Arista Networks, Inc. (ANET) Q4 2014 Earnings Report, Transcript and Summary

Welcome to the Fourth 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 at 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.

Thank you, operator. 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; Kelyn Brannon, Arista's Chief Financial Officer; and Marc Taxay, Arista Vice President and General Counsel. This afternoon, Arista Networks issued a press release announcing the results for its fiscal fourth quarter and year ended December 31, 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 for the first quarter of the 2015 fiscal year and industry innovation, which are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically, in our most recent 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. I'm pleased to report that we had a solid fourth quarter and an overall impressive year of $584.1 million in revenue with a 61.7% annual growth. Consistent with prior quarters, customer demand and our new products drove results that exceeded consensus estimates. From a geographic perspective, our customers in the Americas generated 81% of our sales in Q4. We are investing to improve our global expansion, including recent hires of our EMEA's and APJ sales leaders. Q4 revenue grew 51% year-over-year to a record $173.5 million, driven by our flagship EOS-based 7000 Series platform. We've recorded the largest quarterly revenue ever achieved as an independent switching company. We delivered non-GAAP gross margins of 67.4%, resulting in a non-GAAP earnings per share of $0.53 as we grew profitably in our fast-paced and dynamic industry. Our customers were balanced across 4 major verticals, proving our broadened adoption into mainstream enterprises. In terms of customer concentration, Microsoft, our only top 10% customer, reduced from 22% of 2013 revenue to 15% in 2014. This quarter, we once again differentiated ourselves with key software innovations in our architecture. We announced our flagship EOS+ with a single common image for virtual and physical instances. The EOS+ platform delivers radical and foundational improvements over legacy approaches, with our multi-process shared state model, SDK toolkit and vEOS, a virtual machine version of our software. Arista EOS provides at least 6 types of programmability to take advantage of prebuilt and custom EOS applications. Meaningful integration with our technology partners ranging from A10 Networks, Ansible, Aruba, Cloudera, Nuage, Palo Alto Network, Puppet Labs, Pure Storage, Red Hat, Splunk, VMTurbo, VMware and Zscaler is an important hallmark of our EOS+ solution. We further illustrated our EOS+ use cases with endorsements from 2 of our most strategic customers, Microsoft and Facebook. As I reflect on our first experiences as a public company, I'd like to highlight some key milestones we have achieved in our short history. We have now shipped over 3 million cumulative 10, 40 and 100 gigabits Ethernet ports with a base of more than 3,000 customers. We believe that we have gained market share in this segment throughout the 2014 year and this quarter. We forged a strategic relationship with VMware. Both companies were named as the top 2 visionaries in the Gartner Magic Quadrant of February 2014. Arista pioneered the 25-gigabit Ethernet and 50-gigabit Ethernet consortium with Broadcom, Google and Microsoft as initial founding members. We introduced the industry's only 100-gigabit Ethernet 1RU leaf big buffer switch, the 7280E, for both content and storage applications. Arista was named #15 in Glass Door's Top 50 Best Small and Medium-sized Companies to Work For and we have now crossed over 1,000 employees, doubling in the past 2 years. Many of you had inquired about the Cisco lawsuit. I would like to now turn it over to our General Counsel, Marc Taxay, for a legal update followed by Kelyn Brannon, our CFO, who will review our financial highlights. Marc?

Thank you, Jayshree. Before I get into the details, I'd like to use this time to briefly discuss how we view the litigation. Cisco has filed several complaints against Arista, 2 in the ITC and 2 in the Northern District of California, so they can really be broken down into 2 different disputes. The patent case involves patents covering a number of different software features and functionality. We believe these cases are really about defending our rights, the EOS innovations that we've developed from a clean sheet of paper over the last 10 years. The copyright case relates to the Command Line Interface, which is used by customers to configure our switches. We view this as an issue of open standards, in reach of copyright protection, which we believe affects the entire industry. We've hired an excellent legal team to represent us: Wilson Sonsini, Fish & Richardson and Keker & Van Nest. And we are very confident in our strategy. With that, let me get into the details. On December 19, 2014, Cisco filed the 2 ITC complaints against Arista for alleged violations of Section 337 of Tariff Act, based upon the importation of our products into the United States. The ITC instituted 2 investigations, designated as a 944 and 945 investigations. The 2 investigations involve the same 12 patents that is subject of the district court case. They were simply split into two 6-patent cases in the ITC. The initial determination date for the 944 investigation is scheduled for January 27, 2016, with a target date for completion of May 27, 2016. Based on the current schedule, we expect that the hearing will be sometime in October 2015. As for the 945 investigation, the initial determination date is now scheduled for April 26, 2016 with a target date for completion of August 26, 2016. The hearing is currently set to take place in November of this year. In a nutshell, we do not expect any ITC decisions in these investigations until mid-2016. Regarding the merits, we'll point you to our responses to the 2 ITC complaints, which were filed on February 11, 2015 and we denied the claims asserted against us. In addition to the ITC investigation, Cisco filed 2 complaints against Arista in the Northern District of California on December 5, 2014. In the first case, Cisco asserted claims of patent infringement with respect to the same 12 patents. Because of that overlap, the case has been staved pending resolution in the ITC. Consequently, there will be no activity in this case until the ITC cases are completely resolved through appeal. This could be sometime in 2017 depending upon the ITC schedules. In the second case, Cisco alleged that our use of certain CLI commands infringe various aspects of the copyrighted works and, further, that our products infringed 2 additional Cisco patents. We do not yet have a schedule for this case. Our first case management conference is likely to be sometime this spring and we should have a better idea at that time what the schedule will be. On the merits, we filed a response in February 13, denying the claims asserted against us. In summary, this lawsuit is going to be a multiyear battle and we intend to litigate this in the courts, not in the media. We don't plan to blog on every routine-procedural matter. If blogging won cases, we'd blog, we intend to win. Ultimately, our primary focus is on the continued supply of our award-winning products to our customers. I will now turn the call over to Kelyn Brannon, our CFO.

Thank you, Marc, and good afternoon, everyone. Before I walk through our financial results and guidance, I'd like to note that, except for revenue numbers that are GAAP, our financial numbers are non-GAAP unless stated otherwise. A reconciliation of selected GAAP to non-GAAP results is provided in our earnings release. We reported record revenue of $173.5 million in the fourth quarter, a 12% increase from Q3 2014. Gross margins for Q4 was 67.4% up from 65.2% in the prior quarter and down slightly from 67.6% the year-ago quarter. The sequential increase was primarily caused by a reduction in inventory overhead costs and favorable customer mix. Our gross margin will continue to fluctuate up and down from quarter-to-quarter due primarily to customer mix, seasonality of our business and product mix. We expect our gross margins to average in the low to mid-60% range in the long-term, but will fluctuate above and below this range on a quarterly basis. Turning to operating expenses. R&D spending for Q4 was $39.7 million, increasing sequentially from $31.9 million in the prior quarter and an increase from $29.3 million in the year-ago quarter. The sequential and year-over-year increases reflect headcount additions and higher bonus expenses, in addition to increase development activity for new products. Sales and marketing spending for Q4 was $23.1 million, increasing sequentially from $18.6 million in the prior quarter and an increase from $16.3 million in the year-ago quarter. The sequential and year-over-year increase reflects additional sales and sales engineer headcount, higher bonuses and commissions attributable to our strong revenue growth and an increased marketing activity to support our customer base. G&A spending for Q4 was $7.2 million, decreasing sequentially from $9 million in the prior quarter and an increase from $5.7 million in the year-ago quarter. In Q3, we recorded an additional corporate bonus to G&A that was subsequently allocated in Q4 across other departments, which largely caused the sequential quarter decline. Operating income for the fourth quarter of 2014 was $47.1 million, increasing sequentially from $42 million in the prior quarter and an increase of $26.3 million in the corresponding period in 2013. Our effective tax rate for Q4 was 19.1% triggered by the enactment of 2014 R&D tax credit during Q4 and tax structure reorganization efforts. Net income for Q4 was $37.3 million or $0.53 per diluted share compared with a net income of $17.5 million or fully diluted earnings of $0.27 per share in Q4 2013. We doubled our net income to $105.5 million or fully diluted earnings of $1.54 per share compared to net income of $52.6 million or fully diluted earnings of $0.84 per share. Turning to the balance sheet. We had cash, cash equivalents and investments of $449.4 million at the end of Q4. Cash flow from operations and free cash flow for 2014 was $114.5 million and $101.4 million, respectively. Capital expenditures in 2014 totaled $13.1 million and were primarily related to purchases of development, testing and manufacturing equipment. Accounts receivable was $97 million, an increase from the prior quarter of $84.1 million. DSOs remained steady at 51 in Q4. Current and noncurrent deferred revenue was $106.5 million, an increase of $28.8 million over the prior quarter and primarily resulted from new service agreements and renewals. Inventory was $80.5 million up from $62.6 million in the prior quarter, yielding terms of nearly 3. The increase primarily resulted from increased volumes to support our revenue growth. Let me now move to our guidance. I'd like to emphasize that although our rapid revenue growth has minimized the impact of seasonal factors, Q1 has historically been a seasonally weak quarter followed by stronger sequential revenue growth in Q2 through Q4. We expect this trend to continue in 2015. And as a result, for the first quarter of 2015, we expect our revenue to remain flat from Q4 and have set a target of $164 million to $172 million, which represents 40% to 47% growth year-over-year. Gross margin is anticipated to be in the 63% to 66% range based on forecasted customer mix and seasonality and we anticipate operating margins in the range of 22% to 25%. Starting in Q1 '15 and subsequent quarters, the above guidance excludes legal costs related to the OptumSoft and Cisco litigation, which has been removed from our non-GAAP results. We anticipate that these costs will range between $5 million to $7 million for Q1 '15. Non-GAAP effective tax rate is forecasted to be in the 30% to 32% range. We estimate DSO will be in the low 50s and inventory turns remaining around 3 per year And 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 back to Jayshree

Thank you, Kelyn, and thank you, Marc. In summary, we've had a momentous 2014 with many memorable metrics. We have done this as a team with dedicated focus: focus on pioneering innovation, focus on customer dedication and focus on Arista's results with the right values. It's a cocktail of doing the genuinely right thing that we call in Arista, the Arista way. It means we thrive on fair competition and we welcome that. Our customers though, do not come to us for old school legacy systems or copied code. They seek open innovation. They are embracing Arista for our disruptive programming software model to transition to the new cloud initiatives. So let me be clear. The lawsuit has not impacted our business. In fact, I am energized by our unwavering customer acceptance and the momentum ahead.

[Operator Instructions] Your first question comes the line of Mark Sue with RBC Capital Markets.

Your growth rate seems to suggest a meaning -- significant market share gain. Do you feel now that you're seeing a narrowing of the field when it comes to high-end switching 10, 40, 100? Who are you gaining market share from? And it doesn't seem the lawsuit has any impact to your bookings trends. Maybe if you could give us some qualitative trends of why you are still continuing to gain share. And also, lastly, just on the white box switches, how the needle might be swinging the other way from the initial hard base [ph].

Right. Thank you, Mark. I think when you have such a large total available market opportunity, as you know, the market for 10, 40 and 100 gigabit is $6.9 billion in 2014, according to Dell'Oro/Crehan Research, going to $13 billion in 5 years, it is very possible for Arista to gain market share with sheer execution. And that's what you're seeing here. With a disruptive product, with a software that no one else has, and the customers really wanting to move to SDN and cloud, we're gaining share on our own merits, is the number one. We don't have to take share from anyone. We're gaining on our own merits, is the strong message I'd leave you with. We do believe large dominant players are likely to lose share and are losing share but, independent of that, Arista's execution and market share gains are based on Arista. In terms of white box, I think it's important to understand that whether it's white box, blue box, SDN, Merchant Silicon, whatever you want to call it, this market is still very small. It's a $259 million market estimated by Dell'Oro in 2014. So it's -- again, it's another form factor. Once the market gets big enough for Arista, we'll consider participating in it when we have customers who want it. Arista is not participating in the blade switch market, which is a form factor we're not in. Arista is not participating in the virtual switch market which, again, is a form factor we're not in. But when we see a meaningful market and we see our customers wanting for us to be in that, then absolutely -- to date, that $250 million is largely a captive market in engineering-driven companies.

That's helpful. And Jayshree, lastly, now that you're past your 10-year anniversary, do you feel that customers are considering the networking requirements as more of a 2-player environment? Is it forming in that way from your customers' view?

I think absolutely. We've seen that real change in 2014 where much like the service providers where Juniper became the alternative service provider, Arista is clearly being viewed as the alternative innovator in data center and cloud.

And your next question comes from the line of Simona Jankowski at Goldman Sachs.

Jayshree, just a couple of questions for you. First one is, which of your verticals drove the strength in the quarter and then looking out into your guidance? And then secondly, you said that you're not seeing any impact on the business from the Cisco lawsuit. Can you just expand on that? Is it that customers are not bringing that up as a potential risk? Or is it that they are, but you're successful in navigating around that and able to overcome their concerns?

Okay. Thanks, Simona. The first question, we saw very good balance across our 4 verticals which, as you know, are high-tech enterprise, financials, service providers and tier 2 providers and the cloud titans. And in fact, I would especially call your attention to the fact that we feel good that we're entering the mainstream enterprise adoption, but all 4 verticals did well for us in Q4. In terms of the lawsuit, initially we had customers coming to me that they understand that this is because of our success. Literally, quotes from different folks like, "If they can't innovate, they litigate." So no question that they want us to continue to innovate and indemnify their contracts but, frankly, the investors are more worried about it than our customers.

And your next question comes from the line of Tal Liani from Bank of America.

Hopefully you can hear me well. I want to talk about competition. Juniper launched a software/hardware desegregation strategy with products and we see standalone products from Dell that are separating again the hardware from software. We see the software companies in this space and then Cisco is very aggressive with pricing. So how do you see the market shaping up first because of Cisco's aggressive pricing? How do you deal with it? And second, the software/hardware desegregation and the fact that you are still integrated software/hardware?

Tal, those are both very good questions. In terms of pricing, we have seen a consistent aggression from our competition on prices. And generally, there are 2 or 3 aspects to our price. First of all, there's the CapEx price where sometimes our competitors will often bundle it and give it for 0, right? It's hard to compete against 0. But I think customers have recognized that their total price is really the operations costs and the total cost of ownership, what the OpEx price is. And over there, Arista does particularly well. So even if CapEx is about the same or we're lower or we're higher, people are valuing the programmability and order provisioning and tuning in a significant way that we're not manual and that it doesn't require large amounts of staff and that we can provide that cloud-like experience that they're looking for in all their applications and storage as well is really playing. And Arista EOS is a key hallmark to differentiate us from a price point of view. In terms of bundling of software and hardware, as I said before, Arista, this is a well-known secret actually, started out as a software company and majority of our resources is still software. Out of our R&D organization strength, over 90% is software. So when you look at our EOS+ announcement, it is all about virtual images of software, it's about software development toolkit, it's about customizing and aligning that capability, so we're not afraid to jointly work with customers and offering programmability to our software. If they want to build their hardware, if they want us to run on a white box, we're open to that as well. We've always said we are. We are waiting to see that market develop, and as and when customers want that, we will absolutely offer yet another form factor and business model. We view that as another member of our portfolio, so not a big deal to us.

Got it. And what about the margin and expense outlook? We see more competition now than 2 years ago. And you mentioned on the call, and we know it, you don't do blade, you don't -- you're not into virtual switches, there are certain parts of orchestration maybe you also don't do, so are you -- do you feel the need to increase expenses and go after these market? Or do you think that where you are is where you're going to stay for the next few years, let's say?

Right. With a $584 million revenue out of a $7 billion market going to $10 billion, $11 billion, I think focus is important. So we're definitely not doing blade switches. We believe that footprint belongs to server vendors. We're definitely not doing virtual switches. We work with the OpenStack community, we work with VMware, we work with NSX, we work with Nuage, so we don't see that we should go into markets and technologies that others have strength in, we want to complement that. And we have plenty of room to grow to become $1 billion or $2 billion company with that large market. At the same time, we do not preclude adjacencies. If it makes sense with our software and technology to expand into markets that are more natural where we can be differentiated, we will absolutely consider that in the next 1 to 3 years.

And your next question comes the line of Erik Suppiger at JMP.

Two questions. First off, on the gross margin guidance, are you feeling better about the gross margins? Is that an uptick from where you've been in the past in terms of the guidance for 63% to 67%?

Erik, I'm glad you commented on this and you noticed this. We are feeling good about modeling our gross margins so that we understand it better. However, we do believe -- there's a reason why we gave a wider range this time than normal, that we do believe that our gross margin is quite affected by mix. When we had large volume cloud titans and they're not as balanced, we can swing the gross margin down since they drive on that volume. When we have smaller volumes and more enterprise, or customers who aren't buying as much quantity, then our gross margin increases. So blending the 2 and predicting that mix continues to be a learning experience for us. Kelyn, do you want to comment on that?

No, I would agree with Jayshree. It is still a learning experience, and so we feel very comfortable with the guidance of 63% to 66% for Q1.

Right. And long-term, we've always said that to gain market share and gain footprint, we would not be afraid with a 60% to 65% gross margin range.

So can we assume the enterprise growth is giving you some of that increased confidence in terms of the opportunity for the higher end of your guided range?

I think that's one assumption, but you can -- let me add another assumption to that. You can make the assumption that some of our cloud titan purchases moved out of Q4 to Q1.

Okay. Secondly, are there any new software apps or tools that your customers are using in terms of some of the programmability in EOS? Is there any new dynamics in terms of customer adoption that's been fueling some of the adoption for Arista?

That's an excellent question, Erik, and I'll try and give a short answer because we don't have all day. But the combination of more programmability is making people realize that more than meeting single-function controllers, what they really need is network management done right. So some of our partners like Splunk, VMware, ExtraHop, software companies that can work very -- Palo Alto Networks, that can work -- Ansible, Chef, Puppet, these are all examples of bringing DevOps and NetOps together and that is becoming more and more meaningful and more and more important. So certainly, Arista doesn't feel the need to be that management tool, but we very much are the underpinning to provide the manageability for that tool.

Is that adoption across any particular vertical?

Not really.

Your next question comes from the line of Subu Subrahmanyan from Juda Group.

I have 2 questions, first on the 4 verticals. You mentioned very well balanced growth in the quarter. When you think about 2015, I'm curious to see if you could potentially rank order growth and share gain opportunities in those verticals. And then also a follow-up question on the gross margin side. If you can just talk about what were the swing factors that drove this quarter to be higher. Jayshree, I think, you suggested maybe there are some cloud mix or business that got pushed out next quarter or so. Do you expect that to be a predictable swing factor on the lower side for next quarter for gross margin?

So I'll just quickly take the gross margin question. Absolutely, if you think about the higher gross margin, it's to -- it was customer mix this particular quarter in Q4. Additionally, Q3 kind of -- we had some additional overhead costs that got absorbed, but didn't get replicated in Q4, which benefited the gross margin but, primarily, it's around customer mix. And as we look forward into Q1 with the guidance of 63% to 66%, as that play around our volume customers and how they come in [indiscernible] of the quarter, so we feel comfortable with that.

And Suba, to answer your question on were there verticals that grew faster. Clearly, our largest vertical base is the cloud titan, so that doesn't tend to, in percentage, grew as fast, but all the other 3 verticals grew very nicely for us in Q4. Faster.

And when you look at 2015, are there areas, particularly among those verticals, where you think the share gain opportunity's larger than others?

I think one of the things you'll see us do is just put a deeper focus on all those 4 verticals, and we're not favoring one over the other, but they have so much similarity with each other. There are early adopters, they appreciate technology, they don't fall for B.S. marketing, so all of those make them the natural ones.

And your next question comes from the line of Paul Silverstein with Cowen and Company.

This is Fahad [ph], in for Paul. Could you please comment a little bit on the Web 2.0 vertical? What were the trends? You mentioned that it was slightly weaker. Can you provide some color on it?

I didn't mention it was weaker. It was very balanced, it was strong. But I did mention that our overall customer concentration of Microsoft for the year went down from 22% to 15%, which we view as -- Microsoft's an important partner, but we also view as a positive. Our cloud titans continue to be our most strategic partners. We are in 6 out of 7 of them. An example of Facebook and Microsoft endorsing our EOS+ announcement is a very clear example of that, so we're very bullish about that segment and we continue to be so for 2015.

And just one follow-up on more architectural questions that have come up recently. A lot of the competitors of yours are talking about integrating security down to the silicon level and really kind of addressing the total cost of ownership. Can you address how is that from a competitive perspective?

Yes. We see security as too much of a significant market for Arista to address by itself, so we will be working closely with partners there. Whether that's DDoS mitigation or encryption or firewalls, Palo Alto Networks comes to mind as one of our close partners as well as others, so we will do this in conjunction with key technology partners, not by ourselves.

And your next question comes from the line of James Faucette with Morgan Stanley.

A couple of quick questions from me. First, just clarification on the guidance and the exclusion of the legal expenses, just wanted to understand if you're anticipating the legal expenses reaching that $5 million to $7 million per quarter in the first quarter already or if that's something you're taking into account further in the future? And then my second question was kind of, I guess, looking at your customer base and showing the good growth, how should we think about the diversification of customer base? What was your concentration in the fourth quarter? And how much diversification or increased diversification would you expect to see during 2015?

So as far as looking at the legal expense, we decided that, starting off in Q1 of 2015 to be relatively transparent, go ahead and pull it out of the pro formas, but disclose what it is. As Marc took you through the ITC case and then what's going on in the Northern Court of California and the case is in the timeline of those, you can imagine that the expense is going to be loaded relatively throughout that period and it's just -- it really depends. So what I'm going to do is that on each quarter as we do the earnings call, I'll give you the range of what the legal expenses could be for the next quarter.

And to answer your customer question, as I said, it was very balanced in Q4. Throughout 2015, we expect a good balance. So the low of any contribution of a vertical you can think of is 15% and the high as 25% to 30%.

Your next question comes from the line of Brian Modoff with Deutsche Bank.

A few questions for you. One, in terms of the margins, did the mix shift to 40-gig help your margins as well? And then how do you see Tomahawk helping your margins later on this year? Let's start with that.

Okay. To answer that question, we saw both 40- and 100-gig adoption to really come in and complement our 10-gig, so I wouldn't call out 40-gig only as a sole contributor to our margins specifically. But it's clear that 10-gig, especially 10GBASE-T has -- resembled more like 1-gig whereas the high-performance sub-links like 10-gig, 40-gig or 100-gig generally are healthier. But I would generally tell you our margins are more affected by volume and customer mix than product mix. In terms of...

And Tomahawk?

In terms of chip vendors we work with, we obviously work very closely with them. We are in close trials. And no company knows better how to work with Merchant Silicon than we do. We work with 3 or 4 types of them. We look to add diversity there. We don't just take the silicon. So they're very excited about the -- our partnership with Broadcom and all the opportunities it represents.

And then on the operating expense -- or excuse me, on the legal expense and putting -- taking it out of pro forma. So the logic of that is it's going to be a variable that's going to swing around every quarter depending on court activity?

Exactly right, it could be.

Okay. And last question, are you taking share versus Cisco on the Nexus 9K? Any feedback on that? And then one other one, if I can squeeze in was Microsoft, a 10% customer in Q4.

So I -- we do not break out concentration by quarter, so I can't answer that. But are we taking share relative to the main competitor? We believe we are. We believe Cisco's market share in 10, 40 and 100, when the results come out it will show that they decreased and Arista increased.

And your next question comes from the line of Hendi Susanto with Gabelli.

One question. If I look at your new Arista presentation, the data center switching market size estimates have been revised lower. Would you please share some insight on that lower revision?

We don't control the forecast of products, but I'd say they're generally in the range. ASPs of products has stabilized, but obviously, selling prices have in the past years gone down as much as 10% or 15% a year. So I think the $7 billion got revised to $6.9 billion and the CAGR growth is still a very, very solid 14% to 15% a year, which is double-digit. So I wouldn't read too much into it. It's always hard to project the future years, so I think the difference between 2014 at $6.9 billion and $7 billion, which is the original forecast is within the round-off error.

Your next question comes from the line of Jeff Kvaal at Northland.

I'm hoping that you can give us a few comments about 2015 in general, as I think last year, you did give us a few comments about the balance of the year, although, obviously later in the year. What can you tell us about how you feel the market is going to develop overall for revenue growth? Do you think that Microsoft is going to continue to -- I think, last year, you said it would be flat, and spending overall in decline as a percentage of sales. Should we take -- could you comment on either of those 2 items, please?

I think it's a little too early for me to forecast any specific customer, but I would, in general, tell you, we -- because of our diversification, we are less reliant on any one customer as much as we were, say, back in 2013. Having said that, because we get such a substantial spend and Microsoft is such an important partner, we expect to get a large spend, but we still expect it to be flat to down this year. Not because we're doing anything wrong or they're doing anything wrong, but because they have spent so much with us. So that may change if Microsoft's strategy to spend more changes but, quite frankly, we don't get visibility to it beyond 1 to 2 quarters.

Okay. And then secondly, there's been a lot in the press about what Facebook is up to with its Wedge and 6-pack switches. I think you have in the past, Jayshree, talked about how it's 1 application, et cetera, et cetera. Would you mind providing us a little color on how the relationship between you and Facebook is set to proceed through the course of the year?

Yes -- no. Our relationship with Facebook is stronger than it's ever been. We are very aware of any internal developments. We view them as a customer, a partner, not a competitor. And I think it's a natural progression for them to develop since they have very smart engineers, their FBOSS and Wedge and OCP reference design. And they're very aware of the fact that, that design complements what Arista does. So nothing has changed there in my commentary. I just think you're seeing the examples and evidence of both what we do and what they do, and it really is a joint partnership. So we don't expect substantial change in the Facebook and Arista partnership in 2015.

In what sense are they complementary? If you could spend a little more time on that, I would appreciate it.

I think I've said this before and then we can go longer at a later time which is because we have so many knobs on our EOS for programmability, control plane, management plane, data plane and scripting capabilities, we're able to work with them in a very customized fashion and we're not just dropping boxes. And we also have a lot of features that we've developed. Our EOS code has gone from 1 million lines to over 8 million lines so it's very different than an FBOSS, a singular application. So diversity and gender-purpose applications we support and the customization we do with Facebook is very different than Facebook's use case.

And your next question comes from the line of Georgios Kyriakopoulos from SunTrust.

Jayshree, just to expand the discussion on Facebook. What is the risk that other cloud titans may decide to go the Facebook or Google route and develop their own solutions in the future? So when you spend time talking to them, what are their plans that you seem to get from them?

Right. So it's really important to understand that Arista is a product built by engineers, for engineers. That's why we do so well with these engineering organizations in these cloud titans. But it's also important to understand that these engineering organizations are continuously developing and experimenting and building products of their own. They're not mutually exclusive. As I said, there's a capital market today that builds their own type of rack switches in a lot of these cloud titans. So we work with them. And where they have solutions, they use their solutions. Where they need a spine or additional type of lease or splines, they use our solutions. So I think it's important to understand, very important to understand that there isn't a uniform network design, which is just all 1 type, and a mix-and-match is very common depending on the use cases.

Okay. And then on Cisco ACI, there has now been the full quarter since its availability. Although you discussed previously that customers are finishing the test evaluation, can you discuss if you experienced longer sales cycles as customers evaluate the Cisco solution and especially since your guidance for the March quarter is a bit softer?

Actually, quite the opposite. We are experiencing shorter sales cycles because people finally understands the difference between the wafer ware and what ACI really is and, therefore, are embracing the universal cloud networking solution from Arista much more. And again, I can only speak to the 4 verticals. I'm sure that our areas of coverage where my competitors can speak much better to how it's doing. But in my customer domain, the confusion of ACI is far greater than the acceptance.

Your next question comes from the line of Ben Reitzes with Barclays.

I wanted to ask 2 questions. Can you comment how sales in EMEA and APAC trended versus your expectations and sales investments? And I just have one follow-up.

Okay, Ben. As you can tell, we can do a whole lot better there and I feel like a bit of a broken record because I've said that for the last 3 quarters. I think the issue here is we're doing extremely well in all regions. So all boats are rising the tides. And because we're doing well in the United States, in some ways, it hides the fact that we're doing well in Asia and Europe as well. But we can do a lot better, I'd be the first to admit that. And our Mark Smith, our sales leader has hired an EMEA leader and we have hired leaders for Asia-Pac, Australia, Japan and Korea, all of who are new, so I'm hoping for improved and even better performance in the next 2 years. But I will caution you all to be patient there just like I'll have to be and realize it's not going to happen overnight.

Okay. Great. And just with regard to -- a simple question on pricing. Your gross margin was good, your guidance for gross margins seems quite confident, so in terms of the competitive issue with Cisco in pricing, how is that trending? And obviously, it seems like they're aggressive. Is it -- and you're weathering that fine. And is there any other color you can give around that?

It hasn't changed. We're getting used to it. The weathering is fine. It hasn't changed. It's a way of life. And it's a very competitive industry, but it's driven not just by price, but performance and functionality and TCO. So we're holding our own.

Your next question comes from the line of Sanjiv Wadhwani with Stifel.

Jayshree, can you talk -- give us an update on channel development? What's going on there? Will you guys be spending more dollars and time building that in 2015 versus 2014?

Sanjiv, that's a good question. On one hand, logic would suggest we should. On the other hand, as you know, our 4 verticals are less channel-dependent. They look to buy from Arista and also [ph] through a [ph] channel. So the best answer I can give you at the moment is we will be extremely selective in our choice of channels, picking only elite partners who truly want to disrupt and change the landscape and not just be yet another enterprise provider. So you're not going to see us just sign up volume channels for distribution. And we are especially going to rely on channels internationally. We're also going to be looking at key technology partners, SIs and really the V in value-added resellers and channel is going to be important to us. So look for us to be more selective than sort of carpet bomb channel strategy.

Got it. So no change in terms of the amount of time or money that's going to be spent this year versus last year, it looks like.

We will invest more, but no change in strategy.

Your next question comes from the line of Kulbinder Garcha with Credit Suisse.

My question is how diversified, let's say, by the end of last year, Jayshree, was your business with the other cloud customers outside of Microsoft? And where are we in the penetration of those customers? I'm talking about the other 5 that you have. I'm trying to figure how big that business really is. And is the opportunity really ahead of you? Or have you reached an acceptable run rate you already have with those customers?

Kulbinder, you're fading a little in volume. I'm going to just rephrase the question. How does diversified were you with the cloud titans outside of Microsoft? I think we made big strides in 2014, but we have still a lot of scope and a lot of room in 2015 with our other cloud titans. I don't believe we are as penetrated in them as we are in Microsoft.

The next question is from Alex Henderson from Needham.

First question is on the tax rate. The tax rate guidance for -- that you gave last quarter, is that still accurate and, again, assuming no R&D credit?

Right. So assuming a very similar kind of international to U.S. split, which is around that 80% to 20%, 20% internationally along with no R&D tax credit, that guidance of 30% to 32% holds.

Can you talk a little bit about the ability of the company to hire attractive people? I know you guys are pretty picky about who you hire in both the R&D and in the marketing side of the ledger?

Yes. I'll speak to that. Kelyn, you may want to add to that. We continue to hold the bar very, very high. You're absolutely right. It's getting increasingly competitive to find damn good engineers here in the Silicon Valley. And many engineers in networking we wouldn't hire here. We are expanding our focus and facilities beyond Santa Clara, we already have Bangalore, India and Vancouver, Canada as identified sites to expand internationally and we'll be adding more.

I guess the question really isn't are you adding them, obviously, you are. But when you grow your top line at 50% clip, I don't think you can find people at that rate. Are you finding it difficult to sustain your growth based on the number of people you're able to hire is the question.

No. We're not. Because I think if we can't hire them here, we'll hire them elsewhere. We're not lowering the bar, but we're continuing to put emphasis on hiring. We're pleased with the rate of hiring we've done actually.

Then last question then I'll cede the floor. You've talked a lot about the cloud titans. Can you give us any guidance or any thoughts at all on the rate of change in spending in that arena? Has there been any hiccups in terms of the last couple of quarters in the spending rate that might cause a change in either acceleration or deceleration as we go into 2015?

So I'm not able to answer that Alex because I think our visibility is short-term, but we haven't seen any hiccups but we always see lumpiness.

Your next question comes from the line of Simon Leopold with Raymond James.

This is Victor Chiu, in for Simon Leopold. I just wanted to ask if you could give us an update on the partnership with VMware and how the pipeline is developing based on that.

Again, our partnership with VMware is one of my favorite and never been better. I think we have a common vision, common strategy. And the integration with both ESX and NSX as well as other touch points we have, is the best it's been. It's still early days. We announced this partnership in August, September last year. We have a number of customers together already on ESX, and we're now developing our customer base for NSX as well.

Okay. Great. That's helpful. On the international front, I just wanted to ask if you guys were seeing any impacts from foreign exchange or any currency impacts, if that was a driver at all and are you expecting it might impact your results in 2015?

Absolutely not. We -- as I think about our currency balance, although we -- and our subsidiaries, we have pretty much natural hedges in place. And so we only have the 1 quarter back in Q3 with the euro that had a little bit of an impact, but not really. But it's not -- I'm not seeing an impact from an OpEx perspective, and we're not seeing an impact as we think about our top line growth over there. So no, we're not exposed.

Your next question comes from the line of Jess Lubert at Wells Fargo Securities.

I also had 2 questions. First for Jayshree, another one on the channel and to what degree you're finding partners interested in working with you. Are you seeing competitors make it difficult for you to develop your channel? And how important of a growth driver could the channel be in 2015?

I think the channel will be a very important growth driver for us, internationally. In the U.S., we are going to look for a different breed, those that are capable of selling innovative technology are focusing on new markets like Big Data, data analytics, the virtualization, the cloud, the software-defined networks. And so traditional channels, we will continue to use for fulfillment. But for value-add, I think our criteria is going to make it a more unique requirement. So are we having difficulty? No, because, I think, just like our hiring, we're putting a different bar on it, we have a different criteria. We'll be more selective and we're not going to measure our success by how many channels we sign. We're going to look for quality over quantity.

That's helpful. And then for Kelyn, I had a modeling question. The operating outlook for Q1 was a little better than I would have expected given some of the SOX cost we talked about in the past and the need to invest for growth. I'd like to understand how we should be thinking about these items through the remainder of the year. And assuming we see sequential revenue growth beyond Q1, which I would expect, is there any reason we shouldn't also be modeling sequential operating margin improvement from Q1 levels? Any thoughts there would be helpful.

As I think about it, we have in our annual operating plans all the -- we believe we captured all the costs that's going to take to get SOX-compliant, get the 404 opinion from our auditors, Ernst & Young. But as we kind of give the guidance out, there is a flurry of activity here and there, and then it slacks off as you are back into testing. And so I think what we would -- what I would ask you to do is wait for the guidance on the next quarter because there could be a little bit of lumpiness there, but everything is planned for.

Is it fair to assume that you'd expect higher operating margins in the second half of the year versus the first half of the year as those tail off?

Not necessarily. No.

Any thoughts on what could potentially be the impact there if we do see the growth develop as we expect, what the incremental cost would be to offset that?

Well, I mean, I would tell you that if you think about -- and it's certainly my area, G&A, we're relatively a fixed -- we're relatively fixed with headcount and what we're spending with kind of consultants and getting through SOX, and also investing in our ERP system. So if we do see significant growth on the top line, you'll see -- from a G&A perspective, of course, you will see leverage. Having said that, you'll also see us use the opportunity to continue to invest in R&D both in headcount, and as we think about development activities around new products and new silicon coming in and also in our sales and marketing organization. So if you think about on the bottom line, we feel comfortable for Q1 at that 22% to 25% and, of course, G&A later on if revenue grows, will get leveraged, right, and you would see, as a percent of revenue, improvement there. But we could use those investments in R&D and sales and marketing.

Your next question comes from the line of Rohit Chopra at Buckingham.

A couple of questions, Jayshree. Just given there was a slight shift in the cloud titans, I just want to get a sense on adoption of other platforms, so below the high-end, maybe the 7150, 7280, I know there were some trials of that, so adoption there. And then the other thing I want to ask, just back to legal. I know Marc gave his comments there, but are you guys having to make or are you thinking about making any changes as a contingency? And should we expect R&D to tick up for that as well?

I'm going to answer the first question, I'll let Marc answer the second. In terms of acceptance of platforms, the flagship platform is really our EOS, and then everything else is form factor, right? The 7500E has been particularly well received because it's the only platform in the industry that's a spine platform that can do 10, 40, 100 with the right buffering. It's surprising to me that no one else does that. And so the combination of EOS and 7500E has been just very well received. The 7280 is a cousin of that platform. It's a miniature version, so that's being very well received as well. The 7150, particularly well-received for certain use cases like data analytics, monitoring and VXLAN virtualization. So we really have different folks and different strokes and different platforms and different use cases. But in general, the common thread through it all would be EOS and our spine platforms. Marc, you want to comment on the legal side?

Sure. So I think the nature of litigations, we all know, really is that the claims, learning more about the claims and how they impact the products are going to be developed over time. That comes out through discovery and just through litigation process generally. We clearly have a number of different options that we're going to be considering as part of the defense, some of which may include potential design-arounds, of course, but those things are going to be developed over time.

Too early to call what they would be.

And the last question comes from Ehud Gelblum from Citigroup.

A couple of things. First of all, Kelyn, just a couple of clarifications. Were there any legal costs in Q4, so we can comp it to your guidance going forward? And then OpEx, it seems to be flat going into Q1, flattish. Given the growth in international sales and marketing, just want to just get a sense as to how that TAM's in there. Then on some larger picture questions. Jayshree, are you even running into the 9K at all? Cisco says the 9K is now in 1,700 customers, but out of a platform of, what, 40,000, to 50,000 customers. So there could be large gaps in that customer base where you're not even running into the upgraded 9K. Just want to see how many times you actually go head-to-head with them. And then finally those 4 verticals that you...

One second. Can we just hold on, there's 2 questions, so we can absorb and answer them because...

So as far as legal, there was no legal expense pulled out of Q4 whatsoever. As you know, Cisco, sued us in early December and so no real meaningful legal expense related to Cisco. And OptumSoft litigation, that's consistently been put into the numbers throughout 2014 since that lawsuit occurred in April. And so now, there's nothing pulled out there. And then as far as the OpEx, flattish to slightly up Q4 to Q1, we feel good about the investments that we're making there and we're continuing to hire and we have our marketing programs in place and we have spending there for what we need for any type of prototypes with new products coming on, so we feel good about the number.

What was your second question?

Okay. And then I had actually a follow-up. So that question was, are you even running into the Cisco 9K, given that the number they give seems to be a small number of customers overall?

Look, I think Cisco needs to answer what percentage of their overall switching business the 9K is. I think that's small and, therefore, we don't run into it as often, but we do see it occasionally. And we're able to compete against it very effectively because we've been working with Merchant Silicon a lot longer than they have.

Okay. Then let me ask you 2 quick follow-ups. One is you talked about your big 4 verticals, and you talked about the whole $7 billion data center market. What percent of that market can you hit by just staying in those verticals? What happens if you push too far into the channel? And then as a follow-up to that, when you do push out beyond those in the more mainstream enterprise, as you say you're looking to do, are those mainstream enterprise guys looking to use the same parts of EOS that your big 4 vertical guys are using? Or are there different aspects to that that attract them?

Yes. I'll answer your second question first. The pace of adoption is really defining the 4 verticals, right? And they tend to be the most sophisticated in features and capabilities and in demanding things from us. So the follow-on enterprises tend to use similar features or less of it. So in other words, if we can do these 4 really well, these are our toughest, most mission-critical use cases, so the other ones are natural subsets of that, if you will. We are seeing acceptance in a couple of enterprise verticals that seem to be promising, including education and research labs and media and entertainment. So I do believe we can branch out very easily from the high-tech enterprise into some of these others, but at the moment...

And you're seeing that for the same reasons or for different reasons? Are they -- what are they attracted to in EOS, the same things as the big 4?

Well, similar. Like I said, they're more about pace of adoption not -- the reasons are similar. They're just not at the same early pace of adoption as the first 4 verticals were. So that's consistent uniform cloud networking with programmable features, it's what makes us unique and differentiated from other proprietary lock-in systems. We see all the workloads, and all the workflows have to be handled in a similar fashion rather than customized for each enterprise and application like the mainstream workloads. So not only do the 4 verticals like it, but all the follow-on verticals love that, too. But it does take time to change an old habit. The enterprises have been around for 20 years, and I think that's what we're dealing it. That's when our next 4 verticals would come up when it's time for them to disrupt and change.

Okay. And out of the big 4 verticals you're big in right now, what percentage of the market do they represent, gives us a sense?

I don't know. We've not really broken it down, right?

No.

I don't have the exact...

And how far can you run with those guys before you have get too far into the mainstream?

Okay. Well, thank you, everyone. This concludes the Arista Q4 2014 Earnings Call. I also want to mention that we have posted a presentation, which provides additional perspective on our 2014 fiscal results, which you can access on the Investors section of our website, and thank you to everyone for joining us today.

Thank you for joining, ladies and gentlemen. And this concludes today's call. You may now disconnect.