Arista Networks, Inc. (ANET) Q2 2014 Earnings Report, Transcript and Summary

Welcome to the Second Quarter 2014 Arista Networks Financial Results Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded and will be available for replay from the Investor Relations section of the Arista website following this call. I will now turn the call over to Mr. Chuck Elliott, Director of Investor Relations. Sir, you may begin.

Good afternoon, everyone, and thank you for joining us. With me on today's call are Jayshree Ullal, Arista Networks President and Chief Executive Officer; and Kelyn Brannon, Chief Financial Officer. This afternoon, Arista Networks issued a press release announcing the results for its fiscal second quarter ended June 30, 2014. If you would like a copy of the release, you can access it online at the company's website. During the course of this conference call, Arista Networks management will make forward-looking statements, including those relating to our financial outlook and industry innovation, which are subject to the risks and uncertainties that we discussed in detail in our documents filed with the SEC, specifically in our Form 10-Q and recent prospectus, and which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings press release. With that, I will turn the call over to Jayshree.

Thank you, Chuck. Thank you, everyone, for joining us this afternoon for our inaugural earnings call as a public company. I am pleased to report that we had a good second quarter. Strong customer demand for our products drove Q2 2014 results that exceeded consensus estimates. From a geography perspective, our customers in the Americas generated 74.8% of our sales. We are investing in global expansion of our international distribution. Revenue grew by 65.2% year-over-year to a record $137.9 million, driven by sales of our flagship 7500E Spine and X-Series Spline platform. We delivered non-GAAP gross margin of 67.9%, resulting in a non-GAAP EPS of $0.35, as we grew profitably in a competitive and dynamic industry. Favorable mix and lower OpEx spend, especially in G&A, contributed to this outcome. In terms of customer trend, cloud scale economics and the need for OpEx reductions is driving data center infrastructure spend. It is a top of mind and growing priority for customers across our 4 principle verticals. There is also a clear understanding that the economics of the hyper-scale cloud are achievable within the enterprise using similar clarification approaches. We now have more than 2,700 customers going from a typical 1-a-day customer acquisition in 2013 to 1-to-2 a day at the present. This quarter, we continued a breakthrough leadership via new product innovations and important standard space consortium. Arista furthered industry-wide open standard for announcing partnerships including Puppet Supported Program Certification for server automation, AVnu Alliance for Audio Video Bridging certification and a 25 and 50 gigabit Ethernet consortium with Broadcom, Google, Microsoft, Mellanox and Arista. Since then, the IEEE Standards and additional vendors have endorsed the approach of this consortium. Arista introduced the industry's first leaf switch with 100-gigabit Ethernet uplinks, the Arista 7280, for high-end storage and streaming content application. We believe we have once again outpaced the industry with this disruptive product. Arista also introduced the industry's first universal 40-gigabit Ethernet optic, designed to work on both multi-mode and single-mode fiber. Arista showcased advanced EOS software capabilities with Smart System Upgrades, SSU, at the leaf switch level with close to 0 downtime for software upgrade versus the typical minutes required by legacy alternatives. We also released the Arista 7500-based DANZ, Data AnalyZer, and OpenFlow 1.3 support as network visibility tools. In terms of architecture, Arista's universe of cloud-network approach is a fundamental shift from the old-school networking approach of pulling and reacting to a much more modern proactive model. We believe applications must be handled universally across a state-based programmable and open network. This migration from the archaic policy per app to a universe of cloud network based on modern workloads and workflows is crystal clear in Arista Network design. The legacy 1990s web, file and database tier in client-server architectures with north-south traffic is migrating to universal telemetry and automation for east-west and server-to-server traffic in the 21st century. In terms of wildcard topics, I'm frequently asked about our views on Facebook's Wedge announcement made in June of 2014. We welcome it, in short, as a validation of Arista. Arista has codeveloped API with Facebook, which run on our switches and offer functionality for specific applications in Facebook's network. Facebook's Wedge proposal is a reference design that is not attempting to address broad data center use cases. We believe Arista's EOS is a complimentary approach to Facebook's Wedge. The granular programmability across all elements of an Arista EOS switch has entailed more than 1,000 man year of engineering development in building that centralized shared system database state-oriented OS, which represents a decade of engineering investment from Arista. Today's white boxes have limited support for these advanced capabilities. They are, if you will, more engineering building blocks and represent the LEGO approach to networking. We see these as complementary use cases for solo versus multiple applications. Today, on our inaugural call, I'd like to highlight a special partner, VMware. We are very pleased with the growing partnership with VMware. It continues to get stronger and evolve at both a joint development and go-to market level. Arista's software architecture treats the entire network holistically across physical, virtual and cloud-based infrastructure without necessarily reinventing VMware's industry-leading installed virtualization platform. Arista is interoperable and adds value with existing VMware-based networks. We are committed to working with VMware products, be they ESX, vSphere, vCloud, NSX or vC Ops to optimally combine VMware's overlay and Arista's programmable underlay physical networks for the best network-wide virtualization deployment. Our joint efforts span 3 pillars and 3 phases. One, we have paid careful attention to the visibility of applications, flows, virtual machines and layer 2, 3, 4 addresses for a powerful troubleshooting suite of techniques across virtual and physical workloads with the right instrumentation and tools. Example, VM Tracer and Log Insight. Two, we've worked closely with VMware on OpenStack and OVSDB development as well as interoperability using VXLAN, virtual extensible LAN, a specification we both co-authored. Three, we offer a cloud network for private and hybrid cloud stack with support for the best of breed multi-protocol and multi-hypervisor environments. Our joint efforts and overall partnership represents 4 years of engineering and customer deployment for total network-wide orchestration and visibility. We look forward to seeing many of you at our booth at VMWorld in San Francisco later this month. In summary, I'd like to recap by reminding all of you that Arista pioneered the concept of two-tier leaf spine in 2008 through 2010. And later in 2013, we introduced the one-tier spline for cloud networking. Five years later, the cloud network is much more mainstream. While our peers are still trying to mimic this visionary approach, they lack the fundamental modern software technology or scale to achieve it. Throughout the years, we witnessed many failed attempts to lock in customers with proprietary fabrics, and yet our customers demand an open, agile and standards-based IP framework for their dynamic cloud applications. With that, I'll wrap it up and turn the call over to Kelyn Brannon, CFO of Arista Networks.

Thank you, Jayshree, and good afternoon, everyone. I'll walk through our unaudited statement of operations and compare the second quarter ended June 30, 2014 to the prior quarter of 2014 and the second quarter of 2013, and after that, I will briefly discuss the balance sheet. I'd like to note that except for revenue figures that are GAAP, all financial figures are non-GAAP unless stated otherwise. A reconciliation of selected GAAP to non-GAAP results is provided in our earnings release. Non-GAAP results exclude noncash expenses such as spot-based compensation and a one-time item that includes an unrealized gain on a note receivable. Revenue for the second quarter came in at a record $137.9 million, an increase of 18% compared to the $117.2 million for the first quarter of 2014 and an increase of 65% from the $83.5 million in the second quarter of 2013. Our business displays seasonality, and the second quarter is traditionally sequentially stronger than our first quarter. Q2 of 2014 was no exception. Second quarter comparisons year-over-year showed strong growth on a top of a record Q2 2013 with significant spend by our 4 principle verticals. International revenues comprised 25% of total revenues in the second quarter, an increase from 18% in the prior quarter of 2014 and an increase from 17% in Q2 2013. The geographic mix of revenue was 75% in the Americas, 15% EMEA and 10% APAC. The sequential and year-over-year quarterly increases reflect our existing U.S.-based global customers building out their data centers utilizing our international direct fulfillment centers for efficient purchasing. Non-GAAP gross margin for the second quarter was 67.9% down from 69.6% in the prior quarter and up from 64.7% the year-ago quarter. The sequential decline primarily reflects a onetime benefit in Q1 2014 from a cash settlement that was not repeated in Q2, offset by reductions in required warranty reserves in the second quarter of 2014. In comparison to the prior year quarter, margin improvement resulted from reductions in required warranty and inventory-related reserves. Our performance in Q2 2004 clearly reflects movement in gross margin in accordance with our long-term business plan. Without the onetime benefits in Q1 2014 and the reduction in warranty and inventory-related reserves in Q2 2014, a normalized non-GAAP gross margin would be approximately 67% for both quarters. We expect our gross margins to average in the low- to mid-60% range in the long term. However, it can fluctuate up and down from quarter-to-quarter due to customer mix, product mix and the seasonality of our business. Turning to operating expenses, non-GAAP R&D spending was $31.4 million for the second quarter of 2014, an increase from the $31 million from the prior quarter of 2014 and an increase from the $20 million in the corresponding period in 2013. The sequential increase reflects increased headcount offset by timing of prototype expenses. In comparison to the prior year quarter, the increase reflects headcount addition and project-related expenses supporting our development activities. Non-GAAP sales and marketing spending was $18.8 million for the second quarter of 2014, an increase from the $17.2 million compared to the prior quarter of 2014 and an increase from $12.4 million in the corresponding period of 2013. The sequential quarter increase for the second quarter of 2014 reflects additional sales and sales engineer headcount, higher commissions in line with revenue growth and incremental marketing activities. In comparison to the prior year quarter, the increase reflects additional sales and sales engineer headcount and higher commissions in line with revenue growth. Non-GAAP G&A spending was $6.2 million for the second quarter of 2014, a decrease from the $6.6 million compared to the prior quarter and an increase from the $3.2 million in the corresponding period of 2013. The sequential decrease was primarily a result of lower accounting fees and finance-consulting expenses. In comparison to the prior year quarter, the increase was driven by the cost associated with becoming a fully operational public company litigation expense and a corporate bonus accrual. Non-GAAP operating income for the second quarter of 2014 was $37.4 million, an increase as compared to the $26.8 million in the prior quarter of 2014 and an increase as compared to the income of $18.3 million in the corresponding period of 2013. Our non-GAAP effective tax rate for Q2 was 31%. Non-GAAP net income for the second quarter of 2014 was approximately $23.7 million or $0.35 per diluted share using 67.5 million shares compared with a non-GAAP net income of $12.3 million or fully diluted earnings of $0.20 per share in Q2 of 2013 assuming the full quarter conversion of our IPO shares and the conversion of our notes payable and preferred shares to common shares. Our non-GAAP Q2 2014 fully diluted earnings of $0.35 per share was significantly impacted by a material movement of G&A spend into future quarters as our OptumSoft litigation was delayed, as well as certain accounting and finance compliance activities. Finally, OpEx spend was favorably impacted by timing of headcount additions in the back half of the quarter, which will have a full quarter run rate beginning in Q3 2014 as well as the onetime benefit from the reduction of warranty reserves. Turning to the balance sheet, we had cash, cash equivalents and investments of $397.2 million at June 30, 2014 including net IPO proceeds of $238.7 million. Cash flow from operations and free cash flow for the 6-month period ended June 30, 2014 was $63.9 million and $55.3 million, respectively. Capital expenditures in the 6 months totaled $8.6 million and were primarily related to purchases of development, testing and manufacturing equipment. The accounts receivable balance was $67.9 million, an increase in the prior quarter balance of $63 million. Linearity in the quarter improved, which helped improve average days sales outstanding to 45 days down from the 48 days last quarter. Current and noncurrent deferred revenue was $61.7 million, an increase of $5.6 million over the prior quarter and primarily service-related. The increase resulted from new service agreement and renewals. Inventory was $71.1 million, a decrease of $7.9 million from the prior quarter of 2014, yielding inventory turns of 2.4, an increase from the 1.9 turns in the prior quarter of 2014. Let me now move to our guidance. For the third quarter of fiscal 2014, our revenue target is $142 million to $150 million. Non-GAAP gross margin is anticipated to be in the 64% to 66% range. This excludes approximately $500,000 of stock-based compensation expense. We anticipate non-GAAP operating margins in the range of 19% to 22%. This excludes stock-based compensation of approximately $8 million. We estimate DSO will be in the high 40s to low 50s, and inventory turns remaining around 2 per year. Other than those quantified items noted previously, there are no other significant differences between our GAAP and non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events that may or may not be significant. As a reminder, Arista will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. And with that, I'll turn the call over to the operator for Q&A.

[Operator Instructions] Your first question is from Brian Marshall with ISI.

Can you talk a little bit about the sustainability of that revenue ramp going forward? Obviously, the numbers are getting bigger. Absolutely large numbers are just kind of kicking in, but you're still growing at a pretty phenomenal clip. Can you just talk a little bit about that? And I have one quick follow-up.

Brian, as you know, we live in a competitive dynamic situation, but we also have a large total available market opportunity. We have -- we continue to acquire new customers, and we believe that our 4 principle verticals will drive majority of our growth, which is the cloud titans, the Tier 2 service providers, the financials as well as the high-tech enterprise. Of course, some of these types of customers tend to be lumpy, so while they're hard to predict for the quarter, we have received good acceptance and believe we can continue the growth and guidance we are sharing with you for Q3.

Great, Jayshree. And Kelyn, quick one for you. If you think about your gross margins, obviously the longer-term guidance has forced some erosion there. If you look at the first half of 2014 versus the first half of 2013, you're obviously having some gross margin expansion. So could you talk a little bit about the drivers of what's pushing, propelling the margins up a little bit here?

Thanks, Brian, for the question. Our gross margin is lumpy. It does vary a lot by product and customer mix, and so as we look forward into Q3, as we said, we're looking at a 64% to 66% range, and we still feel very comfortable with our long-term model of around 60% to 65%.

Your next question is from Jess Lubert with Wells Fargo Securities.

Did you have any 10% customers in the period? And if so, can you tell us how many and let us know what percent of revenue these customers represented?

Yes, thank you very much. I'll take the question. We have only reported one 10% customer to date, which is Microsoft. And while we will not be reporting any customer concentration on a quarterly basis, that continues to remain our one customer concentration.

And then on the operating margin, it sounds like some expenses slipped into Q3. So I want to understand if Q3 should reflect the low watermark for operating margins, off which we see gradual improvement moving forward. And do you expect them to remain in the high teens or low 20s for at least a few quarters? Any kind of color on how we should be modeling that going forward? And if we do see additional revenue upside, can we expect that to continue to flow through the bottom line?

I'll let Jayshree address the additional revenue piece, but as I think about OpEx, I will not say that Q3 will be the low watermark simply because we have a number of things we're working on. So as you know, there's some litigation expense going on. By its very nature, it's going to be lumpy, so I can't say that Q4 or Q1 next year might have different impact. It's going to be a long process. Additionally, we have just started our SOX compliance work and continued to invest in our infrastructure, and that's going to continue in the short to medium term.

Yes, I think you answered the question, Kelyn.

Your next question is from Mark Sue with RBC Capital Markets.

If we could get a sense of the data center projects, most of them are very large cycle and project-specific, your overall visibility and pipeline outside of that and how you see the cycle spend by some of your larger customers; and overall, the visibility that you see from now, maybe perhaps at the end of the year as you accelerate your new customer addition. So kind of are some customers actually peaking? But are you actually seeing multiple cycles on top of that?

Thank you, Mark. I'll take the question. First of all, you're absolutely right that data center projects tend to be very large. But for Arista, they first start out small. So every customer acquisition tends to be first a small project and then we have to earn the right to win the data center, if you will, which can be anywhere from 9 months to 2 to 3 years, right? So what you're seeing, for example, with a very large customer like Microsoft or any of our top 10 customers, is that progression from where we start with a small project to obviously becoming the mainstream data center vendor of choice, and that can be over a period of time. So we believe that in all our 4 verticals, we've got tremendous opportunity to deepen our engagements and relationships with every one of them and get more share of wallet with these data center projects. They could be in the area of compute, storage, virtualization, private cloud. You name it. But plenty of opportunity and plenty of market there, especially for 10, 40 and 100-gig.

And just on the 100, who are some of the early adopters? And as they move to 100 from 40, are you seeing the interest level and a pattern replicate itself from your other expanding verticals customers so they also have a line of sight from 10 to 40 to 100?

Yes, I think it's safe to say that the majority of the market we see is really 10 gigabit to the server and compute, but we are starting to, as a result of so much 10-gig deployment, see both 40-gig to the storage especially from a peak traffic there as well as 100-gig between spines or as they interconnect between leaf and spines, I should say. 100-gig deployments tend to be future-proofing themselves for very high-performance content and media applications. They tend to be service providers and content providers and is especially reflected in 1 or 2 of our main verticals.

Next question is from Jeff Kvaal with Northland.

My first question, Jayshree, delves in a little bit more into your cloud titans commentary. When we assemble the CapEx numbers that come out of those cloud titans, there will inevitably be ups and downs in the CapEx numbers that come from them. How should we interpret that in terms of thinking through your results? I'm thinking in particular the Microsoft numbers this quarter weren't that great and yet you seem to have done fairly well. And then Kelyn, on your side, will you be reporting any book-to-bill or progress of services/metrics going forward?

Go ahead.

I'll take the last one so I remember it. So we have no plans to disclose any book-to-bill. We actually view customer acquisition as a leading indicator and bookings quite simply as a lagging indicator.

Thank you, Kelyn. Thank you, Jeff. I think it's fair to say that we seek tremendous opportunity in getting pieces of the cloud titans' CapEx budget because they're all very big. They're in the billions going to trillion, and the networking piece of that is a small component. Very clearly, we've also said that 2013 was a peak year for both Microsoft in terms of their CapEx as well as Arista in terms of being deployed in Microsoft Azure. We continue to enjoy a very good partnership and relationship with them. But as our numbers get larger, we expect a percentage of customer concentration to specifically come down from that specific cloud titan as other titans pick up. We also see some movement between cloud titans and Tier 2 cloud providers and service providers. It's very possible that some of them that we described in the report says 1 of the 7 titans are small and some other ones may emerge. So I think the message to take away from this is the cloud is a mainstream intent not only for public cloud providers but also for service providers and Tier 2 cloud providers who expect to become primary ones, and therefore, additive opportunity in all of those cases for Arista.

The next question is from Subu Subrahmanyan with Juda Group.

Two questions. First on the key verticals. All 4 verticals clearly going well. But Jayshree, I was wondering if there is some color, which are you think over the next 18 months the fastest-growing pieces. And also wondering if you could speak about the competitive environment given product constructions from your major competitors.

Yes, I think -- thank you, Subu. I couldn't point to one of them being faster growing than the others because, especially this quarter, we were equally balanced across them, and so we believe -- there's nothing that stood out in any one particular vertical being favored over the other, if that was your question. In terms of competitive dynamics, I think the competitive pressures for us continue to be as they have been in prior quarters. No change, but always aggressive. We respect our peers a lot. Many of them have dominant and monopolistic positions and are not afraid to cut price to 0 and often bundle with their other products, and it's something we have to selectively choose to compete against or walk away from. So no change from previous quarter but ongoing competitive pressures.

Next question is from Ehud Gelblum with Citigroup.

A couple of things. Kelyn, can you give us a sense -- I know Microsoft weren't going to give a number, but can you at least give us a sense as to whether, on an absolute basis, whether they were up or down or kind of flattish from last quarter? And in your guidance for the following quarter for Q3, what are you expecting them to do kind of just directionally? Just give us a sense on that. That would be awesome. Second thing, share-wise, you're obviously growing much faster than all of your competitors. So technically speaking, I know you're giving share. But are there any accounts that you can point to of material size where they were incumbent with somebody else and you actually took share away, as in -- I mean, I guess the key word here is away, as in an opportunity that they should have -- your competitors should have one that you actually took some. And then finally, the 7280, the high-end storage market, that seems to me it'd be an incremental opportunity on top of the standardized data center switching market that you kind of were originally in it before the 7280. Can you give us a sense as to how large that market could be and what could that grow into and when do you start seeing that?

That was a lot of questions there, Ehud.

I agree.

[indiscernible]

Well, you did that very skillful. So I'm going to go first, so I can get the -- I'll get the Microsoft question out of the way. Microsoft is going to always continue to be a very important customer to us. And as we look at them, we said that we were looking at them kind of flat year-over-year, and that's the trend we're seeing. I would expect over time that they're going to settle in. They're going to be a 10% customer, but they're going to be somewhere in the teens.

So your second question was, did you take share from competition and what's the reception on the 7280 then? It's -- we haven't seen the numbers yet for Q2, but we do believe it's a great software than the market, and we've typically grown 1 to 2 points every year that it wouldn't be surprising to us if we took share this quarter. But we don't have concrete numbers there, just a good wild analytical guess there. And the 7280, I'm very optimistic about this product and a number of customers have been very bullish. First of all, it's very unique value add. It's one of its kind. It's unbelievable and unimaginable that you can compress this kind of poor density in a 1RU Form Factor with 10 and 100-gig with multi-terabit of fabric in full layer 2, layer 3. The kind of applications we are seeing, as I pointed out, is there's a lot of customers who are interested in migrating to more scale out storage, extremely high-density, integrating with their high-performance terabits, storage clusters. This is probably the biggest one we see. And then in some cases also, there will be a slow-and-steady migration from fiber channel to Ethernet.

So should we be looking at the fiber channel market as the opportunity that this can grow into?

I think it's both the Tier 2 Ethernet market, which is more immediate, and then the long term. There is definitely a fiber channel to Ethernet migration.

Okay. And Kelyn, can you just give us a direction on Microsoft? Did it go up or down from last quarter in Q2?

I think what we want to give you in guidance is for the year, we expect it to be flat and become a lower concentration of our total revenue, most likely the teens. But we don't plan to give quarterly guidance on Microsoft.

The next question is from Alex Henderson with Needham & Company.

I was hoping you could step back a little bit from your perspective. You've got a much better read on the overall cloud spending patterns than any of us. Most of the cloud titans are pretty tight on talking about their CapEx plans, but I would assume that you have some better vantage point than the industry as a whole on the financial side with half of that. Can you give us your read of what you think the rate of growth in the aggregated CapEx of those players is doing, whether it's sustaining at a high rate or whether it's accelerating, decelerating? Any color would be very helpful.

I'll probably have to give you a short answer. Believe it or not, our customers are careful and cautious in informing us too, so we probably have a 1 to 2 quarter visibility, but not a 1 to 2 year visibility, right? And what's very clear is every one of our major customer prospects are in build out mode. They're in early stages mode. They're in customer acquisition mode, and they are responding to their customers. So it's not like the old days where they said, "Build it, and they'll come." They build it in real time when they come, and so that requires us, as you can tell, to really respond very quickly to their needs, both from a lead time and future point of view. But I think our visibility is also in the 1 to 2 quarter time frame.

If I could just ask one question on the financial side, and then I'll cede the floor. So obviously, you guys sharply outperformed expectations for the June quarter and your guide as well above what people had expected. I'm questioning whether you think that we should be trying to take that substantial upside surprise on the June and the September results and extrapolate that to higher levels as we look out over the next 3 or 4 quarters. I realize you don't want to give guidance that far out, but I think you've done a great job of keeping the expectations in check, so I just want to make sure that they stay commensurate to what you're looking out over more than one quarter for. Should we be assuming that you're able to ramp expenses faster than revenues at some point over the next 2 or 3 quarters to get those -- to bring those margins back under the 20% vicinity?

Yes, I'm going to take the first part of it and then we can talk about what kind of what those operating margins look like. Today, you now have 3 out of our 4 quarters for 2014, 2 quarters of actuals and then our financial guidance. And if you look, you can see that we continue to experience very strong revenue growth, but the year-over-year growth percentage is declining as our overall revenue increases, so we expect that to continue onwards. And additionally, if you look kind of -- we can peek at Q4, but historically, Q4 is in line with the Q2 and Q3 numbers. And then I'm going to caveat it all by saying our quarters are very lumpy, and we really do keep a weather eye on our competitors because our competitors continue to be very aggressive out in the market.

So costs will or will not catch up with revenue growth?

I think, as I said, as we look over the next 12 to 18 months, we really benefited in Q2 by lower G&A and the push out of some of the litigation expense and SOX compliance work. And so you're going to see starting in Q3 going through 2015, if not into early 2016, increasing cost there as well as us getting SOX compliant by the end of 2015.

And of course, we continue to aggressively invest in engineering that is the hallmark of this company, as well as sales and systems engineering. So we are making the investments, and we're reaping the benefits of investments we really made last year, this year.

Next question is from Brian Modoff with Deutsche Bank.

A couple of questions, if I may. First, can you talk about -- you mentioned earlier about international expansion. Can you give us some more granularity on what you're doing to grow your business internationally? Obviously, you have a good exposure to North America, but international is still a small part of your overall revenue. Some granularity around that, and then I have a follow-up question as well.

Well, Brian, thank you. We are continuing to be focused on the same 4 verticals that we identified in North America. Internationally as well. So a lot of them are global companies, so just making sure we adequately support them and expand our global footprint for major -- a lot of these companies as one aspect. The second is good old-fashioned investment both in our distribution and our channels. We are especially focusing on the developed country, so you can imagine that would be U.K., Germany, Nordics, Netherlands; and in Asia PAC: Japan, Korea; selective parts of the Asia subcontinent; Australia as well of course. So rather than doing a broad sweep of everywhere, we're really focused on the places internationally where -- which favors large data center projects.

Okay. Fair enough. Will this be -- will you also work with large distributors in terms of anything international that you would expand into? How that could be [indiscernible]?

Absolutely. Thank you for reminding me of that. Absolutely more so than the North America is the international is heavily dependent on distribution, and the distribution and partners are much, much more capable. It's almost -- the capability is proportional to distance, and so a very large part of our strategy is signing up, and we have already signed up important distribution in some of these major countries.

And will you see the impact on the revenue side from these efforts?

I think that and going back to our roadshow, we talked about that we are making investments in international and that we expect to see -- start to see fruition of that in the next 2 to 3 years.

Okay. And then my follow-up question is in my understanding, Andy and Arista helped define the future set of Xpliant, which is the company Cavium purchased, and you're one of its lead customers. When do you expect to begin shipping products with the Xpliant switch? And what features and advantages does it have over your -- the competing solutions?

I can't address the specific company or switch or product, but I can tell you that we appreciate silicon diversity. We have 3 architectures in our product portfolio already, and as new ones come in, we'll definitely evaluate them and look at them and build to them as they're good working products.

The next question is Kulbinder Garcha with Credit Suisse.

[Audio Gap] impact to cloud titans. The way it kind of came across in recent months is that there are several cloud titans that you guys are going to pursue. And I'm wondering 3 months in since we last spoke about this, how close are we to ramping one of these new ones materially? Is it something that you would expect over the next 12 months? And I'm just thinking how that might impact your financials because you previously implied that, that's probably going to be gross margin dilutive. Obviously, it didn't really have much of an impact this quarter. I'm just wondering going forward, is that something that you still expect? Then the second question I have is more linked to gross margins for your business full stop, which is that there's a cloud pressure maybe that comes. I understand that. But how about the 2 other pressures that you're dealing against the, as you said, monopolistic competitor and they can respond? Have you seen any evidence of that recently? And then the next one, gross margin, is just that if you do integrate with VMware successfully, isn't there a risk that you have a commoditized part of the deal? And is that really a 60% gross margin business long term? I'm just wondering how you see all those dynamics playing out.

Okay. You managed to get in 3 questions. I'll try to answer them backwards. First of all, I want to address the VMware friend or foe very clearly. We believe that we have formed a very technical and customer-driven partnership with VMware, and I don't know why the industry thinks that it needs to be a foe or a friend. Because really, VMware has brought tremendous status and market and customer capability and virtualization, and companies like Arista are doing the same with physical networks. What's lacking right now is the best of both being combined. They're really 2 different islands, and we believe the ideal customer solution is not companies fighting, but in fact, integrating and bringing the migration from physical to virtual to cloud. And so we very much believe it's complementary. We very much believe a good programmable underlay requires a good set of overlays. We couldn't be more pleased. And architecturally, we view it as not one versus the other, but better together. So in terms of cloud pressures and cloud margins, and et cetera, we have always said that margins from our cloud titans, because they're driven by large volume, is lower than our standard margin. Our margins are deeply tied to volume. And obviously, as a customer buys more volume, they get to influence the pricing and, therefore, our margin. We do expect new cloud titans to come in. We don't know if they'll be over 10% in customer concentration. In fact, most likely they may not, but there may be many of them at less than 10% customer concentration, and we're kind of like that. That's part of the balanced verticals that we are aiming for from a strategy perspective, but absolutely, we expect more than the ones listed today.

And then the final one, Jayshree, just on the pressure from the -- your major competitor. Have you seen any change in how they're behaving in the market? Have you factored any of that in?

No, it's been predictable and the same.

Your next question is from James Faucette with Morgan Stanley.

A couple of questions. I wanted to follow-up on international Puppet first. Can you talk a little bit about the nature of the international customer base? Are they similar to the U.S. customers in that they're mostly large cloud properties? That is, are we likely to see equal amounts of lumpiness out of the international customer base? Or is there a different make up there? And then along a similar line or similar and related question is, how should we think about the tax rate going forward? Should we expect it over time? Eventually, you will have more of your revenue earnings to abroad, and that would typically bring down your effective tax rate. If so, over what time would you expect that to happen?

Yes, so thanks, James. The answer to your international question in a nutshell is we are in 84 countries with the right demo depots and customer support and subsidiaries. We believe out of those 84, at least over 50 of them are purchasing Arista product in some fashion or the other. They tend to be very similar to the way we started in the United States in America, which is start with small projects and then expand to bigger ones. It's too early to call which ones are the bigger ones because we're just beginning there, so give us some time. But hopefully, they will mimic the pattern. But so far, we see that it's very similar. They're in similar verticals, the financials, the high-tech media, the high-tech enterprise. They're in service providers. They're in cloud providers. So the pattern is similar, but the size of the project is smaller.

And then as for the kind of rethink about our effective tax rate, as I mentioned, the Q2 effective tax rate was around 31%. As I look forward to Q3, we're looking at a very similar number between 31% and 32%. And then as we continue to drive, you see the split in our international business. So over the medium term, as our international business grows, it's going to have effect and drive -- help reduce our effective tax rate, but not -- but it's over the medium term as we invest in international and continue to grow that business. What will probably have more of an impact for all of us and including our competitors and all companies will be the reestablishment of the R&D tax credit hopefully happening in Q4. That will have a more of a near-term impact on us versus the international versus domestic split.

Next question is from Tal Liani with Bank of America.

I have 3 quick questions. First one is the -- when we spoke about margins for the year, this year, you saw that margins -- after you reported Q1, you saw that margins for the year will be 12% operating margin, and that's why we model about 10% for the rest of the year. You're coming up at 27%, which is not -- it's more than 5% of us. So the question is what changed in the quarter that only a few weeks ago you thought that this year will be 12% and now suddenly it's almost double that level if we just continue in the fourth quarter? So what happened in the quarter? Or what happened in the last few weeks since the IPO? Second question is when VMware said that they have $109 of revenues in the space, it was kind of a surprise for a few of us. It was a big number, and the question I have is how much of your growth is done through VMware or together with VMware? And how much of it is done directly with the customers? And I'm trying to understand your independent participation in the market versus participation in certain ecosystems. The third and last question is an easy one, why is 2Q strong always? Last year was the strongest quarter of the year on a sequential basis. And at least according to what we expect this year, it's going to be again. What's happening now that is not happening in other quarters?

Tal, thank you very much. So I -- while Kelyn is getting ready for answers, I'll address the VMware one, and then we'll go to your operating margin and Q2 question. So I think the $100 million from NSX was quite impressive, and it shows the power and importance of OpenStack and vShield and layer 4 to 7 and bringing all of these technologies from a networking perspective in a virtual fashion. We are independent, but we jointly sell together especially at a technical level with VMware. In other words, our systems engineers worked together and often provide network designs, and it's still early days. We're only formally announcing the partnership today for the first time on this call, and you'll see subsequent announcements later. But I'd say that network virtualization and the drive to bring multi-hypervisors and networks together is really one of the biggest use cases of SDN, and many pilot projects are starting today, and we expect to see a growing set of customers and more applications in the next few years.

So as your question on gross margins, as I mentioned in my script that operating margins really, really benefited by a push out of some spend that we had been anticipating in G&A primarily around the OptumSoft litigation. Also, we were -- during the IPO process, we had a patent troll that suit us that we had budgeted litigation expense for which we successfully settled a couple of 3 weeks ago, right before the end of the June quarter. And additionally, we had planned on starting SOX work and public company compliance work within Q2 and actually just hired our director of internal audit towards the end of June, and so that spend has now been pushed out for Q3, Q4 and for 2015. Additionally, gross margins benefited primarily around a release of some warranty reserves that are not required to continue on, and that's kind of a onetime benefit. So those actually were the major impacts if you think about kind of operating margins and how we came down to our non-GAAP EPS.

Did you disclose the amount of the warranty reserves that were reversed?

Yes. It's -- the gross amount of the reserve was about $1 million, and it's in the 10-Q, which you'll see later today.

Okay. And why is 2Q so strong on seasonality basis?

This is just customer buying pattern. Technically, come out of a weak Q1. January and much of February is usually very slow and then they get on track, so we see this every year, and this is no surprise.

And the next question is from Sanjiv Wadhwani with Stifel.

[Audio Gap] and whether would that product being available? Has there been any sort of change in pricing dynamics from that company?

Sanjiv, we missed the entire first half of your question. We only got the last few words. Can you repeat it? I'm sorry.

Okay, so just trying to figure with Cisco's ACI now generally available, whether would those any customer feedback that you might be able to share in terms of what you're picking up? And then generally in terms of pricing from Cisco, again with the ACI, has there been any change in terms of pricing dynamics from that company?

I think you know this better than I do, but we have not seen the effects of ACI because the promise of ACI has been greater than the delivery and shipment. I believe it was announced to ship June 30, so it's too early to call. So we'll probably see the impact of ACI more in the second half of this year and next year, but I think it's been more marketing than reality until now.

Got it. And then, I guess, same applies for pricing dynamics. No sort of shift because it's...

That's not true. Pricing dynamics goes beyond one specific product. It is continuously a day-to-day combat for Arista to deal with, and I think it's a lifetime issue for Arista to coexist and interoperate and compete with our competitors especially the one we respect, so that hasn't changed, and it doesn't change. It's not on a product basis. It can be a specific product. It can be a bundle. It can be a discount. It can be a figure. It can be a variety of techniques.

The next question is from Simon Leopold with Raymond James.

So following up in terms of kind of the bridge questions, particularly on gross margin. I think you were anticipating a lower gross margin this quarter. You put up a very nice gross margin. So could you help us understand the bridge between what you had expected 90 days ago and what you reported? And then take us to essentially the bridge or trajectory of why you think your gross margins will come to that lower range that kind of 60% to 65% range over time in terms of what about the decline is relative to international or competitive environment. Just help us understand the levers there.

So I'll take the first part of the question and then turn it over to Jayshree. But if we think about -- when we look at our gross margin, it really varies a lot by product and by customer mix, and so that played a big part. We also, in the quarter, we planned for aggressive tactics from our competition whose products are not yet generally available, so we had planned for that. But in addition, gross margin also benefited from that onetime warranty benefit from the change of estimates that impacted and drove our gross margin up, which is a onetime effect.

Simon, just to add to that. If you look back on our history, we've had gross margins of 64.6% and 65%, so depending on the mix and the concentration and the volume and the type of customer. It is -- and if you look at the standard gross margins in the switching industry, they do tend to be in the 60% to 65% range. I think our aggressive engineering focus on cost reductions and also being selective on what markets we are targeting and were not in the mainstream commodity market allows us to, if you will, manage our mix and our gross margin. But I want to make one thing clear. We are going to favor lower gross margin to gaining footprint and market share, and so we'll continue to signal to you guys that our long-term goal is 60% to 65% in favor of gaining share. Now if it doesn't materialize 1 quarter, it might the next or the following, right? So understand our long-term goals doesn't always vector into the short-term quarter.

Your next question is from the line of John Lucia with JMP Securities.

I know you said you didn't have any concentration in a specific vertical this quarter overall, but you said you're adding about 1 to 2 new customers a day versus 1 in 2013, and I was wondering if there's a concentration in 1 or 2 verticals or for new customers specifically.

That's actually a good question, John. We're actually seeing more additions on our new customer acquisition in the high-tech enterprise, where we've been noticeably more absent in the last few years. So while we're adding in every vertical, I would say that vertical is getting more new customers.

Okay. And then one more question. Can you talk about how your partnership is with the layer 4 through 7 players like Palo Alto and Aruba progressing? How often are you working with these partners? And how often are they bringing you into deals? And are you bringing these vendors in to compete against your largest competitor when it sells bundled solutions?

Yes, I think the partnership with 3 companies you mentioned, Aruba, Palo Alto and F5, are very strong. They tend to be more, again, in the business development and joint systems engineering, so we don't force the sales teams to work together. They have to be customer-driven. To give you examples, in the case of Aruba, we're doing some very interesting work on wired and wireless controller integration. With Palo Alto, we've already demonstrated some really cool capabilities on how you can expand your firewall flows and migrate from 10-gig all the way to multi 10-gig and even up to 100-gig. With F5, we've had a long-standing partnership integrated into their iRules, and they're also doing some very interesting work on workflows and Smart System Upgrades all the way from layer 1 to 7. So every one of them are not just a logo we put on the release but really a technology linkage, and therefore requires systems engineering cooperation, and it's something we do directly and together with the customer.

Your next question is from Brent Bracelin with Pacific Crest Securities.

Actually just had a couple of follow-ups, one for Jayshree on VMware and Kelyn on margins. Jayshree, on VMware, obviously, you're formally announcing the partnership today. You highlighted and talked about some of the technical benefits. My question is really around how are you viewing that relationship relative to broadening your footprint in the enterprise? Is this a go-to market opportunity for you? Obviously, you're very strong on the cloud side, but what's your view relative to VMware opening some doors for you on either enterprise or service provider account?

Yes, now that's a -- hey, Brent, that's a good question. I certainly think VMware has one of the strongest and broadly installed base of products with ESX hypervisor and vCenter and vC suite. We also believe that the -- so therefore, based on that, I would say VMware can certainly help Arista open doors in the enterprise. But we also think the NSX and the integration of NSX and the programmable Arista EOS is a joint opportunity for both companies to implement OpenStack and private cloud as well as in public cloud and service providers, and -- so we see that, yes, we could get some help on the enterprise but we could also help them and work jointly together in cloud projects.

Certainly sounds like something you highlighted, and want to certainly follow with you more on that one. Kelyn, on margins, I wanted to go back here to op margins. I mean, obviously, if I go back over the last couple of years, 16% was the lowest quarterly operating margin. You're guiding to 19% to 22% in Q3 including litigation expenses that are starting to ramp up. Why shouldn't we think about high teens as kind of a low watermark for operating margins for this year and next? Or is the gross margin the big variable there that gives you a little caution? Just trying to understand margins and what we've seen this year and in the past. And why shouldn't that kind of high teens be the low watermark going forward?

So from my chair, and I'm going to put gross margins to the side because that's always the big equalizer, right? But I would look at over 2014, 2015 that if you think about, yes, we will be kind of in those high teens as kind of the low watermark, and we do, and as you notice, we do again focus and can continue to manage operating expense. As we move through the work that's going on with litigation and public company compliance, we would expect at some point in the medium to longer term to return into the -- into the 20s, low 20s.

The last question is from Ehud Gelblum with Citigroup.

A very quick follow-up. Can you just, Kelyn, give us the quarter ending share count? And what we should be looking at for share count for next quarter? Really simple.

So absolutely, so for next quarter, if I was modeling, I would be looking at that 70 million to 71 million. We're very conscious of the movement in our stock price. So the higher the stock price, you know what that does on the waiting of the share count. And so for this quarter, the Q will be filed around 5:00 tonight, and I believe it was around 61 million.

Okay. Well, this concludes the Arista Q2 2014 earnings call. I'd like to say thank you to everyone for joining us today.

That concludes today's conference call. You may now disconnect.