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Arista Networks, Inc. - Quarter Report: 2018 June (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 June 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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post 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 July 31, 2018 was 74,823,689.



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)
 
 
June 30, 2018
 
December 31, 2017
ASSETS
 
 
 

CURRENT ASSETS:
 
 
 
 
Cash and cash equivalents
 
$
711,157

 
$
859,192

Marketable securities
 
1,149,247

 
676,363

Accounts receivable, net of rebates and allowances of $6,541 and $7,535, respectively
 
260,917

 
247,346

Inventories
 
245,439

 
306,198

Prepaid expenses and other current assets
 
253,802

 
177,330

Total current assets
 
2,620,562

 
2,266,429

Property and equipment, net
 
73,736

 
74,279

Investments
 
35,036

 
36,136

Deferred tax assets
 
82,761

 
65,125

Other assets
 
20,019

 
18,891

TOTAL ASSETS
 
$
2,832,114

 
$
2,460,860

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
CURRENT LIABILITIES:
 
 
 
 
Accounts payable
 
$
53,182

 
$
52,200

Accrued liabilities
 
86,693

 
133,827

Accrued legal settlement (Note 10)
 
405,000

 

Deferred revenue
 
262,345

 
327,706

Other current liabilities
 
19,543

 
16,172

Total current liabilities
 
826,763

 
529,905

Income taxes payable
 
40,369

 
34,067

Lease financing obligations, non-current
 
36,594

 
37,673

Deferred revenue, non-current
 
186,299

 
187,556

Other long-term liabilities
 
22,116

 
9,745

TOTAL LIABILITIES
 
1,112,141

 
798,946

Commitments and contingencies (Note 5)
 

 


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

 

Common stock, $0.0001 par value—1,000,000 shares authorized as of June 30, 2018 and December 31, 2017; 74,791 and 73,706 shares issued and outstanding as of June 30, 2018 and December 31, 2017
 
8

 
7

Additional paid-in capital
 
872,559

 
804,731

Retained earnings
 
851,957

 
859,114

Accumulated other comprehensive loss
 
(4,551)

 
(1,938
)
TOTAL STOCKHOLDERS’ EQUITY
 
1,719,973

 
1,661,914

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
2,832,114

 
$
2,460,860

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

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Table of Contents

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

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
444,767

 
$
353,904

 
$
852,384

 
$
645,271

Service
 
75,078

 
51,307

 
139,950

 
95,415

Total revenue
 
519,845

 
405,211

 
992,334

 
740,686

Cost of revenue: 
 
 
 
 
 
 
 
 
Product
 
171,622

 
134,406

 
328,313

 
244,242

Service
 
14,340

 
11,028

 
27,219

 
22,457

Total cost of revenue
 
185,962

 
145,434

 
355,532

 
266,699

Gross profit
 
333,883

 
259,777

 
636,802

 
473,987

Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
104,078

 
81,194

 
206,440

 
162,804

Sales and marketing
 
46,188

 
38,630

 
88,328

 
75,657

General and administrative
 
18,420

 
23,319

 
38,099

 
45,474

Legal settlement (Note 10)
 
405,000

 

 
405,000

 

Total operating expenses
 
573,686

 
143,143

 
737,867

 
283,935

Income (loss) from operations
 
(239,803
)
 
116,634

 
(101,065
)
 
190,052

Other income (expense), net:
 
 
 
 
 
 
 
 
Interest expense
 
(680
)
 
(623
)
 
(1,367
)
 
(1,338
)
Other income (expense), net
 
(1,489
)
 
1,119

 
3,354

 
2,144

Total other income (expense), net
 
(2,169
)
 
496

 
1,987

 
806

Income (loss) before income taxes
 
(241,972
)
 
117,130

 
(99,078
)
 
190,858

Provision for (benefit from) income taxes
 
(86,703
)
 
14,445

 
(88,347
)
 
5,212

Net income (loss)
 
$
(155,269
)
 
$
102,685

 
$
(10,731
)
 
$
185,646

Net income (loss) attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
(155,187
)
 
$
102,454

 
$
(10,725
)
 
$
185,139

Diluted
 
$
(155,187
)
 
$
102,474

 
$
(10,725
)
 
$
185,182

Net income (loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
(2.08
)
 
$
1.42

 
$
(0.14
)
 
$
2.59

Diluted
 
$
(2.08
)
 
$
1.30

 
$
(0.14
)
 
$
2.37

Weighted-average shares used in computing net income (loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
74,503

 
71,992

 
74,250

 
71,555

Diluted
 
74,503

 
78,756

 
74,250

 
78,166


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 (Loss)
(Unaudited, in thousands)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Net income (loss)
 
$
(155,269
)
 
$
102,685

 
$
(10,731
)
 
$
185,646

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
(1,167
)
 
384

 
(814
)
 
157

Net change in unrealized gains (losses) on available-for-sale securities
 
242

 
(7
)
 
(1,799
)
 
65

Other comprehensive income (loss)
 
(925
)
 
377

 
(2,613
)
 
222

Comprehensive income (loss)
 
$
(156,194
)
 
$
103,062

 
$
(13,344
)
 
$
185,868


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)
 
 
Six Months Ended June 30,
 
 
2018

 
2017
  As Adjusted (1)
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income (loss)
 
$
(10,731
)
 
$
185,646

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
 
Depreciation, amortization and other
 
11,328

 
10,033

Stock-based compensation
 
43,329

 
34,839

Deferred income taxes
 
(18,281
)
 
(8,515
)
Unrealized loss on investments in privately-held companies, net
 
9,100

 

Amortization (accretion) of investment premiums (discounts)
 
(783
)
 
753

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
(13,571
)
 
(16,505
)
Inventories
 
60,759

 
(127,313
)
Prepaid expenses and other current assets
 
(72,418
)
 
(22,239
)
Other assets
 
629

 
(470
)
Accounts payable
 
3,597

 
1,299

Accrued liabilities
 
(47,153
)
 
(5,981
)
Accrued legal settlement
 
405,000

 

Deferred revenue
 
(50,096
)
 
181,575

Income taxes payable
 
6,653

 
5,380

Other liabilities
 
(1,237
)
 
3,593

Net cash provided by operating activities
 
326,125

 
242,095

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Proceeds from maturities of marketable securities
 
222,764

 
112,053

Purchases of marketable securities
 
(696,665
)
 
(114,195
)
Purchases of property and equipment
 
(13,071
)
 
(9,534
)
Investments in privately-held companies
 
(8,000
)
 

Other investing activities
 
(2,000
)
 

Net cash used in investing activities (1)
 
(496,972
)
 
(11,676
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Principal payments of lease financing obligations
 
(921
)
 
(773
)
Proceeds from issuance of common stock under equity plans
 
28,810

 
28,105

Tax withholding paid on behalf of employees for net share settlement
 
(4,463
)
 
(1,356
)
Net cash provided by financing activities
 
23,426

 
25,976

Effect of exchange rate changes
 
(607
)
 
411

NET INCREASE/(DECREASE) IN CASH, CASH EQUIVALENTS AND RESTRICTED CASH
 
(148,028
)
 
256,806

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

 
572,168

CASH, CASH EQUIVALENTS AND RESTRICTED CASH —End of period (2)
 
$
716,669

 
$
828,974

 
 
 
 
 
SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING INFORMATION:
 
 
 
 
Property and equipment included in accounts payable and accrued liabilities
 
$
1,077

 
$
672

___________________________________________________
 
 
 
 
(1) Net cash used in investing activities for the six months ended June 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 3 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 six months ended June 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 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; accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; 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 six months ended June 30, 2018, we 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 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

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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 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, 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.
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.

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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.
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.
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 six months ended June 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

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(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 June 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, 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 six months ended June 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.
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, 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. 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. As currently issued, companies are required to adopt this guidance to the earliest period presented using a modified retrospective approach. 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.

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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.    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):
 
 
June 30, 2018
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
 
Level I
 
Level II
 
Level III
Financial Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash Equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds
 
$
462,057

 
$

 
$

 
$
462,057

 
$
462,057

 
$

 
$

Corporate bonds
 
2,999

 

 

 
2,999

 

 
2,999

 

 
 
465,056

 

 

 
465,056

 
462,057

 
2,999

 

Marketable Securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial paper
 
37,274

 

 

 
37,274

 

 
37,274

 

U.S. government notes
 
266,243

 

 
(494
)
 
265,749

 
265,749

 

 

Corporate bonds
 
568,503

 
25

 
(1,999
)
 
566,529

 

 
566,529

 

Agency securities
 
280,615

 
6

 
(926
)
 
279,695

 

 
279,695

 

 
 
1,152,635

 
31

 
(3,419
)
 
1,149,247

 
265,749

 
883,498

 

Other Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Money market funds - restricted
 
5,512

 

 

 
5,512

 
5,512

 

 

Total Financial Assets
 
$
1,623,203

 
$
31

 
$
(3,419
)
 
$
1,619,815

 
$
733,318

 
$
886,497

 
$



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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 six months ended June 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 June 30, 2018.
As of June 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):
 
 
June 30, 2018
Due in 1 year or less
 
$
781,299

Due in 1 year through 2 years
 
367,948

Total marketable securities
 
$
1,149,247

The weighted-average remaining duration of our current marketable securities is approximately 0.8 years as of June 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.

3.    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):
 
 
June 30, 2018
 
June 30, 2017
Cash and cash equivalents
 
$
711,157

 
$
823,475

Restricted cash included in other assets
 
5,512

 
5,499

Total cash, cash equivalents and restricted cash
 
$
716,669

 
$
828,974


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Restricted cash included in other assets as of June 30, 2018 and June 30, 2017 primarily included $4.0 million pledged as collateral representing a security deposit required for a facility lease and $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):
 
 
June 30, 2018
 
December 31, 2017
Accounts receivable
 
$
267,458

 
$
254,881

Allowance for doubtful accounts
 
(183
)
 
(112
)
Product sales rebate and returns reserve
 
(6,358
)
 
(7,423
)
Accounts receivable, net
 
$
260,917

 
$
247,346

Inventories
Inventories consist of the following (in thousands):
 
 
June 30, 2018
 
December 31, 2017
Raw materials
 
$
68,924

 
$
69,673

Finished goods
 
176,515

 
236,525

Total inventories
 
$
245,439

 
$
306,198

Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consists of the following (in thousands):
 
 
June 30, 2018
 
December 31, 2017
Inventory deposit
 
$
25,273

 
$
34,141

Prepaid income taxes
 
129,948

 
38,134

Other current assets
 
87,157

 
96,215

Other prepaid expenses and deposits
 
11,424

 
8,840

Total prepaid expenses and other current assets
 
$
253,802

 
$
177,330

Property and Equipment, Net
Property and equipment, net consists of the following (in thousands):
 
 
June 30, 2018
 
December 31, 2017
Equipment and machinery
 
$
52,390

 
$
47,711

Computer hardware and software
 
25,748

 
22,124

Furniture and fixtures
 
3,464

 
3,020

Leasehold improvements
 
32,202

 
30,548

Building
 
35,154

 
35,154

Construction-in-process
 
4,034

 
4,742

Property and equipment, gross
 
152,992

 
143,299

Less: accumulated depreciation
 
(79,256
)
 
(69,020
)
Property and equipment, net
 
$
73,736

 
$
74,279

Depreciation expense was $5.4 million and $5.0 million for the three months ended June 30, 2018 and 2017, respectively, and $10.7 million and $9.8 million for the six months ended June 30, 2018 and 2017, respectively.

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Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
 
June 30, 2018
 
December 31, 2017
Accrued payroll related costs
 
$
40,896

 
$
56,626

Accrued manufacturing costs
 
21,663

 
35,703

Accrued product development costs
 
4,362

 
21,201

Accrued warranty costs
 
8,182

 
7,415

Accrued professional fees
 
6,267

 
7,086

Accrued taxes
 
717

 
794

Other
 
4,606

 
5,002

Total accrued liabilities
 
$
86,693

 
$
133,827

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

 
$
6,744

Liabilities accrued for warranties issued during the period
 
3,813

 
3,944

Warranty costs incurred during the period
 
(3,046
)
 
(2,426
)
Warranty accrual, end of period
 
$
8,182

 
$
8,262

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

 
$

Add: Contract assets recognized
 
6,959

 
6,959

Contract assets, ending balance
 
$
6,959

 
$
6,959

The following table summarizes the activity related to our contract liabilities (in thousands):
 
 
Three Months Ended
June 30, 2018
 
Six Months Ended
June 30, 2018
Contract liabilities, beginning balance
 
$
18,838

 
$
16,521

Less: Revenue recognized from beginning balance
 
(1,933
)
 
(4,070
)
Less: Beginning balance reclassified to deferred revenue
 
(906
)
 
(731
)
Add: Contract liabilities recognized
 
5,843

 
10,122

Contract liabilities, ending balance
 
$
21,842

 
$
21,842

As of June 30, 2018, $9.4 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
June 30, 2018
 
Six Months Ended
June 30, 2018
 
Deferred revenue, beginning balance
 
$
456,054

 
$
498,740

(1) 
Less: Revenue recognized from beginning balance
 
(112,998
)
 
(238,557
)
 
Add: Deferral of revenue in current period, excluding amounts recognized during the period
 
105,588

 
188,461

 
Deferred revenue, ending balance
 
$
448,644

 
$
448,644

 
_________________________________
 
 
 
 
 
(1) The beginning balance of the six months ended June 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 June 30, 2018, approximately $470.5 million of revenue is expected to be recognized from remaining performance obligations. We expect to recognize revenue on approximately 79% of these remaining performance obligations over the next 2 years and 21% during the 3rd to the 5th year.
Other Income (Expense), Net
Other income (expense), net consists of the following (in thousands):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Interest income
 
$
7,964

 
$
1,425

 
$
13,348

 
$
2,557

Unrealized loss on investments in privately-held companies, net
 
(9,100
)
 

 
(9,100
)
 

Other income (expense)
 
(353
)
 
(306
)
 
(894
)
 
(413
)
Total
 
$
(1,489
)
 
$
1,119

 
$
3,354

 
$
2,144


4.    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 June 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.
Prior to 2018, we did not record any impairment losses for these investments. During the three and six months ended June 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 three and six months ended June 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.
As of June 30, 2018, the carrying amount of these re-measured or impaired equity investments was $27.0 million, and were classified within Level III in the fair value hierarchy because we estimated the value of these investments using unobservable inputs supported by little or no market data in addition to an observable price change for similar investments issued by the same issuer in an inactive market.


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5.    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 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 six months ended June 30, 2018, we entered into new leases primarily related to additional data center capacity and co-location services. As of June 30, 2018, the total minimum future payment commitment under these new leases was approximately $46.4 million, of which $1.0 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 June 30, 2018 and 2017, rent expense for all operating leases amounted to $2.6 million and $2.6 million, respectively, and to $5.1 million and $5.0 million for the six months ended June 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 June 30, 2018 and 2017, and $0.6 million for the six months ended June 30, 2018 and 2017.
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 product 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 June 30, 2018, we had non-cancellable purchase commitments of $269.6 million, of which $215.4 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 $28.0 million and $36.9 million in deposits as of June 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
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

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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 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 December 16, 2015, the Court issued a Proposed Statement of Decision Following Phase 1 Trial, and on January 8, 2016, OptumSoft filed objections to that Proposed Statement of Decision. 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 as set forth in the Final Statement of Decision Following Phase I Trial to any other source code that OptumSoft claims to own following a review and the trade secret misappropriation and confidentiality claims. The Phase II Trial is set to begin on March 4, 2019.
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.    
Cisco Systems, Inc. (“Cisco”) Matters    
Although we have reached a settlement with Cisco, as described in Note 10, we are currently involved in several litigation matters with Cisco Systems, Inc. These matters 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 10, the ’43 Case will be dismissed following execution of a final agreement with Cisco.
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 seeks 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. The matter is fully briefed, and the U.S. Court of Appeals for the Federal Circuit (the “Federal Circuit”) heard oral argument on June 6, 2018. The Federal Circuit has not yet issued a decision. Pursuant to the settlement with Cisco, the ’44 Case will continue until either the judge vacates the judgment or all appeals on the judgment are exhausted, at which time the case will be dismissed, and if the Federal Circuit overturns the scenes a faire verdict or remands the case to the district court for further proceedings Arista will make certain limited changes to its CLI and no further settlement amounts will be paid.
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 10. Pursuant to the settlement with Cisco, the ’23 Case will be dismissed following execution of a final agreement with Cisco.
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 alleges that we are violating 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 have made to those products. Cisco asks the USITC to (1) enforce the cease and desist order; (2) modify the USITC’s limited exclusion order and/or cease and desist order “in any manner that would assist in the prevention of the unfair practices that were originally the basis for issuing such Order or assist in the detection of violations of such Order” (3) impose the maximum statutory civil penalties for violation of the cease and desist order “including monetary sanctions for each day’s violation of the cease and desist order of the greater of $100,000 or twice the domestic value of the articles entered or sold, whichever is higher” (4) bring a civil action in U.S. district court “requesting collection of such civil penalties and the issuance of a mandatory injunction preventing further violation of Cease and Desist Order” and (5) impose “such other remedies and sanctions as are appropriate and within the USITC’s authority.” On September 28, 2016, the USITC instituted the enforcement proceeding. The proceeding has been assigned to ALJ Shaw, who presided over the underlying investigation.

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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. The parties have submitted additional petition for review briefing and the USITC is scheduled to issue a final determination on September 11, 2018. In light of the settlement with Cisco, the parties have filed a joint request to stay the remaining briefing and target dates in the 944 Enforcement Action to halt further activity. Pursuant to the settlement with Cisco, the 944 Enforcement Investigation will be terminated and the remedial orders suspended following execution of a final agreement with Cisco.
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.
* * * * *
Although we have reached a settlement with Cisco, as describe in Note 10, the Cisco lawsuits, as summarized in the preceding paragraphs, remain active subject to a final agreement with Cisco and we remain subject to the exclusion order issued in the 944 Investigation. In light of the settlement with Cisco, the parties are planning to seek suspension of this enforcement proceeding.
If the 944 Enforcement Action is not stayed and/or terminated and if the USITC determines that our redesigned products infringe any of the patents that are the subject of USITC remedial orders, those redesigned products will also be barred from import into the United States, or sale after importation. In addition, the USITC may impose the maximum statutory civil penalties for violation of the cease and desist order “including monetary sanctions for each day’s violation of the cease and desist order of the greater of $100,000 or twice the domestic value of the articles entered or sold, whichever is higher,” bring a civil action in U.S. district court “requesting collection of such civil penalties and the issuance of a mandatory injunction preventing further violation of Cease and Desist Order,” or impose “such other remedies and sanctions as are appropriate and within the Commission’s authority.” In the 944 Enforcement Action, the ALJ recommended a civil penalty of $307 million if the USITC were to reverse the ALJ’s

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finding of no violation. Any such finding by the USITC in the 944 Enforcement Action could materially and adversely affect our business, prospects, reputation, results of operations and financial condition.
An adverse finding in the 944 Enforcement Action would take effect immediately upon USITC’s issuance of the final determination, without any Presidential review period. To address such a finding, we would have to further redesign our products to make them non-infringing, and until we made such changes we would not be able to import or ship our products to customers in the United States. Our further redesign efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management. We may not be able to further redesign the products in a manner that does not continue to infringe the patents or that is acceptable to customers. We may not be able to complete, and our customers may not be able to qualify, such further redesigned products in a timely fashion, if at all, following the issuance of an adverse final determination, leading to a delay or cancellation of purchases by some customers until those redesigned products are qualified or accepted by such customers, a rejection or return of our redesigned products by some customers or a loss of sales to some customers who are unable to qualify or accept the redesigned products. Our redesign efforts could be extremely costly and time consuming as well as disruptive to our other development activities and distracting to management.
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 June 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.
6.    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 June 30, 2018, there remained approximately 23.3 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 June 30, 2018, there remained approximately 2,615,207 shares available for issuance under the ESPP.
During the three and six months ended June 30, 2018, we issued 108,890 shares at a weighted-average purchase price of $67.09 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
 
(720
)
 
29.87

 
 
 
 
Options canceled
 
(25
)
 
42.79

 
 
 
 
Balance—June 30, 2018
 
6,361

 
$
36.10

 
5.7
 
$
1,408,382

Vested and exercisable—June 30, 2018
 
2,827

 
$
22.87

 
5.1
 
$
663,243

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
 
185

 
275.87

 
 
 
 
       RSUs vested
 
(274
)
 
91.96

 
 
 
 
       RSUs forfeited/canceled
 
(42
)
 
128.81

 
 
 
 
Unvested balance—June 30, 2018
 
1,406

 
$
128.50

 
1.6
 
$
361,923

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 June 30, 2018 (in thousands):
 
 
Number of Shares
Balance—December 31, 2017
 
13,512

Authorized
 
2,211

Options granted
 
(82
)
RSUs granted
 
(185
)
Options canceled
 
25

RSUs forfeited
 
42

Shares traded for taxes
 
19

Balance—June 30, 2018
 
15,542


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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 June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Cost of revenue
 
$
1,236

 
$
1,087

 
$
2,438

 
$
2,111

Research and development
 
11,745

 
10,342

 
22,690

 
19,929

Sales and marketing   
 
6,274

 
4,080

 
12,234

 
7,536

General and administrative
 
3,223

 
2,891

 
5,967

 
5,263

           Total stock-based compensation
 
$
22,478

 
$
18,400

 
$
43,329

 
$
34,839

As of June 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).
 
 
June 30, 2018
 
 
Stock Option
 
RSU
 
ESPP
Unrecognized stock-based compensation expense
 
$
64,927

 
$
166,063

 
$
3,470

Weighted-average amortization period
 
3.7 years

 
3.4 years

 
1.0 year



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7.    Net Income (Loss) Per Share Available to Common Stock
The following table sets forth the computation of our basic and diluted net income (loss) per share available to common stock (in thousands, except per share amounts):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Numerator:
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
 
Net income (loss)
 
$
(155,269
)
 
$
102,685

 
$
(10,731
)
 
$
185,646

Less: undistributed earnings (loss) allocated to participating securities
 
82

 
(231
)
 
6

 
(507
)
Net income (loss) available to common stockholders, basic
 
$
(155,187
)
 
$
102,454

 
$
(10,725
)
 
$
185,139

Diluted:
 
 
 
 
 
 
 
 
Net income (loss) attributable to common stockholders, basic
 
$
(155,187
)
 
$
102,454

 
$
(10,725
)
 
$
185,139

Add: undistributed earnings (loss) allocated to participating securities
 

 
20

 

 
43

Net income (loss) attributable to common stockholders, diluted
 
$
(155,187
)
 
$
102,474

 
$
(10,725
)
 
$
185,182

Denominator:
 
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
 
Weighted-average shares used in computing net income (loss) per share available to common stockholders, basic
 
74,503

 
71,992

 
74,250

 
71,555

Diluted:
 
 
 
 
 
 
 
 
Weighted-average shares used in computing net income (loss) per share available to common stockholders, basic
 
74,503

 
71,992

 
74,250

 
71,555

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

 
6,625

 

 
6,474

Employee stock purchase plan
 

 
139

 

 
137

Weighted-average shares used in computing net income (loss) per share available to common stockholders, diluted
 
74,503

 
78,756

 
74,250

 
78,166

Net income (loss) per share attributable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
(2.08
)
 
$
1.42

 
$
(0.14
)
 
$
2.59

Diluted
 
$
(2.08
)
 
$
1.30

 
$
(0.14
)
 
$
2.37

The following weighted-average outstanding shares of common stock equivalents were excluded from the computation of diluted net income (loss) per share available to common stockholders for the periods presented because including them would have been anti-dilutive (in thousands):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Stock options and RSUs to purchase common stock
 
8,011

 
18

 
8,168

 
103

Employee stock purchase plan
 
145

 

 
132

 

Total
 
8,156

 
18

 
8,300

 
103



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8.    Income Taxes
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands, except percentages)
Income (loss) before income taxes
 
$
(241,972
)
 
$
117,130

 
$
(99,078
)
 
$
190,858

Provision for (benefit from) income taxes
 
$
(86,703
)
 
$
14,445

 
$
(88,347
)
 
$
5,212

Effective tax rate
 
35.8
%
 
12.3
%
 
89.2
%
 
2.7
%
The effective tax rates above reflect tax benefits recorded on pre-tax losses in the three and six months ended June 30, 2018, compared to tax expense recorded on pre-tax income in the comparable periods in 2017 and are reflective of a federal and state tax benefit on the $405.0 million charge related to the legal settlement recorded in the three and six months ended June 30, 2018 as well as a lower U.S. corporate tax rate beginning fiscal 2018 under the Tax Cuts and Jobs Act (“Tax Act”) passed in December 2017.  In all periods, excess tax benefits attributable to equity compensation also significantly benefit the effective tax rate. During periods where we experience pre-tax losses, excess tax benefits will generally increase the effective income tax rate above the statutory rate, whereas during periods where we experience pre-tax profits, they will reduce the effective income tax rate below the statutory rate.
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 June 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 six months ended June 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 the 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”).
We have been selected for examination by the Internal Revenue Service (“IRS”) for our 2014 tax year. It is difficult to determine when the examinations will be settled or their final outcomes in the foreseeable future. We believe that we have adequately provided reserves for any reasonably foreseeable adjustment to our tax returns.


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9.    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 June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Americas
 
$
377,460

 
$
304,020

 
$
692,958

 
$
568,883

Europe, Middle East and Africa
 
101,811

 
77,367

 
223,697

 
120,101

Asia-Pacific
 
40,574

 
23,824

 
75,679

 
51,702

Total revenue
 
$
519,845

 
$
405,211

 
$
992,334

 
$
740,686

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):
 
 
June 30, 2018
 
December 31, 2017
United States
 
$
68,003

 
$
69,128

International
 
5,733

 
5,151

Total
 
$
73,736

 
$
74,279


10.    Subsequent Events
Acquisition of Mojo Networks, Inc.
On August 2, 2018, we completed the acquisition of Mojo Networks, Inc., a provider of Cognitive WiFi and cloud-managed wireless networking solutions. The transaction will be included in our condensed consolidated financial statements in the quarter ended September 30, 2018 and will be financed from our existing cash balance.
Settlement of Cisco Lawsuits
On August 6, 2018, we entered into a binding term sheet with Cisco which, upon execution of a final agreement, will result in the dismissal of all pending district court and USITC litigation between the parties. Under the binding term sheet, we will pay Cisco $400.0 million by August 20, 2018. Cisco will grant us a release for all claims of infringement with respect to the patent infringement allegations against us in the pending litigation, and we will grant Cisco a release from all past antitrust claims. These mutual releases will extend to the Company's and Cisco’s customers, contract manufacturers, and partners. The parties have further agreed to a five-year stand-down period as to 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”).
As a result of the agreement described above, we recorded a legal settlement charge of $405.0 million to operating expenses, which included legal fees associated with the settlement, and a corresponding income tax benefit of $99.0 million in the three and six months ended June 30, 2018.  Correspondingly, we recorded $405.0 million in accrued legal settlement charges, $85.0 million in prepaid expenses and other current assets relating to prepaid income taxes, and $14.0 million in deferred tax assets in our condensed consolidated balance sheet as of June 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.

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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 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 pursuant to which we will pay Cisco $400.0 million, and upon execution of a final agreement, will result in the dismissal of all pending district court and USITC litigation between the parties. Cisco will grant us a release for all claims of infringement with respect to the patent infringement allegations against us in the pending litigation, and we will grant Cisco a release from all past antitrust claims. These mutual releases will extend to the Company’s and Cisco’s customers, contract manufacturers, and partners. The parties have further agreed to (i) a five-year stand-down period as to any utility patent infringement claims either may have against features currently implemented in the other party’s products and services, and (ii) 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 the previously issued limited exclusion order and cease and desist orders in the 944 Investigation and the 945 Investigation as described in Note 5 of Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q, we have made design changes to our products for sale in the United States. As of June 30, 2018, final certification of the redesigns for the 945 Investigation had been completed in almost all cases, with minimal ongoing activities around some unique requirements. Following the expiration of the ’577 patent on July 1, 2018 and the invalidation of the relevant claims of the ’668 patent, beginning in the third quarter of 2018, features previously covered by the exclusion and cease and desist

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orders may be re-incorporated into our products. We will need to work with customers on any resulting changes to our products, including the completion of any required re-qualification procedures, the timing of which could result in an impact to our business, our revenue and our deferred revenue balances.
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 six months ended June 30, 2018 and 2017 from our unaudited condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
Revenue
 
 
 
 
 
 
 
 
Product
 
$
444,767

 
$
353,904

 
$
852,384

 
$
645,271

Service
 
75,078

 
51,307

 
139,950

 
95,415

Total revenue
 
519,845

 
405,211

 
992,334

 
740,686

Cost of revenue (1)
 
 
 
 
 
 
 
 
Product
 
171,622

 
134,406

 
328,313

 
244,242

Service
 
14,340

 
11,028

 
27,219

 
22,457

Total cost of revenue
 
185,962

 
145,434

 
355,532

 
266,699

Gross profit
 
333,883

 
259,777

 
636,802

 
473,987

Operating expenses (1)
 
 
 
 
 
 
 
 
Research and development
 
104,078

 
81,194

 
206,440

 
162,804

Sales and marketing
 
46,188

 
38,630

 
88,328

 
75,657

General and administrative
 
18,420

 
23,319

 
38,099

 
45,474

Legal settlement
 
405,000

 

 
405,000

 

Total operating expenses
 
573,686

 
143,143

 
737,867

 
283,935

Income (loss) from operations
 
(239,803
)
 
116,634

 
(101,065
)
 
190,052

Other income (expense), net
 
 
 
 
 
 
 
 
Interest expense
 
(680
)
 
(623
)
 
(1,367
)
 
(1,338
)
Other income (expense), net
 
(1,489
)
 
1,119

 
3,354

 
2,144

Total other income (expense), net
 
(2,169
)
 
496

 
1,987

 
806

Income (loss) before income taxes
 
(241,972
)
 
117,130

 
(99,078
)
 
190,858

Provision for (benefit from) income taxes
 
(86,703
)
 
14,445

 
(88,347
)
 
5,212

Net income (loss)
 
$
(155,269
)
 
$
102,685

 
$
(10,731
)
 
$
185,646

__________________________
 
 
 
 
 
 
 
 
(1) Includes stock-based compensation expense as follows:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(in thousands)
Stock-Based Compensation Expense:
 
 
 
 
 
 
 
 
Cost of revenue
 
$
1,236

 
$
1,087

 
$
2,438

 
$
2,111

Research and development
 
11,745

 
10,342

 
22,690

 
19,929

Sales and marketing
 
6,274

 
4,080

 
12,234

 
7,536

General and administrative
 
3,223

 
2,891

 
5,967

 
5,263

           Total stock-based compensation
 
$
22,478

 
$
18,400

 
$
43,329

 
$
34,839



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Table of Contents

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
 
 
(as a percentage of revenue)
Revenue
 
 
 
 
 
 
 
 
Product
 
85.6
 %
 
87.3
 %
 
85.9
 %
 
87.1
 %
Service
 
14.4

 
12.7

 
14.1

 
12.9

Total revenue
 
100.0

 
100.0

 
100.0

 
100.0

Cost of revenue
 
 
 
 
 
 
 
 
Product
 
33.0

 
33.2

 
33.1

 
33.0

Service
 
2.8

 
2.7

 
2.7

 
3.0

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
 
20.0

 
20.0

 
20.9

 
22.0

Sales and marketing
 
8.9

 
9.5

 
8.9

 
10.2

General and administrative
 
3.5

 
5.8

 
3.8

 
6.1

Legal settlement
 
77.9

 

 
40.8

 

Total operating expenses
 
110.3

 
35.3

 
74.4

 
38.3

Income (loss) from operations
 
(46.1
)
 
28.8

 
(10.2
)
 
25.7

Interest expense
 
(0.1
)
 
(0.2
)
 
(0.1
)
 
(0.2
)
Other income (expense), net
 
(0.3
)
 
0.3

 
0.3

 
0.3

Total other income (expense), net
 
(0.4
)
 
0.1

 
0.2

 
0.1

Income (loss) before income taxes
 
(46.5
)
 
28.9

 
(10.0
)
 
25.8

Provision for (benefit from) income taxes
 
(16.6
)
 
3.6

 
(8.9
)
 
0.7

Net income (loss)
 
(29.9
)%
 
25.3
 %
 
(1.1
)%
 
25.1
 %

Three and Six Months Ended June 30, 2018 Compared to Three and Six Months Ended June 30, 2017
Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
 
$
444,767

 
$
353,904

 
$
90,863

 
25.7
%
 
$
852,384

 
$
645,271

 
$
207,113

 
32.1
%
Service
 
75,078

 
51,307

 
23,771

 
46.3

 
139,950

 
95,415

 
44,535

 
46.7

Total revenue
 
519,845

 
405,211

 
114,634

 
28.3

 
992,334

 
740,686

 
251,648

 
34.0

Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
 
171,622

 
134,406

 
37,216

 
27.7

 
328,313

 
244,242

 
84,071

 
34.4

Service
 
14,340

 
11,028

 
3,312

 
30.0

 
27,219

 
22,457

 
4,762

 
21.2

Total cost of revenue
 
185,962

 
145,434

 
40,528

 
27.9

 
355,532

 
266,699

 
88,833

 
33.3

Gross profit
 
$
333,883

 
$
259,777

 
$
74,106

 
28.5
%
 
$
636,802

 
$
473,987

 
$
162,815

 
34.4
%
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 June 30,
 
Six Months Ended June 30,
 
 
2018
 
% of Total
 
2017
 
% of Total
 
2018
 
% of Total
 
2017
 
% of Total
Americas
 
$
377,460

 
72.6
%
 
$
304,020

 
75.0
%
 
$
692,958

 
69.8
%
 
$
568,883

 
76.8
%
Europe, Middle East and Africa
 
101,811

 
19.6

 
77,367

 
19.1

 
223,697

 
22.5

 
120,101

 
16.2

Asia-Pacific
 
40,574

 
7.8

 
23,824

 
5.9

 
75,679

 
7.7

 
51,702

 
7.0

Total revenue
 
$
519,845

 
100.0
%
 
$
405,211

 
100.0
%
 
$
992,334

 
100.0
%
 
$
740,686

 
100.0
%
Revenue
Product revenue increased $90.9 million, or 25.7%, and $207.1 million, or 32.1%, in the three and six months ended June 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 $23.8 million, or 46.3%, and $44.5 million, or 46.7% in the three and six months ended June 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. 
Excluding the reclassification to other current and noncurrent liabilities in connection with our adoption of ASC 606 on January 1, 2018, deferred revenue decreased $50.1 million from December 31, 2017 to June 30, 2018, which was primarily due to a decrease in deferred product revenue as customers completed certification and acceptance of our 945 Investigation-related product redesigns, partially offset by an increase in deferred service revenue.
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 $40.5 million, or 27.9%, and $88.8 million, or 33.3%, in the three and six months ended June 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 June 30, 2018 and 64.0% to 64.2% for the six months ended June 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 due primarily to product 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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Table of Contents

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
$
104,078

 
$
81,194

 
$
22,884

 
28.2
 %
 
$
206,440

 
$
162,804

 
$
43,636

 
26.8
 %
Sales and marketing
 
46,188

 
38,630

 
7,558

 
19.6

 
88,328

 
75,657

 
12,671

 
16.7

General and administrative
 
18,420

 
23,319

 
(4,899
)
 
(21.0
)
 
38,099

 
45,474

 
(7,375
)
 
(16.2
)
Legal settlement
 
405,000

 

 
405,000

 
*
 
405,000

 

 
405,000

 
*
Total operating expenses
 
$
573,686

 
$
143,143

 
$
430,543

 
300.8
 %
 
$
737,867

 
$
283,935

 
$
453,932

 
159.9
 %
____________________
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
* Not meaningful.
Research and development.
Research and development expenses increased $22.9 million, or 28.2%, and $43.6 million, or 26.8%, for the three and six months ended June 30, 2018, respectively, compared to the same periods in 2017. The increases in the three and six months ended June 30, 2018 included a $12.7 million and a $23.7 million increase in personnel costs, including stock-based compensation and corporate bonuses, driven primary by headcount growth, and a $3.9 million and a $14.5 million increase in third-party engineering costs, driven by additional development projects. In addition, research and development related facilities and IT costs increased $2.7 million and $4.6 million in each period 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 $7.6 million, or 19.6%, and $12.7 million, or 16.7%, for the three and six months ended June 30, 2018, respectively, compared to the same periods in 2017. The increase in each period was driven by personnel costs which increased by $5.4 million and $10.1 million due to growth in headcount. In addition, sales support related costs increased by $1.6 million and $1.8 million in each period, reflecting our increased investment in supporting our sales infrastructure and expanding our customer base.
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 $4.9 million, or 21.0%, and $7.4 million, or 16.2%, for the three and six months ended June 30, 2018, respectively, compared to the same periods in 2017. The decrease in each period was primarily related to litigation related expenses associated with our ongoing Cisco legal matters, including a $6.2 million decrease in bond costs associated with the importation and sale of affected products and components during the presidential review period of the 945 investigation, which expired in July 2017, and a $2.2 million and a $6.6 million decrease in each period in litigation fees due to a reduced level of litigation activities. These decreases were partially offset by a $2.1 million and a $2.2 million increase in each period in other legal and professional fees, and a $0.5 million and a $1.5 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 the binding term sheet that was entered into on August 6, 2018 between the Company and Cisco. See Note 10 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 June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Other income (expense), net:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense
 
$
(680
)
 
$
(623
)
 
$
(57
)
 
9.1
 %
 
$
(1,367
)
 
$
(1,338
)
 
$
(29
)
 
2.2
%
Other income (expense), net
 
(1,489
)
 
1,119

 
(2,608
)
 
(233.1
)
 
3,354

 
2,144

 
1,210

 
56.4

Total other income (expense), net
 
$
(2,169
)
 
$
496

 
$
(2,665
)
 
(537.3
)%
 
$
1,987

 
$
806

 
$
1,181

 
146.5
%
During the three and six months ended June 30, 2018, interest income increased by $6.5 million and $10.8 million, respectively, compared to the same periods of 2017, as we continued to generate cash and expand our marketable securities portfolios. In addition, during the three months ended June 2018, we recorded a $9.1 million net unrealized loss on our investments in privately-held companies. See Note 4 of Notes to Condensed Consolidated Financial Statements for further discussion.
We expect our interest income 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, 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 June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
Change in
 
2018
 
2017
 
Change in
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Income (loss) before income taxes
 
$
(241,972
)
 
$
117,130

 
$
(359,102
)
 
(306.6
)%
 
$
(99,078
)
 
$
190,858

 
$
(289,936
)
 
(151.9
)%
Provision for (benefit from) income taxes
 
$
(86,703
)
 
$
14,445

 
$
(101,148
)
 
(700.2
)%
 
$
(88,347
)
 
$
5,212

 
$
(93,559
)
 
(1,795.1
)%
Effective tax rate
 
35.8
%
 
12.3
%
 


 


 
89.2
%
 
2.7
%
 
 
 
 
The effective tax rates above reflect tax benefits recorded on pre-tax losses in the three and six months ended June 30, 2018, compared to tax expense recorded on pre-tax income in the comparable periods in 2017 and are reflective of a federal and state tax benefit on the $405.0 million charge related to the legal settlement recorded in the three and six months ended June 30, 2018 as well as a lower U.S. corporate tax rate beginning fiscal 2018 under the Tax Act passed in December 2017.  In all periods, excess tax benefits attributable to equity compensation also significantly benefit the effective tax rate. During periods where we experience pre-tax losses, excess tax benefits will generally increase the effective income tax rate above the statutory rate, whereas during periods where we experience pre-tax profits, they will reduce the effective income tax rate below the statutory rate.
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 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

29

Table of Contents

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 June 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 six months ended June 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 the 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 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 June 30, 2018, our total balance of cash, cash equivalents and marketable securities was $1.9 billion, of which approximately $206.0 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.
Cash Flows
 
 
Six Months Ended June 30,
 
 
2018

 
2017
  As Adjusted (1)
 
 
 
 
 
 
 
(in thousands)
Cash provided by operating activities
 
$
326,125

 
$
242,095

Cash used in investing activities (1)
 
(496,972
)
 
(11,676
)
Cash provided by financing activities
 
23,426

 
25,976

Effect of exchange rate changes
 
(607
)
 
411

Net increase/(decrease) in cash, cash equivalents and restricted cash
 
$
(148,028
)
 
$
256,806

___________________________
 
 
 
 
(1) Cash used in investing activities for the six months ended June 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.

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Cash Flows from Operating Activities
During the six months ended June 30, 2018, cash provided by operating activities was $326.1 million, primarily from net loss of $10.7 million with non-cash adjustments to net income of $44.7 million, and a net increase of $292.2 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 a $405.0 million legal settlement liability accrued in the second quarter of 2018 in connection with the legal settlement with Cisco under the binding term sheet entered into on August 6, 2018, a $60.8 million decrease in inventories driven by improved inventory management and timing of receipts, and a $6.7 million increase in income taxes payable. These cash inflows were partially offset by cash outflows of $72.4 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 legal settlement charges referenced above, offset partially by lower deferred costs of inventory associated with the lower product revenue deferrals referenced below, $50.1 million from a decline in deferred revenue primarily related to customer acceptance of our 945 investigation-related product redesigns, $47.2 million from a decline in accrued liabilities due to corporate bonus payments and the timing of vendor payments, and $13.6 million from an increase in accounts receivable due to timing of billing and cash collections.
During the six months ended June 30, 2017, cash provided by operating activities was $242.1 million, resulting from net income of $185.6 million non-cash adjustments to net income of $37.1 million, and a net increase in cash from changes in our operating assets and liabilities of $19.3 million. Our operating cash benefited from increased deferred revenue of $181.6 million resulting from growth in product deferred revenue related to contract acceptance terms and ongoing growth in PCS contracts. These increases were partially offset by growth in inventory of $127.3 million, supporting overall growth in the business and the expansion of our manufacturing and supply chain activities. In addition, accounts receivable increased by $16.5 million related to timing of billing and cash collections, and prepaid expenses and current assets increased by $22.2 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 six months ended June 30, 2018, cash used in investing activities was $497.0 million, consisting of purchases of available-for-sale securities of $696.7 million, offset by proceeds of $222.8 million from maturities of marketable securities, and purchases of property and equipment of $13.1 million.
During the six months ended June 30, 2017, cash used in investing activities was $11.7 million, consisting of purchases of available-for-sale securities of $114.2 million, offset by proceeds of $112.1 million and purchases of property, equipment and other assets of $9.5 million.
Cash Flows from Financing Activities
During the six months ended June 30, 2018, cash provided by financing activities was $23.4 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $28.8 million, offset by minimum tax withheld for employees of $4.5 million.
During the six months ended June 30, 2017, cash provided by financing activities was $26.0 million, consisting primarily of proceeds from the issuance of common stock under employee equity incentive plans of $28.1 million.
Off-Balance Sheet Arrangements
As of June 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 June 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 six months ended June 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 5 of Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q.

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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.
During the three months ended March 31, 2018, we adopted the new revenue recognition guidance under ASC 606 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. 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
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.

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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 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 six months ended June 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 $2.0 million and $4.0 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 June 30, 2018 and December 31, 2017, we had cash, cash equivalents and available-for-sale marketable securities totaling $1.9 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 six months ended June 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. 

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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 June 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 4 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 June 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 June 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 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 5 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1, of this Quarterly Report on Form 10-Q incorporated herein by reference.


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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 December 31, 2017, our headcount grew from approximately 250 employees to approximately 1,800 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 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.
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.

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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;
the cost and potential outcomes of existing and future litigation, including Cisco and OptumSoft litigation matters;
our ability to develop, market and sell new products and services that are acceptable to our customers including redesigned products that comply with any USITC remedial orders issued in connection with the Cisco litigation;
changes in the sales and implementation cycles for our products including the qualification and testing of our redesigned 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;
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;
changes in the growth rate of the networking market;
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 cloud 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;
stock-based compensation expense;
our overall effective tax rate, including impacts caused by any reorganization in our corporate structure, any changes in our valuation allowance for domestic deferred tax assets and any new legislation or regulatory developments, including the Tax Act;
increases or decreases in our expenses caused by fluctuations in foreign currency exchange rates, as an increasing portion of our expenses are incurred and paid in currencies other than the U.S. dollar;
general economic conditions, both domestically and in foreign markets; and
other risk factors described in this Quarterly Report on Form 10-Q.

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Any one of the factors above or the cumulative effect of several of the factors described above may result in significant fluctuations in our financial and other results of operations. This variability and unpredictability could result in our failure to meet our revenue, gross margins, results of operations or other expectations contained in any forward looking financial guidance we have issued or the expectations of securities analysts or investors for a particular period. If we fail to meet or exceed such guidance or expectations for these or any other reasons, the market price of our common stock could decline substantially, and we could face costly lawsuits, including securities class action suits.
The cloud networking market is rapidly evolving. If this market does not evolve as we anticipate or our target end customers do not adopt our cloud networking solutions, we may not be able to compete effectively, and our ability to generate revenue will suffer.
A substantial portion of our business and revenue depends on the growth and evolution of the cloud networking market. The market demand for cloud networking solutions has increased in recent years as end customers have deployed larger, more sophisticated networks and have increased the use of virtualization and cloud computing. The continued growth of this market will be dependent upon many factors including but not limited to the adoption of our end customers’ products and services, the expansion, evolution and build out of our end customers’ networks, the overcapacity of existing network infrastructures, changes in the technological requirements for the products and services to be deployed in these networks, the amount and mix of capital spending by our end customers, the development of network switches and cloud service solutions by our large end customers for internal use, the financial performance and prospects of our end customers, the availability of capital resources to our end customers, changes in government regulation that could impact cloud networking business models including those regulations related to cyber security, privacy, data protection and net neutrality, our ability to provide cloud networking solutions that address the needs of end customers more effectively and economically than those of other competitors or existing technologies and general economic conditions.
If the cloud networking solutions market does not develop in the way we anticipate, if our solutions do not offer benefits compared to competing networking products or if end customers do not recognize the benefits that our solutions provide, then our business, financial condition, results of operations and prospects could be materially adversely affected.
If we are unable to attract new large end customers or to sell additional products to our existing end customers, our revenue growth will be adversely affected and our revenue could decrease.
To increase our revenue, we must add new end customers and large end customers and sell additional products to existing end customers. For example, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing infrastructure and expected future spend. Another one of our sales strategies is focused on increasing penetration in the enterprise market. Enterprise end customers typically start with small purchases, and there is often a long testing period. If we fail to attract new large end customers, including enterprise end customers, or fail to reduce the sales cycle and sell additional products to our existing end customers, our business, financial condition, results of operations and prospects will be harmed.
We expect large purchases by a limited number of end customers to continue to represent a substantial portion of our revenue, and any loss or delay of expected purchases could result in material quarter-to-quarter fluctuations of our revenue or otherwise adversely affect our results of operations.
Historically, large purchases by a relatively limited number of end customers have accounted for a significant portion of our revenue, particularly in the cloud networking market. Many of these end customers make large purchases to complete or upgrade specific data center installations and are typically made on a purchase-order basis rather than pursuant to long-term contracts. Revenue from sales to Microsoft, through our channel partner, World Wide Technology, Inc., accounted for 16%, 16% and 12% of our revenue for the years ended December 31, 2017, 2016 and 2015, respectively.
As a consequence of the concentrated nature of our customer base and their purchasing behavior, our quarterly revenue and results of operations may fluctuate from quarter to quarter and are difficult to estimate. Changes in the business requirements or focus, vendor selection, project prioritization, financial prospects, capital resources and expenditures or purchasing behavior of our key end customers could significantly decrease our sales to such end customers or could lead to delays or cancellations of planned purchases of our products or services. For example, some of our end customers continue to qualify and test our redesigned products to ensure that they meet network requirements, and failure to obtain such qualification or customer acceptance, any cancellation of orders or any acceleration or delay in anticipated product purchases or the acceptance of shipped products by these customers could make it more difficult to predict our end customers’ product needs and materially affect our revenue and results of operations in any quarterly period. Moreover, because our sales will be based primarily on purchase orders, our customers may cancel, delay or otherwise modify their purchase commitments with little or no notice to us. This limited visibility regarding our end customers’ product needs, the timing and quantity of which could vary significantly, requires us to rely on estimated demand forecasts to determine how much material to purchase and product to manufacture.  Our failure to accurately forecast demand can

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lead to product shortages that can impede production by our customers and harm our customer relationships. And, in the event of a cancellation or reduction of an order, we may not have enough time to reduce operating expenses to mitigate the effect of the lost revenue on our business, which could materially affect our operating results.
We may be unable to sustain or increase our revenue from our large end customers, grow revenues with new or other existing end customers at the rate we anticipate or at all, or offset the discontinuation of concentrated purchases by our larger end customers with purchases by new or existing end customers. These customers can drive the growth in revenue for particular products and services based on factors such as: trends in the cloud networking market, business mergers and acquisitions and the overall fast growth of a customer's underlying business. These customers could choose to divert all or a portion of their business with us to one of our competitors, demand pricing concessions for our services, or require us to provide enhanced services that increase our costs. If these factors drove some of our large customers to cancel all or a portion of their business relationships with us, it could materially impact the growth in our business and the ability to meet our current and long-term financial forecasts. We expect that such concentrated purchases will continue to contribute materially to our revenue for the foreseeable future and that our results of operations may fluctuate materially as a result of such larger end customers’ buying patterns. In addition, we may see consolidation of our customer base, such as among Internet companies and cloud service providers, which could result in loss of end customers. The loss of such end customers, or a significant delay or reduction in their purchases, including reductions or delays due to customer departures from recent buying patterns, or an unfavorable change in competitive conditions could materially harm our business, financial condition, results of operations and prospects.
Some of our large end customers require more favorable terms and conditions from their vendors and may request price concessions. As we seek to sell more products to these end customers, we may be required to agree to terms and conditions that may have an adverse effect on our business or ability to recognize revenue.
Our large end customers have significant purchasing power and, as a result, may receive more favorable terms and conditions than we typically provide to other end customers, including lower prices, bundled upgrades, extended warranties, acceptance terms, indemnification terms and extended return policies and other contractual rights. As we seek to sell more products to these large end customers, an increased mix of our shipments may be subject to such terms and conditions, which may reduce our margins or affect the timing of our revenue recognition and thus may have an adverse effect on our business, financial condition, results of operations and prospects.
If we do not successfully anticipate technological shifts, market needs and opportunities, and develop products and product enhancements that meet those technological shifts, needs and opportunities, or if those products are not made available in a timely manner or do not gain market acceptance, we may not be able to compete effectively, and our ability to generate revenue will suffer.
We must continue to enhance our existing products and develop new technologies and products that address emerging technological trends, evolving industry standards and changing end-customer needs. The process of enhancing our existing products and developing new technology is complex and uncertain, and new offerings requires significant upfront investment that may not result in material design improvements to existing products or result in marketable new products or costs savings or revenue for an extended period of time, if at all. The success of new products depends on several factors, including appropriate new product definition, component costs, timely completion and introduction of these products, differentiation of new products from those of our competitors and market acceptance of these products.
In addition, new technologies could render our existing products obsolete or less attractive to end customers, and our business, financial condition, results of operations and prospects could be materially adversely affected if such technologies are widely adopted. For example, end customers may prefer to address their network switch requirements by licensing software operating systems separately and placing them on industry-standard servers or develop their own networking products rather than purchasing integrated hardware products as has occurred in the server industry.
In the past several years, we have announced a number of new products and enhancements to our products and services. The success of our new products depends on several factors including, but not limited to, component costs, timely completion and introduction of these products, prompt solution of any defects