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EX-32.1 - EXHIBIT 32.1 - Arista Networks, Inc.ex321ceoandcfo906certifica.htm
EX-31.2 - EXHIBIT 31.2 - Arista Networks, Inc.ex312cfocertificationq12018.htm
EX-31.1 - EXHIBIT 31.1 - Arista Networks, Inc.ex311ceocertificationq12018.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________________________
FORM 10-Q
__________________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2018
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)
Securities registered pursuant to Section 12(b) of the Act:
_________________________________________________________
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  x
 
 
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 the 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  ý
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of April 27, 2018 was 74,390,994.



ARISTA NETWORKS, INC.
TABLE OF CONTENTS
 
 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 3.
 
Item 4.
 
Item 5.
 
Item 6.
 
 
 
 



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
ARISTA NETWORKS, INC.
Condensed Consolidated Balance Sheets
(Unaudited, in thousands, except par value)
 
 
March 31, 2018
 
December 31, 2017
ASSETS
 
 
 

CURRENT ASSETS:
 
 
 
 
Cash and cash equivalents
 
$
886,160

 
$
859,192

Marketable securities
 
851,880

 
676,363

Accounts receivable, net of rebates and allowances of $7,638 and $7,535, respectively
 
207,339

 
247,346

Inventories
 
268,131

 
306,198

Prepaid expenses and other current assets
 
165,664

 
177,330

Total current assets
 
2,379,174

 
2,266,429

Property and equipment, net
 
73,825

 
74,279

Investments
 
36,136

 
36,136

Deferred tax assets
 
68,020

 
65,125

Other assets
 
22,879

 
18,891

TOTAL ASSETS
 
$
2,580,034

 
$
2,460,860

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
CURRENT LIABILITIES:
 
 
 
 
Accounts payable
 
$
70,431

 
$
52,200

Accrued liabilities
 
85,728

 
133,827

Deferred revenue
 
274,677

 
327,706

Other current liabilities
 
26,943

 
16,172

Total current liabilities
 
457,779

 
529,905

Income taxes payable
 
37,358

 
34,067

Lease financing obligations, non-current
 
37,138

 
37,673

Deferred revenue, non-current
 
181,377

 
187,556

Other long-term liabilities
 
21,343

 
9,745

TOTAL LIABILITIES
 
734,995

 
798,946

Commitments and contingencies (Note 5)
 

 


STOCKHOLDERS’ EQUITY:
 
 
 
 
Preferred stock, $0.0001 par value—100,000 shares authorized and no shares issued and outstanding as of March 31, 2018 and December 31, 2017
 

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of March 31, 2018 and December 31, 2017; 74,338 and 73,706 shares issued and outstanding as of March 31, 2018 and December 31, 2017
 
8

 
7

Additional paid-in capital
 
841,431

 
804,731

Retained earnings
 
1,007,226

 
859,114

Accumulated other comprehensive loss
 
(3,626)

 
(1,938
)
TOTAL STOCKHOLDERS’ EQUITY
 
1,845,039

 
1,661,914

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
2,580,034

 
$
2,460,860

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

1


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Income
(Unaudited, in thousands, except per share amounts)

 
 
Three Months Ended March 31,
 
 
2018
 
2017
Revenue:
 
 
 
 
Product
 
$
407,617

 
$
291,367

Service
 
64,872

 
44,108

Total revenue
 
472,489

 
335,475

Cost of revenue: 
 
 
 
 
Product
 
156,691

 
109,836

Service
 
12,879

 
11,429

Total cost of revenue
 
169,570

 
121,265

Gross profit
 
302,919

 
214,210

Operating expenses:
 
 
 
 
Research and development
 
102,362

 
81,610

Sales and marketing
 
42,140

 
37,027

General and administrative
 
19,679

 
22,155

Total operating expenses
 
164,181

 
140,792

Income from operations
 
138,738

 
73,418

Other income (expense), net:
 
 
 
 
Interest expense
 
(687
)
 
(715
)
Other income (expense), net
 
4,843

 
1,025

Total other income (expense), net
 
4,156

 
310

Income before benefit from income taxes
 
142,894

 
73,728

Benefit from income taxes
 
(1,644
)
 
(9,233
)
Net income
 
$
144,538

 
$
82,961

Net income attributable to common stockholders:
 
 
 
 
Basic
 
$
144,449

 
$
82,694

Diluted
 
$
144,456

 
$
82,716

Net income per share attributable to common stockholders:
 
 
 
 
Basic
 
$
1.95

 
$
1.16

Diluted
 
$
1.79

 
$
1.07

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
Basic
 
73,994

 
71,114

Diluted
 
80,721

 
77,516


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



2


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited, in thousands)
 
 
Three Months Ended March 31,
 
 
2018
 
2017
Net income
 
$
144,538

 
$
82,961

Other comprehensive income (loss), net of tax:
 
 
 
 
Foreign currency translation adjustments
 
353

 
(227
)
Net change in unrealized gains (losses) on available-for-sale securities
 
(2,041
)
 
72

Other comprehensive loss
 
(1,688
)
 
(155
)
Comprehensive income
 
$
142,850

 
$
82,806


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



3


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands)
 
 
Three Months Ended March 31,
 
 
2018

 
2017
  As Adjusted (1)
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income
 
$
144,538

 
$
82,961

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, amortization and other
 
5,697

 
4,939

Stock-based compensation
 
20,851

 
16,439

Deferred income taxes
 
(3,541
)
 
2,521

Amortization (accretion) of investment premiums (discounts)
 
(30
)
 
330

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
40,007

 
44,057

Inventories
 
38,067

 
(50,296
)
Prepaid expenses and other current assets
 
13,722

 
(29,051
)
Other assets
 
(2,027
)
 
69

Accounts payable
 
20,040

 
(18,648
)
Accrued liabilities
 
(48,140
)
 
(15,143
)
Deferred revenue
 
(42,686
)
 
124,236

Income taxes payable
 
3,478

 
2,923

Other liabilities
 
5,565

 
(2,475
)
Net cash provided by operating activities
 
195,541

 
162,862

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Proceeds from maturities of marketable securities
 
90,448

 
64,488

Purchases of marketable securities
 
(267,976
)
 
(61,511
)
Purchases of property and equipment
 
(6,336
)
 
(4,645
)
Net cash used in investing activities (1)
 
(183,864
)
 
(1,668
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Principal payments of lease financing obligations
 
(456
)
 
(383
)
Proceeds from issuance of common stock under equity plans
 
17,300

 
19,481

Tax withholding paid on behalf of employees for net share settlement
 
(1,536
)
 
(580
)
Net cash provided by financing activities
 
15,308

 
18,518

Effect of exchange rate changes
 
(14
)
 
184

NET INCREASE IN CASH, CASH EQUIVALENTS AND RESTRICTED CASH
 
26,971

 
179,896

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —Beginning of period
 
864,697

 
572,168

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —End of period (2)
 
$
891,668

 
$
752,064

 
 
 
 
 
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING INFORMATION:
 
 
 
 
Property and equipment included in accounts payable and accrued liabilities
 
$
2,426

 
$
971

___________________________________________________
 
 
 
 
(1) Net cash used in investing activities for the three months ended March 31, 2017 was adjusted as a result of our adoption of Accounting Standards Update 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in the first quarter of 2018. See Note 1 of the accompanying notes for details of the adjustments.
(2) See Note 3 of the accompanying notes for a reconciliation of the ending balance of cash, cash equivalents and restricted cash as shown in this statements of cash flows.
The accompanying notes are an integral part of these condensed consolidated financial statements.

4


ARISTA NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1.    Organization and Summary of Significant Accounting Policies
Organization
Arista Networks, Inc. (together with our subsidiaries, “we,” “our” or “us”) is a supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation 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 include the accounts of Arista Networks, Inc. and its wholly owned subsidiaries and 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 months ended March 31, 2018, are not necessarily indicative of the results expected for the full fiscal year. The condensed consolidated balance sheet as of December 31, 2017 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. All significant intercompany accounts and transactions have been eliminated.
Our condensed consolidated financial statements and related financial information in this Quarterly Report on Form 10-Q 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, 2017, filed with the SEC on February 20, 2018. Certain reclassifications of prior period amounts were made in the current year to conform to the current period presentation.
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, sales rebates and return reserves; accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; valuation of inventory and contract manufacturer/supplier liabilities; recognition and measurement of contingent liabilities; valuation of equity investments; determination of fair value for stock-based awards; and valuation of warranty accruals. 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.
Significant Accounting Policies
During the three months ended March 31, 2018, we adopted several recent accounting pronouncements as discussed in the section titled Recently Adopted Accounting Pronouncements of this Note 1. As a result, we updated certain significant accounting policies as described below. There have been no other significant changes to our accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018.
Investments
Our equity investments in privately-held companies without readily determinable fair values are measured using the measurement alternative, defined by Accounting Standards Codification (“ASC”) 321-Investments-Equity Securities as cost, less impairments, and adjusted up or down based on observable price changes in orderly transactions for identical or similar investments of the same issuer. Any adjustments resulting from impairments and/or observable price changes are recorded as other income (expense) in our consolidated statement of income. Prior to 2018, such investments were accounted for under the cost method and were recorded at historical cost at the time of investment, with adjustments to the balance only in the event of an impairment.

5


Our equity investments in privately-held companies are included in investments, non-current, in our consolidated balance sheets.
Revenue Recognition
Effective January 1, 2018, we adopted a new revenue recognition policy in accordance with ASC 606 using the modified retrospective method as discussed in the section titled Recently Adopted Accounting Pronouncements of this Note 1. Prior to 2018, our revenue recognition policy was based on ASC 605 Revenue Recognition, and is described in Note 1 of Notes to Consolidated Financial Statements under Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018.
We generate revenue from sales of our products, which incorporate our EOS software and accessories such as cables and optics, to direct customers and channel partners together with post-contract customer support (“PCS”). We typically sell products and PCS in a single contract. We recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:
Identification of the contract, or contracts, with a customer
Identification of the performance obligations in the contract
Determination of the transaction price
Allocation of the transaction price to the performance obligations in the contract
Recognition of revenue when (or as) we satisfy the performance obligation
Post-Contract Customer Support    
Post-contract support, which includes technical support, hardware repair and replacement parts beyond standard warranty, bug fixes, patches and unspecified upgrades on a when-and-if-available basis, is offered under renewable, fee-based contracts. We initially defer PCS revenue and recognize it ratably over the life of the PCS contract as there is no discernable pattern of delivery related to these promises. We do not provide unspecified upgrades on a set schedule and addresses customer requests for technical support if and when they arise, with the related expenses recognized as incurred. PCS contracts generally have a term of one to three years. We include billed but unearned PCS revenue in deferred revenue.
Contracts with Multiple Performance Obligations
Most of our contracts with customers, other than renewals of PCS, contain multiple performance obligations with a combination of products and PCS. Products and PCS generally qualify as distinct performance obligations. Our hardware includes EOS software, which together deliver the essential functionality of our products. For contracts which contain multiple performance obligations, we allocate revenue to each distinct performance obligation based on the standalone selling price (“SSP”). Judgment is required to determine the SSP for each distinct performance obligation. We use a range of amounts to estimate SSP for products and PCS sold together in a contract to determine whether there is a discount to be allocated based on the relative SSP of the various products and PCS.
If we do not have an observable SSP, such as when we do not sell a product or service separately, then SSP is estimated using judgment and considering all reasonably available information such as market conditions and information about the size and/or purchase volume of the customer. We generally use a range of amounts to estimate SSP for individual products and services based on multiple factors including, but not limited to the sales channel (reseller, distributor or end customer), the geographies in which our products and services are sold, and the size of the end customer.
We limit the amount of revenue recognition for contracts containing forms of variable consideration, such as future performance obligations, customer-specific returns, and acceptance or refund obligations. We include some or all of an estimate of the related at risk consideration in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recorded under each contract will not occur when the uncertainties surrounding the variable consideration are resolved.
We account for multiple contracts with a single partner as one arrangement if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract.
We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical returns rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.
Our policy applies to the accounting for individual contracts. However, we have elected a practical expedient to apply the guidance to a portfolio of contracts or performance obligations with similar characteristics so long as such application would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio.

6


Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.
We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.
Assets Recognized from Costs to Obtain a Contract with a Customer
Effective January 1, 2018 in accordance with ASC 606, we recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales commissions earned by our sales force meet the requirements to be capitalized. These costs are deferred and then amortized over a period of benefit that we have determined to be five years. Total capitalized costs to obtain a contract are included in other current and long-term assets on our consolidated balance sheets.
Recently Adopted Accounting Pronouncements
Revenue Recognition
During May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). In 2016, the FASB issued ASU No. 2016-08, ASU No. 2016-10 and ASU No. 2016-12, which provide interpretive clarifications on the new guidance in Topic 606 (collectively, “the new standard”). Under the new standard, the recognition of revenue is based on consideration we expect to be entitled to from the transfer of goods or services to a customer.
The primary impact of the new standard is related to the deferral of incremental commission costs of obtaining customer service contracts, which were previously expensed as incurred. Under the new standard, we defer all such costs and amortize them over the expected period of benefit. The new standard also requires companies to account for termination clauses at the onset of an arrangement. While there is limited history of cancellations, our prepaid subscription offerings are generally cancellable by customers with 30 days’ notice, therefore, the subscription contracts are considered month-to-month. While these prepaid amounts have historically been recorded to deferred revenue, the new standard requires that we record these amounts as other liabilities. In addition, the new standard may impact the amount and timing of revenue recognition of certain sales arrangements and the related disclosures on our consolidated financial statements.
We adopted the new standard in our first quarter of 2018 using the modified retrospective method, which resulted in a cumulative effect adjustment of $3.5 million that increased retained earnings to capitalize certain commission costs that were expensed in the prior year. Correspondingly, we increased prepaid expenses and other current assets by $2.0 million, other assets by $2.2 million, and decreased deferred tax assets by $0.7 million as of January 1, 2018. In addition, we reclassified $16.5 million of deferred revenue as of January 1, 2018 to other current liabilities and other long-term liabilities related to our prepaid subscription offerings. The impact of adopting the new standard was not material to our financial results for the three months ended March 31, 2018 and we do not expect the impact to the financial results for our fiscal 2018 to be material.
We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less, as well as the portfolio approach for the contracts reviewed. These costs include a portion of our sales force compensation program as we have determined annual compensation is commensurate with recurring sales activities.
Financial Instruments
In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which enhances the reporting model for financial instruments to provide users of financial statements with more decision-useful information. In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments, to clarify certain aspects of ASU 2016-01. ASU 2016-01 and ASU 2018-03 (collectively, the “new guidance”) address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. We adopted this new guidance in our first quarter of fiscal 2018. Under the new guidance, there was no change in the accounting of our marketable securities as our investment policy only allows investments in debt securities. For our cost method equity investments in privately-held companies without readily determinable fair value, we elected to use the measurement alternative, defined as cost, less impairments, as adjusted up or down based on observable price changes in orderly transactions for identical or similar investments of the same issuer, which was adopted prospectively. Adjustments resulting from impairments and/or observable price changes are to be recorded as other income (expense) on a prospective basis.
Based on our assessment under the new guidance, there was no impact on our condensed consolidated financial statements from the adoption of the new guidance in the first quarter of 2018. However, the carrying amount of our equity investments and any related gain or loss may fluctuate in the future as a result of the re-measurement of such equity investments upon the occurrence of observable price changes and/or impairments.

7


Income Taxes on Intra-Entity Transfers of Assets
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 must 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. We adopted this guidance in our first quarter of fiscal 2018. As a result, we recognized a cumulative effect adjustment in the condensed consolidated balance sheet as of March 31, 2018 by increasing the beginning balance of the retained earnings and the deferred tax assets by approximately $0.1 million, respectively.
Restricted Cash in Statement of Cash Flows
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 required to be applied using a retrospective transition method to each period presented. We retrospectively adopted ASU 2016-18 in our first quarter of fiscal 2018. As a result of the adoption, we adjusted the condensed consolidated statement of cash flows for the three months ended March 31, 2017 to increase the beginning-of-period and end-of-period cash amounts by $4.2 million and $5.5 million, respectively, and to decrease net cash used in investing activities by $1.3 million.
Recent Accounting Pronouncements Not Yet Effective
Leases
In February 2016, the FASB issued ASU No, 2016-02, Leases. Under the guidance, lessees are required to recognize assets and lease liabilities on the balance sheet for most leases including operating leases and provide enhanced disclosures. There are optional practical expedients that a company may elect to apply. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years and may be early adopted. As currently issued, companies are required to adopt this guidance to the earliest period presented using a modified retrospective approach. We are in the process of reviewing our existing lease agreements to assess the impact this guidance may have on our consolidated financial statements. We currently anticipate that the adoption of ASU 2016-02 will materially affect our consolidated balance sheets by recognizing new right-of-use assets and lease liabilities for operating leases, but will not have a material impact on our consolidated income statements.
Credit Losses of Financial Instruments 
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.
2.    Fair Value Measurements
Assets and liabilities recorded at fair value on a recurring basis in the accompanying condensed 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.

8


We measure and report our cash equivalents, restricted cash, and available-for-sale marketable securities at fair value. The following tables set forth the fair value of our financial assets by level within the fair value hierarchy (in thousands):
 
 
March 31, 2018
 
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
 
Money market funds
 
$
644,273

 
$

 
$

 
$
644,273

Money market funds - restricted
 
5,508

 

 

 
5,508

Commercial paper
 

 
21,820

 

 
21,820

U.S. government notes
 
206,802

 

 

 
206,802

Corporate bonds
 

 
382,165

 

 
382,165

Agency securities
 

 
241,093

 

 
241,093

Total financial assets
 
$
856,583


$
645,078

 
$

 
$
1,501,661


 
 
December 31, 2017
 
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets:
 
 
 
 
 
 
 
 
Money market funds
 
$
701,145

 
$

 
$

 
$
701,145

Money market funds - restricted
 
5,505

 

 

 
5,505

Commercial paper
 

 
11,924

 

 
11,924

U.S. government notes
 
136,647

 

 

 
136,647

Corporate bonds
 

 
312,484

 

 
312,484

Agency securities
 

 
228,036

 

 
228,036

Total financial assets
 
$
843,297

 
$
552,444

 
$

 
$
1,395,741

3.    Financial Statements Details
Cash, Cash Equivalents and Restricted Cash
The following table is a reconciliation of cash, cash equivalents and restricted cash reported within the accompanying condensed consolidated balance sheets that sum to the total of the same such amounts shown in the accompanying condensed consolidated statements of cash flows (in thousands):
 
 
March 31, 2018
 
March 31, 2017
Cash and cash equivalents
 
$
886,160

 
$
746,567

Restricted cash included in other assets
 
5,508

 
5,497

Total cash, cash equivalents and restricted cash
 
$
891,668

 
$
752,064

Restricted cash included in other assets as of March 31, 2018 and March 31, 2017 primarily included $4.0 million pledged as collateral representing a security deposit required for a facility lease and $1.1 million related to a letter of credit issued to a business partner. 

9


Marketable Securities
The following table summarizes the unrealized gains and losses and fair value of our available-for-sale marketable securities (in thousands):
 
 
March 31, 2018
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
 
$
21,820

 
$

 
$

 
$
21,820

U.S. government notes
 
207,359

 

 
(557
)
 
206,802

Corporate bonds
 
384,229

 
1

 
(2,065
)
 
382,165

Agency securities
 
242,114

 

 
(1,021
)
 
241,093

Total marketable securities
 
$
855,522

 
$
1

 
$
(3,643
)
 
$
851,880

 
 
December 31, 2017
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Commercial paper
 
$
11,924

 
$

 
$

 
$
11,924

U.S. government notes
 
137,025

 

 
(378
)
 
136,647

Corporate bonds
 
313,080

 
20

 
(616
)
 
312,484

Agency securities
 
215,923

 
2

 
(617
)
 
215,308

Total marketable securities
 
$
677,952

 
$
22

 
$
(1,611
)
 
$
676,363

We did not realize any other-than-temporary losses on our marketable securities for the three months ended March 31, 2018 and 2017. 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 and therefore, we do not consider any of our marketable securities to be other-than-temporarily impaired as of March 31, 2018.
As of March 31, 2018, 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):
 
 
March 31, 2018
Due in 1 year or less
 
$
559,733

Due in 1 year through 2 years
 
292,147

Total marketable securities
 
$
851,880

The weighted-average remaining duration of our current marketable securities is approximately 0.8 years as of March 31, 2018. 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):
 
 
March 31, 2018
 
December 31, 2017
Accounts receivable
 
$
214,977

 
$
254,881

Allowance for doubtful accounts
 
(149
)
 
(112
)
Product sales rebate and returns reserve
 
(7,489
)
 
(7,423
)
Accounts receivable, net
 
$
207,339

 
$
247,346


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Inventories
Inventories consist of the following (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Raw materials
 
$
62,305

 
$
69,673

Finished goods
 
205,826

 
236,525

Total inventories
 
$
268,131

 
$
306,198

Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consists of the following (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Inventory deposit
 
$
24,423

 
$
34,141

Prepaid income taxes
 
41,048

 
38,134

Other current assets
 
82,837

 
96,215

Other prepaid expenses and deposits
 
17,356

 
8,840

Total prepaid expenses and other current assets
 
$
165,664

 
$
177,330

Property and Equipment, Net
Property and equipment, net consists of the following (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Equipment and machinery
 
$
49,470

 
$
47,711

Computer hardware and software
 
24,048

 
22,124

Furniture and fixtures
 
3,063

 
3,020

Leasehold improvements
 
30,567

 
30,548

Building
 
35,154

 
35,154

Construction-in-process
 
5,549

 
4,742

Property and equipment, gross
 
147,851

 
143,299

Less: accumulated depreciation
 
(74,026
)
 
(69,020
)
Property and equipment, net
 
$
73,825

 
$
74,279

Depreciation expense was $5.3 million and $4.8 million for the three months ended March 31, 2018 and 2017, respectively.
Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Accrued payroll related costs
 
$
28,773

 
$
56,626

Accrued manufacturing costs
 
27,924

 
35,703

Accrued product development costs
 
10,520

 
21,201

Accrued warranty costs
 
7,434

 
7,415

Accrued professional fees
 
5,751

 
7,086

Accrued taxes
 
690

 
794

Other
 
4,636

 
5,002

Total accrued liabilities
 
$
85,728

 
$
133,827


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Warranty Accrual
The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
 
Three Months Ended March 31,
 
 
2018
 
2017
Warranty accrual, beginning of period
 
$
7,415

 
$
6,744

Liabilities accrued for warranties issued during the period
 
1,557

 
1,859

Warranty costs incurred during the period
 
(1,538
)
 
(945
)
Warranty accrual, end of period
 
$
7,434

 
$
7,658

Deferred Revenue and Performance Obligations
Deferred revenue is comprised mainly of unearned revenue related to multi-year PCS contracts, services and product deferrals related to acceptance clauses. During the three months ended March 31, 2018 and 2017, $159.4 million and $171.4 million of deferred revenue was recognized, respectively, which was included in the deferred revenue balances at the beginning of the respective periods. 
Transaction Price Allocated to the Remaining Performance Obligations
As of March 31, 2018, approximately $475.0 million of revenue is expected to be recognized from remaining performance obligations for product and PCS contracts. We expect to recognize revenue on approximately 82% of these remaining performance obligations over the next 2 years and 18% during the 3rd to the 5th year. The remaining performance obligations as of March 31, 2018 included $18.8 million related to our prepaid subscription offerings which are recorded as other liabilities.
4.    Investments
Investments in Privately-Held Companies    
We adopted ASU 2016-01 in the three months ended March 31, 2018. See Note 1. As of March 31, 2018 and December 31, 2017, we held non-marketable equity investments of approximately $36.1 million in privately-held companies. Such equity investments do not have readily determinable fair values. To date, we have not recorded any adjustments to the carrying amounts of our equity investments resulting from impairment or observable price changes in orderly transactions for identical or similar investments of the same issuer.
5.    Commitments and Contingencies
Operating Leases
We lease various offices and data centers in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2025. There have been no material changes in our future minimum payment obligations under our operating leases that existed as of December 31, 2017, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017, except as follows. During the three months ended March 31, 2018, we entered into new leases primarily related to additional data center capacity and co-location services. As of March 31, 2018, the total minimum future payment commitment under these new leases was approximately $43.6 million, of which $0.5 million is due in 2018, with the remainder due in 2021 through 2028.
We recognize rent expense under these arrangements on a straight-line basis over the term of the leases. For the three months ended March 31, 2018 and 2017, rent expense for all operating leases amounted to $2.5 million and $2.4 million, respectively.
Financing Obligation—Build-to-Suit Lease     
In August 2012, we executed a lease for a building then under construction in Santa Clara, California to serve as our headquarters. The lease term is 120 months and commenced in August 2013. The lease is accounted for as a financing obligation and the lease payments are attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense, representing an imputed cost to lease the underlying land of the building. There have been no material changes in our future minimum payment obligations under this financing lease, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017. 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 for the three months ended March 31, 2018 and 2017.

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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 March 31, 2018, we had non-cancellable purchase commitments of $251.1 million, of which $197.7 million was to our contract manufacturers and suppliers. We have not recorded a liability related to these purchase commitments. In addition, we have provided deposits to secure our obligations to purchase inventory. We had $27.2 million and $36.9 million in deposits as of March 31, 2018 and December 31, 2017, respectively. These deposits are classified in “Prepaid expenses and other current assets” and “Other assets” in our accompanying unaudited condensed consolidated balance sheets.
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 leased 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 dated 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

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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. The Phase II Trial is set to begin on March 4, 2019.
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 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.
On March 6, 2018, the Court issued an order directing the parties to file a joint status report updating the Court on the progress of the 944 and 945 Investigations (as defined below) and when the parties expected the stay of the ’43 Case might be lifted or the case dismissed. In Cisco’s portion of the joint status report, Cisco proposed that the judge lift the stay as to the ’597, ’164, ’592, ’145, ’492, ’296, and ’875 patents. We opposed Cisco’s proposal. The judge has not yet responded to Cisco’s proposal, and the stay on the ’43 Case currently remains in place.
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, a 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. 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.

14


Cisco filed a notice of appeal on June 6, 2017. Cisco did not appeal the jury’s noninfringement verdict on the ‘526 patent but did appeal the jury’s finding that we established the defense of scenes a faire. The parties have submitted their appeal briefs to the U.S. Court of Appeals of the Federal Circuit (“Federal Circuit”). The Federal Circuit has not set a date for oral argument.
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.
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. On October 31, 2017, we filed an amended complaint, and on November 14, 2017, Cisco filed its answer. On February 14, 2018, the Court struck certain defenses asserted by Cisco. Both Cisco and we have filed pretrial motions, including motions for summary judgment, and the trial is set for August 3, 2018.
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 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 USITC 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 USITC 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 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 USITC’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 USITC’s authority.” On September 28, 2016, the USITC instituted the enforcement proceeding. The proceeding has been assigned to ALJ 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 USITC 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 USITC issued an order remanding the investigation to the ALJ to make additional findings on certain issues and issue a remand initial determination. The USITC ordered the ALJ to set a schedule for completion of any necessary remand proceedings and a new target date for the enforcement action (the “944 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

15


as the new target date for the enforcement action. On September 18, 2017, the USITC determined not to review the Initial Determination setting the target date. The ALJ held a hearing on February 1, 2018.
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 alleged that certain of our switching products infringe the ’577, ’853, ’875, ’668, ’492, and ’211 patents. 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) related software, and components 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 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 May 4, 2017, the USITC 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 USITC 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. On July 4, 2017, the 60-day Presidential review period for the 945 Investigation expired. During the 60-day Presidential review period, the USITC Orders permitted us 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 USITC 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 USITC 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 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 USITC proceedings are initiated and completed to produce an enforceable determination that such a redesign is barred” by a USITC remedial order.
On September 27, 2017, Cisco filed a petition with the USITC requesting that the USITC institute a modification proceeding (“945 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 USITC instituted the 945 Modification Proceeding. The proceeding has been assigned to ALJ McNamara, who presided over the underlying investigation.
The ALJ held a hearing on January 26, 2018 and issued a recommended determination (“RD”) on March 23, 2018. The RD found that our redesigned products do not infringe the ’577 patent but do infringe the ’668 patent. The RD will be subject to review by the USITC after which the USITC will issue a final determination. The USITC has not set a target date for the final determination.
On April 5, 2018, the USITC issued an order suspending enforcement of the remedial orders as to the ’668 patent following the Federal Circuit’s affirmance of the PTAB’s final written decision for the ’668 patent.
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

16


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 hearing for the ’211 IPR appeal was held in March 2018, and on March 28, 2018, the Federal Circuit remanded the matter back to the PTAB for further proceedings.
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 hearings were held on February 9, 2018. On February 14, 2018, the Federal Circuit affirmed the PTAB’s final written decision on the ’668 patent.
* * * * *
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 and USITC remedial orders, 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.

17


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. 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. Our redesign efforts therefore consisted of removing the feature found to infringe the ’577 patent in all of our products until this patent expires on June 30, 2018, and providing an alternative feature to address the ‘577 patent for a subset of those products. The redesign efforts to address the 945 Investigation findings 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. If the redesigned products are unacceptable to our customers, our business, revenues, deferred revenue balances, prospects, reputation, results of operations or financial condition could be materially and adversely affected.
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 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, 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.
Following a February 14, 2018 Federal Circuit opinion affirming the PTAB’s finding that the asserted claims of the ’668 patent are invalid, on April 5, 2018, the USITC suspended enforcement of its remedial orders in the 945 Investigation as to the ’668 patent. This suspension will remain in effect until the cancellation of the asserted claims of the ’668 patent or the reversal or vacatur of the Federal Circuit’s decision. While remote, there is some possibility that the Supreme Court could decide on the merits to vacate or reverse the Federal Circuit’s affirmance of the PTAB’s final written decision concerning the ’668 patent. Likewise, the Federal Circuit may vacate or reverse the PTAB’s final written decision concerning the ’577 patent.
In either the 944 Enforcement Action or the 945 Modification Proceeding, if the USITC determines that our redesigned products infringe any of the patents that are the subject of USITC remedial orders, those redesigned products will also 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 Enforcement Action, the ALJ recommended a civil penalty of $307 million if the USITC were to reverse the ALJ’s finding of no violation. Any such finding by the USITC in either the 944 Enforcement Action or the 945 Modification Proceeding could materially and adversely affect our business, prospects, reputation, results of operations and financial condition.
An adverse finding in the 944 Enforcement Action or the 945 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. Our further redesign efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. We may not be able to further redesign the products 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 further redesigned products in a timely fashion, if at all, following the issuance of an adverse final determination, leading to a delay or cancellation of purchases by some customers until those redesigned products are qualified or accepted by such customers, a rejection or return of our redesigned products by some customers or a loss of sales to some customers who are unable to qualify or accept the redesigned products. 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 944 Enforcement Action, 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 USITC 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 addition, if we are found to have violated the USITC’s orders while those orders remain in effect, we may be subject to the penalties described above.

18


In the 945 Modification Proceeding, while the USITC has suspended enforcement of its remedial orders as to the ’668 patent, the RD finds that our redesigned products infringe the ’668 patent. If the USITC adopts that finding, and the Federal Circuit’s decision is reversed by the Supreme Court or vacated as a result of a constitutional ruling on the IPR process, 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. Likewise, if the USITC reverses the finding pursuant to the RD that our redesigned products do not infringe the ’577 patent, we will no longer be able to import or ship our products in the U.S. unless and until we make further changes to address those findings; the PTAB decision finding the relevant claims of the ’577 patent are affirmed on appeal and the United States Patent and Trademark Office (“Patent Office”) cancels those claims; or the ’577 patent expires on June 30, 2018. Any requirement that we further modify our products to comply with the ITC’s orders in the 945 Investigation 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 on the ’577 and ’688 patents are ultimately affirmed on appeal and the patent claims are canceled, if we are found to have violated the USITC’s orders while those orders were in effect, we may be subject to the penalties described above.
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 orders and cease and desist orders 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.
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.
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 March 31, 2018, 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.


19


6.    Equity Award Plan Activities
2014 Equity Incentive Plan
Effective January 1, 2018, our board of directors authorized an increase of 2,211,176 shares to the shares available for issuance under the 2014 Equity Incentive Plan (the “2014 Plan”). Pursuant to the 2014 Plan, the 2018 share increase is determined based on the lesser of 3% of total shares of common stock outstanding as of December 31, 2017, 12,500,000 shares, or such amount as determined by our board of directors. As of March 31, 2018, there remained approximately 23.8 million shares available for issuance under the 2014 Plan.
2014 Employee Stock Purchase Plan
Effective January 1, 2018, our board of directors authorized an increase of 737,058 shares to shares available for issuance under our 2014 Employee Stock Purchase Plan (the “ESPP”). Pursuant to the ESPP, the 2018 share increase is determined based the lesser of 1% of the total shares of common stock outstanding on December 31, 2017, 2,500,000 shares, or such amount as determined by our board of directors. As of March 31, 2018, there remained approximately 2,615,207 shares available for issuance under the ESPP.
During the three months ended March 31, 2018, we issued  108,890 shares at a weighted-average purchase price of $67.09 under the ESPP. 
Stock Option Activities
The following table summarizes the option activity under our stock plans and related information (in thousands, except years and per share amounts):
 
 
Options Outstanding 
 
 
 
 
 
 
Number of
Shares
Underlying
Outstanding Options
 
Weighted-
Average
Exercise
Price per Share
 
Weighted-
Average
Remaining
Contractual
Term (Years) of
Stock Options
 
Aggregate
Intrinsic
Value
of Stock
Options
Outstanding
Balance—December 31, 2017
 
7,024

 
$
33.05

 
6.1
 
$
1,422,637

Options granted
 

 

 
 
 
 
Options exercised
 
(394
)
 
25.39

 
 
 
 
Options canceled
 
(18
)
 
41.58

 
 
 
 
Balance—March 31, 2018
 
6,612

 
$
33.48

 
5.9
 
$
1,466,783

Vested and exercisable—March 31, 2018
 
2,911

 
$
22.71

 
5.3
 
$
676,982

Restricted Stock Unit (RSU) Activities
A summary of the RSU activity under our stock plans and related information are presented below (in thousands, except years and per share 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, 2017
 
1,537

 
$
104.29

 
1.6
 
$
362,119

       RSUs granted
 
153

 
279.87

 
 
 
 
       RSUs vested
 
(136
)
 
87.07

 
 
 
 
       RSUs forfeited/canceled
 
(25
)
 
121.92

 
 
 
 
Unvested balance—March 31, 2018
 
1,529

 
$
123.10

 
1.6
 
$
390,315


20


Shares Available for Grant
The following table presents the stock activity and the total number of shares available for grant as of March 31, 2018 (in thousands):
 
 
Number of Shares
Balance—December 31, 2017
 
13,512

Authorized
 
2,211

RSUs granted
 
(153
)
Options canceled
 
18

RSUs forfeited
 
25

Shares traded for taxes
 
7

Balance—March 31, 2018
 
15,620

Stock-Based Compensation Expense
Total stock-based compensation expense related to options, restricted stock awards, restricted stock units and employee stock purchase rights granted were allocated as follows (in thousands):
 
 
Three Months Ended March 31,
 
 
2018
 
2017
Cost of revenue
 
$
1,202

 
$
1,024

Research and development
 
10,945

 
9,587

Sales and marketing   
 
5,960

 
3,456

General and administrative
 
2,744

 
2,372

           Total stock-based compensation
 
$
20,851

 
$
16,439

As of March 31, 2018, unrecognized stock-based compensation expenses by award type and their expected weighted-average recognition periods are summarized in the following table (in thousands, except years).
 
 
March 31, 2018
 
 
Stock Option
 
RSU
 
ESPP
Unrecognized stock-based compensation expense
 
$
61,271

 
$
174,249

 
$
4,996

Weighted-average amortization period
 
3.5 years

 
3.5 years

 
1.1 years



21


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 March 31,
 
 
2018
 
2017
Numerator:
 
 
 
 
Basic:
 
 
 
 
Net income
 
$
144,538

 
$
82,961

Less: undistributed earnings allocated to participating securities
 
(89
)
 
(267
)
Net income available to common stockholders, basic
 
$
144,449

 
$
82,694

Diluted:
 
 
 
 
Net income attributable to common stockholders, basic
 
$
144,449

 
$
82,694

Add: undistributed earnings allocated to participating securities
 
7

 
22

Net income attributable to common stockholders, diluted
 
$
144,456

 
$
82,716

Denominator:
 
 
 
 
Basic:
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
73,994

 
71,114

Diluted:
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
73,994

 
71,114

Add weighted-average effect of dilutive securities:
 
 
 
 
Stock options and RSUs
 
6,670

 
6,321

Employee stock purchase plan
 
57

 
81

Weighted-average shares used in computing net income per share available to common stockholders, diluted
 
80,721

 
77,516

Net income per share attributable to common stockholders:
 
 
 
 
Basic
 
$
1.95

 
$
1.16

Diluted
 
$
1.79

 
$
1.07

The following weighted-average 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 March 31,
 
 
2018
 
2017
Stock options and RSUs to purchase common stock
 
22

 
188

Employee stock purchase plan
 
26

 

Total
 
48

 
188


8.    Income Taxes
 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
 
 
 
 
 
 
(in thousands, except percentages)
Benefit from income taxes
 
$
(1,644
)
 
$
(9,233
)
Effective tax rate
 
(1.2
)%
 
(12.5
)%
We had income taxes benefit of $1.6 million and $9.2 million in the three months ended March 31, 2018 and 2017, respectively. The change in the effective tax rate in the three months ended March 31, 2018, as compared to the same period in

22


2017, was primarily due to the overall increase in earnings and the inclusion of foreign earnings in the U.S. which proportionally exceeded the increase in excess tax benefits attributable to equity compensation. These changes were all taxed at a lower U.S. corporate tax rate under the Tax Cuts and Jobs Act (the “Tax Act”) passed in December 2017.
We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; and (5) creating the base erosion anti-abuse tax (“BEAT”), a new minimum tax.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (“GILTI”) wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. This income will effectively be taxed at a 10.5% tax rate in general. Our deferred tax assets and liabilities are still being evaluated to determine if they should be recognized for the basis differences expected to reverse as a result of GILTI provisions that are effective for us after the calendar year ending December 31, 2017. Because of the complexity of the new provisions, we are continuing to evaluate how the provisions will be accounted for under the U.S. GAAP wherein companies are allowed to make an accounting policy election of either (i) account for GILTI as a component of tax expense in the period in which we are subject to the rules (the “period cost method”), or (ii) account for GILTI in our measurement of deferred taxes (the “deferred method”). Currently, we have not elected a method but we have included an estimate of the impact to our effective tax rate for the year ended December 31, 2018. A formal election will only be made after our completion of the analysis of the GILTI provisions and our election method will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in our taxable income related to GILTI and, if so, the impact that is expected.
As of March 31, 2018, we have not yet completed our accounting for the tax effects of the enactment of the Tax Act. We recognized a provisional tax amount of $51.8 million in the fourth quarter of 2017 for the transition tax liability and the revaluation of our deferred income taxes as a result of the rate change. In the three months ended March 31, 2018, we did not revise this estimate. In addition, we recorded a reasonable estimate for the effect of the new legislation as discussed above, which impacts the US income tax liabilities for the year ending December 31, 2018. Our estimates may also be affected as we gain a more thorough understanding of the tax law. These changes could be material to income tax expense. We will continue to refine our estimates related to the impact of the Tax Act during the one year measurement period allowed under Staff Accounting Bulletin 118 (“SAB 118”).
We have been selected for examination by the Internal Revenue Service (“IRS”) for our 2014 tax year. It is difficult to determine when the examinations will be settled or their final outcomes in the foreseeable future. We believe that we have adequately provided reserves for any reasonably foreseeable adjustment to our tax returns.
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 March 31,
 
 
2018
 
2017
Americas
 
$
315,498

 
$
264,863

Europe, Middle East and Africa
 
121,886

 
42,734

Asia-Pacific
 
35,105

 
27,878

Total revenue
 
$
472,489

 
$
335,475

Long-lived assets, excluding intercompany receivables, investments in subsidiaries, privately-held equity investments and deferred tax assets, net by location are summarized as follows (in thousands):
 
 
March 31, 2018
 
December 31, 2017
United States
 
$
68,277

 
$
69,128

International
 
5,548

 
5,151

Total
 
$
73,825

 
$
74,279



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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 20, 2018. 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 operating 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 in Note 5 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q, we have made design changes to our products for sale in the United States to address the features that were found to infringe the patent claims underlying the remedial orders in the 945

24


Investigation. We made significant progress with respect to customer certification of these redesigns during the first quarter of 2018, with final certification pending for a limited number of specific use cases at the end of the period. We will continue to work with customers to further improve the redesigns in order to meet their requirements, including consideration of the impact of the expiration of the ‘577 patent on June 30, 2018, and the likely invalidation of the ‘668 patent. We will need to complete any outstanding product modifications and qualification and acceptance processes for these customer use cases, 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 “Federal Circuit”) requesting that it stay the orders of the United States International Trade Commission (“USITC”), pending completion of the appeals of the decisions of the PTAB, and sought an expedited schedule for those appeals. On September 22, 2017, the Federal Circuit denied the motion to stay, but has allowed us to import our 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 ALJ held a hearing on January 26, 2018 and issued a recommended determination (“RD”) on March 23, 2018. The RD found that our redesigned products do not infringe the ’577 patent but do infringe the ’668 patent. The RD will be subject to review by the USITC after which the USITC will issue a final determination. The USITC has not set a target date for the final determination. On April 5, 2018, the USITC issued an order suspending enforcement of the remedial orders as to the ’668 patent.
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 months ended March 31, 2018 and 2017 from our unaudited condensed consolidated financial statements included in this Form 10-Q.
 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
 
 
 
 
 
 
(in thousands)
Consolidated Statements of Operations Data:
 
 
 
 
Revenue
 
 
 
 
Product
 
$
407,617

 
$
291,367

Service
 
64,872

 
44,108

Total revenue
 
472,489

 
335,475

Cost of revenue (1)
 
 
 
 
Product
 
156,691

 
109,836

Service
 
12,879

 
11,429

Total cost of revenue
 
169,570

 
121,265

Gross profit
 
302,919

 
214,210

Operating expenses (1)
 
 
 
 
Research and development
 
102,362

 
81,610

Sales and marketing
 
42,140

 
37,027

General and administrative
 
19,679

 
22,155

Total operating expenses
 
164,181

 
140,792

Income from operations
 
138,738

 
73,418

Other income (expense), net
 
 
 
 
Interest expense
 
(687
)
 
(715
)
Other income (expense), net
 
4,843

 
1,025

Total other income (expense), net
 
4,156

 
310

Income before benefit from income taxes
 
142,894

 
73,728

Benefit from income taxes
 
(1,644
)
 
(9,233
)
Net income
 
$
144,538

 
$
82,961

__________________________
 
 
 
 
(1) Includes stock-based compensation expense as follows:

25


 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
 
 
 
 
 
 
(in thousands)
Stock-Based Compensation Expense:
 
 
 
 
Cost of revenue
 
$
1,202

 
$
1,024

Research and development
 
10,945

 
9,587

Sales and marketing
 
5,960

 
3,456

General and administrative
 
2,744

 
2,372

           Total stock-based compensation
 
$
20,851

 
$
16,439


 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
 
 
 
 
 
 
(as a percentage of revenue)
Revenue
 
 
 
 
Product
 
86.3
 %
 
86.9
 %
Service
 
13.7

 
13.1

Total revenue
 
100.0

 
100.0

Cost of revenue
 
 
 
 
Product
 
33.2

 
32.7

Service
 
2.7

 
3.4

Total cost of revenue
 
35.9

 
36.1

Gross margin
 
64.1

 
63.9

Operating expenses
 
 
 
 
Research and development
 
21.6

 
24.4

Sales and marketing
 
8.9

 
11.0

General and administrative
 
4.2

 
6.6

Total operating expenses
 
34.7

 
42.0

Income from operations
 
29.4

 
21.9

Interest expense
 
(0.1
)
 
(0.2
)
Other income (expense), net
 
0.9

 
0.3

Total other income (expense), net
 
0.8

 
0.1

Income before benefit from income taxes
 
30.2

 
22.0

Benefit from income taxes
 
(0.4
)
 
(2.8
)
Net income
 
30.6
 %
 
24.8
 %


26


Three Months Ended March 31, 2018 Compared to Three Months Ended March 31, 2017
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
 
Three Months Ended March 31,
 
Change in
 
 
2018
 
2017
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
Product
 
$
407,617

 
$
291,367

 
$
116,250

 
39.9
%
Service
 
64,872

 
44,108

 
20,764

 
47.1

Total revenue
 
472,489

 
335,475

 
137,014

 
40.8

Cost of revenue
 
 
 
 
 
 
 
 
Product
 
156,691

 
109,836

 
46,855

 
42.7

Service
 
12,879

 
11,429

 
1,450

 
12.7

Total cost of revenue
 
169,570

 
121,265

 
48,305

 
39.8

Gross profit
 
$
302,919

 
$
214,210

 
$
88,709

 
41.4
%
Gross margin
 
64.1
%
 
63.9
%
 
 
 
 

Revenue by Geography (in thousands, except percentages)
 
 
Three Months Ended March 31,
 
 
2018
 
% of Total
 
2017
 
% of Total
Americas
 
$
315,498

 
66.8
%
 
$
264,863

 
79.0
%
Europe, Middle East and Africa
 
121,886

 
25.8

 
42,734

 
12.7

Asia-Pacific
 
35,105

 
7.4

 
27,878

 
8.3

Total revenue
 
$
472,489

 
100.0
%
 
$
335,475

 
100.0
%
Revenue
Product revenue increased $116.3 million, or 39.9%, in the three months ended March 31, 2018 compared to the same period in 2017. The increase was primarily driven by 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 $20.8 million, or 47.1%, in the three months ended March 31, 2018 compared to the same period in 2017 as a result of continued growth in initial and renewal support contracts as our customer installed base continued to expand. We continue to experience pricing pressure on our products and services due to competition, but demand for our products and growth in our installed base more than offset this pricing pressure. 
Excluding the reclassification to other current and noncurrent liabilities in connection with our adoption of ASC 606, deferred revenue decreased $42.7 million from December 31, 2017 to March 31, 2018, which was primarily due to a decrease in deferred product revenue as customers continued to certify and accept our 945 investigation-related product redesigns. We expect to continue to work with these customers to complete their remaining qualification activities and expect to recognize any remaining 945 investigation-related deferred revenue as revenue at that time.
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.  In addition, while we expect our revenue to continue to grow in absolute dollars on a year over year basis, our revenue growth rates are expected to decline as our business scales.
Cost of Revenue and Gross Margin
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. Cost of revenue increased $48.3 million or 39.8% for the three months ended March 31, 2018 compared to the same period in 2017. The increase in cost of revenue was primarily due to the corresponding increase in product revenue. We expect our cost of product revenue to increase as our product revenue increases. Cost of providing PCS and other services consists primarily of personnel costs for our global customer support organization.
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, the mix of products sold, and excess/obsolete inventory write-downs, including charges for excess/obsolete component inventory held by our contract manufacturers. Gross margin remained consistent, increasing slightly from 63.9% to 64.1% for the three months ended March 31, 2018 compared to the same period in 2017. This increase was primarily driven by relatively fixed manufacturing overhead and service costs as we scaled our business, partially offset by a decrease

27


in product margins due primarily to product mix. We expect our gross margins to fluctuate over time, depending on the factors described above.
Operating Expenses (in thousands, except percentages)
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 March 31,
 
Change in
 
 
2018
 
2017
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
$
102,362

 
$
81,610

 
$
20,752

 
25.4
 %
Sales and marketing
 
42,140

 
37,027

 
5,113

 
13.8

General and administrative
 
19,679

 
22,155

 
(2,476
)
 
(11.2
)
Total operating expenses
 
$
164,181

 
$
140,792

 
$
23,389

 
16.6
 %
Research and development.
Research and development expenses increased $20.8 million, or 25.4%, for the three months ended March 31, 2018 compared to the same period in 2017. The increase was primarily due to an $11.0 million increase in personnel costs, including stock-based compensation and corporate bonuses, driven primary by headcount growth and an increase in the grant-date fair value of equity awards, a $9.2 million increase in third-party engineering costs driven by additional outsourced development projects, and a $1.9 million increase in facility and IT costs due to headcount growth and increased business activities.
We expect our research and development expenses to increase in absolute dollars as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.
Sales and marketing.
Sales and marketing expenses increased $5.1 million, or 13.8% for the three months ended March 31, 2018 compared to the same period in 2017. The increase was primarily due to a $4.7 million increase in personnel costs, including higher stock-based compensation, driven by headcount growth and an increase in the grant date fair value of equity awards.
We expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our sales and marketing efforts worldwide.
General and administrative.
General and administrative expenses decreased $2.5 million, or 11.2%, for the three months ended March 31, 2018 compared to the same period in 2017. The decrease was primarily due to a $4.4 million decrease in litigation related expenses due to the timing of litigation activities associated with our ongoing Cisco legal matters. This decrease was offset partially by a $1.0 million increase in personnel related costs, including increased stock-based compensation, driven by increased headcount and an increase in the grant-date fair value of our equity awards.
We expect our general and administrative expenses to fluctuate in absolute dollars from period to period depending on the timing and progress of our litigation activities.
Other Income (Expense), Net (in thousands, except percentages)
 
 
Three Months Ended March 31,
 
Change in
 
 
2018
 
2017
 
$
 
%
Other income (expense), net:
 
 
 
 
 
 
 
 
Interest expense
 
$
(687
)
 
$
(715
)
 
$
28

 
(3.9
)%
Other income (expense), net
 
4,843

 
1,025

 
3,818

 
372.5

Total other income (expense), net
 
$
4,156

 
$
310

 
$
3,846

 
1,240.6
 %
Other income (expense), net increased during the three months ended March 31, 2018 compared to the same period in 2017 primarily due to an increase in interest income as we continued to generate cash and expand our marketable securities portfolios.
We expect our interest income continue to grow in 2018 as we continue to grow our cash balance and invest our excess cash in marketable securities. We expect our foreign currency gains and losses continue to fluctuate in the future due to changes in foreign currency exchange rates. In connection with our adoption of ASU 2016-01, other income (expense) may fluctuate in the future as a result

28


of the re-measurement of our private company equity investments upon the occurrence of observable price changes and/or impairments. See Note 1 of Notes to Condensed Consolidated Financial Statements for details of this new guidance.
Benefit from Income Taxes (in thousands, except percentages)
We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, our U.S. tax obligations are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes.
 
 
Three Months Ended March 31,
 
Change in
 
 
2018
 
2017
 
$
 
%
Benefit from income taxes
 
$
(1,644
)
 
$
(9,233
)
 
$
7,589

 
(82.2
)
Effective tax rate
 
(1.2
)%
 
(12.5
)%
 


 


The change in the effective tax rate in the three months ended March 31, 2018, as compared to the same period in 2017, was primarily due to the overall increase in earnings and the inclusion of foreign earnings in the U.S. which proportionally exceeded the increase in excess tax benefits attributable to equity compensation. These changes were all taxed at a lower U.S. corporate tax rate under the Tax Cuts and Jobs Act (the “Tax Act”) passed in December 2017.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; and (5) creating the base erosion anti-abuse tax (“BEAT”), a new minimum tax.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (“GILTI”) wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. This income will effectively be taxed at a 10.5% tax rate in general. Our deferred tax assets and liabilities are still being evaluated to determine if they should be recognized for the basis differences expected to reverse as a result of GILTI provisions that are effective for us after the calendar year ending December 31, 2017. Because of the complexity of the new provisions, we are continuing to evaluate how the provisions will be accounted for under U.S. GAAP wherein companies are allowed to make an accounting policy election of either (i) account for GILTI as a component of tax expense in the period in which we are subject to the rules (the “period cost method”), or (ii) account for GILTI in our measurement of deferred taxes (the “deferred method”). Currently, we have not elected a method but we have included an estimate of the impact to our effective tax rate for the year ended December 31, 2018. A formal election will only be made after our completion of the analysis of the GILTI provisions and our election method will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in our taxable income related to GILTI and, if so, the impact that is expected.
As of March 31, 2018, we have not yet completed our accounting for the tax effects of the enactment of the Tax Act. We recognized a provisional tax amount of $51.8 million in the fourth quarter of 2017 for the transition tax liability and the revaluation of our deferred income taxes as a result of the rate change. In the three months ended March 31, 2018, we did not revise this estimate. In addition, we recorded a reasonable estimate for the effect of the new legislation as discussed above, which impacts the US income tax liabilities for the year ending December 31, 2018. Our estimates may also be affected as we gain a more thorough understanding of the tax law. These changes could be material to income tax expense. We will continue to refine our estimates related to the impact of the Tax Act during the one year measurement period allowed under Staff Accounting Bulletin 118 (“SAB 118”).
Liquidity and Capital Resources
Our principal sources of liquidity are cash, cash equivalents, marketable securities, and cash generated from operations. As of March 31, 2018, our total balance of cash, cash equivalents and marketable securities was $1.7 billion, of which approximately $197.3 million was held outside the U.S. in our foreign subsidiaries. 
Our cash, cash equivalents and marketable securities are held for working capital purposes. Our marketable securities investment portfolio is primarily invested in highly-rated securities with the primary objective of minimizing the potential risk of principal loss. We plan to continue to invest for long-term growth. We believe that our existing balances of cash, cash equivalents and marketable securities together with cash generated from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced product and service offerings, our costs associated with supply chain activities, including access to outsourced manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and costs incurred related to outstanding litigation claims. If we require or elect to seek additional capital through debt or equity financing in the future, we may not be able to raise capital on terms acceptable to us or at all. If

29


we are required and unable to raise additional capital when desired, our business, operating results and financial condition may be adversely affected.
Cash Flows
 
 
Three Months Ended March 31,
 
 
2018

 
2017
  As Adjusted (1)
 
 
 
 
 
 
 
(in thousands)
Cash provided by operating activities
 
$
195,541

 
$
162,862

Cash used in investing activities (1)
 
(183,864
)
 
(1,668
)
Cash provided by financing activities
 
15,308

 
18,518

Effect of exchange rate changes
 
(14
)
 
184

Net increase in cash, cash equivalents and restricted cash
 
$
26,971

 
$
179,896

___________________________
 
 
 
 
(1) Cash used in investing activities for the three months ended March 31, 2017 was adjusted as a result of our adoption of ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in the first quarter of 2018. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q for more information.
Cash Flows from Operating Activities
During the three months ended March 31, 2018, cash provided by operating activities was $195.5 million, primarily from net income of $144.5 million with non-cash adjustments to net income of $23.0 million, and a net increase of $28.0 million in cash from changes in our operating assets and liabilities. Our operating cash benefited $40.0 million from a decline in accounts receivable resulted from strong cash collections in the quarter, $38.1 million from decreased inventory driven by improved management and timing of receipts, and $20.0 million from an increase in accounts payable due to timing of inventory purchases and receipts. These favorable changes were partially offset by a $48.1 million decline in accrued liabilities due to corporate bonus payments and timing of vendor payments related to product development activities and inventory purchases, a $42.7 million decline in deferred revenue primarily due to revenue recognition as customers continued to certify and accept our 945 investigation-related product redesigns in the first quarter of 2018.
During the three months ended March 31, 2017, cash provided by operating activities was $162.9 million, resulting from net income of $83.0 million, non-cash adjustments to net income of $24.2 million, and a net increase in cash from changes in our operating assets and liabilities of $55.7 million. Our operating cash benefited from increased deferred revenue of $124.2 million resulting from growth in product deferred revenue related to contract acceptance terms and ongoing growth in PCS contracts. In addition, we experienced strong cash collections in the period, generating $44.1 million of cash. These increases were partially offset by growth in inventory of $50.3 million, supporting overall growth in the business and the expansion of our manufacturing and supply chain activities. In addition, accounts payable and accrued liabilities declined $33.8 million primarily due to corporate bonus payments and the timing of vendor payments related to inventory purchases. Prepaid expenses and current assets increased by $29.1 million primarily due to higher deferred cost of inventory associated with the increased product revenue deferrals referenced above, and an increase in income taxes receivable from excess tax benefits generated from stock option exercises and vesting of stock awards.
Cash Flows from Investing Activities
During the three months ended March 31, 2018, cash used in investing activities was $183.9 million, consisting of purchases of available-for-sale securities of $268.0 million, offset by proceeds of $90.4 million from maturities of marketable securities, and purchases of property and equipment of $6.3 million.
During the three months ended March 31, 2017, cash used in investing activities was $1.7 million, consisting of purchases of available-for-sale securities of $61.5 million, offset by proceeds of $64.5 million and purchases of property, equipment and other assets of $4.6 million.
Cash Flows from Financing Activities
During the three months ended March 31, 2018, cash provided by financing activities was $15.3 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $17.3 million.
During the three months ended March 31, 2017, cash provided by financing activities was $18.5 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $19.5 million.

30


Off-Balance Sheet Arrangements
As of March 31, 2018, we did not have any relationships with any unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commitments
Our contractual obligations represent material expected or contractually committed future payment obligations. We believe that we will be able to fund these obligations through cash generated from operations and from our existing balances of cash, cash equivalent and marketable securities. As of March 31, 2018, our principal commitments consist primarily of obligations under operating and financing leases for offices and data centers and purchase commitments with our contract manufacturers and suppliers. There have been no significant changes to these obligations during the three months ended March 31, 2018, compared to the contractual obligations disclosed in our “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K, filed with the SEC on February 20, 2018, other than the new operating leases entered into in 2018 and the purchase commitments described in Note 5 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q.
Critical Accounting Policies and Estimates 
Our management’s discussion and analysis of financial condition and results of operations is based on our unaudited condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.
During the three months ended March 31, 2018, we adopted the new revenue recognition guidance under ASC 606 as discussed in the section titled Recently Adopted Accounting Pronouncements of Note 1 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q. As a result, we updated our critical accounting policy on revenue recognition as follows. There have been no changes to our other critical accounting policies and estimates discussed in the section titled Management's Discussion and Analysis of Financial Condition and Results of Operations under PART II, Item 7, of our Annual Report on Form 10-K filed with the SEC on February 20, 2018. We believe our critical accounting policies and estimates reflect our significant judgments and estimates used in the preparation of the condensed consolidated financial statements in this Form 10-Q.
Revenue Recognition
The following revenue recognition policy was effective January 1, 2018 following our adoption of the new revenue recognition guidance under ASC 606 using the modified retrospective method as discussed in the section titled Recently Adopted Accounting Pronouncements of Note 1 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q. Prior to 2018, our revenue recognition policy was under ASC 605, Revenue Recognition, and is described in Note 1 of Notes to Consolidated Financial Statements under PART II, Item 8, of our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018.
We generate revenue from sales of our products, which incorporate our EOS software and accessories such as cables and optics, to direct customers and channel partners together with PCS. We typically sell products and PCS in a single contract. We recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:
Identification of the contract, or contracts, with a customer
Identification of the performance obligations in the contract
Determination of the transaction price
Allocation of the transaction price to the performance obligations in the contract
Recognition of revenue when (or as) we satisfy the performance obligation
Post-Contract Customer Support    
PCS, which includes technical support, hardware repair and replacement parts beyond standard warranty, bug fixes, patches and unspecified upgrades on a when-and-if-available basis, is offered under renewable, fee-based contracts. We initially defer PCS revenue and recognize it ratably over the life of the PCS contract as there is no discernable pattern of delivery related to these promises. We do not provide unspecified upgrades on a set schedule and addresses customer requests for technical support if and when they arise, with the related expenses recognized as incurred. PCS contracts generally have a term of one to three years. We include billed but unearned PCS revenue in deferred revenue.

31


Contracts with Multiple Performance Obligations
Most of our contracts with customers, other than renewals of PCS, contain multiple performance obligations with a combination of products and PCS. Products and PCS generally qualify as distinct performance obligations. Our hardware includes EOS software, which together deliver the essential functionality of our products. For contracts which contain multiple performance obligations, we allocate revenue to each distinct performance obligation based on the SSP. Judgment is required to determine the SSP for each distinct performance obligation. We use a range of amounts to estimate SSP for products and PCS sold together in a contract to determine whether there is a discount to be allocated based on the relative SSP of the various products and PCS.
If we do not have an observable SSP, such as when we do not sell a product or service separately, then SSP is estimated using judgment and considering all reasonably available information such as market conditions and information about the size and/or purchase volume of the customer. We generally use a range of amounts to estimate SSP for individual products and services based on multiple factors including, but not limited to the sales channel (reseller, distributor or end customer), the geographies in which our products and services are sold, and the size of the end customer.
We limit the amount of revenue recognition for contracts containing forms of variable consideration, such as future performance obligations, customer-specific returns, and acceptance or refund obligations. We include some or all of an estimate of the related at risk consideration in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recorded under each contract will not occur when the uncertainties surrounding the variable consideration are resolved.
We account for multiple contracts with a single partner as one arrangement if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract.
We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical returns rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.
Our policy applies to the accounting for individual contracts. However, we have elected a practical expedient to apply the guidance to a portfolio of contracts or performance obligations with similar characteristics so long as such application would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio. Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.
We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.
Recent Accounting Pronouncements
Refer to the sections titled “Recently Adopted Accounting Pronouncements” and Recent Accounting Pronouncements Not Yet Effective” in Note 1 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q.

Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and investments in privately-held companies.
Foreign Currency Exchange Risk
Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Substantially all of our revenue is denominated in U.S. dollars, and therefore, our revenue is not directly subject to foreign currency risk. However, we are indirectly exposed to foreign currency risk. A stronger U.S. dollar could make our products and services more expensive in foreign countries and therefore reduce demand. A weaker U.S. dollar could have the opposite effect. Such economic exposure to currency fluctuations is difficult to measure or predict because our sales are also influenced by many other factors.
Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the U.S. and to a lesser extent in Europe and Asia. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. For the three months ended March 31, 2018 and 2017, the effect of a hypothetical 10% change in foreign currency exchange rates applicable to our business would not have had a material impact on our operating results. To date, foreign currency transaction gains and losses and exchange rate fluctuations have not been material to our financial statements. While we have not engaged in the hedging of our foreign currency transactions to date, we may in the future hedge selected significant transactions denominated in currencies other than the U.S. dollar.

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Interest Rate Sensitivity
As of March 31, 2018 and December 31, 2017, we had cash, cash equivalents and available-for-sale marketable securities totaling $1.7 billion and $1.5 billion, respectively. Cash equivalents and marketable securities were invested primarily in money market funds, corporate bonds, U.S. agency mortgage-backed securities, U.S. treasury securities and commercial papers. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of the interest rates in the U.S. A decline in interest rates would reduce our interest income. For the three months ended March 31, 2018 and 2017, the effect of a hypothetical 100 basis point increase or decrease in overall interest rates would not have had a material impact on our interest income. 
On the other hand, when interest rates rise, our marketable securities purchased at a lower yield would incur a mark-to-market unrealized loss. Under certain circumstances, if we are forced to sell our marketable securities prior to maturity, we may incur realized losses in such investments. However, because of the conservative and short-term nature of the investments in our portfolio, a change in interest rates is not expected to have a material impact on our condensed consolidated financial statements.
Investments in Privately-Held Companies
Our non-marketable equity investments in privately-held companies are recorded in investments, non-current in our consolidated balance sheets. As of March 31, 2018 and December 31, 2017, the total carrying amount of our investments in privately-held companies was $36.1 million. See Note 4 of Notes to Condensed Consolidated Financial Statements of this Form 10-Q.
The privately-held companies in which we invested are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire investment in these companies. Our evaluation of investments in privately-held companies is based on the fundamentals of the businesses invested in, including among other factors, the nature of their technologies and potential for financial return.



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Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Management, with the participation of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on the evaluation of our disclosure controls and procedures as of March 31, 2018, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended March 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
In connection with our adoption of the new revenue recognition guidance in the first quarter of 2018, we implemented internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new revenue recognition standards on our financial statements. There were no significant changes to our internal control over financial reporting due to the adoption of the new revenue recognition guidance.
Inherent Limitations of Internal Controls
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The information set forth under the “Legal Proceedings” subheading in Note 5 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1, of this Quarterly Report on Form 10-Q incorporated herein by reference.

Item 1A. Risk Factors
You should consider carefully the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, which could materially affect our business, financial condition, results of operations and prospects. The risks described below are not the only risks facing us. Risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially affect our business, financial condition, results of operations and prospects.
Risks Related to Our Business and Our Industry
Our business and operations have experienced rapid growth, and if we do not appropriately manage any future growth or are unable to improve our systems and processes, our business, financial condition, results of operations and prospects will be adversely affected.
We have experienced rapid growth and increased demand for our products over the last several years, which has placed a strain on our management, administrative, operational and financial infrastructure. Our employee headcount and number of end customers have increased, and we expect both to continue to grow over the next year. For example, between December 31, 2011 and December 31, 2017, our headcount grew from approximately 250 employees to approximately 1,800 employees, and our cumulative number of end customers grew from approximately 1,100 to over 4,900. As we have grown, we have had to manage an increasingly large and more complex array of internal systems and processes to scale with all aspects of our business, including our hardware and software development, contract manufacturing, purchasing, logistics, fulfillment and maintenance and support. Our success will depend in part upon our ability to manage our growth effectively. To do so, we must continue to increase the productivity of our existing employees and continue to hire, train and

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manage new employees as needed. To manage domestic and international growth of our operations and personnel, we will need to continue to improve our operational, financial and management controls and our reporting processes and procedures and implement more extensive and integrated financial and business information systems. We may not be able to successfully implement these or other improvements to our systems and processes in an efficient or timely manner, and we may discover deficiencies in their capabilities or effectiveness. We may experience difficulties in managing improvements to our systems and processes or in connection with third-party technology. In addition, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate effectively and in the intended manner, may result in disruption of our current operations and end-customer relationships, our inability to manage the growth of our business and our inability to accurately forecast our revenue, expenses and earnings and prevent certain losses.
Our limited operating history makes it difficult to evaluate our current business and future prospects and may increase the risk associated with your investment.
We shipped our first products in 2008 and the majority of our revenue growth has occurred since the beginning of 2010. Our limited operating history makes it difficult to evaluate our current business and our future prospects, including our ability to plan for and model future growth. We have encountered and will continue to encounter risks and difficulties frequently experienced by rapidly growing companies in constantly evolving industries, including the risks described elsewhere in this Quarterly Report on Form 10-Q. If we do not address these risks successfully, our business, financial condition, results of operations and prospects will be adversely affected, and the market price of our common stock could decline. Further, we have limited historical financial data, and we operate in a rapidly evolving market. As such, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.
Our revenue growth rate in recent periods may not be indicative of our future performance.
Our revenue growth rate in recent periods may not be indicative of our future performance. We experienced annual revenue growth rates of 45.8%, 34.8%, and 43.4% in 2017, 2016, and 2015, respectively. In addition, we experienced quarterly revenue growth rates of 38.5%, 50.8%, 50.8%, and 42.7% in 2017 versus the comparable period in 2016 due to stronger than expected demand for our products and services. In the future, we expect our revenue growth rates to decline as the size of our customer base increases, we achieve higher market penetration in our current target market and we continue to enter and expand into new target markets. Other factors may also contribute to declines in our growth rates, including changes in demand for our products and services, increased competition, our ability to successfully manage our expansion or continue to capitalize on growth opportunities, the maturation of our business and general economic conditions. You should not rely on our revenue for any prior quarterly or annual period as an indication of our future revenue or revenue growth. If we are unable to maintain consistent revenue or revenue growth, our business, financial condition, results of operations and prospects could be materially adversely affected, our stock price could be volatile, and it may be difficult for us to achieve and maintain profitability.
Our results of operations are likely to vary significantly from period to period and be unpredictable and if we fail to meet the expectations of analysts or investors or our previously issued financial guidance, or if any forward-looking financial guidance does not meet the expectation of analysts or investors, the market price of our common stock could decline substantially.
Our results of operations have historically varied from period to period, and we expect that this trend will continue. As a result, you should not rely upon our past financial results for any period as indicators of future performance. Our results of operations in any given period can be influenced by a number of factors, many of which are outside of our control and may be difficult to predict, including:    
our ability to increase sales to existing customers and attract new end customers, including large end customers;
the budgeting cycles, purchasing practices and buying patterns of end customers, including large end customers who may receive lower pricing terms due to volume discounts and who may or may not make large bulk purchases in certain quarters;
changes in end-customer, geographic or product mix;
the cost and potential outcomes of existing and future litigation, including Cisco and OptumSoft litigation matters including our ability to comply with any USITC remedial orders issued in connection with the Cisco litigation;
our ability to develop, market and sell new products and services that are acceptable to our customers including redesigned products that comply with any USITC remedial orders issued in connection with the Cisco litigation;
changes in the sales and implementation cycles for our products including the qualification and testing of our redesigned products by our customers and any delays or cancellations of purchases caused by such activities;
the rate of expansion and productivity of our sales force;
changes in our pricing policies, whether initiated by us or as a result of competition;
our inability to fulfill our end customers’ orders due to the availability of inventory, supply chain delays, access to key commodities or technologies or events that impact our manufacturers or their suppliers;
the amount and timing of operating costs and capital expenditures related to the operation and expansion of our business;
changes in end-customer, distributor or reseller requirements or market needs;

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difficulty forecasting, budgeting and planning due to limited visibility beyond the first two quarters into the spending plans of current or prospective customers;
deferral or cancellation of orders from end customers, including in anticipation of new products or product enhancements announced by us or our competitors, or warranty returns;
the inclusion of any acceptance provisions in our customer contracts or any delays in acceptance of those products;
changes in the growth rate of the networking market;
the actual or rumored timing and success of new product and service introductions by us or our competitors or any other change in the competitive landscape of our industry, including consolidation among our competitors or end customers;
our ability to successfully expand our business domestically and internationally;
our ability to increase the size of our sales or distribution channel, any disruption in our sales or distribution channels, and/or termination of our relationship with important channel partners;
decisions by potential end customers to purchase cloud networking solutions from larger, more established vendors, white box vendors or their primary network equipment vendors;
price competition;
insolvency or credit difficulties confronting our end customers, which could adversely affect their ability to purchase or pay for our products and services, or confronting our key suppliers, including our sole source suppliers, which could disrupt our supply chain;
seasonality or cyclical fluctuations in our markets;
future accounting pronouncements or changes in our accounting policies;
stock-based compensation expense;
our overall effective tax rate, including impacts caused by any reorganization in our corporate structure, any changes in our valuation allowance for domestic deferred tax assets and any new legislation or regulatory developments, including the Tax Act;
increases or decreases in our expenses caused by fluctuations in foreign currency exchange rates, as an increasing portion of our expenses are incurred and paid in currencies other than the U.S. dollar;
general economic conditions, both domestically and in foreign markets; and
other risk factors described in this Quarterly Report on Form 10-Q.
Any one of the factors above or the cumulative effect of several of the factors described above may result in significant fluctuations in our financial and other results of operations. This variability and unpredictability could result in our failure to meet our revenue, gross margins, results of operations or other expectations contained in any forward looking financial guidance we have issued or the expectations of securities analysts or investors for a particular period. If we fail to meet or exceed such guidance or expectations for these or any other reasons, the market price of our common stock could decline substantially, and we could face costly lawsuits, including securities class action suits.
The cloud networking market is rapidly evolving. If this market does not evolve as we anticipate or our target end customers do not adopt our cloud networking solutions, we may not be able to compete effectively, and our ability to generate revenue will suffer.
A substantial portion of our business and revenue depends on the growth and evolution of the cloud networking market. The market demand for cloud networking solutions has increased in recent years as end customers have deployed larger, more sophisticated networks and have increased the use of virtualization and cloud computing. The continued growth of this market will be dependent upon many factors including but not limited to the adoption of our end customers’ products and services, the expansion, evolution and build out of our end customers’ networks, the overcapacity of existing network infrastructures, changes in the technological requirements for the products and services to be deployed in these networks, the amount and mix of capital spending by our end customers, the development of network switches and cloud service solutions by our large end customers for internal use, the financial performance and prospects of our end customers, the availability of capital resources to our end customers, changes in government regulation that could impact cloud networking business models including those regulations related to cyber security, privacy, data protection and net neutrality, our ability to provide cloud networking solutions that address the needs of end customers more effectively and economically than those of other competitors or existing technologies and general economic conditions.
If the cloud networking solutions market does not develop in the way we anticipate, if our solutions do not offer benefits compared to competing networking products or if end customers do not recognize the benefits that our solutions provide, then our business, financial condition, results of operations and prospects could be materially adversely affected.
If we are unable to attract new large end customers or to sell additional products to our existing end customers, our revenue growth will be adversely affected and our revenue could decrease.
To increase our revenue, we must add new end customers and large end customers and sell additional products to existing end customers. For example, one of our sales strategies is to target specific projects at our current end customers because they are familiar

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with the operational and economic benefits of our solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing infrastructure and expected future spend. Another one of our sales strategies is focused on increasing penetration in the enterprise market. Enterprise end customers typically start with small purchases, and there is often a long testing period. If we fail to attract new large end customers, including enterprise end customers, or fail to reduce the sales cycle and sell additional products to our existing end customers, our business, financial condition, results of operations and prospects will be harmed.
We expect large purchases by a limited number of end customers to continue to represent a substantial portion of our revenue, and any loss or delay of expected purchases could result in material quarter-to-quarter fluctuations of our revenue or otherwise a