. As described in Note 5, we will need to complete any outstanding product modifications and the qualification and acceptance processes of our customers and any inability to do so in a timely manner may result in an impact to our business, our revenue and our deferred revenue balances.
We also filed a motion with the U.S. Court of Appeals for the Federal Circuit (the "CAFC") requesting that they stay the orders of the United States International Trade Commission (“USITC”), pending completion of the appeals of the decisions of the United States Patent Trial and Appeal Board (“PTAB”), and sought an expedited schedule for those appeals. On September 22, 2017, the CAFC denied the motion to stay, but has allowed us to import its redesigned products into the United States without being blocked by the USITC’s orders, subject to any determinations by the USITC in subsequent proceedings regarding the redesigned products. On October 27, 2017, the USITC instituted a modification proceeding to determine whether our redesigned products infringe the patent claims underlying the remedial orders in the 945 Investigation. The USITC has set a deadline of five months for the ALJ to issue a recommended determination, which may be extended by one month upon a showing of good cause. The recommended determination will be subject to review by the Commission after which the Commission will issue a final determination. The Commission has not set a target date for the final determination.

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, 2017 and 2016 from our unaudited condensed consolidated financial statements (in thousands, except for percentages).    
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue:
 
 
 
 
 
 
 
Product
$
380,344

 
$
254,238

 
$
1,025,615

 
$
702,329

Service
57,289

 
36,023

 
152,704

 
98,869

Total revenue
437,633

 
290,261

 
1,178,319

 
801,198

Cost of revenue (1): 
 
 
 
 
 
 
 
Product
145,874

 
94,777

 
390,116

 
261,711

Service
11,142

 
9,064

 
33,599

 
26,526

Total cost of revenue
157,016

 
103,841

 
423,715

 
288,237

Gross profit
280,617

 
186,420

 
754,604

 
512,961

Operating expenses (1):
 
 
 
 
 
 
 
Research and development
79,610

 
70,648

 
242,414

 
202,183

Sales and marketing
40,640

 
33,216

 
116,297

 
92,566

General and administrative
19,535

 
19,535

 
65,009

 
52,298

Total operating expenses
139,785

 
123,399

 
423,720

 
347,047

Income from operations
140,832

 
63,021

 
330,884

 
165,914

Interest expense
(701
)
 
(735
)
 
(2,039
)
 
(2,218
)
Other income (expense), net
2,136

 
639

 
4,280

 
1,392

Total other income (expense), net
1,435

 
(96
)
 
2,241

 
(826
)
Income before provision for income taxes
142,267

 
62,925

 
333,125

 
165,088

Provision for income taxes
8,545

 
11,668

 
13,757

 
39,682

Net income
$
133,722

 
$
51,257

 
$
319,368

 
$
125,406




29


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
 
(as a percentage of revenue)
Revenue:
 
 
 
 
 
 
 
Product
86.9
 %
 
87.6
 %
 
87.0
 %
 
87.7
 %
Service
13.1

 
12.4

 
13.0

 
12.3

Total revenue
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue:
 
 
 
 
 
 
 
Product
33.4

 
32.7

 
33.1

 
32.7

Service
2.5

 
3.1

 
2.9

 
3.3

Total cost of revenue
35.9

 
35.8

 
36.0

 
36.0

Gross margin
64.1

 
64.2

 
64.0

 
64.0

Operating expenses:
 
 
 
 
 
 
 
Research and development
18.2

 
24.3

 
20.5

 
25.2

Sales and marketing
9.2

 
11.5

 
9.9

 
11.6

General and administrative
4.5

 
6.7

 
5.5

 
6.5

Total operating expenses
31.9

 
42.5

 
35.9

 
43.3

Income from operations
32.2

 
21.7

 
28.1

 
20.7

Interest expense
(0.1
)
 
(0.2
)
 
(0.2
)
 
(0.3
)
Other income (expense), net
0.5

 
0.2

 
0.4

 
0.2

Total other income (expense), net
0.4

 

 
0.2

 
(0.1
)
Income before provision for income taxes
32.6

 
21.7

 
28.3

 
20.6

Provision for income taxes
2.0

 
4.0

 
1.2

 
5.0

Net income
30.6
 %
 
17.7
 %
 
27.1
 %
 
15.6
 %
________________________________________________________________________ 
(1) Includes stock-based compensation expense as follows (in thousands):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Cost of revenue
$
1,113

 
$
955

 
$
3,224

 
$
2,616

Research and development
11,048

 
8,010

 
30,977

 
23,062

Sales and marketing
5,115

 
3,947

 
12,651

 
11,374

General and administrative
2,876

 
2,204

 
8,139

 
5,656

           Total stock-based compensation
$
20,152

 
$
15,116

 
$
54,991

 
$
42,708


Three and Nine Months Ended September 30, 2017 Compared to Three and Nine Months Ended September 30, 2016
Revenue, Cost of Revenue and Gross Margin
We generate revenue primarily from sales of our switching products, and a portion of our revenue from sales of PCS. 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. In the third quarter, we offered U.S. customers a contractual acceptance period associated with the qualification of our new 945 related product redesigns. The impact of this program on revenue and deferred revenue was offset by the expiration of some new product and new customer contractual acceptance clauses from prior period arrangements.
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

30


organization.
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, manufacturing-related costs including costs associated with supply chain sourcing activities, 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.

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
Change in
 
2017
 
2016
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
 
 (in thousands, except percentages)
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
380,344

 
$
254,238

 
$
126,106

 
49.6%
 
$
1,025,615

 
$
702,329

 
$
323,286

 
46.0%
Service
57,289

 
36,023

 
21,266

 
59.0
 
152,704

 
98,869

 
53,835

 
54.5
Total revenue
437,633

 
290,261

 
147,372

 
50.8
 
1,178,319

 
801,198

 
377,121

 
47.1
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
145,874

 
94,777

 
51,097

 
53.9
 
390,116

 
261,711

 
128,405

 
49.1
Service
11,142

 
9,064

 
2,078

 
22.9
 
33,599

 
26,526

 
7,073

 
26.7
Total cost of revenue
157,016

 
103,841

 
53,175

 
51.2
 
423,715

 
288,237

 
135,478

 
47.0
Gross profit
$
280,617

 
$
186,420

 
$
94,197

 
50.5%
 
$
754,604

 
$
512,961

 
$
241,643

 
47.1%
Gross margin
64.1
%
 
64.2
%
 
 
 
 
 
64.0
%
 
64.0
%
 

 
 

Revenue by Geography
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
% of Total
 
2016
 
% of Total
 
2017
 
% of Total
 
2016
 
% of Total
 
 (in thousands, except percentages)
Americas
$
309,318

 
70.7
%
 
$
237,099

 
81.7
%
 
$
878,201

 
74.5
%
 
$
621,057

 
77.5
%
Europe, Middle East and Africa
79,143

 
18.1

 
37,728

 
13.0

 
199,244

 
16.9

 
124,111

 
15.5

Asia-Pacific
49,172

 
11.2

 
15,434

 
5.3

 
100,874

 
8.6

 
56,030

 
7.0

Total revenue
$
437,633

 
100.0
%
 
$
290,261

 
100.0
%
 
$
1,178,319

 
100.0
%
 
$
801,198

 
100.0
%
Revenue
Product revenue increased 49.6% in the three months ended September 30, 2017 and 46.0% in the nine months ended September 30, 2017, compared to the same periods in 2016. The increase in each period was primarily driven by increased product shipments to our existing customers as they continued to expand their businesses. In addition, our newer switch products have continued to gain market acceptance, which has contributed to our revenue growth. Service revenue increased 59.0% in the three months ended September 30, 2017 and 54.5% in the nine months ended September 30, 2017, compared to the same periods in 2016, as a result of continued growth in initial and renewal support contracts as our customer installed base continued to expand. We continue to experience pressure on both product and service pricing due to competitive market conditions, but demand for our products and growth in our installed base has more than offset this pricing pressure. As we enter the fourth quarter of 2017, we expect to continue to work with customers to complete the qualification of our 945 related product redesigns, and this may have some impact on our business for the quarter.
Cost of Revenue and Gross Margin
Cost of revenue increased $53.2 million in the three months ended September 30, 2017 and $135.5 million for the nine months ended September 30, 2017, compared to the same periods in 2016. The increase in cost of revenue was primarily due to an increase in product shipment volumes and the corresponding increase in product revenue. Gross margin remained generally consistent, decreasing slightly from 64.2% to 64.1% for the three months ended September 30, 2017 and remained the same at

31


64.0% for the nine months ended September 30, 2017, compared to the same periods in 2016. Gross margin benefited from improved service margins as we scale our services business, on a relatively fixed cost base. This improvement was largely offset by slightly lower product margins reflecting a somewhat higher mix of shipments to larger end customers who receive lower pricing terms due to volume discounts and some increase in inventory related costs.
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.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
Change in
 
2017
 
2016
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
 
 (in thousands, except percentages)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
79,610

 
$
70,648

 
$
8,962

 
12.7%
 
$
242,414

 
$
202,183

 
$
40,231

 
19.9%
Sales and marketing
40,640

 
33,216

 
7,424

 
22.4
 
116,297

 
92,566

 
23,731

 
25.6
General and administrative
19,535

 
19,535

 

 
 
65,009

 
52,298

 
12,711

 
24.3
Total operating expenses
$
139,785

 
$
123,399

 
$
16,386

 
13.3%
 
$
423,720

 
$
347,047

 
$
76,673

 
22.1%
Research and development
Research and development expenses consist primarily of personnel costs, prototype expenses, third-party engineering and contractor support costs, and an allocated portion of facility and IT costs. Our research and development efforts are focused on maintaining and developing additional functionality for our existing products and on new product development, including new releases and upgrades to our EOS software and applications. We expect our research and development expenses to increase in absolute dollars as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.
Research and development expenses increased for the three and nine months ended September 30, 2017 compared to the same periods in 2016. The increase in each period was primarily due to increased personnel costs of $11.0 million and $25.6 million in the three and nine months ended September 30, 2017, respectively as compared to the same periods in 2016. These increases were driven by headcount growth, resulting in additional compensation costs including stock-based compensation. In addition, prototype, third-party engineering and consulting costs declined by $2.9 million and grew $11.8 million in the three and nine months ended September 30, 2017, respectively as compared to the same periods in 2016. The decline in the three month period was primarily due to timing of projects, while the growth in the nine month period was driven by additional outsourced development projects and costs associated with litigation-related changes in product design.
Sales and marketing
Sales and marketing expenses consist primarily of personnel costs, marketing and promotional activities, and an allocated portion of facility and IT costs. We expect our sales and marketing expenses to increase in absolute dollars as we expand our sales and marketing efforts worldwide, and our relationships with current and future channel partners and end customers.
Sales and marketing expenses increased for the three and nine months ended September 30, 2017 compared to the same periods in 2016. The increase in each period was driven by personnel costs which increased by $4.0 million and $16.0 million in the three and nine months ended September 30, 2017, respectively as compared to the same periods in 2016. These increases were primarily due to headcount growth and higher sales volumes, driving increased compensation costs, including commissions and stock-based compensation. In addition, sales support costs increased by $2.8 million and $6.9 million, in the three and nine months ended September 30, 2017, respectively as compared to the same periods in 2016, reflecting increased professional services and field demonstration costs to support our sales infrastructure and expand our customer base.
General and administrative

32


General and administrative expenses consist primarily of Cisco and Optumsoft litigation related expenses, personnel costs, professional services, and an allocated portion of facility and IT costs. General and administrative personnel costs include those for our executive, finance, human resources and legal functions. Our professional services costs are primarily due to external legal, accounting, and tax services.
General and administrative expenses remained consistent for the three months ended September 30, 2017, and increased for the nine months ended September 30, 2017 compared to the same periods in 2016. The increase in the nine month period was primarily related to Cisco litigation related expenses of $7.7 million, which included bond costs associated with the importation and sale of affected products and components during the presidential review period of the 945 investigation. In addition, personnel costs increased by $3.4 million during the nine month period driven by increased compensation costs, including stock-based compensation costs.
Other Income (Expense), Net
Other income (expense), net primarily consists of interest income on cash and marketable securities and foreign currency transaction gains and losses, and interest expense from our lease financing obligation.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
Change in
 
2017
 
2016
 
Change in
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
 
 (in thousands, except percentages)