Earnings Call Transcript - ANET Q3 2020

Operator, Operator

Welcome to the Third Quarter 2020 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. 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, Director of Corporate and Investor Development. Sir, you may begin.

Curtis McKee, Director of Corporate and Investor Development

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 for its fiscal third quarter ending September 30, 2020. 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 fourth quarter of the 2020 fiscal year, longer-term financial outlook for 2021 and beyond, our total addressable market and strategy for addressing these market opportunities, the potential impact of COVID-19 on our business, our product innovation, and the benefits of recent acquisitions, 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 Form 10-K. 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.

Jayshree Ullal, President and CEO

Thank you, Curtis. Thank you, everyone for joining us this afternoon for our third quarter 2020 earnings call. To start with, we hope that you and your families are safe during the global pandemic. At Arista, we recognize our role and responsibility in supporting global communications and private infrastructure during these challenging times. We are working closely with our employees, supply chain, contract manufacturers, customers, and Arista Foundation to assist in business continuity initiatives and people to life. Back to Q3 2020. We delivered $605.4 million for the quarter with a non-GAAP earnings per share of $2.42. ACA services and software and support renewals contributed approximately 21% of revenue. Our non-GAAP gross margins were 64.6%, influenced by software and services mix and a higher Asia Pacific contribution. We registered a record number of new customer logos this quarter, as well as million-dollar customers, a direct result of our momentum in the enterprise vertical and campus traction this quarter. In Q3 2020, cloud titans was our largest vertical, followed by enterprise, which is consistently our second-largest performer. What is clear is that Arista's cloud and support now apply to all sectors, and we are diversifying roles across customers and verticals. We believe Arista will emerge stronger, not only returning to double-digit growth in 2021 but also aiming for consistent growth in the years beyond. We expect our multi-year growth cycles from three major product line contributors. Our core cloud and data center products, which are built upon our flagship Arista EOS. Our second market is adjacent sectors, as we have recently entered the cognitive campus market. The campus brings a unified edge for wired and WiFi endpoints, as well as new IoT devices. Our third category is network software and services, based on software subscription models, such as Arista A-Care and CloudVision. The capabilities offered by this software stack will be fundamental in our current environment.

Andy Bechtolsheim, Founder and Chief Development Officer

Yes. We like markets that are right for real innovation, and the campus networking market is a prime example of that. With the launch of our 750 Series modular chassis, we are introducing a next generation platform that delivers more performance, more security, more visibility and more power capabilities than any other products in its class. The 750 has 400-gigabits per second uplink throughput, which is 5 times the performance of our nearest competitor. This level of performance is key to support WiFi 6, where each access point has up to 5 gigabits throughput.

Jayshree Ullal, President and CEO

Thanks, Andy. That was great. I'm excited, I could use one at home. Next generation routing is another key adjacent market for us, as we aim to bring together layer two switches and layer three routers together for rich protocol support, resiliency, scale, and programmability. This has been a four to five-year endeavor for us. We're starting to see the fruits of this labor as Arista customers are now seeing us as a compelling and cloud-grade routing alternative to expensive legacy routers. We're extending beyond classical use cases to multi-terabit routing offerings, accelerating WAN and inter-DC routing use cases. Our investments in the simplification of Arista's routing stack with standards-based protocols are yielding early traction. We have won a few important Tier 2 and Tier 3 service provider customers for various use cases, including multi-access edge and pairings.

Anshul Sadana, Chief Operating Officer

Thank you, Jayshree. Arista has been a leader in cloud networking based on our nimble execution, product quality, and ability to co-develop with our customers. Cloud companies are engaging us more than ever to discuss their architectures for the future. We are winning new RFPs on next-gen products, both 100-gig and 400-gig. Our customers see immense value in working with us, and we have high customer satisfaction here. Our portfolio is highly competitive, and we are being told that we are ahead of the competition.

Ita Brennan, Chief Financial Officer

Thanks, Jayshree, and good afternoon. Let me announce our Q3 results, our guidance for Q4 2020 based on non-GAAP and excludes all non-cash stock-based compensation impacts, acquisition-related charges, and other non-recurring items. Total revenues in Q3 were $605.4 million, down 7.5% year-over-year and well above our guidance of $570 million to $590 million. Service and software support revenues represented approximately 21% of total revenue, down slightly from 22% last quarter. International revenue for the quarter came in at $152.7 million or 25.2% of total revenue, up from 19.4% in the second quarter.

Jayshree Ullal, President and CEO

In summary, Arista's vision includes LAN, WAN, cloud networking, with clear diversification across customers, products, and verticals. We have built a transformative architecture to harness the new trends in IoT computing and unified edge. Our customers resonate with this vision. And I couldn't be more optimistic about our strategy, our innovation, and our quality of support.

Curtis McKee, Director of Corporate and Investor Development

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. Operator, you may go ahead.

Samik Chatterjee, Analyst

Jayshree, you sound a lot more confident about returning to double-digit growth than you did 90 days ago. What's driving that? Is it some of the 400-gig wins coming in as you expected or is it the underlying customer spending starting to improve?

Jayshree Ullal, President and CEO

The foundation and fundamentals of Arista didn't change. We've always had superior products and very strong customer traction. But as we navigated COVID-19, we saw balanced customer traction across all our verticals and sectors in Q3. So, the combination of an unchanged strategy, a highly differentiated product, and consistent performance gives us newfound confidence.

David Vogt, Analyst

Can you share your thoughts on the proposed Marvell Inphi transaction announced last week and what it might mean for the industry moving forward?

Jayshree Ullal, President and CEO

There has been a lot of semiconductor consolidation recently. The larger semiconductor companies are trying to get larger, while smaller ones are producing innovative technology but need scale. We are very impressed with Inphi and hopeful that its strength will help Marvell, especially in the cloud.

Sami Badri, Analyst

Can you explain why some customers may deploy white boxes initially and then eventually swap that out for Arista’s feature-rich products?

Anshul Sadana, Chief Operating Officer

Our customers do that analysis in both directions. As their scale grows, their needs become more complex, and they look for features that may be better served by our products. These transitions take time but they are happening.

Alex Kurtz, Analyst

Regarding the services becoming roughly 20% of the business, can this growth in your software product portfolio accelerate the software renewal base? Can we see it reach 30% or 40%?

Jayshree Ullal, President and CEO

While it could grow to 25%, it may be harder to reach 30% and 40%, especially as cloud titans may prefer to build some tools themselves. Other verticals are more likely to embrace our software subscriptions.

Tal Liani, Analyst

Overall revenues are down 7.5% year-over-year. Product growth is down about 13.5% year-over-year, while services are up 26%. What accounts for the strong growth in services versus the decline in products?

Jayshree Ullal, President and CEO

Services include many of our software subscriptions and multi-year contracts. The trends indicate we're getting stickier with services and we can do better with product sales.

Ita Brennan, Chief Financial Officer

Service revenue continues to grow and is now a more meaningful piece of the business. While product is recovering, it is being driven by different factors at this particular point in time.

Fahad Najam, Analyst

Your inventories have gone up significantly. Are you expecting a significant demand ramp in the next few quarters?

Ita Brennan, Chief Financial Officer

We’re buffering against uncertainties around COVID. We aim for more inventory flexibility to be prepared for future supply chain disruptions.

Paul Silverstein, Analyst

You expect campus revenue to double. Can you elaborate on your growth expectations across cloud, enterprise, financials, and service providers to reach double-digit growth?

Jayshree Ullal, President and CEO

We aim to double campus revenue from $100 million to $200 million by the end of 2021 based on our product announcements and market traction. However, it is too early to predict exact breakdowns by verticals.

Ita Brennan, Chief Financial Officer

While cloud has resumed growth and the rest of the business is performing well, we believe multiple drivers will contribute to our growth into next year.

Jeff Kvaal, Analyst

Could you outline the rationale behind the guidance? Has the semiconductor issue at one of your partners been resolved?

Ita Brennan, Chief Financial Officer

We've seen positive trends across our sectors, and we're starting to understand our cloud customers' plans for next year, feeling more confident around growth drivers. Our guidance reflects that.

Jayshree Ullal, President and CEO

We expect cloud titan trends to improve in 2021 based on CapEx projections and deployment patterns. Status quo remains unchanged, and we look forward to capturing share in new roles.

George Notter, Analyst

Can you define success in routing for Arista? What percentage of sales or revenue are you currently driving there?

Jayshree Ullal, President and CEO

Routing and switching often go together, and we are seeing success with Tier 2 and Tier 3 providers, leading to early design wins. However, significant growth takes time.

Rod Hall, Analyst

Do you believe deferred revenue will become an issue in 2021 because of the 400-gig rollout? How are you seeing the enterprise spend trends?

Ita Brennan, Chief Financial Officer

Deferred revenue is more dependent on the term and timing of multi-year contracts. However, we see enterprise still performing strongly, pulling through demand nicely.

Jim Suva, Analyst

Regarding your 2021 outlook, does your consensus of 13% to 14% include the recent CapEx outlooks provided? How do you see that impacting your business?

Ita Brennan, Chief Financial Officer

Our guidance reflects current views on CapEx trends, but the networking component of total CapEx is small, below 5% typically. We'll watch this quarterly as it tends to be volatile.

James Fish, Analyst

Can you clarify how server cycles affect your business moving into 2021?

Jayshree Ullal, President and CEO

We generally see a one to two quarter lag for network spending post-server upgrades. We hope to gain with customers as they navigate their own data center upgrades.

Pierre Ferragu, Analyst

How do you expect growth from routing, campus, and software/services compared to your core switching market over the next three to five years?

Jayshree Ullal, President and CEO

We believe the new markets we are entering will grow faster than our core market. But I'll leave it at that.

Tim Long, Analyst

Can we discuss the telco vertical and any plans to boost revenue through routing or security features?

Jayshree Ullal, President and CEO

It's been taking us time to win over telcos. We've had some wins in Tier 1 this year, but it always requires more investment and longer timelines for adoption.

Amit Daryanani, Analyst

Is your expected double-digit sales growth for calendar '21 an organic statement?

Jayshree Ullal, President and CEO

Yes, it is based on organic growth based on products. We're not factoring any future products or M&A in that discussion.

Simon Leopold, Analyst

If a customer wants to upgrade their data center to 200-gig, how does that impact Arista?

Anshul Sadana, Chief Operating Officer

We support multiple gig options. We're well positioned to adapt to both 200-gig and 400-gig requirements.

Woo Jin Ho, Analyst

Does the emergence of DPUs present a growth opportunity for you in the cloud?

Anshul Sadana, Chief Operating Officer

It's too early to determine their impact on networking. However, they could benefit us as they drive changes in architecture.

Jon Lopez, Analyst

Can you clarify the trend of deferred revenue? Should we be concerned about services revenue in 2021?

Ita Brennan, Chief Financial Officer

Deferred revenue will be influenced by the timing of renewals. The revenue for services will remain consistent.

Curtis McKee, Director of Corporate and Investor Development

This concludes the Arista Q3 2020 Earnings Call. We have posted a presentation providing additional information on our fiscal results, which you can access on the Investors section of our website. Thank you for joining us today. And everyone, please be safe.

Operator, Operator

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