Q3 2022 Arista Networks Inc Earnings Call

Welcome to the third quarter 2022 Arista networks financial results earnings Conference call.

During the call all participants will be in a listen only mode. After the presentation, we will conduct a question and answer session.

Instructions will be provided at that time.

At any time during the conference you need to reach an operator. Please press the star followed by zero as a reminder, this conference is being recorded and will be available for replay from the Investor Relations section at the Arista website. Following this call.

MS Philistine Arista as director of Investor Relations you may begin.

Thank you operator, good afternoon, everyone and thank you for joining us.

With me on todays call are Jay for you all Arista Networks', President and Chief Executive Officer, and either Brennan <unk> Chief Financial Officer.

This afternoon Arista networks issued a press release announcing the results for its fiscal third quarter ending September 30th 'twenty 'twenty. Two if you would like a copy of the release you can access it online at our website.

During the course of this conference call Arista networks management will make forward looking statements, including those relating to our financial outlook for the fourth quarter of the 2022 fiscal year.

Longer term financial outlooks for 2022, and beyond our total addressable market and strategy for addressing these market opportunities.

Why chain constraints component cost manufacturing capacity inventory purchases and inflationary pressures on our business the potential impact of COVID-19 extended lead times product innovation and the benefit of acquisitions, which are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC.

D C. Specifically in our most recent Form 10-Q, and Form 10-K, and which could cause actual results to differ materially from those anticipated by these statements.

These forward looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements. After this call.

Also please note that certain financial measures. We use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges.

We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings press release with that I will turn the call over to Jay Shri.

Thank you Liz and thank.

Thank you everyone for joining us this afternoon for our third quarter 2022 earnings call.

We delivered record revenues of 1.1 dollars 7 billion for the quarter with a non-GAAP earnings per share of $1 25.

Services and software support renewals contributed approximately 16, 3% of the revenue.

Our non-GAAP gross margins of 61, 2% was pressured by escalated costs due to supply chain as well as a substantially higher cloud Titan mix we.

We expect some of these trends to continue into 2023.

Cloud Titans was our largest vertical followed by enterprise and then cloud specialty provider financial and finally service providers.

International contribution was at 17% with the Americas at 83% once again, reflecting stronger cloud customer influence.

Our Q3 2022 results reinforced arista customer relevance in both cloud Titan and specialty cloud providers.

I would like to invite onshore so Donna our chief operating officer and clubs are to shed some light on this.

Thank you Jesse.

Our partnership with the cloud Titans and space.

Specialty providers keeps getting stronger.

While supply chain got most of the attention for the last two years.

We have achieved several technical milestones with our customers during this period.

Taking our products from labs to pilot to high volume deployment.

We have successfully deployed and more use cases done before <unk>.

Including the leaf spine cluster design.

Data center wide spine.

Data center interconnect backbone Lan and edge.

Our customers have a deep appreciation of our expertise and execution.

The Titans, starting with Microsoft and met up.

Continuing with their 400 gig journey.

They're using our latest fixed and the buffer modular 400 gig switches in these new deployments.

We are continuing to expand our use cases with the other tightens too.

While they are relatively smaller these partners and continuing to grow as well.

The specialty cloud providers are continuing to grow too.

They have very similar leaf spine designs, but with smaller clusters.

And they too have the same Dci and regional designs just pure pork.

We are in a competitive industry and our customers like some diversity.

However, we are very well positioned to maintain and grow our share given our quality execution and strong partnerships back.

Back to you Joseph.

Thanks, Joe.

We are experiencing one of our best ever cloud pricing growth in revenue this year since IPO.

Before we expect north of 45% contribution in 2022 from this category with a diversified product portfolio and use cases as you heard from onshore.

Speaking of new products Arista introduced the next phase of routing this quarter in Q3.

Or is this cloud grade routing platform powered by extensible operating system and our network data Lake net deal is built on a consistent architectural foundation for multiple routing use cases, such as steering content delivery networks cloud connect enterprise edge.

Mobile and metro edge as well as carrier Corp.

We have successfully transformed legacy routers to modern routing.

For our customer securing data in transit Arista is innovative tunnel SEC technology provides inline encryption at wire speed from 10 gig all the way up to 400 gig eliminating the performance bottleneck of traditional encryption.

Arista is latest our three series routing portfolio continues to deliver for our adjacent market sector that'd be began six years ago.

As I mentioned previously our customer momentum continues.

A million dollar logos have doubled in the last few years and Arista is market share and 100 204 hundred gig ports clients, placing us at a number one market leader position. According to many industry analysts let.

Let me illustrate with a few customer wins this year.

The recurring theme to remember is that risked is diversifying its business with many use cases, such as data center campus routing cloud and edge based all on cloud principles.

Our first enterprise win highlights the ever growing strength of a single solution for diverse use cases.

In the data center in the campus and in data Center interconnect routing.

Based on industry standards, and monitoring capabilities with a risk of DANZ monitoring fabric our DMF.

If that was uniquely positioned to provide a single Eos binary code version using cloud vision and our net Dl stack.

The next is an international America's win in the financial sector, providing secure data center solutions.

Arista is competitive advantage was twofold first a single U S Tech provided reassurance that they could handle security patches bug patches, new software code upgrades with zero down time, much better than our peers in the industry.

So we can do much better automation.

Traditionally it used to take customers several months if not years to go live with a single data center with their incumbent vendor.

Chris does programmatic API continue.

Continuous integration validation with Dev ops integration was deployed across multiple data centers within just a few days with no human intervention or errors offering the lowest total cost of ownership.

Our third customer win demonstrates our strength in campus in the health care sector.

This customer was looking to upgrade its legacy infrastructure in multiple hospital locations and moving more to a cloud operated model.

Arista provided that cloud managed network offering across the data center campus and called the Wi Fi and also Wan edge and Internet edge.

The single pane of glass offers real time network as a service with visibility health checks troubleshooting and provisioning to the client all the way to campus and to the cloud infrastructure.

The next international win chose our continuing presence in the public sector discussed.

This customer wanted to move to a 100 gigabit Ethernet using arista spine and client platforms to connect into incumbent TWD him edge and load balances for massive routes scale.

Our risk has advantage was the lowest software security vulnerabilities over a nine year period compared to alternatives that were significantly higher.

This is by the way also apply to Arista as cognitive Wi Fi with zero vulnerabilities.

Our final win emphasizes a risked his ability to provide encryption as a part of a secure routing solution.

This was an international tier two service provider, where whereby Arista delivered full line rate data in transit for the customers remote sites.

This bespoke design encompasses layer three virtual private network VPN over VX Lan routing solutions with macro segmentation based on access lists and direct slow rose all managed by cloud vision.

Overall, you can see that Arista continues to gain customer relevance in market share and building our vision for a client to cloud network.

The promise of not only delivering on superior technology, but the ability to help our customers realize the operational benefits via a world class quality support services is a real compelling advantage.

We look forward to sharing more of our vision and strategy at our analyst day. This Thursday November three 2022.

Now I will turn it over to EDA for all financial specifics.

Thanks, Tricia and good afternoon. This analysis of our Q3 results and our guidance for Q4 2022 is based on non-GAAP and excludes all noncash stock based compensation impacts certain acquisition related charges and other nonrecurring items a.

A full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release.

Total revenues in Q3 were $1 177 billion up 57, 2% year over year and well above the upper end of our guidance range of one point there are two five to 1.075 billion.

Overall demand for our products remains healthy across all areas of the business.

Supply challenges continued throughout the quarter with ongoing supplier decommit constraining shipments and requiring higher cost broker purchases and expedite fees.

Services and subscription software contributed approximately 16, 3% of revenue in the third quarter down from 17, 6% in Q2.

This largely reflected accelerated growth in product revenues, while services and software continue to grow on a more consistent basis.

International revenues for the quarter came in at $199 1 million or 17% of total revenue.

<unk> from 20% in the second quarter. This reflected strength in U S revenues in the period, and particularly with our larger cloud customers.

Overall gross margin in Q3 was 61, 2% just above the midpoint of our guidance range of 60% to 62%.

As previously discussed our current lower gross margin ranges reflect a healthy cloud mix and higher levels of broker component sourcing and expedite fees.

Operating expenses for the period were mostly flat to last quarter at $227 7 million or.

<unk> 19, 3% of revenue.

R&D spending came in at $150 1 million or 12, 8% of revenue.

From last quarter at $148 million.

This primarily reflected increased head count costs in the period, but slightly lower new product introduction costs.

Sales and marketing expense was $62 8 million or five 3% of revenue and G&A costs were $14 7 million or one 3% of revenue both mostly consistent with last quarter.

Our operating income for the quarter was 490 to $2 1 million or 41, 8% of revenue.

Other income and expense for the quarter was a favorable $6 1 million.

Our effective tax rate was approximately 21, 3%.

This resulted in net income for the quarter of $391 9 million or 33, 3% of revenue.

Our diluted share number was $314 4 million shares resulting in a diluted earnings per share number for the quarter of $1 25 up approximately 69% from the prior year.

Now turning to the balance sheet cash cash equivalents and investments ended the quarter at approximately $2 nine 8 billion.

We repurchased $47 $6 million of our common stock during the third quarter at an average price of approximately $99 per share.

As a reminder, we've now repurchased approximately $740 million or 7 million shares against our October 2000, $21 billion Board authorization.

The actual timing and amount of future repurchases will be dependent on market and business conditions business requirements stock priced acquisition opportunities and other factors.

Now turning to our operating cash performance for the third quarter with.

We generated $134 1 million of cash from operations in the quarter.

<unk> strong earnings performance somewhat offset by increased working capital investments.

Increases in inventory and other assets are mainly driven by receipt of components for future shipments, including shipments delayed due to supplier decommit.

This trend should reverse once overall supply conditions for these decommit of components improve.

Dsos came in at 51 days flat to last quarter.

Inventory turns were one seven times down from one nine times in the prior quarter.

Inventory increased to $1 1 billion in the quarter up from $852 8 million in the prior period.

Selecting higher component and peripherals inventory and an increase in switch related finished goods in transition.

Our purchase commitment number for the quarter was $4 3 billion down from $4 5 billion in Q2.

These multi year purchase commitments reflect overall strengthened demand and the current long lead times supply environment.

A reminder, we continue to prioritize newer early lifecycle products for inclusion in these strategies in order to help mitigate the risk of excess or obsolescence.

Our total deferred revenue balance was $941 million down from 1 billion in Q2 the.

The majority of the deferred revenue balance is services related and directly linked to the timing in term of service contracts, which can vary on a quarter by quarter basis.

Approximately $165 million of balance down from $228 million last quarter represents product deferred revenue largely related to customer specific acceptance clauses for new products with our larger customers.

Accounts payable days were 56 days down from 63 days in Q2, reflecting the timing of inventory receipts and payments.

Capital expenditures for the quarter were $10 4 million.

Now turning to our outlook for the fourth quarter.

We came into the year, calling for 30% year over year revenue growth.

Balanced across our market sectors and heavily constrained by supply.

We now expect revenue growth for the year of approximately 45% at the midpoint of our Q4 guidance with a healthy contribution coming from our cloud Titan customers.

In what has remained stubbornly constrained supply environment.

Our cloud Titan customers are now expected to account for approximately 45% of our revenue for the year with major contributions from meta and Microsoft.

Demand from our enterprise our provider businesses has also been strong exceeding our original expectations from a demand perspective with revenue somewhat constrained by supply.

We expect gross margin pressure to continue in the quarter with some continued need for broker purchases and expedite fees in response to AD hoc supplier decommit combined with a healthy cloud mix.

Even allowing for the lower gross margins, we expect healthy operating margins for the quarter again, demonstrating the resiliency of the business model with significant bottom line flow through from increased revenue scale.

With all of this as a backdrop our guidance for the fourth quarter, which is based on non-GAAP results and excludes any noncash stock based compensation impacts and other nonrecurring items is as follows revenues of approximately 1.1 dollars 75 to $1 2 billion gross margin of approximately 60% to 62% operating <unk>.

Of approximately 40%.

Our effective tax rate is expected to be 21, 5%.

But diluted shares on a post split basis of approximately 316 million shares.

I will now turn the call back to list less thank.

Thank you Peter we will now move to the Q&A portion of the Arista earnings call to allow for greater participation I'd like to request that everyone. Please limit themselves to a single question. Thank you for your understanding operator take it away.

Yes.

We will now begin the Q&A portion of the Arista earnings call in order to ask a question. During this time simply press Star then the number one on your telephone keypad. If you would like to withdraw your question again press the star one.

We ask that you pick up your handset before asking a question to ensure in order to ensure optimal sound quality.

Your first question today comes from the line of Tim Long with Barclays. Your line is now open.

Okay.

Thank you.

Yeah, I was hoping you could just talk a little bit about kind of the enterprise and campus strategy.

Obviously, you guys have been growing pretty well there if you could kind of update.

Now the $400 million bogie for the year.

And you've mentioned.

Oh, we lost him Jim are you there.

Okay.

Yeah.

Your audio.

Yeah.

Well Phil.

Good morning.

Right.

Why don't I think I'll interpret your question, Tim even though it only had half of it which is what is your status on campus and enterprise strategy and how are you doing the 400 million target.

We'll get back to you when we are competing.

But at this point, we would say that the strength of our campus business from an orders and protective.

And we fully expect.

$400 million.

We are very supply constrained so we're not yet sure. If we will hit the 400 from a revenue and shipment perspective.

And I'm sorry, if you could just touch on the wireless Lan contribution it sounds like that's doing a little bit better now sorry about that I was muffled a little yeah no.

We are very pleased with our wireless Lan card contribution you. If you think back we acquired Mojo networks. In 2000 1918 late 2018, and early 2019 and it was a very small single digit business and we expect the wireless Lan contribution to become a triple digit business next year.

Thank you Tim Thank you.

Thanks, Tim.

Your next question comes from the line of Alex Henderson with Needham. Your line is now open.

Great. Thank you very much.

Spectacular results.

For the quarter for the year.

Exactly the results last year.

And I guess the question really boils down to.

Are we going to see a reversion to more normalized growth.

If that happens does that bring the margins back in to the.

The 37% range.

Set ourselves up.

Against a extremely difficult comps as we go into 2023, how do we.

Think about the mechanics of where we are.

Alternatively, clearly supply constraints persists yourself.

Screen, then you had earlier and that would imply to me that at least for the first half of next year or even longer you might still be in the strong growth.

Trajectory can you address how we should be thinking about the environment as we move forward.

Alex Thank you for the kind words.

Ill tee it up and secondly that speak to some of the details you are asking about.

First of all I, just want to say I'm very proud of the team for executing as you know we came into the air expecting 30% growth and here. We are telling you it's going to be 45. So.

A huge contribution from onshore and the team not only on the cloud Titans, but also on the enterprise and rest of the card business as we call. It led by Chris Schmidt and Ashwin, a lot to be proud of especially as the numbers get larger so I just think about the numbers getting larger it's going to be difficult to sustain 45% growth every year I'd love to have it but.

As you know Arista is a volatile business and you have to think of us across a three to five year CAGR not just on an annual basis. So I still think we have a large town, we're going to do very well.

But you know.

With a with a looming uncertainty of recession, and capex spend et cetera, it's definitely difficult to predict beyond a year.

Having said that I think are as I said before we're having one of our best every years in 2022, and even though the comps will be difficult.

We feel confident that as supply chain gives us some relief, we can do well in 2023 as well.

Would you like to add.

Yes.

Yeah, I think Alex if you go back to the business model.

Obviously, the gross margin kind of variability that we see that's kind of inherent to the business model has to do with the mix of the business right and that kind of works works very nicely. When you see accelerated cloud you'll see that flow through to the operating margin line, even though it might be impacting the gross margin.

In that time period right.

As we talk next Thursday, we'll talk some more about kind of what the growth rates look like for next year and kind of how that flows through the model, but theres no doubt that when we accelerate growth like this it's hard for us to accelerate spending in the same rate and you've never really kind of catch up for that Brian .

I just want to be proud effort.

Okay.

Thanks, so much.

Thanks, Alex.

Your next question comes from the line of Paul Silverstein with Cowen. Your line is now open.

So I guess I should ask you what everybody wants to know which is what is your outlook for next year.

You made a couple of more days, Paul just a couple of more days.

I'd ask that everybody else is asking.

So it's sort of looking at selling from the numbers that macro had much.

Impact.

Five last week did identified macro as a meaningful driver of a very disappointing outlook any thoughts you can share in terms of what youre seeing is it.

Affecting one iota customer decisions as to your products and solutions.

Any thoughts would be appreciated.

Look I'd say, you know I don't think of Arista as a bellwether for macro so we let the pundits on economists speak about that but I think it's fair to say that data center spend has been very strong.

And we're confident of our near term strength, both in cloud Titans enterprise and campus.

If there's a place that we see some softening at all geographically I would point to Europe , they've had the effect of the pandemic the energy crisis. The war. The Brexit is just a whole lot of things going on there, but our numbers are small and even there I would say, it's more enough to execute better. So overall macro is not yet in.

Issue for US, we will keep a vigilant eye on it but so far so good.

Sure just to be clear youre, not seeing elongated sales cycles, you're not see cutbacks deferrals or cancellations to any appreciable extent in orders, especially from enterprise I. Appreciate your small with your enterprise not nothing it's a growing business and correct me, if I'm wrong, but historically in times of economic.

Dress most organizations have declined to change vendors or put off.

Changes in their infrastructure that would result in bringing in new vendors like yourself.

Right I don't think I missed is anymore, new vendor I think we are the best of breed vendor and what we see especially networking unlike on Colombia.

Yes, not quite we're not done yet.

Yes.

I would say if anything Paul just to answer your question more directly. Unlike server storage networking is a very very strategic spend theres, a long qualification cycle that goes and as proof of concept lags as intense testing for scale and we're all struggling with lead times. So switching vendors doesn't give you any particular advantage and if.

We're looking for best of breed and best operational advantages.

Our customers would prefer to wait for us. So of course, we don't want to test their patients who are going to do everything we can to execute you're seeing that in our purchase commitment.

But we got to execute even better.

Alright I appreciate the response. Thank you. Thank you Paul.

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

Thanks for taking the question.

Wanted to get a little bit of help.

Understanding how to think about the purchase order commitments just looking at the prior.

10-Q filing you had a 12 month commitment by $2 9 billion in Europe , you mentioned today that the overall commitment came down a little bit to $4 3 billion.

What I'm struggling with is if we just sort of tried it back into implied revenue, it's well above what most of the street is modeling for the next year.

And there are a number of ways. We can think about it you could either write off the inventory you could hold higher inventory levels were certainly you could have much higher revenue than we expect.

I'm wondering if you could give us.

Some advice on how to interpret these purchase orders for network. Thank you.

Yes, Simon I think the obviously the goal is to.

Make the purchase commitments that we need to support the business, but it is multi year right and we are thinking about those kind of longer term than just the.

The year that's ahead right so.

That's why you're seeing the numbers kind of not match perfectly to whatever your revenue assumption is for.

Just for 2023, alright, so well again, well talk about 2023 and the growth rates when we get gets the analyst day.

And then maybe you can ask this question again, and we'll try to provide some more guidance, but it really is about being multi year in some of these products are early stage products, where we believe we can you know we can put it.

So that there is a limited risk in terms of <unk> reserves and.

Really you're tying up cash, but that's kind of the that's worth it in terms of being able to have the products and have the components in place when we need them.

Thank you.

Thanks Simon.

Your next.

Question comes from the line of meta Marshall with Morgan Stanley . Your line is now open.

Great. Thanks.

Sure you know.

Maybe if you could just comment on whether some of the upside that you're seeing from the cloud Titans are share is due to kind of greater ability to serve them and get them more product than they wanted or if you're actually getting kind of stronger orders than I expected and just kind of on the deferred revenue being recognized.

If there are projects that are kind of changing that and timing that led to kind of the stronger than expected results. Thanks.

Thanks meta.

So I think it's fair to say as the actual is often said that our relationship and partnership with the cloud Titans continues to be strong and couldnt be better, especially with Microsoft in meta we fully expect to be greater than 10% concentration I wish we could ship them more and I think if they were hearing this call they would be saying I.

Wish you could ship us more too so I don't think it is a case of shipping them more I think it's a case of demand from them in a very strategic partnership at the engineering level at the network design level at the operational level at the procurement level and actually I actually I'd like you to since Youre dealing with this daily say some more hot metal demand from these coastal.

Russell just strong yes, there is some timing of revenue and deferred and so on but that's not what's leading into this trend. The raw demand from these customers continues to be strong they wanted to model it out.

You look at how many data centers and regions do you want to build out its very strong if you look at their Dci.

For 400 gig and 100 kilometer type distances breathing big regions, that's very very strong.

They love our execution, just you might shift if we could get them more product they would have to be to take it as well so.

All in all our phenomenal outcome competitive over two years ago, but we're in a very healthy cycles with our cloud customers.

And Matt on the deferred I mean, it's it's nothing for the year now stage right. If you look at it year to date is really the deferred is not a contributor at all at this point.

Okay.

Alright. Thanks.

Thanks.

Your next question comes from the line of Ben Bolan with Cleveland Research. Your line is now open.

Okay.

Good afternoon, everyone. Thanks for taking the question.

I was hoping we could talk a little bit about.

Just the broader supply and demand balance.

Sure.

You included would love to know when this and but I'm curious, how you're thinking about it evolving.

From a supply perspective.

When you think it maybe get Directionally better when it's really better and then.

Also curious how it's influencing.

The duration of visibility you're seeing from customers that has gotten longer.

Is it still getting longer is that starting to shrink what are you seeing there that's it for me. Thanks.

Okay, Hey, Ben.

Australia two questions, what's the direction of our visibility is getting longer generally right now because of our lead times. Our visibility is approximately six months to a year and we've never had that kind of visibility, particularly from our cloud providers. So directionally, it's not getting longer but staying about the same is is what I would tell you.

And then what are we seeing on supply chain and when is it going to get better gosh.

One of the reasons that are either onshore and myself made such a concerted effort. We got board approval for very large purchase commitments multiyear. Despite a smaller revenue is exactly not to be in the spot. We are which is we wanted to get all our components, but sadly.

We have almost all of the components, except a handful you can build a system without the last few components.

We do have still subsidies shortages as I've said before we expect this to go into 2023, and I think our long lead times will persist in the industry for networking, especially.

For the next several months and for 2023, so we don't see a lot of relief in sight until we can get all the components.

Being short of a few components still means we can build a system. So expect us, it's improving but expect us to really only see improvement a year from now.

Thanks, Jason.

And our next.

Your next question comes from the line of Matt <unk> with Deutsche Bank. Your line is now open.

Hey, Thank you so much for taking the question.

On the guide for the non-GAAP Op income margin. So I think you did 42 ish percent. This quarter I know the guide talks about a nearly 200 basis point step down despite stable gross margin. So I'm just wondering if you can talk about.

Where you see opportunity for incremental investment and then if I could just sneak in one follow up on the deferred revenue question. So it looks like deferred has dipped about deferred revenue dipped to about $92 million sequentially I'm, just wondering what's baked into the revenue outlook for <unk> from a deferred perspective. Thanks.

Yeah. So on the deferred the product deferred decline in Q3 was about $60 million. So there's a piece of it is just services service contract timing and stuff in there. So really the thing that is kind of directly linked to the revenue is about $60 million for Q4, and the guide we're assuming no deferred right and no deferred impact right.

So thats that question and then the other question was on the expensing Yeah. The expenses and operating margin I think look we were flat pretty much on opex in Q3.

Some of that is timing.

That wasn't the original plan, obviously, so some of that will recover in some of as we head into Q4, we'll see.

Some sales commissions and other things.

At the back end of the year tend.

<unk> tends to be a little higher as well right. So it's kind of a combination of maybe some timing and then just the normal kind of Q4 dynamics.

Thank you very much thank.

Thank you.

Thanks, Matt welcome to your first call.

Your next question comes from the line of Fahad <unk> with loop capital. Your line is now open.

Thank you for taking my question.

In January I think at a recent Investor Conference you said that you think the industry could grow double digit.

Revenue if I can.

The call you said you were connecting clouds of data.

Centers of data.

So I want to.

Whether I understand your response to a previous question that as the supply chain improve next year, you would do well.

Well versus what that double digit.

All of that you had earlier.

Is that what you were thinking just can you help us understand that.

Yes, I'll try.

I think in terms of demand, we fully expect to grow double digits.

Next year and I hope for years to come unless there's some real macro issues.

Specific to next year again, we will try it specifically at analyst day, but I think if supply chain would have be relieved we would grow double digits is supply chain continues to make a change we will still grow double digits, so either way.

And do well next year.

I have one follow up.

How well.

What's the risk of <unk>.

Our cloud customers, having some level of inventory buildup.

I understand that there is a significant constraint on that booking question, but that has been evident so.

England matches.

The server and storage space and some other cloud Titans. So once there was a.

Any mismatch.

Very little for hard I think it's important to understand that nobody has been in a position to have any kind of inventory on networking until you want to add to that further our customers will consume everything we can ship we are not worried about inventory build out anytime soon.

Sure.

I appreciate it thank you.

Thanks Pat.

Your next question comes from the line of <unk> Kidron with Oppenheimer. Your line is now open.

Thanks, ladies and great quarter.

I guess a couple of questions just for you to talk about.

Your activity with the cloud guys.

Ill.

The cloud guys do want diversity suppliers.

And of course, there's always timing and projects where you.

You kind of run ahead or below where you probably should be just given the timing of projects.

Do you get a sense right now on <unk>.

Youre punching above or below your weight.

And I'm, calling weight whatever.

Cloud guys really think you should be long term from a share standpoint.

Hey, welcome back in time, we Havent chatted in a long time, that's a really good question. You had you have to ask a tough one.

I do think we're punching at our weight.

In terms of demand even above our weight in terms of actually supplying maybe below our weight.

But by the way I'm only talk about the cloud guys knocked myself.

Yes.

I'll tell you we're not after that.

I'm not here to wrap a boxing match, but.

So in terms of supply.

And overall demand custom.

Customers like to diversify I think most customers have already set their plans.

Not expecting any big dramatic changes from here on and we've talked about for a couple of your snow that cosmos truly like our product they like our execution of the partnership is healthy <unk>.

Worried because claims from many companies on how there'll be ahead in the results and all of that and then we've done really well.

It takes a shared in one of the roles we they shed another roles too.

Does that because of the expansion in van and edge routing other use cases, we've done well and our expectation is we will actually continue to do well going forward as well.

Got it okay, and maybe as a follow up.

Just maybe just talk about the weakness in Europe , and it's obvious that there should be weakness over there, but your business over there was down on a year over year basis, I guess I'm kind of wondering.

Yeah.

The traction of the share gains that you're having a U S. One would think that even in the current environment. If you were able to get share gains in Europe , as well you'd still be able to growth out of there, maybe not 30 or 40%, but perhaps with 10 15. So help me understand what maybe you could go a layer deeper into what's going on.

You're open and do you think that the current environment, maybe going back to a previous question Paul's question.

This environment, perhaps customers are just less likely to consider a change we'll just stick with what they have gone and maybe thats a hindering element.

So no I don't I was answering the question anytime more on is there a recession.

In a broad sense if the if at all we are generally seeing very strong demand worldwide. If at all we are seeing some softness and weakness it would be in parts of Europe because of all that theyre going through specific to Arista I see no reason, we shouldnt be growing everywhere, including Europe .

Rate of growth in Europe may be slower for exactly the reasons you you mentioned that their overall economy. If you look at the GDP and if you look at the top three countries Germany.

UK and.

From France, none of them are really substantially investing.

I think because we have small numbers, we can do fine.

We should be able to still grow double digits, but that is the only sign of recession. We are so far seeing got it alright.

Good luck thanks Maggie.

<unk>, we did we are growing year over year in Europe as well okay.

Geo numbers, if I have a lot of cloud influence in them. So it depends when you strip that out that kind of in region business is growing.

Okay, well, maybe just on that point it did the U S grow can you tell us how much of the U S grew with all the titles.

Top my head no.

Yeah.

Yes, we do by year end.

I'll show you some stuff at year end for sure.

Verticals of the business I appreciate it good luck. Thanks, Okay. Thank you.

Your next question comes from the line of David <unk> with UBS. Your line is now open.

Thanks, guys for taking the question.

I just wanted to go back to the margin.

Our formats, if I go back to 2019, I think your Titan mix was relatively similar to where we are today, maybe a little bit less but your gross margins were almost 300 on your product gross margins almost 300 basis points higher.

So can we kind of disaggregate that delta is how much of that is from expedited freight supply chain versus maybe somewhat structurally lower margins with some of the new Titans <unk>, Microsoft and meta and then on Opex. Just a quick question you know growth has been 15% to 20% sort of on a year over year basis is that kind of how we should think about the business as we progress over.

A couple of years cycle. Thanks.

Yes, I think on the on the gross margin piece I mean, there is there is more cloud mix in the business I think we've said we've seen and we've ever seen this time, we've seen the highest mix we've had but we also have remember don't forget the expediting fees and stuff. We've talked about this 200 to 300 basis points I mean that is still there I think.

That will be there for a while.

Certainly in our Q4 guide.

So I think it's a combination of those two right. When you think back in that time period, you could run the business for cost right and we were optimizing costs in every way today, we're kind of hamstrung because of supply.

So it's inefficient right now to be honest right, particularly with these decommit. So.

So we need to get out of that and then we can kind of start.

To drive for some improvements on the gross margin side as well.

I think on the Opex side, if you look back historically, we've probably been in the 2022% growth.

Type range on Opex.

Except in times of disruption right. So I mean, that's probably not a bad way to think about it.

Got it and then maybe just a quick follow up so it sounds like youre structural margins on the tightened to a relatively unchanged over the last call. It two to three years outside of the expedite fee in supply chain is that a fair characterization on the product side.

I think it depends on the product mix to some degree right I mean, you've got.

Theres more you'd have to do more disaggregation to really get to what's happening there right, but those are the <unk>.

Product mix is a part of that as well.

Okay. Thanks, guys.

Okay.

Your next question comes from the line of Amit <unk> with Evercore. Your line is now open.

Thanks for taking my question and congrats on a good quarter.

I guess my question is you've got this cloud Titan side.

Broader level by vertical we're seeing with increased focus on profitability from the cloud company and I'm just wondering as they start to focus perhaps more of their resources on their own core competencies could.

Could you see a lot of these cloud companies started to shift from.

Building their own solutions on the networking spot side, which is starting to buy them more often is would love to understand a little.

The existing customer base are you seeing an expansion of engagement with them beyond what you've traditionally done and then B. More importantly are you seeing newer customers come to you don't want to start buying some you have been building it organically themselves.

Okay, I'll take I'll take it and thank you. Thank.

Taken in two parts the cloud Titans have always had a combination of build and buy.

So I don't think that's changing they they continue to look at whether it's Sonic RF boss working closely with us, but in some layers there absolutely sourcing their own products and technology at the same time I think the cloud guidance tightens up to run very mission critical networks and they recognize the value in the partnership at an engineering level too.

Build themselves, but really co developed with us. So these I would say are not build or buy they're really co developed partnerships, where they get the best of both.

Despite all of their.

Focus on costs and believe me theyre getting their best of both because they're getting great cost for us without making the direct investment themselves and it really is a unique partnership.

I actually wanted to say similar to that sure.

In general these cloud companies keep exploring every possible way to go faster that's a misunderstanding.

So it's on the Wall Street sort of thing sometimes people have said hey people wanted to find something that's cheaper because they can save money. The reality is they have to look at the total overall business impact and if we can go faster and get a competitive advantage, that's a huge benefit to them.

Most of these companies do not build their own products saw stocks.

Just to build a cheaper they believe it because there's some secret sauce to some IP. There is some integration that's what youre seeing with the co development redo with Microsoft whether it's on the Sonic side on some of the hardware with developers.

The other tightened to explore the same use cases are similar themes, but also on an ongoing basis.

So these are not new discussions to us and I think we will continue execute growth clearly the majority of the business continues to come from our top two customers.

We are happy with that the orders are engaged because we've taught us Don previously, but there was a long running projects both of them to get to a decision point on actually impact you'll have to wait with us.

And we'll get there, but there is nothing that changed in the industry people out in general happy with the way status quo has been maintained with a little bit of let's explore other options and work with working with companies like us where possible.

Yes.

Okay.

Thanks, Amit.

Operator, we can take the next question.

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

Yes, thanks for taking the question congratulations as well on the quarter I wanted to ask a little bit more of a technical question. As we think about 400 gig and you think about the traction you're seeing with your cloud Titans as well as some of the specialty cloud guys. I'm. Just curious if you could level set us of where you think we're at in terms of the 400 gig cycle.

On that topic as well any updated thoughts on this idea of the AI fabric networks, representing an incremental adjacent a growth driver for your business at the cloud Titans. Thank you.

Unquestionably I think while majority of the enterprise is still on 10 and 40, we're seeing more and more combinations of 104 hundred gig not only in the cloud Titans, but also in the rest of the.

Our customer base.

To level set on the numbers you may recall that we had 70 or so customers in 2020.

We doubled to 300 into 2021, and if I had to guess I would say we would double again in 2022 in terms of 400 gig customers, but the important thing to remember here is theyre not just 400, they really are a permutation and combination of multiple speeds multiple use cases and together they are an important contributor but it's new.

Never in isolation hundred some of them are upselling some of them are native connection some of them as actual alluded our Dci routing solutions.

Our market share in this combination of 100 400 and in some cases 200 is number one for good reason because they really have to work together with the right software and right management.

Find cluster is emerging as a new use case, it's still early days and we've talked about it some who will talk about it more at the analyst day, but more use case emergence.

Or applications that really pushed the speed and latency and performance and predictable bandwidth of 400 gig is going to add additional fuel to a to a 400 gig demand.

Okay.

Thank you.

Thanks Erin.

Wishes.

Your next question comes from the line of Jim Suva with Citigroup. Your line is now open.

Thank you J stream either I noticed in your press release that you made a comment to new market expansion could you elaborate a little bit like what is that or is that going to be a focus for the event on Thursday.

I assume it's not just continual strength the way youre seeing or maybe it is but if you can give any expansion on that because I know in the past current currently you've seen a lot of expansion into campus growth, but I saw the new market expansion literally word for word and I got I think there were some purpose behind that thank you.

Maybe you read more into my quote that I meant.

The end of the day Arista is viewed as a data center company, but if you look at the diversified portfolio, where we're trying to say we're entering many more new markets like routing like campus and even subsets of the market like securing our solutions better with encryption with better visibility and observer ability and indeed, we will talk more about <unk>.

Market expansion in a couple of days.

So not undoubtedly we're moving from becoming a pure data center company to many more markets that center the data in different locations.

Thank you so much.

Jim.

Your next question comes from the line of Cemig Chatterji with J P. Morgan. Your line is now open.

Yeah. Thank you hi, Thanks for squeezing me into I guess.

A question to the last one but I just wanted to understand.

And as we look at your growth with cloud customers, how should we think about sort of the growth relative to sort of how much of that growth is coming from the additional use cases, yet addressing beyond.

Traditional switching so for example, like the CIO routing how much of that is probably contributing to the strong growth you're seeing with cloud customers. As we think about sort of the next couple of years, how should we think about given the visibility you have in terms of designs how is that sort of momentum progressing from here on.

Just a quick follow up there so outside of Facebook and <unk> as we think about engagement with other cloud companies is that on some of the new use case is always that traditional switching in the leaf and spine.

Firstly, I think it's super important to understand that even though it's leaf and spine semi these data centers, whether they were building them at a regional level or at a mega scale level.

The leaf and spine is really going to expand and explode as the cloud Titans expand their presence so that growth that organic growth that we began our journey with them will continue and we will depend on that growth. In addition to that as <unk> said, we will have new use cases on the Wan the regional the Dci and especially.

The AI spine, particularly with the cloud Titans it.

It may expand to add those new use cases may also expand to other specialty cloud providers, but I would say we would be looking for sources of growth in both areas expansion of the existing data centers into new locations and more scale as well as new use cases.

Thank you fix a one and a half a dozen of the other.

Okay.

Thanks Alec.

Your next question comes from the line of George Notter with Jefferies. Your line is now open.

Hi, guys. Thanks, very much I guess I wanted to go back to the question of the cloud Titan customers potentially building inventory in.

I guess on an earlier question on onshore you were pretty dismissive of that idea I guess I was just wondering what what additional detail you might kind of have that supports that idea.

If I look at your business, you've been growing product sales.

50, 567% year on year, the last couple of quarters, it's pretty outstanding growth and given the mixed shift in the company I would guess that the cloud Titan customers have been growing 70 or 80% year on year right. So.

I know you guys are building your own inventories many companies are building their own inventory in the supply chain environment. So I do think it is important question and I guess I'm wondering exactly how you know customers arent aren't building inventories it yourself.

So that is a good question.

I get asked that internally daily because we have to worry about what's going on on the other side.

Most buffering.

The bad side is the number of phone calls.

So other than the company guide on when a window I know youre shipping so.

These customers are still roughly hunter moat. There are few places where they can sort of calibrate with computer to come up and so on but in most cases customers are desperate the deployment teams are waiting for the geared us show up they light it up as quickly as possible.

Have to realize where we came from but since the start of covered the world has been constrained.

And a constrained over such a long period generally means people kind of executed their project timelines and as to chart at some point the food color got nowhere close to that.

Today's claim so I think it would take a long time, maybe out of tissue of things with the political with by the end of 'twenty three.

That's when customers we feel comfortable.

They will eventually have an opportunity to buffer up but not yet not there today.

Okay. Thank you.

George.

Your next question comes from the line of Sami Badri with Credit Suisse. Your line is now open.

Hi, Thank you.

I wanted to go to gross margins I think you've made two references on this call regarding just the trajectory of margins I think you said that we're probably not going to see an improvement in gross margins for at least a year from now and then the other comment you made regarding the two to 300 basis points.

Thank you said, it's going to be there for a while so does that imply that we should be modeling gross margin at least through maybe the first half of 2023, a little bit more in line to last couple of quarters.

First question second question is if.

If you were to give us an idea on how many ports or how many switches with 400 gig ports shipped in 2022 could you give us kind of like a percentage of total shipments and maybe what that would look like in 2023.

Yeah. So just on the gross margin I think given where we are today I think it's not a bad idea to.

The model that that gross margin is being kind of constrained until we get out from under the constraint honestly.

I think that's a very real kind of costs that we're carrying and it's not clear yet exactly when that starts to improve so yeah. I think it's not a it's not a bad idea to hold it there until we're able to kind of show real.

Demonstrable improvement in more predictability I guess on these recommitted parts.

Yeah and to answer your question I don't have exact numbers on 400 gig, but if I had to guess, even though regaining customers. Most of them are Rs uplink. So the number of ports is still small I would say our penetration is well under 10% maybe even five.

A good guess.

Yes.

And then thank you for answering in gross margin and that piece, but when you go into 2023 are you seeing almost like a sharp increase in that from sub 10 two.

Obviously, much higher than that or not quite yet no.

If you go into 'twenty three the way to think of this is.

People are still migrating from 10 gig.

10, 4200 will still be the largest migration as a result of that migration you will see more deployment of 400 gig 400 gig will still be small and maybe it will go from five to 10.

Perfect all right. Thank you very much.

Okay. Thanks.

Your next question comes from the line of James Fish with Piper Sandler Your line is now open.

Hey, ladies nice quarter in onshore as well.

It's a metric I know you don't really want to emphasize as much as others do in your space you still have.

Visibility here and confidence in that visibility.

Maybe asking it a different way than others as supply chain here starts to normalize how are you guys thinking about how long that path.

Backlog actually it takes to turn back to a more normal level is at 468 quarters. That's currently in your thought process for next year are you seeing any change in cancellation rates and then just lastly.

What's going on with that services deferred revenue as an aggregate we were down about $92 million.

Product was only went down $63 million of trying to understand why services is being impacted here.

Yes, maybe let's start with the services piece of it. It's just all about the timing of the of the service agreements right. If you think about what deferred revenue is as if I sign a contract from day one.

The two year three year contracts are going to have the maximum amount of deferred wherever you can have and then when it comes towards the renewal of that contract youre going to have the least amount of deferred revenue that you could have from a services perspective right. So it's purely on timing on the services side right.

Lumpier thing is obviously on the product, but the services is to really just the mechanics of how.

How the services contracts flow.

Right.

And then I guess on the cancellations et cetera, I mean, we have not seen any change in the business I think.

<unk> point I mean, we're still seeing customers very intently focused on getting products at this point.

Im not going to try to age out the backlog that's kind of a thing.

We're not quite there ready to do that just given some of the uncertainties on supply and so on.

And I think as lead times improve we expect customer visibility to shrink, but right now we're working hard on that lead time improvement.

We're a year away from that.

Got it.

Operator, we have time for one more question.

Your last question today comes from the line of Tom Blakey with Keybanc. Your line is now open.

Hey, Thanks for squeezing me in and happy Halloween everybody.

Yes.

Looking at your.

I'm curious about the cadence of the cloud Titan revenue it seems like a big uptick here in the second half if I'm characterizing that correctly from kind of the mid to high thirty's to get to that 45% for the year.

You need to imply kind of over half and if I do that simple arithmetic.

Applies that may be the cumulative revenue service providers specialty service providers financial and enterprise would be kind of flattening out in the second half.

Maybe comment on Mike as my characterization correct and.

There and as a follow up are we.

Relying a little bit more on one of those particular cloud Titans more than the other and about a correlation to actual capex spend comment would be helpful too.

Thank you.

Yeah, I mean, I think as you look at the year I mean, obviously, we've been ramping revenues ramping shipments. So we have been ramping kind of with cloud as well right.

And cloud has grown faster it started off from a lower base. Obviously, so it did it did need to recover if you like was at 30%, which was pretty much the lowest we've seen it last year.

It's definitely recovered from there I think on the rest of the business. The demand is there the demand is certainly exceeded our expectations. When we came into the year.

But given the shipment constraints et cetera.

It is kind of enough we've been trying to stick to the FIFO first in first out as much as we can and.

So that has been more constrained I think we would expect to see that kind of start to improve hopefully here as we head into next year.

Okay.

Okay.

Thank you <unk> versus.

Versus Microsoft maybe into the second half that well have to wait till year end for that I think.

Okay.

Thanks, everybody.

This concludes the Arista Networks' third quarter 2022 earnings call. We have posted a presentation, which provides additional information on our results, which you can access on the investors section of our website.

For joining us today and thank you for your interest in Arista.

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

Please wait the conference will begin shortly.

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