Arista Networks, Inc. Q1 FY2021 Earnings Call

Welcome to the First Quarter 2021 Arista Networks Financial Results Earnings Conference Call. During the call, all participants will be in a listen-only mode. After the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time. 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. Curtis McKee, AVP, Corporate and Investor Development. 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; and Ita Brennan, Arista’s Chief Financial Officer. This afternoon, Arista Networks issued a press release announcing the results of the fiscal first quarter ending March 31, 2021. If you would like a copy of the release, you can access it online at our 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 second quarter of the 2021 fiscal year, longer-term financial outlooks for 2021 and beyond, our total addressable market and strategy for addressing these market opportunities, the potential impact of COVID-19 on our business and product innovation, and the benefits of recent acquisitions, which are subject to the risks and uncertainties that we will discuss in detail in our documents filed with the SEC, specifically in our most recent Form 10-Q and Form 10-K, 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, Curtis. Thank you, everyone, for joining us this afternoon for our first quarter 2021 earnings call. I hope you are all being safe and vaccinated in these pandemic times. At Arista, we are especially deeply concerned by the heightened COVID crisis in India. We are taking steps to assist our local teams as best we can. Back to Q1 2021 specifics, we delivered revenues of $667.6 million for the quarter, with a non-GAAP earnings per share of $2.50. Services, EOS renewals, and subscription software contributed approximately 21.4% of the revenue. Our non-GAAP gross margin at 64.7% was influenced by software and services mix, as well as higher enterprise and Cloud Titan contributions for the quarter. We continue to experience good customer traction and growth with new customer logos and increasing million-dollar customers in the enterprise segment. In the quarter, Cloud Titans was our largest vertical; Enterprise was a close second; followed by financials and specialty cloud providers tied at third place; and service providers at fourth place. International contribution was 25%, and the Americas were 75% in the quarter. In terms of sector and product trends, we will report the specifics annually. They are consistent with the ranges we have already provided in our Investor Relations deck. To reiterate, our Cloud Titans are in the 35% to 39% range, the Enterprises are in the 35% to 39% range also, and the providers in the 25% to 30% range. Our product line forecast annually is expected to be 60% to 65% for core data center, 10% to 15% for adjacent campus and routing, and 20% to 25% for software and services. In light of the industry-wide chip and supply chain shortages, I'd like to shed more light on this topic, especially as it pertains to Arista. First and foremost, we are pleased with the healthy demand we are experiencing, and Arista is resonating well with customers and prospects as they are driving our multi-year growth projections. We share a preferred status with many of our top 100 and more customers and work intimately with them. However, the supply chain has never been so constrained in Arista history. To put this in perspective, we now have to plan for many components with 52-week lead time. COVID has resulted in substrate and wafer shortages and reduced assembly capacity. Our contract manufacturers have experienced significant volatility due to country-specific COVID orders. Naturally, we're working more closely with our strategic suppliers to improve planning and delivery. Customer demand and visibility, though, has improved in the past few months. We are working with our customers to understand the timing of their deployment needs. We do not believe at this time that our customers are pre-ordering. However, we do think they’re exercising prudent planning for the second half of 2021 and even into 2022. But this is a backdrop; we believe supply chain will remain a pain point for the balance of this year as a result of all these shortages. Therefore, Arista is taking decisive steps to invest and increase inventory and manufacturing capacity. I often ask my customers, especially risk-averse enterprises, why they chose Arista. Arista’s recent enterprise momentum spans many vertical markets, and includes a suite of data center, campus, routing, and software products. Our customers are aligned with our software-driven, data-centric approach to building their cloud architecture, their cloud operations, and their cloud experience. A key part of our enterprise traction is addressing the CIO’s pain points to build a cloud-first and a data-driven network, spanning clients to cloud networking. Historically, disparate functions and data sets in routers, security, switches, and network management functions can now be integrated by Arista into a seamless network architecture with programmability, state, and AI-driven characteristics. Let me try to illustrate a few enterprise examples to highlight this. Our recent data center customer win was in the hospitality sector. They chose us because of our single EOS software image across multiple leaf and spine platforms. Using CloudVision for automation, for zero-touch provisioning, easy upgrades, telemetry and compliance was only feasible because of Arista. Arista’s deep buffer spine switches also enhanced their availability. A second example is an international retail customer for data center and routing application. A million-dollar customer, this was based on EVPN and VXLAN modern leaf-spine design, and once again leveraged CloudVision and EOS for improved automation, programmability, and change control. NetOps vs DevOps automation with Ansible integration was another key deliverable for their distribution center. A third enterprise win was in campus in Europe. The 720XP is differentiated as a PoE platform with multi-gig capability across campus workspaces for both chassis and 1RU form factors. The 7050 CX spine and spine alternative brought low power, low footprint, and high density as an alternative to the chassis. The campus customer also implemented unified wired and Wi-Fi cognitive capabilities and this played a key role. Migrating from manual operations, once again, CloudVision with streaming telemetry was a key factor. In all these three examples, there were some common themes. The customer was very fatigued with legacy issues and embraced our U.S. software and our CloudVision as key differentiators and advantages. They also have much confidence in Arista’s support, quality, and continued innovation. They embraced our strategy and build upon our differentiated state-driven and programmable software foundation to deliver our cognitive five A's of agility, availability, analytics, automation, and AI- and API-driven architectures. Switching to the Cloud Titans, we are pleased to also state that we now see increased visibility across 100-gig, 200-gig and 400-gig demand from our Cloud Titan customers. While this business can be volatile, we have enjoyed a preferred partnership status, with many of them deploying us in diverse use cases and deployments consistent with the overall CapEx reported recently. I'd like to invite Anshul, our Chief Operating Officer, to elaborate more on this. Anshul?

Thank you, Jayshree. We are driving next-generation cloud networking architectures for compute, storage, AI, data center interconnect, and WAN. These designs continue to improve resiliency, scale, and operational efficiencies for our customers. The much talked-about 400-gig upgrade cycle, or as we have been seeing the next-gen 100, 200, and 400-gig upgrade cycle, is expected to start second half of this year. The availability of ZR optics, MACsec encryption, and software features to monitor these optical links is also well-aligned in this timeframe. While our customers have always wanted multi-vendor environments, we remain their preferred partner and continue to get our fair share. Demand for our products in the Cloud Titan segment is healthier than what we expected a quarter ago. Back to you, Jayshree.

Thank you, Anshul. Well said. And so for all the reasons Anshul just mentioned, we are more constructive on the Cloud Titan demand in the second half of 2021, although shipments may trail due to our increased lead time. So, in summary, our client-to-cloud networking strategy unifies siloed data sets consistently. We are at the cusp of a network transformation, resulting in growth and diversification across both market sectors and product lines in the future. I will now pass it over to our CFO, Ita Brennan for more financial specifics. Ita?

Thanks, Jayshree, and good afternoon. This analysis of our Q1 results and our guidance for Q2 2021 is based on non-GAAP and excludes all non-cash stock-based compensation impacts, certain acquisition-related charges, and other non-recurring items. A full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release. Total revenues in Q1 were $667.6 million, up 27.6% year-over-year, and well above the upper end of our guidance of $630 million to $650 million. Shipments remain somewhat constrained in the period as we continue to carefully navigate industry-wide supply chain constraints and COVID-related disruptions. Services and subscription software contributed approximately 21.4% of revenue in the first quarter. International revenue for the quarter came in at $165.7 million, or 25% of total revenue, down slightly from 26% in the fourth quarter. This shift in geographical mix was largely due to the location of deployments by our larger Cloud Titan and specialty cloud customers. Overall gross margin in Q1 was 64.7%, above the mid-point of our guidance of approximately 63% to 65%, reflecting a balanced customer mix for the quarter. Operating expenses for the quarter were $180.9 million or 27.1% of revenue, up from last quarter at $178.1 million. R&D spending came in at $110 million or 16.5% of revenue, consistent with last quarter at $110.2 million. This reflected increased employee-related costs offset by lower new product introduction spending in the period. Sales and marketing expense was $59.5 million or 8.9% of revenue, up from $54.9 million last quarter with increased variable compensation and other headcount-related charges. As a reminder, we continue to benefit from lower COVID-related travel and marketing expenses. Our G&A costs came in at $11.4 million or 1.7% of revenue, down from last quarter at approximately $13 million, reflecting normal fourth quarter compliance-related activities. Our operating income for the quarter was $251.3 million or 37.6% of revenue. Other income and expense for the quarter was a favorable $1.6 million, and our effective tax rate was approximately 21.4%. Other income and expense included $2 million of interest income, offset by some unfavorable foreign exchange amount. This resulted in net income for the quarter of $198.8 million or 29.8% of revenue. Our diluted share number was 79.6 million shares, resulting in a diluted earnings per share number for the quarter of $2.50, up approximately 23.8% from the prior year. Now turning to the balance sheet. Cash, cash equivalents, and investments ended the quarter at approximately $3 billion. We repurchased $101 million of our common stock during the first quarter at an average price of $276 per share. As a reminder, we’ve now repurchased $763 million or 3.6 million shares against our board authorization to repurchase $1 billion worth of shares over three years, commencing in Q2 2019. We will continue to execute opportunities against the remaining mandate. Turning to operational cash performance for the first quarter, we generated $254.7 million of cash from operations in the period, reflecting solid net income performance and continued investments in inventory and supply chain. Days sales outstanding came in at 51 days down from 55 days in Q4 affecting the linearity of billings in the period. Inventory turns are 1.8 times consistent with last quarter. Inventory increased to $483.2 million in the quarter, up from $480 million in the prior period, as we continue to buffer certain components and products. Our total deferred revenue balance was $720 million, up from $651 million in Q4. Approximately $40 million of this increase related to product deferred revenue with acceptance clauses for new products across various customers and sectors. The remainder of the increase in deferred revenue related to service renewal activity, and is directly linked to the timing and term of service renewals, which can vary on a quarter-by-quarter basis. Looking forward, we expect 2021 to be a year of significant new product introductions, combined with a healthy new customer acquisition rate and expanded use cases with existing customers. These trends in conjunction with reduced levels of upfront in-person testing may result in increased customer specific acceptance clauses and increased volatility in our product deferred revenue amount. Accounts payable days were 52 days down from 54 days in Q4, reflecting the timing of inventory receipts and payments. Capital expenditures for the quarter were $5.1 million. Now, turning to our outlook for the second quarter and beyond. We saw healthy demand across all of our market segments in the first quarter. These demand trends, combined with favorable year-over-year comparisons continue to support an improving top line growth rate for the year. That said, we still expect some deceleration in quarterly year-over-year growth rates as we move through the year, given the top line recovery experienced in the second half of 2020. On the gross margin front, we will continue to reiterate our overall gross margin outlook of 63% to 65%, with customer mix remaining the key driver. Turning to spending and investments, we remain committed to growing our investments in R&D to support innovation across the business and sales and marketing to support our go-to-market expansion. Finally, our outlook discussed above, and our guidance for Q2 reflects our current understanding of COVID-19 and its impact on our business and supply chain. This is, however, an inherently uncertain situation, and we will need to continue to monitor and attempt to mitigate any challenges as the situation unfolds. With all of this as a backdrop, our guidance for the second quarter, which is based on non-GAAP results, and excludes any non-cash stock-based compensation impacts and other non-recurring items is as follows: revenues of approximately $675 million to $695 million, gross margin of 63% to 65%, and operating margin of approximately 37%. Our effective tax rate is expected to be approximately 21.9% with diluted shares of approximately 79.7 million. I'll now turn the call over to Curtis. Curtis?

Thank you, Ita. We are now going to move to the Q&A portion of the Arista earnings call. Due to time constraints, I'd like to request that everyone please limit themselves to a single question. Thank you for your understanding and operator please take it away.

We will now begin the Q&A portion of the Arista earnings call. Operator Instructions. Your first question comes from Sami Badri with Credit Suisse. Your line is open.

Hi, thank you for the question and congratulations on such a solid quarter and guidepost. So, I wanted to just go back to something Anshul said regarding the expectations for hyperscale and comments being better today than it was just three months ago. Anshul and maybe Jayshree, could you guys just walk us through kind of what you saw from your customers as far as planning and build-out plans that helps you reach that conclusion? And was it broad-based across all major customers, or maybe two or three big standouts, or how much they want to bring online?

Sure, Sami. For quite some time, there's been this talk about the 400-gig upgrade cycle and we've been saying for almost two years that it will take some time. And while we always knew it would be coming, now we can see customers doing the pilot runs and so on and getting ready for second half. So that's really what gives us the confidence. It's not much more than that. It's not much more than that. As Jayshree mentioned, there's plenty of issues on the supply chain side and so on that all customers have to work through as well. So, it's really more in the planning stages right now. But we certainly are feeling better than before.

And I just want to add, Sami, that Anshul and his team make sure that our status with the Cloud Titans is not just a regular vendor. So, the emphasis on a preferred partnership and the intimacy on their deployments, their needs, the priority, the products, the use cases, the different permutations and combinations has allowed us to go from strength-to-strength, if you will.

Right. Thanks, Sami.

Your next question comes from Jason Ader with William Blair. Your line is open.

Yes, thank you. First of all, I want to tell you Jayshree, the supply chain team deserves a raise.

I’ll take that under advisement, when I get the lead times down. Thank you.

But my question, I guess, is on the enterprise side of the business. And as you've ramped up your enterprise efforts over the last few years, what are some learnings that you've come away with? And where do you feel like you can do better maybe in a particular vertical or customer segment or geography?

I think the learnings are two or three items. The first thing I would say is, it just takes longer. It's not instant gratification, like we've often had with Cloud providers or even early enterprise decision makers. So, investments we made two years ago are the fruits of the labors we're seeing now. So that's one point. The second thing is, our product line is more diverse. Before, we were only selling data center, and the expansion from client-to-cloud, including our software products, our DANZ monitoring fabric, our Awake security, our routing, our campus, most importantly, CloudVision, which is the epicenter of all their manual-to-automation migration, I think has been a huge advantage because we really modernized the network. Until then the migration was almost impossible, because it was all in silos, different operating systems. So, another big learning is the product line diversity, combined with the relationship we have formed over the last couple of years, I think, has been key. And in an odd sort of way, my third point would be COVID itself. COVID has been an equalizer for Arista with dominant enterprise competitors. So, it has given our customers a chance to plan and think about alternatives. And I think we've had some advantage and disadvantage with that. The advantage is, they're more willing to work with Arista. The disadvantage is, they can't physically come and see us and do physical parts that we've had to move more virtually.

Great. Thank you, Jayshree.

Your next question comes from Paul Silverstein with Cowen and Company. Your line is open.

Thanks. Jayshree, I want to congratulate you personally on your new grandchild.

Oh, thank you so much. He is about to hit…

Wishing you all much happiness. With respect to the business, can you give some more insight on the different customer markets? And going back to your cloud comments, was that still most, I assume Microsoft and Facebook are still dominant, but any insight you can share in terms of how much of the strength you're looking at? Or how much improvement is specific to those two? And how much of that improvement within Cloud Titans is also some of the other folks? And also with respect to your other customer segments, what are you seeing?

Right. Okay. Anshul help me out here. Well, first of all, our Cloud Titan customer base is a very small sample size of five to seven customers, right? So the two you mentioned, Microsoft and Facebook, continue to be very relevant, very important. If we don't do well with them, the others can't quite make up the difference. So, you need to know that the intimacy with them, the strategic nature of our joint partnership is very important. And they definitely contributed in Q1. Having said that, Anshul and the team have been working with other Cloud Titans. They are getting healthier. And in Q1 and throughout 2021, we will fuel their contributions and design wins, specifically one or two of them.

Absolutely, Jayshree. As we mentioned this call as well as previous ones, we're winning at multiple layers of the network. Inside the data center, as well as outside the data center, especially WAN and related areas for these customers as well. So that's giving us an opportunity to expand and grow beyond where we were. But having said that, instead of specific numbers, I think everyone should note that there are always uncertainties when multiple factors are related with upgrade cycles, including some we don't control at all, like the availability of optics. And all of you remember what happened in the 100-gig cycle. So, the comments are really that we are feeling better that all of the elements are adding up nicely to start the upgrade cycle in second half.

Great. Thank you, Anshul.

Your next question comes from Jim Suva with Citi. Your line is open.

Thank you, and also a big congratulations to you and everyone there at Arista. You beat materially, I mean very, very materially on your sales and a lot of other companies are citing component shortages. So, you got the components, which is great. From the end market perspective or your verticals, which were the biggest? It was cloud, service, wide enterprise that really drove even above your expectations, the stronger sales, as well as the outlook? Thank you.

Jim, thank you. And I really want to give kudos to Anshul, Chris Schmidt, Ashwin and the entire sales team for beating materially. We can only beat materially if we drive sales materially, and then of course we have to ship. One of the things you might have heard from Ita’s statements is, all our five verticals performed very, very well in Q1. So they were all up. If I had to highlight which ones were up more, I would go by the ratings. I would say both Cloud Titans and Enterprise definitely made the contribution and made their mark. And especially, combined with the new logo acquisitions and increase in million-dollar customers, I think those two stood out, but all five were very good.

Thanks, Jim.

Your next question comes from Fahad Najam with MKM Partners. Your line is open.

Thank you, Jayshree, for taking my question. In terms of any impact on the quarter from component shortages, were you able to ship as much as demand? That's a question mark and I have a follow-up.

Yes, I think there's no doubt that we're facing the extended lead times, right. So, clearly, customers would like to have stuff sooner, and we would like to give it to them sooner. But we are facing extended lead time. So, I think it's hard to quantify that, which I know everybody would like us to do. But I mean, we are definitely operating under a constrained supply environment with longer lead times.

Alright. So my question on your improved visibility in Cloud Titans, if I'm not mistaken, your largest Cloud Titan customer, Microsoft, is talking about building 50 to 100 data centers each year for the foreseeable future and entering 10 new countries this year alone. So, why is this kind of slight positive tone, why not a significant lift from your Cloud Titan customer segment overall, given the substantial infrastructure build-out? I would be expecting more orders or trends given the long lead times being shared with you. Is the improved visibility quantifiable? How much improved visibility are you seeing?

Yes, so Fahad, I'll take the question. Normally, we get one to two quarter visibility. This time, you're absolutely right. We now have visibility throughout 2021; perhaps some of that will even extend into 2022, right Anshul? So because of the reasons you say, we now have longer-term visibility that they have shared with us on their future plans. Now, having said that, as you know, we're not going to take that to the bank, there's still an awful lot of execution on their part and our part to turn that visibility into actual results. They've got to build the data centers, they got to acquire the compute, the storage, the power, the cooling, you name it, and we got to also execute. So, while you're definitely detecting an optimistic tone and a more upbeat view, you never know things may change, but definitely, we feel like we have a better view into more than the typical one to two quarters.

Thanks, Fahad.

Your next question comes from David Vogt with UBS. Your line is open.

Thank you, everyone for taking the question. I just had a question about the supply chain and inventory. If you look at your inventory position, it's basically flat sequentially. How do we interpret that in terms of your commentary that you're spending capital to improve manufacturing and increase inventory, when we should be expecting a fairly meaningful ramp in the second half of the year from some of the Cloud Titans? And does your inventory position sort of get into the guidance—give us a sense for where you think Q3 might be at this point? Thanks.

Yes, so I think if you look at the inventory balance, as they started at the beginning of the year and look at it from the beginning of last year all the way through Q1 of this year, I mean, it has been growing each quarter. And if you look at the mix of that, as you'd expect, the growth has been more in the components and the raw materials side. And then we've been using the finished goods pretty much as fast as we can, right. The other place that you'll see when we file the 10-Q, you'll see purchase commitments are up to like $750 million at the end of Q1, which is as high as it's been — significantly higher than what it's been historically — and that's what's putting commitments on the table with various suppliers across the supply chain to make sure that supply comes in. So, we are kind of pushing on all fronts and being aggressive. These are new products. So they have a lower risk profile. We never say no risk, but they have a lower risk profile. But we are being aggressive in terms of funding inventory and supply chain.

And can you, Ita, can you tell us what the purchase commitment growth rate would be, sort of on a year-over-year basis before the Q was filed? What was it last year at plan? Do you have that data handy?

Significantly lower. Yes. So, I think if you take a look at it, I mean we'll provide more detail when we file, but it's significantly higher. We haven't been in that realm historically.

Understood. Thanks. We'll find it in the filing. Thanks.

Your next question comes from Simon Leopold with Raymond James. Your line is open.

Great. Thanks for taking the question. Last quarter, you were kind enough to indicate that you were comfortable with the consensus view that 2021 could grow 15%. That seems like a pretty low bar, and I'm not ignoring the comment you offered about deceleration in the back half of the year. But I would like to get an update because you certainly sound more positive. We've had two quarters in terms of March and the June guide of high-20 growth. What are you thinking for the full year at this point? Thank you.

So Simon, I’ll let Ita answer the question, but we're definitely thinking it'll be higher than 15%.

Right, right. I mean, Simon, without trying to guide the year every quarter, which is not our normal practice. I mean, obviously, we've given you some upside in Q1, there's upside in the guide. I think we can continue to see some growth there. But don't forget the comparatives: if you look on a year-over-year basis, I think you need to think about it more quarterly and sequentially in the quarters than trying to do it year-over-year from here on out, because there was a significant step up in revenue between Q2 2020 and Q3 2020. So just keep that in mind. But I think obviously, we've shown you some improvements. I think we're feeling better, but it's still an incremental quarterly growth rate as I think it’s the right way to think about it.

Just to clarify, other than the supply chain, are there other obstacles we should be considering when we think about seasonal patterns, sequential patterns?

I mean, I think the supply chain is probably the biggest constraint, right?

Yes, I think we've indicated that demand was healthy. So, if we could fulfill more of it, we would be feeling a lot better.

Your next question comes from Rod Hall with Goldman Sachs. Your line is open.

Yes, thanks for the question. I wanted to go back to the Cloud Titans in just kind of the trajectory there in the quarter. We had detected significantly improved orders that tend to project what your revenues are going to look like in March. So January and February were sort of okay, but then March picked up quite a bit. So, I'm curious what your linearity was in terms of orders for Cloud Titans? And is that one of the things that gives you so much more confidence as you look into the back-end of the year?

Rod, normally we would have experienced seasonality in Q1, right? But this Q1, we didn't have the seasonality nor did we have linearity issues. We were pretty consistent in Cloud Titans or for that matter our entire customer base, all verticals were linear in January, February, and March. So, we felt pretty good, right? Maybe this is a post-COVID situation. But because there were no weather storms or impact of Chinese New Year or any of the normal things we have, we didn't have the normal seasonal issues in January and February.

For all the verticals?

Yes.

Rod, as you know, the Cloud Titans are lumpy by nature. So, trying to measure them on a month-by-month basis just won't work. It really comes down to timing of when they want to deploy and so on. At this point, as Jayshree mentioned, it's much more tied to supply of products, and the way we ship them. So, I don't know what you are measuring, but that's certainly not how we saw it.

Thank you, Rod.

Your next question comes from Samik Chatterjee with JPMorgan. Your line is open.

Thank you. Hi. Jayshree, I just wanted to go back to the breadth of the portfolio that you’ve talked about, particularly with enterprise customers. I know you've expanded the portfolio and added campus, etc. I think the broader impression still remains that some of the other companies are positioning themselves for the next generation enterprise network like SD-WAN, some are talking about multi-cloud networking. So, just wanted to get your thoughts on where you are in terms of Arista’s breadth today in terms of the portfolio and potential expansion there? How much of that is organic, or how much do you see a need to continue to expand through M&A?

That's a good question Samik. Obviously, from Arista’s perspective, we've gone from best-of-breed data center to a more complete enterprise portfolio, but that doesn't mean we play in every market segment or every space. Our focus has largely been on SD-LAN more than SD-WAN for campus and data center to our more of medium-to-high end enterprise, right. So where we're not building products today is more for the SMB, I would say that's first of all an area we haven't focused on. So, if you think of our focus, we have DCI, we have multi-cloud. And I would even say we have WAN routing, which could be a form of regional SD-WAN, and we'll continue to build on that. But in terms of SD-WAN for the branch and SMB market we will continue to partner with best of breed, whether it's VMware or Palo Alto, or you name it. So, we feel good that we have a very good rich portfolio for the high-end of the enterprise, and we’ll complement that with the SMB portfolios of other companies.

Got it. Thank you.

Your next question comes from Amit Daryani with Evercore. Your line is open.

Thanks for taking my question and congratulations on a really good quarter. When I look at your recent performance, it looks like you're sustaining really good top-line growth, but you're doing better diversity versus just being Cloud Titan or switching driven, as it was in the past. So, my question is really two dynamics. A: inherently is selling software, security and routing a more complicated operation than selling switching? And do you need to alter anything internally on go-to-market to keep sustaining this product diversity? And then secondly, as you start selling more to enterprises and service providers, what do you think is the biggest challenge you have to overcome to get success in that space? Thank you.

All right, you got your two questions in. Thank you, Amit. So, yes, I would say once you — selling routing and software was hard too when we first got started, because we were a new vendor. But now that we have entered switching with good market share, our approach to selling software and routing is to enhance our switching platforms. So, it's not inherently harder, but it does take different systems engineering and technical expertise. So, what we find ourselves doing in Ashwin and Anshul’s organization is augmenting our switching expertise with more software and routing. And we have specialists for the DANZ Monitoring Fabric, we have specialists for the Awake network detection and response, we have specialists for routing. So naturally, we need to build upon that switching foundation and add these layers of capability. In terms of enterprise and service provider challenges, no doubt, we're the new kid on the block. And we are still best of breed there. And we're dealing with incumbency of vendors who've been there easily 10 to 20 to 30 years longer. So, I would say our biggest challenge is breaking old habits. And I don't think we have any challenge showing our technical prowess. But being offered the opportunity to get there and overcoming the incumbency continues to be an important challenge.

Thanks, Amit.

Your next question comes from Jeff Kvaal with Wolfe Research. Your line is open.

Yes. On a perhaps more prosaic nature, Ita for you. It seems there are a couple of crosscurrents going on in the margin structure and that the enterprise mix may be changing a little bit, components are tight and OpEx may come back a little bit with travel. So, I'm wondering if you could parse out for us how you are balancing those and what we might expect over the course of the year?

Yes, no, I mean, I think we're executing pretty well to the midpoint about 63 to 65, a little bit better, right? There are lots of moving pieces, obviously. There's no doubt we're still carrying some burden from whether it's COVID or supply constraints in the inventory numbers, and then in the P&L as we sell those inventories, right. So there is some burden there for sure. It's somewhat offset by the fact that we have the benefit on the OpEx side of lower travel, lower payments, marketing expenses, etcetera. So, I think we'll see both of those play out over time. And hopefully they're somewhat offsetting. So I think that's how to think about it in the short-term. I think the 63 to 65 is still a good range for gross margins, and we’ll operate somewhere in the middle of that hopefully, as we go forward.

And operating margins, Ita?

We've talked about this being approximately 37%. So, I think that's still where we feel comfortable. There are moving pieces but we feel good about staying in that range.

Thanks, Jeff.

Your next question comes from Ittai Kidron with Oppenheimer. Your line is open.

Thanks and very nice quarter ladies. Congrats. I have a couple questions. First, can you clarify the improved visibility on the cloud side? Is this improved visibility a reflection of new projects and design wins that require more forward planning, or a reflection of the supply chain issues meaning once those are resolved visibility should shorten back down again? And then on the security side, you talk a lot about automation and AI and monitoring, but security and networking are blending on the edges. You haven't talked much about your plans in security. How relevant do you think security will be longer-term and is partnership the best way to play there or will you pursue more internal development or acquisitions?

Ittai, which question do you want me to answer?

All of them.

We'll need an hour for that one. We'll do more on the callbacks. But to answer your specific question on Cloud Titans, definitely Anshul and the team are very involved with the projects. And yes, those tend to be one to two quarters. But because of their long-term planning and our supply chain constraints, they both go hand-in-hand; they're making some CapEx decisions, and we have some supply constraints. We are getting beyond that two-quarter visibility to at least a year's visibility. So, I think you're absolutely right in saying it's going beyond the typical one to two quarters to one year because of supply constraints and because of their long-term decisions. On security, I'll give you the short answer and there's a longer discussion later. We will continue to partner with best-of-breed security vendors, number one. Our approach to zero-trust networking will really be holistic and network centric. There are three parts to it. One is how we provide the right network segmentation. We introduced macro segmentation; how we provide the right encryption capabilities at the DCI layer — this has been a huge differentiator for us in our data center products. So how we do wireless intrusion protection; all of those are network-related security. The second I would largely call visibility or situational analysis. The combination of both the Awake products, as well as the real-time telemetry, streaming and DANZ monitoring fabric really allows us to attack security from a visibility perspective. The third is the proactive acquisition of Awake itself. We didn't acquire Awake just to be a point security product. We really acquired it — Anshul and Rahul are working on this — to make it a more seamless network and proactive network detection and response capability that's AI-driven. So stay tuned, you'll hear more from us on that. But all of this basically is our zero-trust networking strategy different from our partnerships with firewall vendors or cloud security vendors.

Very good.

Thank you.

Your next question comes from Meta Marshall with Morgan Stanley. Your line is open.

Got it. Thanks. Maybe circling back on the Awake security and Big Switch acquisitions, how is the integration going and where are you seeing customer interest in products from those acquisitions? How should we think about that over the next year?

Meta, I think both Big Switch and Awake are very strategic acquisitions for us. And like all strategic acquisitions, they take time. Our goal, and let me start with Big Switch first: we were already building the DANZ monitoring fabric into our switching fabric. With the Big Switch acquisition, we are now able to integrate more monitoring fabric capabilities, correlation, visualization, etc. on our switches. We just introduced that recently, and you'll be seeing variants of that on different platforms, including the 7050 and 7280, towards the end of this year. So, the Big Switch integration is very strategic not only because of the monitoring capabilities, but because of the switch integration. On the Awake side, the team has done a fantastic job first of all, of really focusing not just on the CSO, but on the CIO. You really have to target both decision makers.

Absolutely. With all acquisitions, you have to figure out how to integrate them based on the teams, the product go-to-market, and then the product integration. And we have done fairly quick integration with Awake. There's more to do, but at least on the go-to-market side, it's coming along well. As Jayshree mentioned, there is a phase where I'm able to take this to the customer and take it to the networking team to give them more visibility, and sometimes in collaboration with security to sell the product. So it's coming along well and faster than what we typically would have done in other situations.

Great. Thanks.

Your next question comes from Pierre Ferragu with New Street. Your line is open.

Hi, thank you for taking my question. I have a nitty-gritty question. I hear you talk about your supply constraints, and at the same time you beat your guide and you guide above expectations. So, if you have supply constraints that get you to beat expectations every quarter, I'd really love to have you be constrained for as long as possible. My question is, how much visibility do you have to keep operating the way you're operating this quarter and to upgrade next quarter? When do you really get into trouble if more capacity is not coming online?

Yes, Pierre. It's a good question. If we were the only vendor with supply constraint issues, we would be in more trouble quickly because customers would have alternatives. But because this is an industry-wide shortage, I think we're all in deep trouble, including our customers who are trying to do the planning. So, I would tell you, we're on an equal footing. And we're all in bad shape on the supply constraints side, but not everyone is in good shape on the demand side. So, we feel good about that.

Your next question comes from Aaron Rakers with Wells Fargo. Your line is open.

Yes, thanks for taking the questions and congratulations on the quarter as well. I want to go back to the deferred revenue discussion. You mentioned in your prepared remarks you have $40 million of product deferred revenue build. It's been quite some time since we've seen any product deferred revenue build into that deferred revenue bucket. How do you think about that in the concept of guidance? Are you expecting that to come into the revenue number next quarter or over the next couple quarters? And any comments on performance obligations that are outside of deferred, what is that, how did that expand?

So I think on the deferred, it's always hard to forecast that kind of movement multiple quarters out. But I will say that we do not expect it to come down in the second quarter; that's not an assumption for the Q2 guide. But I'm not in a position to guide that multiple quarters out yet. I think we do not expect it to come down; it's likely that we'll at least have that level of deferred going forward. On the RPOs, we did some work in the quarter which you'll see later around the RPO disclosure and consolidated a little bit so that you can see the pieces. A lot of the movement is in deferred revenue between product and services. The other items didn't move that much quarter-over-quarter, but again you'll see that and we've consolidated some of those disclosures into a single footnote so that you can see it all together. The non-balance-sheet RPO amounts are mostly around services and billed amounts, as opposed to build product, which is in deferred revenue.

Great. Thank you.

Thanks Aaron.

Your next question comes from Tal Liani with Bank of America. Your line is open.

Hi, guys. I wanted to congratulate you about the quarter, but I'm not going to be unique, and I wanted to congratulate you about your grandchild — more important. I want to ask about enterprise data centers. One of the companies said that enterprises sweated their assets during 2020 and now they see renewed momentum because there is a snapback in spending in data centers. Did you have the same experience where corporates underspent last year and now they just have to spend to modernize and add capacity, or are other drivers behind enterprise data center spend?

Tal, enterprise data centers are much more of a long-term decision. They generally sweat their assets for three to five years, and then they're looking for consolidation and upgrades, including to 100-gig or 400-gig. If anything, it's less tied to one year; it's more tied to needing a cloud-first strategy and figuring out which workloads go to the cloud and which remain on-premise. Bringing cloud principles into their data centers is probably the number one motivator.

Got it. Thank you.

Thank you.

Your next question comes from Ben Bollin with Cleveland Research. Your line is open.

Good afternoon. Thanks for taking the question. Jayshree, you talked about COVID resulting in more planning from customers. Could you share thoughts about how that planning and return to work may be influencing the trajectory of new customer wins? And how are you executing on the overall campus initiative?

That's a good question Ben. Last year during the initial COVID period many customers froze decisions. Towards the second half of the year they started engaging in decision making. This year many are looking at hybrid workspaces. Arista is doing the same: we don't see a full return to work for all employees until it's safe, but we don't see a 100% return either. Some teams that are hardware intensive will come in more, while software teams may remain more distributed. The campus is changing: it is moving to a more fluid, elastic set of workspaces where you need wired, Wi-Fi and equal access to multiple geographies. Whether you're at home or at work or in transit, you still have to work. That is influencing campus decisions. Our enterprise customers are constructive on coming back to headquarters but also want ubiquitous campus connectivity for remote employees. In retail, we see activity on distribution centers which are regional and connected to retail spaces. Arista is doing well in the campus market we target — the high-end enterprise. Where we are not focused is the SMB, which is more channel-driven. So, we're doing well in our target campus segments and not focused on non-targets.

Okay. Thanks.

Thanks, Ben.

Your next question comes from Tim Long with Barclays. Your line is open.

Thank you. Maybe Jayshree can update a little bit on what you're seeing from the white box community. Two parts: are you seeing any move with new customers versus Tier 2 Cloud or SaaS companies trying to white-box more on the switching side? And second, are you seeing any opposite trends where traditional white-box customers are going more branded for certain portions of their networks?

Tim, there are two parts. In terms of Tier 2 Cloud or SaaS companies we haven't really seen any change in the white box scenarios in that part of the market. White box is largely limited to the very large Cloud Titans in the United States or some in Asia and it hasn't changed beyond that. The supply chain discussions apply equally to the white boxes as well. Many cloud companies are struggling because not every ODM and supplier are going to carry so much inventory and have large commitments. On the second part, some larger cloud companies are looking at going branded and we're doing well in our engineering projects in those opportunities. But these things take a couple of years to materialize. We feel very good about our execution and the opportunity, but you have to give it time — let it bake in labs, pilots, and when it's ready we'll share the news.

No change in status; status quo.

Okay. Thank you.

Your next question comes from an analyst with KeyBanc. Your line is open.

Hey. Thanks for taking my question. I just touched on the 400-gig opportunity. What are your expectations and timing differences? Do you expect timing to differ between major verticals?

Yes, the early adoption of 400-gig will definitely be in our Cloud Titans and our specialty cloud providers, and some of our high-end enterprises, but the first place you'd see them is the Cloud Titans.

And will the enterprise adoption lag into 2022 and beyond?

Yes, I think enterprises will take longer. Many enterprises are still adopting 100-gig. You'll see a combination of 100-gig and 400-gig start in 2022, but it could go well into 2023, 2024, and 2025 as well.

All right. Thanks.

Your next question comes from Erik Suppiger with JMP Securities. Your line is open.

Yes, thanks for taking the question. First, Jayshree you said you were on track to hit targets for campus. Can you remind us, does that mean you are on track for $200 million in 2021?

The answer is, yes.

Very good. And on the 400-gig, are you still anticipating you'll be the market share leader in 400-gig as that ramps up or can you talk about competitive dynamics?

From a competitive standpoint not much has changed, and product feedback is still very, very good. Customers are happy with our products. Market share will be the result of customers buying our products, not our forecast, so let the results speak for themselves. We feel good about our position.

All right, Erik, thanks.

Your next question comes from Jon Lopez with Vertical Group. Your line is open.

Hey. Thanks so much. I have a quick follow-up. Ita, service revenue very rarely declines quarter-to-quarter; it did marginally this quarter. Why is that and is there anything to extrapolate from that activity?

I wouldn't try to draw any conclusions from that. It's really just timing of when you close renewal contracts and whether you bill in the quarter, and then there's some catch up or not. It doesn't change the fundamentals; typically Q4 is strong, Q1 can be a little lighter. I wouldn't try to read more into that.

Okay. Second, on seasonality: forgetting year-over-year for a second, you generally see Q3 to Q4 up mid to high single digits sequentially. Is what you're saying that some of that activity has been pushed earlier into the year? Or are you just focused on the year-over-year comps?

My only comment was around the year-over-year comps: you're growing off Q1 2020 and there was a step-up later last year. So the year-over-year growth rate will come down naturally because of those comparatives. If you look at quarter-over-quarter growth that's an easier thing to model.

Thanks so much for the help.

Thanks, Jon.

Your last question comes from Kyle on for George with Jefferies. Your line is open.

Hi, this is Kyle on for George, thanks for the question and fitting me in here. My main questions were on campus and 400-gig. To avoid beating those to death, I’ll ask a simple one. Do you have any expectation currently on when travel expenses would pick back up again? I know you said that they're currently out of the model, but do you have any plans on when they may turn back on? Or is it kind of wait and see still? How should we contemplate that in OpEx expectations?

It wasn't huge to begin with; sales and marketing travel expenses aren't massive. I think travel doesn't start to come back until later in the year. We'll update as we go — there are a lot of moving pieces right now.

Okay, thanks very much.

Okay. So, this concludes the Arista Q1 2021 earnings call. We have posted a presentation which provides additional information on our fiscal results, which you can access on the investor section of our website. Thank you for joining us today and everyone, please continue to be safe.

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