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Arista Networks, Inc. - Quarter Report: 2018 September (Form 10-Q)


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________________________
FORM 10-Q
__________________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
Or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission file number: 001-36468
___________________________________________
ARISTA NETWORKS, INC.
(Exact name of registrant as specified in its charter)
___________________________________________
Delaware
 
20-1751121
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
5453 Great America Parkway
Santa Clara, California 95054
(Address of principal executive offices)
(408) 547-5500
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
_________________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o   
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
 
 
Accelerated filer  o
 
 
Non-accelerated filer  o
 
 
Smaller reporting company  o
 
 
 
 
 
Emerging growth company  o
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  ý
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of October 26, 2018 was 75,427,300.



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


Table of Contents

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
ARISTA NETWORKS, INC.
Condensed Consolidated Balance Sheets
(Unaudited, in thousands, except par value)
 
 
September 30, 2018
 
December 31, 2017
ASSETS
 
 
 

CURRENT ASSETS:
 
 
 
 
Cash and cash equivalents
 
$
524,687

 
$
859,192

Marketable securities
 
1,137,112

 
676,363

Accounts receivable, net of rebates and allowances of $11,251 and $7,535, respectively
 
322,053

 
247,346

Inventories
 
216,313

 
306,198

Prepaid expenses and other current assets
 
235,881

 
177,330

Total current assets
 
2,436,046

 
2,266,429

Property and equipment, net
 
75,397

 
74,279

Acquisition-related intangible assets, net
 
62,110

 

Goodwill
 
55,168

 

Investments
 
35,036

 
36,136

Deferred tax assets
 
114,282

 
65,125

Other assets
 
20,199

 
18,891

TOTAL ASSETS
 
$
2,798,238

 
$
2,460,860

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
CURRENT LIABILITIES:
 
 
 
 
Accounts payable
 
$
85,097

 
$
52,200

Accrued liabilities
 
103,108

 
133,827

Deferred revenue
 
318,850

 
327,706

Other current liabilities
 
32,727

 
16,172

Total current liabilities
 
539,782

 
529,905

Income taxes payable
 
42,470

 
34,067

Lease financing obligations, non-current
 
36,040

 
37,673

Deferred revenue, non-current
 
211,005

 
187,556

Other long-term liabilities
 
23,065

 
9,745

TOTAL LIABILITIES
 
852,362

 
798,946

Commitments and contingencies (Note 6)
 

 


STOCKHOLDERS’ EQUITY:
 
 
 
 
Preferred stock, $0.0001 par value—100,000 shares authorized and no shares issued and outstanding as of September 30, 2018 and December 31, 2017
 

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of September 30, 2018 and December 31, 2017; 75,393 and 73,706 shares issued and outstanding as of September 30, 2018 and December 31, 2017
 
8

 
7

Additional paid-in capital
 
929,829

 
804,731

Retained earnings
 
1,020,481

 
859,114

Accumulated other comprehensive loss
 
(4,442)

 
(1,938
)
TOTAL STOCKHOLDERS’ EQUITY
 
1,945,876

 
1,661,914

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
2,798,238

 
$
2,460,860

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

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

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
485,481

 
$
380,344

 
$
1,337,865

 
$
1,025,615

Service
 
77,828

 
57,289

 
217,778

 
152,704

Total revenue
 
563,309

 
437,633

 
1,555,643

 
1,178,319

Cost of revenue: 
 
 
 
 
 
 
 
 
Product
 
187,764

 
145,874

 
516,077

 
390,116

Service
 
13,962

 
11,142

 
41,181

 
33,599

Total cost of revenue
 
201,726

 
157,016

 
557,258

 
423,715

Gross profit
 
361,583

 
280,617

 
998,385

 
754,604

Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
117,589

 
79,610

 
324,029

 
242,414

Sales and marketing
 
47,903

 
40,640

 
136,231

 
116,297

General and administrative
 
15,321

 
19,535

 
53,420

 
65,009

Legal settlement (Note 11)
 

 

 
405,000

 

Total operating expenses
 
180,813

 
139,785

 
918,680

 
423,720

Income from operations
 
180,770

 
140,832

 
79,705

 
330,884

Other income (expense), net:
 
 
 
 
 
 
 
 
Interest expense
 
(673
)
 
(701
)
 
(2,040
)
 
(2,039
)
Other income (expense), net
 
9,292

 
2,136

 
12,646

 
4,280

Total other income (expense), net
 
8,619

 
1,435

 
10,606

 
2,241

Income before income taxes
 
189,389

 
142,267

 
90,311

 
333,125

Provision for (benefit from) income taxes
 
20,865

 
8,545

 
(67,482
)
 
13,757

Net income
 
$
168,524

 
$
133,722

 
$
157,793

 
$
319,368

Net income attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
168,439

 
$
133,540

 
$
157,706

 
$
318,643

Diluted
 
$
168,445

 
$
133,555

 
$
157,713

 
$
318,704

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
2.25

 
$
1.84

 
$
2.12

 
$
4.43

Diluted
 
$
2.08

 
$
1.68

 
$
1.95

 
$
4.06

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
75,011

 
72,588

 
74,506

 
71,903

Diluted
 
81,018

 
79,322

 
80,844

 
78,528


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



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ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited, in thousands)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Net income
 
$
168,524

 
$
133,722

 
$
157,793

 
$
319,368

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
(379
)
 
343

 
(1,193
)
 
500

Net change in unrealized gains (losses) on available-for-sale securities
 
488

 
(165
)
 
(1,311
)
 
(100
)
Other comprehensive income (loss)
 
109

 
178

 
(2,504
)
 
400

Comprehensive income
 
$
168,633

 
$
133,900

 
$
155,289

 
$
319,768


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



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ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands)
 
 
Nine Months Ended September 30,
 
 
2018

 
2017
  As Adjusted (1)
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income
 
$
157,793

 
$
319,368

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, amortization and other
 
18,440

 
15,355

Stock-based compensation
 
66,583

 
54,991

Deferred income taxes
 
(49,615
)
 
(22,743
)
Unrealized loss on investments in privately-held companies, net
 
9,100

 

Amortization (accretion) of investment premiums (discounts)
 
(1,863
)
 
1,106

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
(68,192
)
 
40,508

Inventories
 
98,284

 
(96,667
)
Prepaid expenses and other current assets
 
(50,507
)
 
(20,973
)
Other assets
 
(767
)
 
(1,560
)
Accounts payable
 
30,515

 
(46,075
)
Accrued liabilities
 
(35,917
)
 
4,175

Deferred revenue
 
13,161

 
192,210

Income taxes payable
 
10,311

 
7,421

Other liabilities
 
9,974

 
847

Net cash provided by operating activities
 
207,300

 
447,963

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Proceeds from maturities of marketable securities
 
366,999

 
135,483

Purchases of marketable securities
 
(827,198
)
 
(325,414
)
Business acquisitions, net of cash acquired
 
(95,640
)
 

Purchases of property and equipment
 
(17,613
)
 
(12,159
)
Investments in privately-held companies
 
(8,000
)
 

Proceeds from repayment of notes receivable
 

 
3,000

Other investing activities
 
(2,000
)
 

Net cash used in investing activities (1)
 
(583,452
)
 
(199,090
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Principal payments of lease financing obligations
 
(1,392
)
 
(1,170
)
Proceeds from issuance of common stock under equity plans
 
49,642

 
41,870

Tax withholding paid on behalf of employees for net share settlement
 
(6,914
)
 
(2,457
)
Net cash provided by financing activities
 
41,336

 
38,243

Effect of exchange rate changes
 
(984
)
 
697

NET INCREASE/(DECREASE) IN CASH, CASH EQUIVALENTS AND RESTRICTED CASH
 
(335,800
)
 
287,813

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

 
572,168

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —End of period (2)
 
$
528,897

 
$
859,981

 
 
 
 
 

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Nine Months Ended September 30,
 
 
2018

 
2017
  As Adjusted (1)
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING INFORMATION:
 
 
 
 
Common stock issued for business acquisition
 
$
15,555

 
$

Property and equipment included in accounts payable and accrued liabilities
 
$
2,479

 
$
468

___________________________________________________
 
 
 
 
(1) Net cash used in investing activities for the nine months ended September 30, 2017 was adjusted as a result of our adoption of Accounting Standards Update 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in the first quarter of 2018. See Note 1 of the accompanying notes for details of the adjustments.
(2) See Note 4 of the accompanying notes for a reconciliation of the ending balance of cash, cash equivalents and restricted cash as shown in this condensed consolidated statements of cash flows.
The accompanying notes are an integral part of these condensed consolidated financial statements.

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ARISTA NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1.    Organization and Summary of Significant Accounting Policies
Organization
Arista Networks, Inc. (together with our subsidiaries, “we,” “our” or “us”) is a supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation enterprise. Our cloud networking solutions consist of our Extensible Operating System (“EOS”), a set of network applications and our 10/25/40/50/100 Gigabit Ethernet switching and routing platforms. We were incorporated in October 2004 in the State of California under the name Arastra, Inc. In March 2008, we reincorporated in the State of Nevada and in October 2008 changed our name to Arista Networks, Inc. We reincorporated in the state of Delaware in March 2014. Our corporate headquarters are located in Santa Clara, California, and we have wholly-owned subsidiaries throughout the world, including North America, Europe, Asia and Australia.
Basis of Presentation and Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements include the accounts of Arista Networks, Inc. and its wholly owned subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and the requirements of the U.S. Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. In management’s opinion, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our financial information. The results for the three and nine months ended September 30, 2018, are not necessarily indicative of the results expected for the full fiscal year. The condensed consolidated balance sheet as of December 31, 2017 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by GAAP for complete financial statements. All significant intercompany accounts and transactions have been eliminated.
Our condensed consolidated financial statements and related financial information in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and related footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017, filed with the SEC on February 20, 2018. Certain reclassifications of prior period amounts were made in the current year to conform to the current period presentation.
Use of Estimates
The preparation of the accompanying condensed consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and accompanying notes. Those estimates and assumptions include, but are not limited to, revenue recognition and deferred revenue; allowance for doubtful accounts, sales rebates and return reserves; valuation of goodwill and acquisition-related intangible assets, accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; estimate of useful lives of long-lived assets including intangible assets; valuation of inventory and contract manufacturer/supplier liabilities; recognition and measurement of contingent liabilities; valuation of equity investments in privately-held companies; determination of fair value for stock-based awards; and valuation of warranty accruals. We evaluate our estimates and assumptions based on historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. Actual results could differ materially from those estimates.
Significant Accounting Policies
During the nine months ended September 30, 2018, we completed two business acquisitions (see Note 2) and adopted several recent accounting pronouncements as discussed in the section titled Recently Adopted Accounting Pronouncements of this Note 1. As a result, we updated certain significant accounting policies as described below. There have been no other significant changes to our accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018.
Investments in Privately-held Companies
Our equity investments in privately-held companies without readily determinable fair values are measured using the measurement alternative, defined by Accounting Standards Codification (“ASC”) 321-Investments-Equity Securities as cost, less impairments, and adjusted up or down based on observable price changes in orderly transactions for identical or similar investments

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

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We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical returns rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.
Our policy applies to the accounting for individual contracts. However, we have elected a practical expedient to apply the guidance to a portfolio of contracts or performance obligations with similar characteristics so long as such application would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio. Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.
We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.
Contract Balances
A contract asset is recognized when we have performed under the contract, but our right to consideration is conditional on something other than the passage of time. Contract assets are included in “Other current assets” on our condensed consolidated balance sheets.
A contract liability is recognized when we have received customer payments in advance of our satisfaction of a performance obligation under a contract that is cancellable. Contract liabilities are included in “Other current liabilities” and “Other long-term liabilities” on our condensed consolidated balance sheets.
Assets Recognized from Costs to Obtain a Contract with a Customer
Effective January 1, 2018 in connection with the adoption of ASC 606, we recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales commissions earned by our sales force meet the requirements for capitalization. These costs are deferred and then amortized over a period of benefit that we have determined to be five years. Total capitalized costs to obtain a contract are included in other current and long-term assets on our condensed consolidated balance sheets.
Business Combinations
We use the acquisition method to account for our business combinations in accordance with ASC 805 - Business Combinations (“ASC 805”). We allocate the total purchase consideration to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The excess of the consideration transferred over the fair values of the assets acquired and liabilities assumed is recorded as goodwill. The results of operations of the acquired businesses are included in our consolidated financial statements from the date of acquisition. Acquisition-related costs and restructuring costs are expensed as incurred.
Goodwill
We perform our annual goodwill impairment analysis in the fourth quarter of each year or more frequently if there are any events or circumstances that would indicate the carrying amount is not recoverable. We first perform a qualitative assessment to determine if it’s necessary to perform a quantitative assessment. If after our qualitative assessment, we determine it is more likely than not that the fair value of the Company is less than its carrying amount, then a quantitative test is performed by comparing the fair value of the Company with its carrying amount in accordance with Accounting Standard Update (“ASU”) No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. We would recognize an impairment loss for the amount by which the carrying amount exceeds the fair value.
Intangible Assets
Intangible assets are carried at cost less accumulated amortization. All intangible assets have been determined to have definite lives and are amortized on a straight-line basis over their estimated remaining useful lives, ranging from one to seven years. Intangible assets are tested for impairment annually in the fourth quarter of each year or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. 
Recently Adopted Accounting Pronouncements
Revenue Recognition
During May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). In 2016, the FASB issued ASU No. 2016-08, ASU No. 2016-10 and ASU No. 2016-12, which provide interpretive clarifications on the new guidance in Topic 606 (collectively, “the new standard”). Under the new standard, the recognition of revenue is based on consideration we expect to be entitled to from the transfer of goods or services to a customer.

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The primary impact of the new standard is related to the deferral of incremental commission costs of obtaining customer service contracts, which were previously expensed as incurred. Under the new standard, we defer all such costs and amortize them over the expected period of benefit. The new standard also requires companies to account for termination clauses at the onset of an arrangement. While there is limited history of cancellations, our prepaid subscription offerings are generally cancellable by customers with 30 days’ notice, therefore, the subscription contracts are considered month-to-month. While these prepaid amounts have historically been recorded to deferred revenue, the new standard requires that we record these amounts as other liabilities. In addition, the new standard may impact the amount and timing of revenue recognition of certain sales arrangements and the related disclosures on our consolidated financial statements.
We adopted the new standard in our first quarter of 2018 using the modified retrospective method, which resulted in a cumulative effect adjustment of $3.5 million that increased retained earnings to capitalize certain commission costs that were expensed in the prior year. Correspondingly, we increased prepaid expenses and other current assets by $2.0 million, other assets by $2.2 million, and decreased deferred tax assets by $0.7 million as of January 1, 2018. In addition, we reclassified $16.5 million of deferred revenue as of January 1, 2018 to other current liabilities and other long-term liabilities related to our prepaid subscription offerings. The impact of adopting the new standard was not material to our financial results for the three and nine months ended September 30, 2018 and we do not expect the impact to be material to the financial results for our fiscal 2018.
We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less, as well as the portfolio approach for the contracts reviewed. These costs include a portion of our sales force compensation program as we have determined annual compensation is commensurate with recurring sales activities.
Financial Instruments
In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which enhances the reporting model for financial instruments to provide users of financial statements with more decision-useful information. In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments, to clarify certain aspects of ASU 2016-01. ASU 2016-01 and ASU 2018-03 (collectively, the “new guidance”) address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. We adopted this new guidance in our first quarter of fiscal 2018. Under the new guidance, there was no change in the accounting of our marketable securities as our investment policy only allows investments in debt securities. For our cost method equity investments in privately-held companies without readily determinable fair value, we elected to use the measurement alternative, defined as cost, less impairments, as adjusted up or down based on observable price changes in orderly transactions for identical or similar investments of the same issuer, which was adopted prospectively. Adjustments resulting from impairments and/or observable price changes are to be recorded as other income (expense) on a prospective basis.
The carrying amount of our equity investments and any related gain or loss may fluctuate in the future as a result of the re-measurement of such equity investments upon the occurrence of observable price changes and/or impairments.
Income Taxes on Intra-Entity Transfers of Assets
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, which addresses recognition of current and deferred income taxes for intra-entity asset transfers when assets are sold to an outside party. Current GAAP prohibits the recognition of current and deferred income taxes until the asset has been sold to an outside party. This prohibition on recognition is considered an exception to the principle of comprehensive recognition of current and deferred income taxes in GAAP. The new guidance requires an entity to recognize the income tax consequences when the transfer occurs eliminating the exception. The guidance must be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We adopted this guidance in our first quarter of fiscal 2018. As a result, we recognized a cumulative effect adjustment in the condensed consolidated balance sheet as of September 30, 2018 by increasing the retained earnings and the deferred tax assets as of January 1, 2018 by approximately $0.1 million, respectively.
Restricted Cash in Statement of Cash Flows
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force (“ASU 2016-18”), which requires that amounts generally described as restricted cash or restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. This standard is required to be applied using a retrospective transition method to each period presented. We retrospectively adopted ASU 2016-18 in our first quarter of fiscal 2018. As a result of the adoption, we adjusted the condensed consolidated statement of cash flows for the nine months ended September 30, 2017 to increase the beginning-of-period and end-of-period cash amounts by $4.2 million and $5.5 million, respectively, and to decrease net cash used in investing activities by $1.3 million.

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Recent Accounting Pronouncements Not Yet Effective
Nonemployee Share-Based Payments
In June 2018, the FASB issued ASU 2018-07, Compensation—Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), to simplify the accounting for share-based payments to nonemployees by aligning it with the accounting for share-based payments to employees with certain exceptions. Under the guidance, the measurement of equity-classified nonemployee awards will be fixed at the grant date, which may lower their cost and reduce volatility in the income statement. The guidance is effective for us for our first quarter of 2019. Early adoption is permitted. ASU 2018-07 shall be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year in which the guidance is adopted. We are currently assessing the impact this guidance may have on our consolidated financial statements.
Leases
In February 2016, the FASB issued ASU No. 2016-02, Leases (“ASU 2016-02”). In July 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842): Targeted Improvements (“ASU 2018-11”). Under the guidance, lessees are required to recognize assets and lease liabilities on the balance sheet for most leases including operating leases and provide enhanced disclosures. There are optional practical expedients that a company may elect to apply. The guidance is effective for our first quarter of 2019 and may be early adopted. Companies can adopt this guidance using a modified retrospective approach or, pursuant to ASU 2018-11, using an additional optional transition method. Under the optional transition method, a company initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. We plan to adopt the guidance in the first quarter of 2019 using the additional optional transition method. Management’s evaluation of the new standard is underway, and we have identified the significant changes between the current guidance and the new guidance and expect to elect certain available transitional practical expedients. In addition, we have developed a project plan, performed a risk assessment, and have summarized the terms of our major lease agreements. We are in the process of reviewing our existing lease agreements to assess the impact this guidance may have on our consolidated financial statements. We currently anticipate that the adoption of ASU 2016-02 will materially affect our consolidated balance sheets by recognizing new right-of-use assets and lease liabilities for operating leases, but will not have a material impact on our consolidated statements of operations.
Credit Losses of Financial Instruments 
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires a financial asset measured at amortized cost basis to be presented at the net amount expected to be collected. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses. This standard is effective for us for our first quarter of 2020. We are currently assessing the impact this guidance may have on our consolidated financial statements.
2.    Business Combinations
In the three months ended September 30, 2018, we acquired Mojo Networks, Inc. (“Mojo”) and Metamako Holding PTY LTD. (“Metamako”) in order to extend our cognitive cloud networking architecture and to improve our next generation platforms for low-latency applications. 
The total consideration transferred for these acquisitions was approximately $116.5 million, which consisted of $100.9 million in cash and $15.6 million for the fair value of 58,072 shares of our common stock issued. The following table summarizes our preliminary purchase price allocation of the two acquisitions, in aggregate, based on the estimated fair value of the assets acquired and liabilities assumed at their respective acquisition dates (in thousands):
 
 
Purchase Price Allocation
Cash and cash equivalents
 
$
4,953

Other tangible assets
 
22,445

Liabilities
 
(29,780
)
Intangible assets
 
63,720

Goodwill
 
55,168

Net assets acquired
 
$
116,506


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The acquired intangible assets are amortized on a straight-line basis over their estimated useful lives as we believe this method most closely reflects the pattern in which the economic benefits of the assets will be consumed. The following table shows the valuation of the intangible assets acquired (in thousands) along with their estimated useful lives.
 
 
Acquisition Date Fair Value
 
Estimated Useful Life
(year)
Developed technology
 
$
52,510

 
5 years
Customer relationships
 
7,080

 
7 years
Trade name
 
2,470

 
3 years
Others
 
1,660

 
1 year
Total intangible assets acquired
 
$
63,720

 
 
The goodwill of $55.2 million is primarily attributable to the expected synergies created by incorporating the solutions of the acquired businesses into our technology platform, and the value of the assembled workforce. We operate under a single reportable segment. The goodwill is not deductible for income taxes purposes.
For the three and nine months ended September 30, 2018, revenue and earnings from the acquired businesses included in our condensed consolidated statements of operations were immaterial. Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate.
3.    Fair Value Measurements
Assets and liabilities recorded at fair value on a recurring basis in the accompanying condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. We use a fair value hierarchy to measure fair value, maximizing the use of observable inputs and minimizing the use of unobservable inputs. The three-tiers of the fair value hierarchy are as follows:
Level I - Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;
Level II - Inputs are observable, unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities; and
Level III - Unobservable inputs that are supported by little or no market data for the related assets or liabilities and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.
We measure and report our cash equivalents, restricted cash, and available-for-sale marketable securities at fair value on a recurring basis. The following tables summarize the unrealized gains and losses and fair value of these financial assets by significant investment category and their level within the fair value hierarchy (in thousands):
 
 
September 30, 2018
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
Level I
 
Level II
 
Level III
Financial Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash Equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
 
$
170,604

 
$

 
$

 
$
170,604

 
$
170,604

 
$

 
$

Marketable Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial paper
 
46,572

 

 

 
46,572

 

 
46,572

 

U.S. government notes
 
227,086

 

 
(513
)
 
226,573

 
226,573

 

 

Corporate bonds
 
581,093

 
19

 
(1,408
)
 
579,704

 

 
579,704

 

Agency securities
 
285,261

 

 
(998
)
 
284,263

 

 
284,263

 

 
 
1,140,012

 
19

 
(2,919
)
 
1,137,112

 
226,573

 
910,539

 

Other Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds - restricted
 
4,210

 

 

 
4,210

 
4,210

 

 

Total Financial Assets
 
$
1,314,826

 
$
19

 
$
(2,919
)
 
$
1,311,926

 
$
401,387

 
$
910,539

 
$



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December 31, 2017
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
Level I
 
Level II
 
Level III
Financial Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash Equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
 
$
701,145

 
$

 
$

 
$
701,145

 
$
701,145

 
$

 
$

Agency securities
 
12,728

 

 

 
12,728

 

 
12,728

 

 
 
713,873

 

 

 
713,873

 
701,145

 
12,728

 

Marketable Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial paper
 
11,924

 

 

 
11,924

 

 
11,924

 

U.S. government notes
 
137,025

 

 
(378
)
 
136,647

 
136,647

 

 

Corporate bonds
 
313,080

 
20

 
(616
)
 
312,484

 

 
312,484

 

Agency securities
 
215,923

 
2

 
(617
)
 
215,308

 

 
215,308

 

 
 
677,952

 
22

 
(1,611
)
 
676,363

 
136,647

 
539,716

 

Other Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds - restricted
 
5,505

 

 

 
5,505

 
5,505

 

 

Total Financial Assets
 
$
1,397,330

 
$
22

 
$
(1,611
)
 
$
1,395,741

 
$
843,297

 
$
552,444

 
$

We did not realize any other-than-temporary losses on our marketable securities for the three and nine months ended September 30, 2018 and 2017. We invest in marketable securities that have maximum maturities of up to two years and are generally deemed to be low risk based on their credit ratings from the major rating agencies. The longer the duration of these marketable securities, the more susceptible they are to changes in market interest rates and bond yields. As interest rates increase, those marketable securities purchased at a lower yield show a mark-to-market unrealized loss. The unrealized losses are due primarily to changes in credit spreads and interest rates. We expect to realize the full value of these investments upon maturity or sale and therefore, we do not consider any of our marketable securities to be other-than-temporarily impaired as of September 30, 2018.
As of September 30, 2018, the contractual maturities of our investments did not exceed 24 months. The fair values of available-for-sale marketable securities, by remaining contractual maturity, are as follows (in thousands):
 
 
September 30, 2018
Due in 1 year or less
 
$
792,542

Due in 1 year through 2 years
 
344,570

Total marketable securities
 
$
1,137,112

The weighted-average remaining duration of our current marketable securities is approximately 0.7 years as of September 30, 2018. As we view these securities as available to support current operations, we classify securities with maturities beyond 12 months as current assets under the caption marketable securities in the accompanying unaudited condensed consolidated balance sheets.

4.    Financial Statements Details
Cash, Cash Equivalents and Restricted Cash
The following table is a reconciliation of cash, cash equivalents and restricted cash reported within the accompanying condensed consolidated balance sheets that sum to the total of the same such amounts shown in the accompanying condensed consolidated statements of cash flows (in thousands):
 
 
September 30, 2018
 
September 30, 2017
Cash and cash equivalents
 
$
524,687

 
$
854,479

Restricted cash included in other assets
 
4,210

 
5,502

Total cash, cash equivalents and restricted cash
 
$
528,897

 
$
859,981


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Restricted cash included in other assets as of September 30, 2018 and September 30, 2017 primarily included $4.0 million pledged as collateral representing a security deposit required for a facility lease. In addition, September 30, 2017 included $1.1 million related to a letter of credit issued to a business partner. 
Accounts Receivable, Net
Accounts receivable, net consists of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Accounts receivable
 
$
333,304

 
$
254,881

Allowance for doubtful accounts
 
(498
)
 
(112
)
Product sales rebate and returns reserve
 
(10,753
)
 
(7,423
)
Accounts receivable, net
 
$
322,053

 
$
247,346

Inventories
Inventories consist of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Raw materials
 
$
48,697

 
$
69,673

Finished goods
 
167,616

 
236,525

Total inventories
 
$
216,313

 
$
306,198

Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consists of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Inventory deposit
 
$
19,290

 
$
34,141

Prepaid income taxes
 
83,598

 
38,134

Other current assets
 
118,262

 
96,215

Other prepaid expenses and deposits
 
14,731

 
8,840

Total prepaid expenses and other current assets
 
$
235,881

 
$
177,330

Property and Equipment, Net
Property and equipment, net consists of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Equipment and machinery
 
$
54,169

 
$
47,711

Computer hardware and software
 
28,549

 
22,124

Furniture and fixtures
 
3,641

 
3,020

Leasehold improvements
 
36,350

 
30,548

Building
 
35,154

 
35,154

Construction-in-process
 
1,931

 
4,742

Property and equipment, gross
 
159,794

 
143,299

Less: accumulated depreciation
 
(84,397
)
 
(69,020
)
Property and equipment, net
 
$
75,397

 
$
74,279

Depreciation expense was $5.4 million and $5.2 million for the three months ended September 30, 2018 and 2017, respectively, and $16.0 million and $15.0 million for the nine months ended September 30, 2018 and 2017, respectively.

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Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
 
September 30, 2018
 
December 31, 2017
Accrued payroll related costs
 
$
55,422

 
$
56,626

Accrued manufacturing costs
 
21,282

 
35,703

Accrued product development costs
 
7,552

 
21,201

Accrued warranty costs
 
10,115

 
7,415

Accrued professional fees
 
6,262

 
7,086

Accrued taxes
 
770

 
794

Other
 
1,705

 
5,002

Total accrued liabilities
 
$
103,108

 
$
133,827

Warranty Accrual
The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
Warranty accrual, beginning of period
 
$
7,415

 
$
6,744

Liabilities accrued for warranties issued during the period
 
6,898

 
5,020

Warranty costs incurred during the period
 
(4,198
)
 
(3,478
)
Warranty accrual, end of period
 
$
10,115

 
$
8,286

Contract Balances
The following table summarizes the activity related to our contract assets (in thousands):
 
 
Three Months Ended
September 30, 2018
 
Nine Months Ended
September 30, 2018
Contract assets, beginning balance
 
$
6,959

 
$

Less: Beginning balance reclassified to accounts receivable upon invoice
 
(1,505
)
 

Add: Contract assets recognized
 
3,963

 
9,417

Contract assets, ending balance
 
$
9,417

 
$
9,417

The following table summarizes the activity related to our contract liabilities (in thousands):
 
 
Three Months Ended
September 30, 2018
 
Nine Months Ended
September 30, 2018
Contract liabilities, beginning balance
 
$
21,842

 
$
16,521

Less: Revenue recognized from beginning balance
 
(2,157
)
 
(6,107
)
Less: Beginning balance reclassified to deferred revenue
 
(970
)
 
(521
)
Add: Contract liabilities recognized
 
6,580

 
15,402

Contract liabilities, ending balance
 
$
25,295

 
$
25,295

As of September 30, 2018, $10.9 million of our contract liabilities was included in “Other current liabilities” with the remaining balance included in “Other long-term liabilities”.

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Deferred Revenue and Performance Obligations
Deferred revenue is comprised mainly of unearned revenue related to multi-year PCS contracts, services and product deferrals related to acceptance clauses. The following table summarizes the activity related to our deferred revenue (in thousands):
 
 
Three Months Ended
September 30, 2018
 
Nine Months Ended
September 30, 2018
 
Deferred revenue, beginning balance
 
$
448,644

 
$
498,740

(1) 
Less: Revenue recognized from beginning balance
 
(97,995
)
 
(306,350
)
 
Add: Deferral of revenue in current period, excluding amounts recognized during the period
 
179,206

 
337,465

 
Deferred revenue, ending balance
 
$
529,855

 
$
529,855

 
_________________________________
 
 
 
 
 
(1) The beginning balance of the nine months ended September 30, 2018 excluded the $16.5 million that was reclassified to other current liabilities and other long-term liabilities at January 1, 2018 as a result of our adoption of ASC 606. See Note 1 for details.
 
Revenue from Remaining Performance Obligations
Revenue from remaining performance obligations represents contracted revenue that has not yet been recognized, which includes contract liabilities and deferred revenue that will be recognized as revenue in future periods. As of September 30, 2018, approximately $555.2 million of revenue is expected to be recognized from remaining performance obligations. We expect to recognize revenue on approximately 84% of these remaining performance obligations over the next 2 years and 16% during the 3rd to the 5th year.
Other Income (Expense), Net
Other income (expense), net consists of the following (in thousands):
 
 
Three Months Ended 
 September 30, 2018
 
Nine Months Ended 
 September 30, 2018
 
 
2018
 
2017
 
2018
 
2017
Interest income
 
$
8,585

 
$
2,332

 
$
21,933

 
$
4,889

Unrealized loss on investments in privately-held companies, net
 

 

 
(9,100
)
 

Other income (expense)
 
707

 
(196
)
 
(187
)
 
(609
)
Total
 
$
9,292

 
$
2,136

 
$
12,646

 
$
4,280


5.    Investments
Investments in Privately-Held Companies    
We adopted ASU 2016-01 in the three months ended March 31, 2018 (refer to Note 1). As of September 30, 2018 and December 31, 2017, we held non-marketable equity investments of approximately $35.0 million and $36.1 million, respectively, in privately-held companies. These investments do not have readily determinable fair values and are measured using the measurement alternative. As of September 30, 2018, $27.0 million of the total investment amount of $35.0 million was re-measured as further described below, and are classified within Level III of the fair value hierarchy.
Prior to 2018, we did not record any impairment losses for these investments. During the three months ended September 30, 2018, no impairment or adjustment was recorded. During the nine months ended September 30, 2018, we recorded $1.2 million of unrealized gain on investments in one company after they were re-measured to fair value as of the date observable transactions occurred. In addition, during the nine months ended September 30, 2018, we recorded $10.3 million of impairment loss on an investment. The unrealized gain and loss are classified in “Other income (expense), net” in our accompanying unaudited condensed consolidated statements of operations.

6.    Commitments and Contingencies
Operating Leases
We lease various offices and data centers in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2025. There have been no material changes in our future minimum payment

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obligations under our operating leases that existed as of December 31, 2017, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017, except as follows. During the nine months ended September 30, 2018, we entered into new leases primarily related to additional data center capacity and co-location services. As of September 30, 2018, the total minimum future payment commitment under these new leases was approximately $47.7 million, of which $1.2 million is due in 2018, with the remainder due in 2021 through 2028.
We recognize rent expense under these arrangements on a straight-line basis over the term of the leases. For the three months ended September 30, 2018 and 2017, rent expense for all operating leases amounted to $2.8 million and $2.5 million, respectively, and to $7.9 million and $7.5 million for the nine months ended September 30, 2018 and 2017, respectively.
Financing Obligation—Build-to-Suit Lease
In August 2012, we executed a lease for a building then under construction in Santa Clara, California to serve as our headquarters. The lease term is 120 months and commenced in August 2013. The lease is accounted for as a financing obligation and the lease payments are attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense, representing an imputed cost to lease the underlying land of the building. There have been no material changes in our future minimum payment obligations under this financing lease, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017. Land lease expense related to our lease financing obligation is classified as rent expense in our unaudited condensed consolidated statements of operations, and amounted to $0.3 million for the three months ended September 30, 2018 and 2017, and $1.0 million for the nine months ended September 30, 2018 and 2017, respectively.
Purchase Commitments
We outsource most of our manufacturing and supply chain management operations to third-party contract manufacturers, who procure components and assemble products on our behalf based on our forecasts in order to reduce manufacturing lead times and ensure adequate component supply. We issue purchase orders to our contract manufacturers for finished products and a significant portion of these orders consist of firm non-cancellable commitments. In addition, we purchase strategic component inventory from certain suppliers under purchase commitments that in some cases are non-cancellable, including integrated circuits, which are consigned to our contract manufacturers. As of September 30, 2018, we had non-cancellable purchase commitments of $423.1 million, of which $370.4 million was to our contract manufacturers and suppliers. We have not recorded a liability related to these purchase commitments. In addition, we have provided deposits to secure our obligations to purchase inventory. We had $22.0 million and $36.9 million in deposits as of September 30, 2018 and December 31, 2017, respectively. These deposits are classified in “Prepaid expenses and other current assets” and “Other assets” in our accompanying unaudited condensed consolidated balance sheets.
Guarantees
We have entered into agreements with some of our direct customers and channel partners that contain indemnification provisions relating to potential situations where claims could be alleged that our products infringe the intellectual property rights of a third party. We have at our option and expense the ability to repair any infringement, replace product with a non-infringing equivalent-in-function product or refund our customers all or a portion of the value of the product. Other guarantees or indemnification agreements include guarantees of product and service performance and standby letters of credit for leased facilities and corporate credit cards. We have not recorded a liability related to these indemnification and guarantee provisions and our guarantee and indemnification arrangements have not had any significant impact on our consolidated financial statements to date.
Legal Proceedings
Cisco Systems, Inc. (“Cisco”) Matters
On August 6, 2018, we entered into a settlement agreement with Cisco Systems, Inc. (“Cisco”) as described in Note 11 relating to several litigation matters which are summarized below.
Cisco Systems, Inc. v. Arista Networks, Inc. (Case No. 4:14-cv-05343) (“’43 Case”)
On December 5, 2014, Cisco filed a complaint against us in the District Court for the Northern District of California alleging that we infringe U.S. Patent Nos. 6,377,577; 6,741,592; 7,023,853; 7,061,875; 7,162,537; 7,200,145; 7,224,668; 7,290,164; 7,340,597; 7,460,492; 8,051,211; and 8,356,296 (respectively, “the ’577 patent,” “the ’592 patent,” “the ’853 patent,” “the ’875 patent,” “the ’537 patent,” “the ’145 patent,” “the ’668 patent,” “the ’164 patent,” “the ’597 patent,” “the ’492 patent,” “the ’211 patent,” and “the ’296 patent”). Pursuant to the settlement with Cisco, as described in Note 11, the ’43 Case was dismissed on August 27, 2018.
Cisco Systems, Inc. v. Arista Networks, Inc. (Case No. 5:14-cv-05344) (“’44 Case”)
On December 5, 2014, Cisco filed a complaint against us in the District Court for the Northern District of California alleging that we infringe numerous copyrights pertaining to Cisco’s “Command Line Interface” or “CLI” and U.S. Patent Nos.

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7,047,526 and 7,953,886 (respectively, “the ’526 patent” and “the ’886 patent”). As relief for our alleged copyright infringement, Cisco sought monetary damages for alleged lost profits, profits from our alleged infringement, statutory damages, attorney’s fees, and associated costs. The ’526 patent is subject to a non-appealable final judgment of non-infringement and the ’886 patent was dismissed with prejudice.
On December 14, 2016, following a two-week trial, a jury found that we had proven our copyright defense of scenes a faire. Cisco filed a notice of appeal on June 6, 2017. Cisco did not appeal the jury’s noninfringement verdict on the ’526 patent but did appeal the jury’s finding that we established the defense of scenes a faire. On October 1, 2018, at the parties’ request and pursuant to the settlement agreement, the District Court vacated the jury verdict regarding our copyright defense and dismissed the case.
Arista Networks, Inc. v. Cisco Systems, Inc. (Case No. 5:16-cv-00923) (“’23 Case”)
On February 24, 2016, we filed a complaint against Cisco in the District Court for the Northern District of California alleging antitrust violations and unfair competition. On August 6, 2018, the Court vacated trial in light of the settlement with Cisco as describe in Note 11. Pursuant to the settlement with Cisco, the ’23 Case was dismissed.
Certain Network Devices, Related Software, and Components Thereof (Inv. No. 337-TA-944) (“944 Investigation”)
On December 19, 2014, Cisco filed a complaint against us in the USITC alleging that we violated 19 U.S.C. § 1337 (“Section 337”). The USITC instituted Cisco’s complaint as Investigation No. 337-TA-944. Cisco initially alleged that certain of our switching products infringe the ’592, ’537, ’145, ’164, ’597, and ’296 patents.
On February 2, 2016, the Administrative Law Judge (“ALJ”) issued his initial determination finding a violation of Section 337. The ALJ found that a violation had occurred in the importation into the United States, the sale for importation or the sale within the United States after importation, of certain network devices, related software, and components thereof that the ALJ found infringed asserted claims 1, 2, 8-11, and 17-19 of the ’537 patent; asserted claims 6, 7, 20, and 21 of the ’592 patent; and asserted claims 5, 7, 45, and 46 of the ’145 patent. The ALJ did not find a violation of Section 337 with respect to any asserted claims of the ’597 and ’164 patents. Cisco dropped the ’296 patent before the hearing. On June 23, 2016, the USITC issued its Final Determination, which found a violation with respect to the ’537, ’592, and ’145 patents, and found no violation with respect to the ’597 and ’164 patents. The USITC also issued a limited exclusion order and a cease and desist order pertaining to network devices, related software, and components thereof that infringe one or more of claims 1, 2, 8-11, and 17-19 of the ’537 patent; claims 6, 7, 20, and 21 of the ’592 patent; and claims 5, 7, 45, and 46 of the ’145 patent. On August 22, 2016, the Presidential review period for the 944 Investigation expired. The USITC orders will be in effect until the expiration of the ’537, ’592, and ’145 patents.
Both we and Cisco filed petitions for review of the USITC’s Final Determination to the Federal Circuit. The appeal was fully briefed and oral argument was held on June 6, 2017. On September 27, 2017, the Federal Circuit affirmed the USITC’s Final Determination.
In response to the USITC’s findings in the 944 Investigation, we made design changes to our products for sale in the United States to address the features that were found to infringe the ’537, ’592, and ’145 patents. Following the issuance of the final determination in the 944 Investigation, we submitted a Section 177 ruling request to CBP seeking approval to import these redesigned products into the United States.
On August 26, 2016, Cisco filed an enforcement complaint under Section 337 with the USITC. Cisco alleged that we violated the cease and desist and limited exclusion orders issued in the 944 Investigation by engaging in the “marketing, distribution, offering for sale, selling, advertising, and/or aiding or abetting other entities in the sale and/or distribution of products that Cisco alleges continue to infringe claims 1-2, 8-11, and 17-19 of the ’537 patent,” despite the design changes we made to those products. On September 28, 2016, the USITC instituted the enforcement proceeding.
On April 7, 2017, we received a 177 ruling from CBP finding that our redesigned products did not infringe the relevant claims of the ’537, ’592, and ʼ145 patents, and approving the importation of those redesigned products into the United States.
On June 20, 2017, the ALJ issued his initial determination finding that we did not violate the June 23, 2016 cease and desist order. The initial determination also recommended a civil penalty of $307 million if the USITC decided to overturn the finding of no violation. On July 3, 2017, the parties filed petitions for review of certain findings in the initial determination.
On August 4, 2017, the USITC issued an order remanding the investigation to the ALJ to make additional findings on certain issues and issue a remand initial determination. The USITC ordered the ALJ to set a schedule for completion of any necessary remand proceedings and a new target date for the enforcement action (the “944 Enforcement Action”). The ALJ held a hearing on February 1, 2018 and issued a remand initial determination on June 4, 2018, again finding that we did not violate the June 23, 2016 cease and desist order. Pursuant to the settlement with Cisco, the 944 Enforcement Investigation was terminated on September

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17, 2018. The parties have jointly requested suspension of the remedial orders in the 944 Investigation, and on October 23, 2018, the ITC instituted a modification proceeding to determine how to modify the orders consistent with the parties’ request.
Certain Network Devices, Related Software, and Components Thereof (Inv. No. 337-TA-945) (“945 Investigation”)
On December 19, 2014, Cisco filed a complaint against us in the USITC alleging that we violated Section 337. The USITC instituted Cisco’s complaint as Investigation No. 337-TA-945. The remedial orders from the 945 Investigation are no longer in effect and will terminate when the USPTO issues a certificate cancelling the asserted claims of the ’668 patent based on the IPR proceeding described below.
Inter Partes Reviews
We have filed petitions for Inter Partes Review of the ’597, ’211, ’668, ’853, ’537, ’577, ’886, and ’526 patents. IPRs relating to the ’597 (IPR No. 2015-00978) and ’211 (IPR No. 2015-00975) patents were instituted in October 2015 and hearings on these IPRs were completed in July 2016. On September 28, 2016, the PTAB issued a final written decision finding claims 1, 14, 39-42, 71, 72, 84, and 85 of the ’597 patent unpatentable. The PTAB also found that claims 29, 63, 64, 73, and 86 of the ’597 patent had not been shown to be unpatentable. On October 5, 2016, the PTAB issued a final written decision finding claims 1 and 12 of the ’211 patent unpatentable. The PTAB also found that claims 2, 6-9, 13, and 17-20 of the ’211 patent had not been shown to be unpatentable. Both parties have appealed the final written decisions on the ’211 and ’537 patent IPRs. The hearing for the ’211 IPR appeal was held in March 2018, and on March 28, 2018, the Federal Circuit remanded the matter back to the PTAB for further proceedings.
IPRs relating to the ’668 (IPR No. 2016-00309), ’577 (IPR No. 2016-00303), ’853 (IPR No. 2016-0306), and ’537 (IPR No. 2016-0308) patents were instituted in June 2016 and hearings were held on March 7, 2017. On May 25, 2017, the PTAB issued final written decisions finding claims 1, 7-10, 12-16, 18-22, 25, and 28-31 of ’577 patent unpatentable, and that claim 2 of the ’577 patent, claim 63 of the ’853 patent, and claims 1, 10, 19, and 21 of the ’537 patent had not been shown to be unpatentable. On June 1, 2017, the PTAB issued a final written decision finding claims 1-10, 12-13, 15-28, 30-31, 33-36, 55-64, 66-67, and 69-72 of the ’668 patent unpatentable. We filed a Notice of Appeal concerning the ’577 patent on July 21, 2017, and Notices of Appeal concerning the ‘853 and ’537 patents on July 26, 2017. Cisco cross-appealed concerning the ’577 patent on July 26, 2017 and filed a Notice of Appeal concerning the ’668 patent on August 1, 2017. For the appeals of the IPRs on the ’668 and ’577 patents, the Federal Circuit granted our motion for an expedited briefing schedule, and the hearings were held on February 9, 2018. On February 14, 2018, the Federal Circuit affirmed the PTAB’s final written decision on the ’668 patent.
OptumSoft, Inc. Matters
On April 4, 2014, OptumSoft filed a lawsuit against us in the Superior Court of California, Santa Clara County titled OptumSoft, Inc. v. Arista Networks, Inc., in which it asserts (i) ownership of certain components of our EOS network operating system pursuant to the terms of a 2004 agreement between the companies; and (ii) breaches of certain confidentiality and use restrictions in that agreement. Under the terms of the 2004 agreement, OptumSoft provided us with a non-exclusive, irrevocable, royalty-free license to software delivered by OptumSoft comprising a software tool used to develop certain components of EOS and a runtime library that is incorporated into EOS. The 2004 agreement places certain restrictions on our use and disclosure of the OptumSoft software and gives OptumSoft ownership of improvements, modifications and corrections to, and derivative works of, the OptumSoft software that we develop.
In its lawsuit, OptumSoft has asked the Court to order us to (i) give OptumSoft access to our software for evaluation by OptumSoft; (ii) cease all conduct constituting the alleged confidentiality and use restriction breaches; (iii) secure the return or deletion of OptumSoft’s alleged intellectual property provided to third parties, including our customers; (iv) assign ownership to OptumSoft of OptumSoft’s alleged intellectual property currently owned by us; and (v) pay OptumSoft’s alleged damages, attorney’s fees, and costs of the lawsuit. David Cheriton, one of our founders and a former member of our board of directors, who resigned from our board of directors on March 1, 2014 and has no continuing role with us, is a founder and, we believe, the largest stockholder and director of OptumSoft. The 2010 David R. Cheriton Irrevocable Trust dated July 28, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is one of our largest stockholders.
On April 14, 2014, we filed a cross-complaint against OptumSoft, in which we asserted our ownership of the software components at issue and our interpretation of the 2004 agreement. Among other things, we asserted that the language of the 2004 agreement and the parties’ long course of conduct support our ownership of the disputed software components. We asked the Court to declare our ownership of those software components, all similarly-situated software components developed in the future and all related intellectual property. We also asserted that, even if we are found not to own certain components, such components are licensed to us under the terms of the 2004 agreement. However, there can be no assurance that our assertions will ultimately prevail in litigation. On the same day, we also filed an answer to OptumSoft’s claims, as well as affirmative defenses based in part on OptumSoft’s failure to maintain the confidentiality of its claimed trade secrets, its authorization of the disclosures it asserts and its delay in claiming ownership of the software components at issue. We have also taken additional steps to respond to OptumSoft’s allegations that we improperly used and/or disclosed OptumSoft confidential information. While we believe we have meritorious

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defenses to these allegations, we believe we have (i) revised our software to remove the elements we understand to be the subject of the claims relating to improper use and disclosure of OptumSoft confidential information and made the revised software available to our customers and (ii) removed information from our website that OptumSoft asserted disclosed OptumSoft confidential information.
The parties tried Phase I of the case, relating to contract interpretation and application of the contract to certain claimed source code, in September 2015. On March 23, 2016, the Court issued a Final Statement of Decision Following Phase I Trial, in which it agreed with and adopted our interpretation of the 2004 agreement and held that we, and not OptumSoft, own all the software at issue in Phase I. The remaining issues that were not addressed in the Phase I trial are set to be tried in Phase II, including the application of the Court’s interpretation of the 2004 agreement to any other source code that OptumSoft claims to own and the trade secret misappropriation and confidentiality claims. The Phase II Trial is set for September 23, 2019 by the judge.
We intend to vigorously defend against any claims brought against us by OptumSoft.  However, we cannot be certain that, if litigated, any claims by OptumSoft would be resolved in our favor.  For example, if it were determined that OptumSoft owned components of our EOS network operating system, we would be required to transfer ownership of those components and any related intellectual property to OptumSoft.  If OptumSoft were the owner of those components, it could make them available to our competitors, such as through a sale or license.  An adverse litigation ruling could result in a significant damages award against us and injunctive relief. In addition, OptumSoft could assert additional or different claims against us, including claims that our license from OptumSoft is invalid.
With respect to the legal proceedings described above, it is our belief that while a loss is not probable, it may be reasonably possible. Further, at this stage in the litigation, any possible loss or range of loss cannot be estimated.  However, the outcome of litigation is inherently uncertain. Therefore, if one or more of these legal matters were resolved against us in a reporting period for a material amount, our consolidated financial statements for that reporting period could be materially adversely affected.    
Other Matters
In the ordinary course of business, we are a party to other claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property.
We record a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. As of September 30, 2018, provisions recorded for contingent losses related to other claims and matters have not been significant. Based on currently available information, management does not believe that any additional liabilities relating to other unresolved matters are probable or that the amount of any resulting loss is estimable, and believes these other matters are not likely, individually and in the aggregate, to have a material adverse effect on our financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties and our view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on our financial position, results of operations or cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods.
7.    Equity Award Plan Activities
2014 Equity Incentive Plan
Effective January 1, 2018, our board of directors authorized an increase of 2,211,176 shares to the shares available for issuance under the 2014 Equity Incentive Plan (the “2014 Plan”). Pursuant to the 2014 Plan, the 2018 share increase is determined based on the lesser of 3% of total shares of common stock outstanding as of December 31, 201712,500,000 shares, or such amount as determined by our board of directors. As of September 30, 2018, there remained approximately 22.9 million shares available for issuance under the 2014 Plan.
2014 Employee Stock Purchase Plan
Effective January 1, 2018, our board of directors authorized an increase of 737,058 shares to shares available for issuance under our 2014 Employee Stock Purchase Plan (the “ESPP”). Pursuant to the ESPP, the 2018 share increase is determined based the lesser of 1% of the total shares of common stock outstanding on December 31, 2017, 2,500,000 shares, or such amount as determined by our board of directors. As of September 30, 2018, there remained 2,533,438 shares available for issuance under the ESPP.
During the three and nine months ended September 30, 2018, we issued 81,769 shares and 190,659 shares at a weighted-average purchase price of $98.00 and $80.35 per share, respectively, under the ESPP. 

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Stock Option Activities
The following table summarizes the option activity under our stock plans and related information (in thousands, except years and per share amounts):
 
 
Options Outstanding 
 
 
 
 
 
 
Number of
Shares
Underlying
Outstanding Options
 
Weighted-
Average
Exercise
Price per Share
 
Weighted-
Average
Remaining
Contractual
Term (Years) of
Stock Options
 
Aggregate
Intrinsic
Value
of Stock
Options
Outstanding
Balance—December 31, 2017
 
7,024

 
$
33.05

 
6.1
 
$
1,422,637

Options granted
 
82

 
244.20

 
 
 
 
Options exercised
 
(1,038
)
 
33.07

 
 
 
 
Options canceled
 
(41
)
 
53.44

 
 
 
 
Balance—September 30, 2018
 
6,027

 
$
35.78

 
5.4
 
$
1,386,807

Vested and exercisable—September 30, 2018
 
2,734

 
$
22.39

 
4.8
 
$
665,576

Restricted Stock Unit (RSU) Activities
A summary of the RSU activity under our stock plans and related information are presented below (in thousands, except years and per share amounts):
 
 
Number of
Shares
 
Weighted-
Average Grant
Date Fair Value Per Share
 
Weighted-Average
Remaining
Contractual Term (in years)
 
Aggregate Intrinsic Value
Unvested balance—December 31, 2017
 
1,537

 
$
104.29

 
1.6
 
$
362,119

       RSUs granted
 
231

 
274.46

 
 
 
 
       RSUs vested
 
(405
)
 
93.92

 
 
 
 
       RSUs forfeited/canceled
 
(56
)
 
127.57

 
 
 
 
Unvested balance—September 30, 2018
 
1,307

 
$
136.63

 
1.5
 
$
347,386

Shares Available for Grant
The following table presents the stock activity and the total number of shares available for grant under the 2014 Plan as of September 30, 2018 (in thousands):
 
 
Number of Shares
Balance—December 31, 2017
 
13,512

Authorized
 
2,211

Options granted
 
(82
)
RSUs granted
 
(231
)
Options canceled
 
41

RSUs forfeited
 
56

Shares traded for taxes
 
27

Balance—September 30, 2018
 
15,534


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Stock-Based Compensation Expense
Total stock-based compensation expense related to options, restricted stock units and employee stock purchase rights granted were allocated as follows (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended 
 September 30,
 
 
2018
 
2017
 
2018
 
2017
Cost of revenue
 
$
1,268

 
$
1,113

 
$
3,706

 
$
3,224

Research and development
 
12,010

 
11,048

 
34,700

 
30,977

Sales and marketing   
 
6,537

 
5,115

 
18,771

 
12,651

General and administrative
 
3,439

 
2,876

 
9,406

 
8,139

           Total stock-based compensation
 
$
23,254

 
$
20,152

 
$
66,583

 
$
54,991

As of September 30, 2018, unrecognized stock-based compensation expenses by award type and their expected weighted-average recognition periods are summarized in the following table (in thousands, except years).
 
 
September 30, 2018
 
 
Stock Option
 
RSU
 
ESPP
 
Restricted Stock
Unrecognized stock-based compensation expense
 
$
60,754

 
$
161,733

 
$
9,722

 
$
5,825

Weighted-average amortization period
 
3.6 years

 
3.2 years

 
1.2 years

 
4.0 years

Restricted Stock
Pursuant to the close of an acquisition during the current quarter (see Note 2), we issued 21,749 restricted shares of our common stock to certain key employees. These restricted shares vest over 4 years from the acquisition date and any unvested shares will be forfeited upon termination of such employees under certain conditions. The acquisition date fair value of these shares will be recognized as stock-based compensation over their vesting period.

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8.    Net Income Per Share Available to Common Stock
The following table sets forth the computation of our basic and diluted net income per share available to common stock (in thousands, except per share amounts):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Numerator:
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
 
Net income
 
$
168,524

 
$
133,722

 
$
157,793

 
$
319,368

Less: undistributed earnings allocated to participating securities
 
(85
)
 
(182
)
 
(87
)
 
(725
)
Net income available to common stockholders, basic
 
$
168,439

 
$
133,540

 
$
157,706

 
$
318,643

Diluted:
 
 
 
 
 
 
 
 
Net income attributable to common stockholders, basic
 
$
168,439

 
$
133,540

 
$
157,706

 
$
318,643

Add: undistributed earnings allocated to participating securities
 
6

 
15

 
7

 
61

Net income attributable to common stockholders, diluted
 
$
168,445

 
$
133,555

 
$
157,713

 
$
318,704

Denominator:
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
75,011

 
72,588

 
74,506

 
71,903

Diluted:
 
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
 
75,011

 
72,588

 
74,506

 
71,903

Add weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
 
Stock options and RSUs
 
5,967

 
6,636

 
6,298

 
6,528

Employee stock purchase plan
 
40

 
98

 
40

 
97

Weighted-average shares used in computing net income per share available to common stockholders, diluted
 
81,018

 
79,322

 
80,844

 
78,528

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
2.25

 
$
1.84

 
$
2.12

 
$
4.43

Diluted
 
$
2.08

 
$
1.68

 
$
1.95

 
$
4.06

The following weighted-average outstanding shares of common stock equivalents were excluded from the computation of diluted net income per share available to common stockholders for the periods presented because including them would have been anti-dilutive (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Stock options and RSUs to purchase common stock
 
82

 
14

 
87

 
73

Employee stock purchase plan
 
98

 

 
59

 

Total
 
180

 
14

 
146

 
73



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9.    Income Taxes
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
Income before income taxes
 
$
189,389

 
$
142,267

 
$
90,311

 
$
333,125

Provision for (benefit from) income taxes
 
$
20,865

 
$
8,545

 
$
(67,482
)
 
$
13,757

Effective tax rate
 
11.0
%
 
6.0
%
 
(74.7
)%
 
4.1
%
The effective tax rates above reflect tax expense recorded on pre-tax income in the three months ended September 30, 2018 and an overall tax benefit recorded on pre-tax income in the nine months ended September 30, 2018. The tax expense recorded in the three months ended September 30, 2018 includes a lower U.S. corporate tax and U.S. tax on foreign earnings, as a result of the Tax Cuts and Jobs Act (“Tax Act”), and the tax effects of business acquisitions, including integration. For the nine months ended September 30, 2018, the rate also includes a federal and state tax discrete benefit on a $405.0 million charge related to our legal settlement with Cisco recorded in the three months ended June 30, 2018. In all periods, excess tax benefits attributable to equity compensation also significantly benefit the effective tax rate.
Integrating intellectual property from acquisitions into our business generally involves intercompany transactions and legal entity restructurings that have the impact of increasing our provision for income taxes. Consequently, our provision for income taxes and our effective tax rate may initially increase in the period of and shortly after an acquisition and integration. The magnitude of this impact will depend upon the specific type, size, and taxing jurisdictions of the intellectual property as well as the relative contribution to income in subsequent periods. 
We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; and (5) creating the base erosion anti-abuse tax (“BEAT”), a new minimum tax.
The Tax Act includes provisions for Global Intangible Low-Taxed Income (“GILTI”) wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. This income will effectively be taxed at a 10.5% tax rate in general. Our deferred tax assets and liabilities are still being evaluated to determine if they should be recognized for the basis differences expected to reverse as a result of GILTI provisions that are effective for us after the calendar year ending December 31, 2017. Because of the complexity of the new provisions, we are continuing to evaluate how the provisions will be accounted for under U.S. GAAP wherein companies are allowed to make an accounting policy election of either (i) account for GILTI as a component of tax expense in the period in which we are subject to the rules (the “period cost method”), or (ii) account for GILTI in our measurement of deferred taxes (the “deferred method”). Currently, we have not elected a method but we have included an estimate of the impact to our effective tax rate for the year ended December 31, 2018. A formal election will only be made after our completion of the analysis of the GILTI provisions and the release of new regulations providing further insight into the new rules. Our election method will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in our taxable income related to GILTI and, if so, the impact that is expected.
As of September 30, 2018, we have not yet completed our accounting for the tax effects of the enactment of the Tax Act. We recognized a provisional tax amount of $51.8 million in the fourth quarter of 2017 for the transition tax liability and the revaluation of our deferred income taxes as a result of the rate change. In the nine months ended September 30, 2018, we did not revise this estimate. In addition, we recorded a reasonable estimate for the effect of the new legislation as discussed above, which impacts our US income tax liabilities for the year ending December 31, 2018. Our estimates may also be affected as we gain a more thorough understanding of the tax law. These changes could be material to income tax expense. We will continue to refine our estimates related to the impact of the Tax Act during the one-year measurement period allowed under Staff Accounting Bulletin 118 (“SAB 118”).

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10.    Segment Information
We have determined that we operate as one reportable segment. The following table represents revenue based on the customer’s location, as determined by the customer’s shipping address (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Americas
 
$
406,666

 
$
309,318

 
$
1,099,624

 
$
878,201

Europe, Middle East and Africa
 
92,911

 
79,143

 
316,608

 
199,244

Asia-Pacific
 
63,732

 
49,172

 
139,411

 
100,874

Total revenue
 
$
563,309

 
$
437,633

 
$
1,555,643

 
$
1,178,319

Long-lived assets, excluding intercompany receivables, investments in subsidiaries, privately-held equity investments and deferred tax assets, net by location are summarized as follows (in thousands):
 
 
September 30, 2018
 
December 31, 2017
United States
 
$
69,093

 
$
69,128

International
 
6,304

 
5,151

Total
 
$
75,397

 
$
74,279


11.    Legal Settlement
On August 6, 2018, we entered into a binding term sheet with Cisco (“Term Sheet”). Under the Term Sheet, we paid Cisco $400.0 million on August 20, 2018, and the parties obtained dismissals of all ongoing district court and USITC litigation between them. Cisco granted us a release for all past claims relating to the patents Cisco asserted against us in the district court and USITC, and we granted Cisco a release from all past antitrust and unfair competition claims. These mutual releases extended to the Company's and Cisco’s customers, contract manufacturers, and partners. The parties further agreed to a five-year stand-down period for any utility patent infringement claims either may have against features currently implemented in the other party’s products and services, with some carve-outs for products stemming from acquired companies. The parties further agreed to a three-year dispute resolution process for allegations by either party against new and/or modified features in the other party’s products. We also agreed to make certain modifications to our Command Line Interface (“CLI”).
Upon signing the Term Sheet, we recorded a legal settlement charge of $405.0 million to operating expenses, which included legal fees associated with the settlement in the three months ended June 30, 2018. We have also recorded a corresponding income tax benefit of $0.9 million and $99.9 million for the three and nine months ended September 30, 2018. 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis of our financial condition and results of operations together with the unaudited condensed consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q, and our Annual Report on Form 10-K filed with the SEC on February 20, 2018. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.
Overview
We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation data centers for enterprise support. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our Ethernet switching and routing platforms. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.
We believe that cloud networks will continue to replace legacy network technologies, and that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of

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adoption. Cloud networks are subject to increasing performance requirements due to the growing number of connected devices, as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We expect to continue growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. Accordingly, we intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features, and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications.
We generate revenue primarily from sales of our switching products which incorporate our EOS software. We generate the majority of our services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. As we have grown the functionality of our EOS software, expanded the range of our product portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. We have also been profitable and operating cash flow positive for each year since 2010.
To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. We expect that a substantial portion of our future sales will be follow-on sales to existing customers. We intend to continue expanding our sales force and marketing activities in key geographies, as well as our relationships with channel, technology and system-level partners in order to reach new end customers more effectively, increase sales to existing customers, and provide services and support effectively. In order to support our strong growth, we have and may continue to accelerate our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations.
Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching and routing products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. We work closely with third party contract manufacturers to manufacture our products. Our contract manufacturers deliver our products to our third party direct fulfillment facilities.  We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers.
Historically, large purchases by a relatively limited number of end customers have accounted for significant portion of our revenue. We have experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test, qualify and accept our products and factors specific to our end customers. Due to these factors, we expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers.
On August 6, 2018, we entered into a binding term sheet with Cisco ("Term Sheet"). Under the Term Sheet, we paid Cisco $400.0 million on August 20, 2018, and the parties obtained dismissals of all ongoing district court and USITC litigation between them. Cisco granted us a release for all past claims relating to the patents Cisco asserted against us in the district court and USITC, and we granted Cisco a release from all past antitrust and unfair competition claims. These mutual releases extended to the Company's and Cisco’s customers, contract manufacturers, and partners. The parties further agreed to a five-year stand-down period for any utility patent infringement claims either may have against features currently implemented in the other party’s products and services, with some carve-outs for products stemming from acquired companies. The parties further agreed to a three-year dispute resolution process for allegations by either party against new and/or modified features in the other party’s products. We also agreed to make certain modifications to our Command Line Interface (“CLI”).
Furthermore, in order to comply with USITC exclusion and cease and desist orders previously issued in relation to the Cisco legal matter, we made certain design changes to our products for sale in the United States. Following the expiration and invalidation of related patent claims, effective July 1, 2018, certain features previously covered by the orders could be re-incorporated into our products. We are working with customers to complete any remaining re-qualification procedures related to the reintroduction of these features, the timing of which could result in an impact to our revenue and our deferred revenue balances.
Acquisitions
On August 2, 2018, we completed the acquisition of Mojo Networks, Inc. (“Mojo”), a provider of Cognitive WiFi and cloud-managed wireless networking solutions headquartered in Mountain View, California. We expect to extend our cognitive cloud networking architecture with the addition of Mojo by providing secure, high performance cognitive WiFi at cloud scale. On September 12, 2018, we completed the acquisition of Metamako Holding PTY LTD. (“Metamako”). Headquartered in Sydney,

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Australia, Metamako was a leader in solutions for latency sensitive business applications. We expect this acquisition to play a key role in the delivery of our next generation platforms for low-latency applications.
Results of Operations
The following table summarizes historical results of operations for the periods presented and as a percentage of revenue for those periods. We have derived the data for the three and nine months ended September 30, 2018 and 2017 from our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
Revenue
 
 
 
 
 
 
 
 
Product
 
$
485,481

 
$
380,344

 
$
1,337,865

 
$
1,025,615

Service
 
77,828

 
57,289

 
217,778

 
152,704

Total revenue
 
563,309

 
437,633

 
1,555,643

 
1,178,319

Cost of revenue (1)
 
 
 
 
 
 
 
 
Product
 
187,764

 
145,874

 
516,077

 
390,116

Service
 
13,962

 
11,142

 
41,181

 
33,599

Total cost of revenue
 
201,726

 
157,016

 
557,258

 
423,715

Gross profit
 
361,583

 
280,617

 
998,385

 
754,604

Operating expenses (1)
 
 
 
 
 
 
 
 
Research and development
 
117,589

 
79,610

 
324,029

 
242,414

Sales and marketing
 
47,903

 
40,640

 
136,231

 
116,297

General and administrative
 
15,321

 
19,535

 
53,420

 
65,009

Legal settlement
 

 

 
405,000

 

Total operating expenses
 
180,813

 
139,785

 
918,680

 
423,720

Income from operations
 
180,770

 
140,832

 
79,705

 
330,884

Other income (expense), net
 
 
 
 
 
 
 
 
Interest expense
 
(673
)
 
(701
)
 
(2,040
)
 
(2,039
)
Other income (expense), net
 
9,292

 
2,136

 
12,646

 
4,280

Total other income (expense), net
 
8,619

 
1,435

 
10,606

 
2,241

Income before income taxes
 
189,389

 
142,267

 
90,311

 
333,125

Provision for (benefit from) income taxes
 
20,865

 
8,545

 
(67,482
)
 
13,757

Net income
 
$
168,524

 
$
133,722

 
$
157,793

 
$
319,368

__________________________
 
 
 
 
 
 
 
 
(1) Includes stock-based compensation expense as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
Stock-Based Compensation Expense:
 
 
 
 
 
 
 
 
Cost of revenue
 
$
1,268

 
$
1,113

 
$
3,706

 
$
3,224

Research and development
 
12,010

 
11,048

 
34,700

 
30,977

Sales and marketing
 
6,537

 
5,115

 
18,771

 
12,651

General and administrative
 
3,439

 
2,876

 
9,406

 
8,139

           Total stock-based compensation
 
$
23,254

 
$
20,152

 
$
66,583

 
$
54,991



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Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(as a percentage of revenue)
Revenue
 
 
 
 
 
 
 
 
Product
 
86.2
 %
 
86.9
 %
 
86.0
 %
 
87.0
 %
Service
 
13.8

 
13.1

 
14.0

 
13.0

Total revenue
 
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue
 
 
 
 
 
 
 
 
Product
 
33.3

 
33.4

 
33.2

 
33.1

Service
 
2.5

 
2.5

 
2.6

 
2.9

Total cost of revenue
 
35.8

 
35.9

 
35.8

 
36.0

Gross margin
 
64.2

 
64.1

 
64.2

 
64.0

Operating expenses
 
 
 
 
 
 
 
 
Research and development
 
20.9

 
18.2

 
20.9

 
20.5

Sales and marketing
 
8.5

 
9.2

 
8.8

 
9.9

General and administrative
 
2.7

 
4.5

 
3.4

 
5.5

Legal settlement
 

 

 
26.0

 

Total operating expenses
 
32.1

 
31.9

 
59.1

 
35.9

Income from operations
 
32.1

 
32.2

 
5.1

 
28.1

Interest expense
 
(0.1
)
 
(0.1
)
 
(0.1
)
 
(0.2
)
Other income (expense), net
 
1.6

 
0.5

 
0.8

 
0.4

Total other income (expense), net
 
1.5

 
0.4

 
0.7

 
0.2

Income before income taxes
 
33.6

 
32.6

 
5.8

 
28.3

Provision for (benefit from) income taxes
 
3.7

 
2.0

 
(4.3
)
 
1.2

Net income
 
29.9
 %
 
30.6
 %
 
10.1
 %
 
27.1
 %

Three and Nine Months Ended September 30, 2018 Compared to Three and Nine Months Ended September 30, 2017
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
 
$
485,481

 
$
380,344

 
$
105,137

 
27.6
%
 
$
1,337,865

 
$
1,025,615

 
$
312,250

 
30.4
%
Service
 
77,828

 
57,289

 
20,539

 
35.9

 
217,778

 
152,704

 
65,074

 
42.6

Total revenue
 
563,309

 
437,633

 
125,676

 
28.7

 
1,555,643

 
1,178,319

 
377,324

 
32.0

Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
 
187,764

 
145,874

 
41,890

 
28.7

 
516,077

 
390,116

 
125,961

 
32.3

Service
 
13,962

 
11,142

 
2,820

 
25.3

 
41,181

 
33,599

 
7,582

 
22.6

Total cost of revenue
 
201,726

 
157,016

 
44,710

 
28.5

 
557,258

 
423,715

 
133,543

 
31.5

Gross profit
 
$
361,583

 
$
280,617

 
$
80,966

 
28.9
%
 
$
998,385

 
$
754,604

 
$
243,781

 
32.3
%
Gross margin
 
64.2%
 
64.1%
 
 
 
 
 
64.2%
 
64.0%
 
 
 
 


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Table of Contents

Revenue by Geography (in thousands, except percentages)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
% of Total
 
2017
 
% of Total
 
2018
 
% of Total
 
2017
 
% of Total
Americas
 
$
406,666

 
72.2
%
 
$
309,318

 
70.7
%
 
$
1,099,624

 
70.7
%
 
$
878,201

 
74.5
%
Europe, Middle East and Africa
 
92,911

 
16.5

 
79,143

 
18.1

 
316,608

 
20.4

 
199,244

 
16.9

Asia-Pacific
 
63,732

 
11.3

 
49,172

 
11.2

 
139,411

 
8.9

 
100,874

 
8.6

Total revenue
 
$
563,309

 
100.0
%
 
$
437,633

 
100.0
%
 
$
1,555,643

 
100.0
%
 
$
1,178,319

 
100.0
%
Revenue
Product revenue increased $105.1 million, or 27.6%, and $312.3 million, or 30.4%, in the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The increases were primarily driven by sales to our existing customers as they continued to expand their businesses. In addition, our newer switch products have continued to gain market acceptance, which has contributed to our revenue growth. Service revenue increased $20.5 million, or 35.9%, and $65.1 million, or 42.6% in the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017 as a result of continued growth in initial and renewal support contracts as our customer installed base has continued to expand. We continue to experience pricing pressure on our products and services due to competition, but demand for our products and growth in our installed base has more than offset this pricing pressure. 
We expect our revenue may vary from period to period based on, among other things, the timing and size of orders, the delivery and acceptance of products, and the impact of significant transactions.  In addition, while we expect our revenue to continue to grow in absolute dollars on a year-over-year basis, our revenue growth rates are expected to decline as our business scales.
Cost of Revenue and Gross Margin
Cost of revenue primarily consists of amounts paid for inventory to our third-party contract manufacturers and merchant silicon vendors, overhead costs in our manufacturing operations department, and other manufacturing-related costs associated with manufacturing our products and managing our inventory. Cost of revenue increased $44.7 million, or 28.5%, and $133.5 million, or 31.5%, in the three and nine months ended September 30, 2018 compared to the same periods in 2017. The increases in cost of revenue were primarily due to the corresponding increases in product revenues. We expect our cost of product revenue to continue to increase as our product revenue increases. Cost of providing PCS and other services consists primarily of personnel costs for our global customer support organization.
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, manufacturing-related costs including costs associated with supply chain sourcing activities, merchant silicon costs, the mix of products sold, and excess/obsolete inventory write-downs, including charges for excess/obsolete component inventory held by our contract manufacturers. Gross margin remained consistent, increasing slightly from 64.1% to 64.2% for the three months ended September 30, 2018, and from 64.0% to 64.2% for the nine months ended September 30, 2018 compared to the same periods in 2017. These increases were primarily driven by relatively fixed manufacturing overhead and service costs as we scaled our business, partially offset by a decrease in product margins primarily due to customer mix. We expect our gross margins to fluctuate over time, depending on the factors described above.
Operating Expenses (in thousands, except percentages)
Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. We expect operating expenses to continue to increase in absolute dollars in the near term as we continue to invest in the growth of our business.

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Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
$
117,589

 
$
79,610

 
$
37,979

 
47.7
 %
 
$
324,029

 
$
242,414

 
$
81,615

 
33.7
 %
Sales and marketing
 
47,903

 
40,640

 
7,263

 
17.9

 
136,231

 
116,297

 
19,934

 
17.1

General and administrative
 
15,321

 
19,535

 
(4,214
)
 
(21.6
)
 
53,420

 
65,009

 
(11,589
)
 
(17.8
)
Legal settlement
 

 

 

 
*
 
405,000

 

 
405,000

 
*
Total operating expenses
 
$
180,813

 
$
139,785

 
$
41,028

 
29.4
 %
 
$
918,680

 
$
423,720

 
$
494,960

 
116.8
 %
____________________
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
* Not meaningful.
Research and development.
Research and development expenses increased $38.0 million, or 47.7%, and $81.6 million, or 33.7%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The increases in the three and nine months ended September 30, 2018 included a $11.5 million and a $35.2 million increase in personnel costs, including stock-based compensation and corporate bonuses, driven primary by headcount growth from normal hiring process and from the two acquisitions we completed in the third quarter of 2018, and a $20.4 million and a $32.9 million increase in new product introduction costs, driven by additional development projects. In addition, research and development related facilities and IT costs increased $2.1 million and $6.7 million in each period accommodating our acquired businesses and also reflecting ongoing headcount growth and higher IT and other consulting costs.
We expect our research and development expenses to increase in absolute dollars as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.
Sales and marketing.
Sales and marketing expenses increased $7.3 million, or 17.9%, and $19.9 million, or 17.1%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The increase in each period was primarily driven by personnel costs which increased by $7.7 million and $17.8 million due to growth in headcount from normal hiring process and from the two acquisitions completed in the third quarter of 2018.
We expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our sales and marketing efforts worldwide.
General and administrative.
General and administrative expenses decreased $4.2 million, or 21.6%, and $11.6 million, or 17.8%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The decrease in each period was primarily related to a reduced level of litigation activity and bond fee requirement as a result of the settlement of the Cisco litigation in August 2018. These decreases were partially offset by a $1.7 million and a $3.9 million increase in each period in other legal and professional fees, and a $1.1 million and a $2.7 million increase in each period in personnel costs, including increased stock-based compensation, driven by increased headcount.
We expect our general and administrative expenses to fluctuate in absolute dollars from period to period depending on the timing and progress of our litigation activities.
Legal settlement.
During the three months ended June 30, 2018, we recorded $405.0 million in legal settlement expenses in connection with a binding term sheet that was entered into on August 6, 2018 between the Company and Cisco. The amount was paid to Cisco in August of 2018. See Note 11 of Notes to Condensed Consolidated Financial Statements for further discussion.

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Other Income (Expense), Net (in thousands, except percentages)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Other income (expense), net:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense
 
$
(673
)
 
$
(701
)
 
$
28

 
(4.0
)%
 
$
(2,040
)
 
$
(2,039
)
 
$
(1
)
 
%
Other income (expense), net
 
9,292

 
2,136

 
7,156

 
335.0

 
12,646

 
4,280

 
8,366

 
195.5

Total other income (expense), net
 
$
8,619

 
$
1,435

 
$
7,184

 
500.6
 %
 
$
10,606

 
$
2,241

 
$
8,365

 
373.3
%
The increases in other income (expense), net during the three and nine months ended September 30, 2018 as compared to the same periods of 2017 were primarily driven by a $6.3 million and a $17.0 million increase in interest income, respectively, as we continued to generate cash and expand our marketable securities portfolios. In addition, during the nine months ended September 2018, we recorded a $9.1 million net unrealized loss on our investments in privately-held companies. See Note 5 of Notes to Condensed Consolidated Financial Statements for further discussion.
We expect our interest income to continue to grow in 2018 as we continue to grow our cash balance and invest our excess cash in marketable securities. We expect our foreign currency gains and losses continue to fluctuate in the future due to changes in foreign currency exchange rates. In connection with our adoption of ASU 2016-01 in the first quarter of 2018, other income (expense) may fluctuate in the future as a result of the re-measurement of our private company equity investments upon the occurrence of observable price changes and/or impairments. See Note 1 of Notes to Condensed Consolidated Financial Statements for details of this new guidance.
Provision for (Benefit from) Income Taxes (in thousands, except percentages)
We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, our U.S. tax obligations are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes.
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Income before income taxes
 
$
189,389

 
$
142,267

 
$
47,122

 
33.1
%
 
$
90,311

 
$
333,125

 
$
(242,814
)
 
(72.9
)%
Provision for (benefit from) income taxes
 
20,865

 
8,545

 
12,320

 
144.2
%
 
(67,482
)
 
13,757

 
(81,239
)
 
(590.5
)%
Effective tax rate
 
11.0%
 
6.0%
 

 

 
(74.7)%
 
4.1%
 
 
 
 
The effective tax rates above reflect tax expense recorded on pre-tax income in the three months ended September 30, 2018 and an overall tax benefit recorded on pre-tax income in the nine months ended September 30, 2018. The tax expense recorded in the three months ended September 30, 2018 includes a lower U.S. corporate tax and U.S. tax on foreign earnings as a result of the Tax Cuts and Jobs Act (“Tax Act”), and the tax effect of acquisitions, including integration. For the nine months ended September 30, 2018, the rate also includes a federal and state tax discrete benefit on the $405.0 million charge related to the legal settlement with Cisco recorded in the three months ended June 30, 2018. In all periods, excess tax benefits attributable to equity compensation also significantly benefit the effective tax rate.     
Integrating intellectual property from acquisitions into our business generally involves intercompany transactions and legal entity restructurings that have the impact of increasing our provision for income taxes. Consequently, our provision for income taxes and our effective tax rate may initially increase in the period of and shortly after an acquisition and integration. The magnitude of this impact will depend upon the specific type, size, and taxing jurisdictions of the intellectual property as well as the relative contribution to income in subsequent periods. 
On December 22, 2017, the U.S. government enacted comprehensive tax legislation. The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring a current inclusion in

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U.S. federal taxable income of certain earnings of controlled foreign corporations; and (5) creating the BEAT, a new minimum tax.
The Tax Act includes provisions for GILTI wherein taxes on foreign income are imposed in excess of a deemed return on tangible assets of foreign corporations. This income will effectively be taxed at a 10.5% tax rate in general. Our deferred tax assets and liabilities are still being evaluated to determine if they should be recognized for the basis differences expected to reverse as a result of GILTI provisions that are effective for us after the calendar year ending December 31, 2017. Because of the complexity of the new provisions, we are continuing to evaluate how the provisions will be accounted for under U.S. GAAP wherein companies are allowed to make an accounting policy election of either (i) account for GILTI as a component of tax expense in the period in which we are subject to the rules (the “period cost method”), or (ii) account for GILTI in our measurement of deferred taxes (the “deferred method”). Currently, we have not elected a method but we have included an estimate of the impact to our effective tax rate for the year ended December 31, 2018. A formal election will only be made after our completion of the analysis of the GILTI provisions and our election method will depend, in part, on analyzing our global income to determine whether we expect to have future U.S. inclusions in our taxable income related to GILTI and, if so, the impact that is expected.
As of September 30, 2018, we have not yet completed our accounting for the tax effects of the enactment of the Tax Act. We recognized a provisional tax amount of $51.8 million in the fourth quarter of 2017 for the transition tax liability and the revaluation of our deferred income taxes as a result of the rate change. In the nine months ended September 30, 2018, we did not revise this estimate. In addition, we recorded a reasonable estimate for the effect of the new legislation as discussed above, which impacts our U.S. income tax liabilities for the year ending December 31, 2018. Our estimates may also be affected as we gain a more thorough understanding of the tax law. These changes could be material to income tax expense. We will continue to refine our estimates related to the impact of the Tax Act during the one-year measurement period allowed under SAB 118.
On July 24, 2018, in the case of Altera Corp. v. Commissioner, the U.S. Court of Appeals for the Ninth Circuit (“Ninth Circuit”) reversed a 2015 decision of the U.S. Tax Court that had found U.S. Treasury Regulations requiring the inclusion of stock-based compensation in intercompany cost-sharing arrangements to be invalid (“Tax Court Decision”).  On August 7, 2018, the Ninth Circuit withdrew its opinion to reverse the Tax Court Decision to allow time for a reconstituted panel to confer on the appeal.  We are currently evaluating the impact of these decisions on our financial statements, which may adversely affect our effective tax rate in future periods.
Liquidity and Capital Resources
Our principal sources of liquidity are cash, cash equivalents, marketable securities, and cash generated from operations. As of September 30, 2018, our total balance of cash, cash equivalents and marketable securities was $1.7 billion, of which approximately $265.9 million was held outside the U.S. in our foreign subsidiaries. 
Our cash, cash equivalents and marketable securities are held for working capital purposes. Our marketable securities investment portfolio is primarily invested in highly-rated securities with the primary objective of minimizing the potential risk of principal loss. We plan to continue to invest for long-term growth. We believe that our existing balances of cash, cash equivalents and marketable securities together with cash generated from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced product and service offerings, our costs associated with supply chain activities, including access to outsourced manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and costs incurred related to outstanding litigation claims. If we require or elect to seek additional capital through debt or equity financing in the future, we may not be able to raise capital on terms acceptable to us or at all. If we are required and unable to raise additional capital when desired, our business, operating results and financial condition may be adversely affected.

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Table of Contents

Cash Flows
 
 
Nine Months Ended September 30,
 
 
2018

 
2017
  As Adjusted (1)
 
 
 
 
 
 
 
(in thousands)
Cash provided by operating activities
 
$
207,300

 
$
447,963

Cash used in investing activities (1)
 
(583,452
)
 
(199,090
)
Cash provided by financing activities
 
41,336

 
38,243

Effect of exchange rate changes
 
(984
)
 
697

Net increase/(decrease) in cash, cash equivalents and restricted cash
 
$
(335,800
)
 
$
287,813

___________________________
 
 
 
 
(1) Cash used in investing activities for the nine months ended September 30, 2017 was adjusted as a result of our adoption of ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in the first quarter of 2018. See Note 1 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for more information.
Cash Flows from Operating Activities
During the nine months ended September 30, 2018, cash provided by operating activities was $207.3 million, primarily from net income of $157.8 million, non-cash adjustments to net income of $42.6 million, and a net increase of $6.9 million in cash from changes in our operating assets and liabilities. The increase in cash from changes in operating assets and liabilities was primarily due to cash inflows of $98.3 million from a decrease in inventories driven by improved inventory management and timing of receipts, $30.5 million from an increase in accounts payable due to timing of inventory receipts and payments, $13.2 million from an increase in deferred revenue primarily from growth in customer PCS contracts, $10.3 million from an increase in income taxes payable, and $10.0 million from increases in other liabilities primarily driven by increased customer prepayments under concealable contracts. These cash inflows were partially offset by cash outflows of $68.2 million from an increase in accounts receivable due to increased billing and timing of customer shipments, $50.5 million from an increase in prepaid expenses and other current assets primarily due to higher prepaid income taxes in connection with an income tax benefit associated with the Cisco legal settlement charges referenced above, and $35.9 million from a decline in accrued liabilities due primarily to a decline in supplier liabilities and the completion of product development projects.
During the nine months ended September 30, 2017, cash provided by operating activities was $448.0 million, resulting from net income of $319.4 million, non-cash adjustments to net income of $48.7 million, and a net increase in cash from changes in our operating assets and liabilities of $79.9 million. Our operating cash benefited from increased deferred revenue of $192.2 million resulting from growth in product and service deferred revenue related to contract acceptance terms and ongoing growth in PCS contracts. We also experienced strong cash collections on accounts receivable during the period generating $40.5 million in cash. These increases were partially offset by growth in inventory of $96.7 million, supporting overall growth in the business and the expansion of our manufacturing and supply chain activities, with a decline in accounts payable of $46.1 million related to timing of vendor payments related to inventory purchases. Prepaid expenses and other assets increased by $22.5 million primarily due to higher deferred cost of inventory associated with the increased product revenue deferrals referenced above, partially offset by a reduction in inventory deposits.
Cash Flows from Investing Activities
During the nine months ended September 30, 2018, cash used in investing activities was $583.5 million, consisting of purchases of available-for-sale securities of $827.2 million, offset by proceeds of $367.0 million from maturities of marketable securities, $95.6 million for business acquisitions, and purchases of property and equipment of $17.6 million.
During the nine months ended September 30, 2017, cash used in investing activities was $199.1 million, consisting of purchases of available-for-sale securities of $325.4 million, offset by proceeds of $135.5 million and purchases of property, equipment and other assets of $12.2 million.
Cash Flows from Financing Activities
During the nine months ended September 30, 2018, cash provided by financing activities was $41.3 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $49.6 million, offset by minimum tax withheld for employees of $6.9 million and payments for lease financing obligations of $1.4 million.

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During the nine months ended September 30, 2017, cash provided by financing activities was $38.2 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $41.9 million, offset by minimum tax withheld for employees of $2.5 million and payments for lease financing obligations of $1.2 million.
Off-Balance Sheet Arrangements
As of September 30, 2018, we did not have any relationships with any unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commitments
Our contractual obligations represent material expected or contractually committed future payment obligations. We believe that we will be able to fund these obligations through cash generated from operations and from our existing balances of cash, cash equivalent and marketable securities. As of September 30, 2018, our principal commitments consist primarily of obligations under operating and financing leases for offices and data centers and purchase commitments with our contract manufacturers and suppliers. There have been no significant changes to these obligations during the nine months ended September 30, 2018, compared to the contractual obligations disclosed in our “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K, filed with the SEC on February 20, 2018, other than the new operating leases entered into in 2018 and the purchase commitments described in Note 6 of Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q.
Critical Accounting Policies and Estimates 
Our management’s discussion and analysis of financial condition and results of operations is based on our unaudited condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.
Effective January 1, 2018, we adopted the new revenue recognition guidance under ASC 606 as discussed in the section titled Recently Adopted Accounting Pronouncements in Note 1 of the Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q. As a result, we updated our critical accounting policy on revenue recognition as follows. There have been no changes to our other critical accounting policies and estimates discussed in the section titled Management's Discussion and Analysis of Financial Condition and Results of Operations under PART II, Item 7, of our Annual Report on Form 10-K filed with the SEC on February 20, 2018. We believe our critical accounting policies and estimates reflect our significant judgments and estimates used in the preparation of the condensed consolidated financial statements in this Quarterly Report on Form 10-Q.
Revenue Recognition
The following revenue recognition policy was effective January 1, 2018 following our adoption of the new revenue recognition guidance under ASC 606 using the modified retrospective method as discussed in the section titled Recently Adopted Accounting Pronouncements of Note 1 of Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q. Prior to 2018, our revenue recognition policy was under ASC 605, Revenue Recognition, and is described in Note 1 of Notes to Consolidated Financial Statements under PART II, Item 8, of our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on February 20, 2018.
We generate revenue from sales of our products, which incorporate our EOS software and accessories such as cables and optics, to direct customers and channel partners together with PCS. We typically sell products and PCS in a single contract. We recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:
Identification of the contract, or contracts, with a customer
Identification of the performance obligations in the contract
Determination of the transaction price
Allocation of the transaction price to the performance obligations in the contract
Recognition of revenue when (or as) we satisfy the performance obligation

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and investments in privately-held companies.
Foreign Currency Exchange Risk
Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Substantially all of our revenue is denominated in U.S. dollars, and therefore, our revenue is not directly subject to foreign currency risk. However, we are indirectly exposed to foreign currency risk. A stronger U.S. dollar could make our products and services more expensive in foreign countries and therefore reduce demand. A weaker U.S. dollar could have the opposite effect. Such

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economic exposure to currency fluctuations is difficult to measure or predict because our sales are also influenced by many other factors.
Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the U.S. and to a lesser extent in Europe and Asia. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. For the three and nine months ended September 30, 2018, the effect of a hypothetical 10% change in foreign currency exchange rates applicable to our business would have had a maximum impact of approximately $2.5 million and $6.4 million, respectively, on our operating results. To date, foreign currency transaction gains and losses and exchange rate fluctuations have not been material to our financial statements. While we have not engaged in the hedging of our foreign currency transactions to date and do not enter into any hedging contracts for trading or speculative purposes, we may in the future hedge selected significant transactions denominated in currencies other than the U.S. dollar.
Interest Rate Sensitivity
As of September 30, 2018 and December 31, 2017, we had cash, cash equivalents and available-for-sale marketable securities totaling $1.7 billion and $1.5 billion, respectively. Cash equivalents and marketable securities were invested primarily in money market funds, corporate bonds, U.S. agency mortgage-backed securities, U.S. treasury securities and commercial papers. We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of the interest rates in the U.S. A decline in interest rates would reduce our interest income. For the three and nine months ended September 30, 2018 and 2017, the effect of a hypothetical 100 basis point increase or decrease in overall interest rates would not have had a material impact on our interest income. 
On the other hand, when interest rates rise, our marketable securities purchased at a lower yield would incur a mark-to-market unrealized loss. Under certain circumstances, if we are forced to sell our marketable securities prior to maturity, we may incur realized losses in such investments. However, because of the conservative and short-term nature of the investments in our portfolio, a change in interest rates is not expected to have a material impact on our condensed consolidated financial statements.
Investments in Privately-Held Companies
Our non-marketable equity investments in privately-held companies are recorded in “Investments” in our condensed consolidated balance sheets. As of September 30, 2018 and December 31, 2017, the total carrying amount of our investments in privately-held companies was $35.0 million and $36.1 million. See Note 5 of Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q.
The privately-held companies in which we invested are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire investment in these companies. Our evaluation of investments in privately-held companies is based on the fundamentals of the businesses invested in, including among other factors, the nature of their technologies and potential for financial return.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Management, with the participation of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on the evaluation of our disclosure controls and procedures as of September 30, 2018, our CEO and CFO concluded that, as of such date, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended September 30, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
In connection with our adoption of the new revenue recognition guidance in the first quarter of 2018, we implemented internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new revenue recognition

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standards on our financial statements. There were no significant changes to our internal control over financial reporting due to the adoption of the new revenue recognition guidance.
Inherent Limitations of Internal Controls
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The information set forth under the “Legal Proceedings” subheading in Note 6 and in Note 11 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1, of this Quarterly Report on Form 10-Q is incorporated herein by reference.

Item 1A. Risk Factors
You should consider carefully the risks and uncertainties described below, together with all of the other information in this Quarterly Report on Form 10-Q, which could materially affect our business, financial condition, results of operations and prospects. The risks described below are not the only risks facing us. Risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially affect our business, financial condition, results of operations and prospects.
Risks Related to Our Business and Our Industry
Our business and operations have experienced rapid growth, and if we do not appropriately manage any future growth or are unable to improve our systems and processes, our business, financial condition, results of operations and prospects will be adversely affected.
We have experienced rapid growth and increased demand for our products over the last several years, which has placed a strain on our management, administrative, operational and financial infrastructure. Our employee headcount and number of end customers have increased, and we expect both to continue to grow over the next year. For example, between December 31, 2011 and September 30, 2018, our headcount grew from approximately 250 employees to approximately 2,280 employees, and our cumulative number of end customers grew from approximately 1,100 to over 4,900. As we have grown, we have had to manage an increasingly large and more complex array of internal systems and processes to scale with all aspects of our business, including our hardware and software development, contract manufacturing, purchasing, logistics, fulfillment and maintenance and support. Our success will depend in part upon our ability to manage our growth effectively. To do so, we must continue to increase the productivity of our existing employees and continue to hire, train and manage new employees as needed. To manage domestic and international growth of our operations and personnel, we will need to continue to improve our operational, financial and management controls and our reporting processes and procedures and implement more extensive and integrated financial and business information systems. We may not be able to successfully implement these or other improvements to our systems and processes in an efficient or timely manner, and we may discover deficiencies in their capabilities or effectiveness. We may experience difficulties in managing improvements to our systems and processes or in connection with third-party technology. In addition, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate effectively and in the intended manner, may result in disruption of our current operations and end-customer relationships, our inability to manage the growth of our business and our inability to accurately forecast our revenue, expenses and earnings and prevent certain losses.
Our limited operating history makes it difficult to evaluate our current business and future prospects and may increase the risk associated with your investment.
We shipped our first products in 2008 and the majority of our revenue growth has occurred since the beginning of 2010. Our limited operating history makes it difficult to evaluate our current business and our future prospects, including our ability to plan for and model future growth. We have encountered and will continue to encounter risks and difficulties frequently experienced

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by rapidly growing companies in constantly evolving industries, including the risks described elsewhere in this Quarterly Report on Form 10-Q. If we do not address these risks successfully, our business, financial condition, results of operations and prospects will be adversely affected, and the market price of our common stock could decline. Further, we have limited historical financial data, and we operate in a rapidly evolving market. As such, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.
We pursue new product offerings and technology initiatives from time to time, and if we fail to successfully carry out these initiatives, our business, financial condition, or results of operations could be adversely impacted.
As part of the evolution of our business, we have made substantial investments to develop new products and enhancements to existing products through our acquisitions and research and development efforts. If we are unable to anticipate technological changes in our industry by introducing new or enhanced products in a timely and cost-effective manner, or if we fail to introduce products that meet market demand, we may lose our competitive position, our products may become obsolete, and our business, financial condition or results of operations could be adversely affected.
Additionally, from time to time, we invest in expansion into adjacent markets, including the campus switching and WiFi networking markets. Although we believe these solutions are complementary to our current offerings, we have less experience and a more limited operating history in these markets, and our efforts in this area may not be successful. Expanding our services in existing and new markets and increasing the depth and breadth of our presence imposes significant burdens on our marketing, compliance, and other administrative and managerial resources. Our plan to expand and deepen our market share in our existing markets and possibly expand into additional markets is subject to a variety of risks and challenges. Our success in these new markets depends on a variety of factors, including the following:
Our ability to attract a customer base in markets in which we have less experience;
Our successful development of new sales and marketing strategies to meet customer requirements;
Our ability to compete with new and existing competitors in these adjacent markets, many of which may have more financial resources, market experience, brand recognition, relevant intellectual property rights, or established customer relationships than we currently do;
Our ability to skillfully balance our investment in adjacent markets with investment in our existing products and services;
Additionally, future market share gains may take longer than planned and cause us to incur significant costs. Difficulties in any of our new product development efforts or our efforts to enter adjacent markets could adversely affect our operating results and financial condition.
Our revenue growth rate in recent periods may not be indicative of our future performance.
Our revenue growth rate in recent periods may not be indicative of our future performance. We experienced annual revenue growth rates of 45.8%, 34.8%, and 43.4% in 2017, 2016, and 2015, respectively. In addition, we experienced quarterly revenue growth rates of 38.5%, 50.8%, 50.8%, and 42.7% in 2017 versus the comparable period in 2016 due to stronger than expected demand for our products and services. In the future, we expect our revenue growth rates to decline as the size of our customer base increases, we achieve higher market penetration in our current target market and we continue to enter and expand into new target markets. Other factors may also contribute to declines in our growth rates, including changes in demand for our products and services, increased competition, our ability to successfully manage our expansion or continue to capitalize on growth opportunities, the maturation of our business and general economic conditions. You should not rely on our revenue for any prior quarterly or annual period as an indication of our future revenue or revenue growth. If we are unable to maintain consistent revenue or revenue growth, our business, financial condition, results of operations and prospects could be materially adversely affected, our stock price could be volatile, and it may be difficult for us to achieve and maintain profitability.
Our results of operations are likely to vary significantly from period to period and be unpredictable and if we fail to meet the expectations of analysts or investors or our previously issued financial guidance, or if any forward-looking financial guidance does not meet the expectation of analysts or investors, the market price of our common stock could decline substantially.
Our results of operations have historically varied from period to period, and we expect that this trend will continue. As a result, you should not rely upon our past financial results for any period as indicators of future performance. Our results of operations in any given period can be influenced by a number of factors, many of which are outside of our control and may be difficult to predict, including:    
our ability to increase sales to existing customers and attract new end customers, including large end customers;
the budgeting cycles, purchasing practices and buying patterns of end customers, including large end customers who may receive lower pricing terms due to volume discounts and who may or may not make large bulk purchases in certain quarters;
changes in end-customer, geographic or product mix;

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changes in growth rates of the networking market;
the cost and potential outcomes of existing and future litigation, including the OptumSoft litigation matters;
increased expenses resulting from the tariffs imposed by the U.S. on goods from other countries and tariffs imposed by other countries on U.S. goods, including the tariffs recently implemented and additional tariffs that have been proposed by the U.S. government on various imports from China;
changes in the sales and implementation cycles for our products including the qualification and testing of our products by our customers and any delays or cancellations of purchases caused by such activities;
the rate of expansion and productivity of our sales force including any expansion into new markets;
changes in our pricing policies, whether initiated by us or as a result of competition;
our inability to fulfill our end customers’ orders due to the availability of inventory, supply chain delays, access to key commodities or technologies or events that impact our manufacturers or their suppliers;
the amount and timing of operating costs and capital expenditures related to the operation and expansion of our business;
changes in end-customer, distributor or reseller requirements or market needs;
difficulty forecasting, budgeting and planning due to limited visibility beyond the first two quarters into the spending plans of current or prospective customers;
deferral or cancellation of orders from end customers, including in anticipation of new products or product enhancements announced by us or our competitors, or warranty returns;
the inclusion of any acceptance provisions in our customer contracts or any delays in acceptance of those products;
the actual or rumored timing and success of new product and service introductions by us or our competitors or any other change in the competitive landscape of our industry, including consolidation among our competitors or end customers;
our ability to successfully expand our business domestically and internationally;
our ability to increase the size of our sales or distribution channel, any disruption in our sales or distribution channels, and/or termination of our relationship with important channel partners;
decisions by potential end customers to purchase our networking solutions from larger, more established vendors, white box vendors or their primary network equipment vendors;
price competition;
insolvency or credit difficulties confronting our end customers, which could adversely affect their ability to purchase or pay for our products and services, or confronting our key suppliers, including our sole source suppliers, which could disrupt our supply chain;
seasonality or cyclical fluctuations in our markets;
future accounting pronouncements or changes in our accounting policies;