Arista Networks Inc

NYSE:ANET

Earnings Call Transcript 2020-Q3

[Operator]

Welcome to the Third Quarter 2020 Arista Networks’ Financial Results Earnings Conference Call. During the call, all participants will be in a listen-only mode. After the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time [Operator Instructions]. As a reminder, this conference is being recorded and will be available for replay from the Investor Relations section at the Arista Web site following this call.

I will now turn the call over to Mr. Curtis McKee, Director of Corporate and Investor Development. Sir, you may begin.

[Curtis McKee, Director of Corporate and Investor Development]

Thank you, operator. Good afternoon, everyone and thank you for joining us. With me on today’s call are Jayshree Ullal, Arista Networks’ President and Chief Executive Officer and Ita Brennan, Arista’s Chief Financial Officer. This afternoon, Arista Networks issued a press release announcing the results for its fiscal third quarter ending September 30, 2020. If you would like a copy of the release, you can access it online at our Web site.

During the course of this conference call, Arista Networks management will make forward-looking statements, including those relating to our financial outlook for the fourth quarter of the 2020 fiscal year, longer term financial outlook for the 2021 and beyond, our total addressable market and strategy for addressing these market opportunities, the potential impact of COVID-19 on our business, our product innovation and the benefits of recent acquisitions, which are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically in our most recent Form 10-Q and Form 10-K and which could cause actual results to differ materially from those anticipated by these statements.

These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings press release.

With that, I will turn the call over to Jayshree.

[Jayshree Ullal, President and Chief Executive Officer]

Thank you, Curtis. Thank you, everyone for joining us this afternoon for our third quarter 2020 earnings call. To start with, we all hope that you and your families are safe during the global pandemic. At Arista, we recognize our role and responsibility in supporting global communications and private infrastructure during these challenging times. We are working closely with our employees, supply chain, contract manufacturers, customers and Arista Foundation to assist in business continuity initiatives and people to life.

Back to Q3 2020. We delivered $605.4 million for the quarter with a non-GAAP earnings per share of $2.42. ACA services and software and support renewals contributed approximately 21% of revenue. Our non-GAAP gross margins were 64.6% influenced by software and services mix and a higher Asia Pacific contribution. We registered a record number of new customer logos this quarter and million dollar customers, a direct result of our momentum in the enterprise vertical and campus traction this quarter. In Q3 2020, cloud titans was our largest vertical. The enterprise is once again consistently our second largest performer followed by a Tier 2 cloud service providers and financials cite for third place, and service providers in fourth place.

With respect to sector trends, cloud titans are now approximately 37%, enterprise and financials also are approximately 37% and providers, which is our cloud service providers’ combination is approximately at 26%. What is clear is Arista's cloud and support now apply to all sectors, and we are diversifying roles across customers and verticals. In terms of geography mix, international contribution was 25% with the Americas at 75%. The European business recovered from Q2 and the Asia business has had a particularly strong quarter.

In the absence of a physical Analyst Day this year, we would like to shed some light on our strategy for addressing our 30-plus billion dollar plan. The past decade can be best characterized by Arista’s momentum in cloud networking. But in the past four quarters, we have experienced a triad storm of cloud titan volatility, COVID pandemic and deferred revenue related comp. Despite this tough reset year, we believe Arista will emerge stronger, not only returning to double-digit growth in 2021 but also aiming for consistent growth in the years beyond.

We expect our multi-year growth cycles from three major product line contributors. One, our core cloud and data center products, our largest business building upon our flagship Arista EOS with the hallmarks of lease fine topology across our five major verticals. Two, our second market is the number of adjacencies, with routing replacing routers and our recent entry into the cognitive, campus workspaces. The routing market consists of core spine, edge and peering use-cases for a Tier 1, 2, 3 service cloud and enterprises. The campus brings a cognitive unified edge for wired and WiFi endpoints, as well as new IoT devices and a two tier leaf spine or spline network. We do expect to disrupt the campus and rather incumbency of the last few decades in the next few years.

Our third category is network, software and services, based on software subscription models, such as Arista A-Care, CloudVision, Cloud EOS router for multi cloud, big switch monitoring and our latest entry into advanced network detection and response with the acquisition of Awake Security. Elaborating on our focus on subscription-based software, this product line is typically multi-year contracts. Customer are driving mandates for network automation, monitoring visibility across their dataset. We believe the recent acquisition of Awake Security is a strategic contributor that transforms the silo aspects of security into a seamless, secure network.

The moment a cloud blurs the perimeter and the increased use of IoT and shadow IT means that our CIOs and CSOs need a network ground of truth. Simply storing the raw data or alerts isn't comprehensible data. A new AI driven, data driven, state driven software stack, like Arista provides is foundational. In our opinion, the security in the industry is going through a metamorphosis, from point security to proactive, predictive, secure networking. CloudVision, combined with Arista’s 2020 acquisitions of Big Switch Networks observability and Awake Security for autonomous spec hunting are very natural software additions to this category.

The Cognitive Campus is a priority for Arista's adjacent product line. We are witnessing a massive transition in the COVID era to work-from-home. But the boundary between the office, the home, the teleworker transit and the user is blurring into elastic and flexible workspaces. Arista's recent introduction of the Cognitive Campus is a safe and data driven model, coupled with a unified dashboard for wired and wireless edge for next generation zero touch campus deployments. This combined with the Awake network detection and response security feeds into our campus visibility flow tracker for both IoT and OT application.

We do expect our campus portfolio to double by the end of 2021, as we invest in both engineering and go-to-market models. A fitting example is today's announcement of our flagship 750 Series campus chassis, delivering a combination of industry leading chassis density, performance for high definition video failover resilience for rolling upgrades, cognitive COE and secure encryption. I would like to invite Andy Bechtolsheim, our Founder and Chief Development Officer to highlight our launch today. Andy?

[Andy Bechtolsheim, Founder and Chief Development Officer]

Yes. We like markets that are right for real innovation and the campus networking market is a prime example of that. With the launch of our 750 Series modular chassis, we are introducing a next generation platform that delivers more performance, more security, more visibility and more power capabilities than any other products in its class. The 750 has 400-gigabits per second uplink throughput, which is 5 times the performance of our nearest competitor. This level of performance is key to support WiFi 6 where each access point has upto 5 gigabits throughput. With a single 750 chassis, we can support a full complement of 384 WiFi 6 access points.

In addition the 750 offers MACsec encryption on every port, which supports secure communication from the WiFi through the entire campus network. The 750 also breaks new ground in density being 3U more compact than our closest competitor. Combined with the legendary reliability of Arista's EOS offering system, the 750 offers unmatched performance, security, availability, visibility and power handling.

[Jayshree Ullal, President and Chief Executive Officer]

Thanks, Andy. That was great. I'm excited, I could use one at home. Next generation routing is another key adjacent market for us lead by the bringing the union of two boss level approaches, layer two switches and layer three routers together for rich protocol support, resiliency, scale, and programmability. This has been a four to five-year endeavor for us to bring disruptive economics via advanced merchant silicon and Arista's modern software stack, EOS.

We're starting to see the fruits of this labor. Arista customers now see us as a compelling and cloud -- and carrier grade routing alternative to expensive legacy routers. We're extending beyond classical lease spine intra DC use cases to multi terabit routing offering lower power and higher density interconnect, accelerating WAN and inter-DC routing use cases. Our investments in the simplification of Arista's routing stack with standards-based EVP and BTP and segment routing are yielding early traction. We have won a few important Tier 2, Tier 3 service provider customers for many of these use-cases, including fine interconnect, multi-access edge, layer two layer three VPNs and pairing use cases.

Our core universal cloud network design for data center continues to expand with Arista as the pioneer. We have been the market leader, driving to the number one position 100 gigabit ethernet switching market and early leadership in 400-gig with flexible software partnerships for SONIC, open config and FBOSS with our cloud titan customers. We have been pushing beyond the local storage compute and AI clusters at cloud scale. This quarter, we delivered CloudVision managed in a time series state driven database as a network-wide service hosted in the cloud. Clearly, their enabling cloud principals across the entire enterprise with five As of agility, availability, automation, analytics, and an AI and API driven network. Anshul Sadana, our Chief Operating Officer, will add some more color on our cloud customer traction. Anshul?

[Anshul Sadana, Chief Operating Officer]

Thank you, Jayshree. Arista has a been a leader in cloud networking based on our nimble execution, product quality and ability to co-develop with our customers. Cloud companies are highly impressed with the work we've done over the last decade are engaging us more than ever to discuss their architectures for the future. The advent of the facilities and related silicon is driving a product transition. We are winning new RFPs on next gen products, both 100 gig and 400 gig.

We have expanded our footprint from data center leaf spine and DCI to now encompass WAN and Edge used cases traditionally supported by legacy routers. While there's a lot of talk about white boxes and 400 gig, our customers have maintained status quo. We have not seen a change in position from this status quo. Customers for used white boxes are continuing to use white boxes. Whereas customers who use Arista switches are continuing to use our products for today and for the future design.

If anything, some use cases currently covered by internally developed white boxes may transition to our feature rich products in a few years. Cloud companies upgrade at a massive scale and they're continuing to grow. This scale makes them lean more on us for technology and support. Our cloud customers see immense value in working with us, and we have high customer satisfaction here. Our portfolio is highly competitive and we are being told that we are ahead of competition. Hence it is unlikely that we will see significant share shift. Savvy cloud titans are not influenced by pretty marketing slides. Our R3 Series products have now been quantified by all our major cloud customers for several 100 gig times 400 gig use cases. We will keep marching on. Back to you Jayshree.

[Jayshree Ullal, President and Chief Executive Officer]

Thanks Anshul, and we will be marching on. Well said on the cloud titan success. So in summary, Arista's vision now traces LAN, WAN, cloud networking, with clear diversification across customers, products and verticals. It's rooted in a more software data driven network, built across customer data sets and managed by CloudVision.

We have built a transformative architecture, harnessing the new trends in IoT computing, unified edge, archiving data across the network. Our customers resonate with this vision. And I couldn't be more upbeat on our strategy, our innovation, our quality of support and our customer migration from legacy siloed places in the network to cognitive clients to cloud networking, which we call places in the cloud. We have now deployed a cumulative of 40 million ports over the past 12-years.

With that, I will turn it over to Ita our Chief Financial Officer for more financial specifics. Ita?

[Ita Brennan, Chief Financial Officer]

Thanks, Jayshree, and good afternoon. Let me announce our Q3 results, our guidance for Q4 2020 based on non-GAAP and excludes all non-cash stock based compensation impacts, certain acquisition related charges and other non-recurring items. Full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release.

Total revenues in Q3 were $605.4 million, down 7.5% year-over-year, well above the upper end of our guidance or $570 million to $590 million and up 12% from the prior quarter. While we saw some improvements on the supply chain front, shipments remain somewhat constrained to some extent with continuation of extended lead times into Q4. Service and software support revenues represented approximately 21% of total revenue, down slightly from 22% last quarter. International revenue for the quarter came in at $152.7 million or 25.2% of total revenue, up from 19.4% in the second quarter.

While the shift in the geographical mix on a quarter-over-quarter and year-over-year basis was largely due to the location of deployments by our cloud titan customers, we did see some incremental improvements in our in region businesses also. Overall, gross margin in Q3 was 64.6%, above the midpoint of our guidance of approximately 63% to 65% and consistent with last quarter. We continue to recognize incremental COVID related costs in the period, including elevated freight and component costs.

Operating expenses for the quarter were $159.4 million or 26.3% of revenue, up from last quarter at $144.1 million. We began to increase operating expense investments during the third quarter as our top line performance for the year continued to improve. R&D spending came in at $106.1 million or 17.5% of revenue, up from $91.6 million last quarter. This reflected increased employee costs and increased new product introductions related spending in the period.

Sales and marketing expenses -- $43.1 million or 7.1% of revenue, up from $41.9 million last quarter with increased variable compensation and other personnel costs. As a reminder, we continue to benefit from lower COVID related travel and marketing expenses. Our G&A costs came in at $10.2 million or 1.7% of revenue, down slightly from last quarter at approximately $10.6 million. Our operating income for the quarter was $231.5 million or 38.2% of revenue. Other income and expense for the quarter was a favorable $13.2 million, and our effective tax rate was approximately 21.6%. This resulted in net income for the quarter of $192 million or 31.7% of revenue.

Our diluted share number was 79.3 million shares, resulting in diluted earnings per share for the quarter of $2.42, down 10% from the prior year. Please note that included in other income and expense for the quarter was a one-time gain on the sale of investments of $9.4 million. In addition, given current low interest rate environment, all other things being equal, we would expect other income of approximately $3 million per quarter throughout the coming year. The acquisition of Awake Security closed on October 7th and we are now focused on integrating of purchase accounting. The acquisition will not have a material impact on the financials for the current quarter.

Now turning to the balance sheet. Cash, cash equivalents and investments ended the quarter at approximately $2.85 billion. We repurchased $167.3 million of our common stock during the third quarter at an average price of $208 per share. As a reminder, we have now repurchased $661 million or 3.2 million shares against our Board organization to repurchase $1 billion worth of shares over three years commencing in Q2 '19. In terms of capital allocation, which expects us to continue to execute opportunistically against the remaining authorization.

We generated $215.1 million of cash from operations in the third quarter, reflecting solid net income performance and a consistent level of overall working capital investment. We expect to continue to strategically increase inventory levels through the end of the year as we improve lead times and attempt to buffer against any future COVID-related supply chain disruptions. DSOs came in at 46 days, down from 65 days in Q2, reflecting linearity of billings in the period. Inventory turns were 2 times, down from 2.3 last quarter. Inventory increased to $438 million in the quarter, up from $327 million in the prior period as we continue to buffer certain components and products.

Our total deferred revenue balance was $562 million, down from $577 million in Q2. As a reminder, our deferred revenue balance is now almost exclusively services-related. The level of services of our revenue is directly linked to the timing and term of service renewal, which can vary on a quarter-by-quarter basis. Accounts payable days were 70 days, up from 59 days in Q2, reflecting the timing of inventory receipts and payments. Capital expenditures for the quarter were $2.5 million.

Now turning to our outlook for the fourth quarter and beyond. While we remain cautious around the impact of COVID-19 on the economy and our business, we have seen some incremental improvement in underlying business trends. Activity in our enterprise and provider sectors has remained healthy, with increased win rates across what is for us a relatively underpenetrated part of the market. In addition, we have continued to solidly and consistently execute against the needs of our cloud titans customers. We believe a combination of these trends, combined with favorable year over year comparatives, supports the current consensus growth rate of 13% to 14% for fiscal 2021. On the gross margin front, we will continue to reiterate our overall gross margin outlook of 53% to 55%, with customer mix remaining the key driver.

Turning to spending and investment. While we will continue to carefully manage spending, we are committed to making go-forward, results-based investments in the business. This includes continued go-to-market expansion to support enterprise and campus growth and investments in R&D to support innovation across the business. While it won't happen overnight, especially in an environment of resumed top line growth, we would take this opportunity to remind you of our long-term operating margin targets of plus or minus 35%.

Finally, our outlook discussion above and our guidance for Q4 reflects our current understanding of COVID-19 and its impact to our business and supply chain. This is, however, inherently uncertain and we will need to continue to monitor and attempt to mitigate new challenges as the situation unfolds. With all of this as a backdrop, our guidance for the fourth quarter, which is based on non-GAAP results and excluded noncash stock-based compensation impacts and other nonrecurring items is as follows; revenues of approximately $615 million to $635 million, gross margin of approximately 63% to 65%, operating margin of approximately 37%. Our effective tax rate is expected to be approximately 21.9%, diluted shares of approximately 79 million shares.

I will now turn the call back to Curtis. Curtis?

[Curtis McKee, Director of Corporate and Investor Development]

Thank you, Ita. We are now going to move to the Q&A portion of the Arista earnings call. Due to time constraints, I’d like to request that everyone please limit themselves to a single question [Operator Instructions]. Thank you for your understanding. Operator, you may go ahead.

[Operator]

[Operator Instructions] Your first question comes from the line of Samik Chatterjee from JPMorgan.

[Samik Chatterjee, JPMorgan]

I'll just keep it simple. Jayshree, I think everyone on the call would recognize that you sound a lot more confident about returning to double-digit growth than you did 90 days ago. So I'm wondering what's driving that. Is it some of the 400-gig wins coming in as you expected or is it the underlying customer spending starting to improve that's driving that increased confidence to what we heard a quarter ago? Thank you.

[Jayshree Ullal, President and Chief Executive Officer]

I think when you look at the foundation and fundamentals of Arista, they didn't change. We've always had superior products and very strong customer traction. But I think we got our customers and Arista got used to the uncertainty of COVID, and COVID became a new norm, and people have to start planning their spends. So we saw a very balanced and customer traction across all our verticals and all our sectors in Q3. Whereas I wouldn't say the same for Q2 and Q1, whereas we were still figuring things out. So I think the combination of an unchanged strategy, a highly differentiated product and we're just winning in every sector. And there's no silver bullet but humming on all four cylinders gives us a newfound confidence.

[Operator]

Your next question comes from the line of David Vogt from UBS.

[David Vogt, UBS]

Maybe just a big picture industry question, if you guys could entertain me. Can you share your thoughts on the proposed Marvell Inphi transaction that was announced last week and maybe what it might mean for the industry holistically as we kind of move forward into 2021? That would be great.

[Jayshree Ullal, President and Chief Executive Officer]

I'll try. I mean, I came from the semiconductor world two decades ago. But as you know, there's been a lot of semi consolidation in video arm, Maxim, analog digital and now Marvell Inphi. I think the way to look at this is semiconductor companies are -- the large ones are trying to get larger and the smaller ones are producing some real innovative technology but need scale. We are very impressed with Inphi. They've been an important partner for us and they have both very best-of-breed technology in the 30s and optic side, and it's something that Marvell lacks. So hopefully, some of the strength they bring, especially to the cloud will help Marvell.

[Operator]

Your next question comes from the line of Sami Badri from Credit Suisse.

[Sami Badri, Credit Suisse]

I just wanted to just check on a comment made by Anshul earlier in a transcript regarding white boxes. And you made the comment that some customers may deploy white boxes today and then eventually swap that out for a feature-rich Arista product in the future. Now is there maybe a rationale behind why they would want to deploy data centers filled with white box infrastructure or white box equipment and then eventually swap it out? Can you just explain to us the transition that would take place in design or just in the thought process for why they would do that after they've gone down the white box route?

[Anshul Sadana, Chief Operating Officer]

Sami, the word has talked about by just from one dimension for many, many years but remember, our customers do that analysis in both directions, not just one. And as their scale grows and their needs grow, the network is getting more complicated. And in certain situations when they reach a point where they need even more functionality than is EV to build internally. And they want to stay competitive in the market and not miss on timing, they do start looking out as well. But as I mentioned, these are future trends that take a couple of years at least to happen. But these are certainly ongoing discussions and issues going on in our space today.

[Operator]

Your next question comes from the line of Alex Kurtz from KeyBanc Capital Markets.

[Alex Kurtz, KeyBanc Capital Markets]

Glad to hear everyone's doing well and safe at Arista, and congrats on the quarter, Jayshree. Just on your comments about software and maintenance becoming roughly 20% of the business. Can this growth in your portfolio of software products, whether designed internally or acquired, to maybe accelerate that software renewal base to where maybe in a couple of years, we're looking at 30%, 40% of the business, if you can go back to these big cloud titans and kind of demonstrate the value of these bigger software portfolios that you didn't have a couple of years ago and really expand that base of software?

[Jayshree Ullal, President and Chief Executive Officer]

I think very observant of you to note that when we say it's 20% of our business, it's not just services, it's software renewals and subscriptions. So it's already starting to have a contribution.

Can it be greater, greater than 20, 25? Yes. It would be harder to be 30 and 40, especially with the cloud titans, because cloud titans tend to think they can and they have the resources to build many of these tools themselves. So I would say all the other four verticals are more likely to embrace our software subscription while the cloud titans may take it in bits and pieces. They would take it in components but not an entirety. But I certainly think this segment where we can have subscription multiyear contracts is an important part of our triad stool of core networking, adjacent networking and network as a service capability.

[Operator]

Your next question comes from the line of Tal Liani from Bank of America.

[Tal Liani, Bank of America]

I have a question on the trends in the quarter. Product growth. So overall revenues are down 7.5%, but it's not even between products and services. Product growth is down about 13.5% year-over-year and services are up 26%. So I'm trying to understand both sides. I'm trying to understand the strong growth in services versus the steeper decline in products?

[Jayshree Ullal, President and Chief Executive Officer]

So first, remember, again, services includes many of our software subscriptions and multiyear contracts. So it's not just services whereas product is very clearly perpetual product. So look, I think the comps with deferred revenue never helped us from last year to this year. But I wouldn't read too much into the trend, except to say we're getting stickier with services and software, and we can only do better with product.

[Ita Brennan, Chief Financial Officer]

I mean, I think, Tal, the services should continue to grow and continue to be a more meaningful piece of the business and layer the software on top of that. And then product is recovering but it is recovering. You can see that in the Q4 guide and into our commentary for next year as well. So I think they're just different drivers at this particular point in time, but they should both start to grow as we go forward.

[Operator]

Your next question comes from the line of Fahad Najam from MKM Partners.

[Fahad Najam, MKM Partners]

A couple of things. If I look at your working capital, it seems like your inventories have gone up significantly, while your accounts payable are also awful. But can you just help us understand what's happening, why the investors are up so much? Are you expecting a significant forthcoming demand ramp in the next couple of quarters?

[Ita Brennan, Chief Financial Officer]

No, I think, Fahad, what we're really doing is we're buffering, again, some of the uncertainties around COVID. And if you look at the Q when we file it, you'll see that a good portion of that increase is still raw materials and components. There was some uptick in the finished goods right at the end of the quarter for particular products but we still have more work to do around expanding that to other products. But our goal is to have sufficient buffers that if we do get some more shocks from COVID that we're able to react and that we're in a better position to react than we were maybe on the first wave. So it really is just a focus around making sure we've got more optionality and flexibility.

[Operator]

Your next question comes from the line of Paul Silverstein from Cowen and Company.

[Paul Silverstein, Cowen and Company]

Jayshree, I think you kind of said it during the call, but I'm going to ask you if you could -- in your outlook for next year, the double digit growth in your endorsement of the 13% to 14% consensus number. To get there, I think I heard you say you expect your campus portfolio to double by the end of 2021. Are you saying you expect campus revenue to double? And can I ask you to go through what your expectations are for the cloud, for enterprise and financials and for your service providers to get to that double-digit growth?

[Jayshree Ullal, President and Chief Executive Officer]

So as you know, we said last quarter that we have achieved -- this is our first year at campus. We're still young kids here, and we've achieved our first 100 million. And if you may recall, we said it would take us four to six quarters to double. I don't yet know if it will be four or six but we are feeling pretty good, particularly with our product announcement today and the campus traction we're getting that we didn't feel last quarter. So yes, the goal is to definitely double that $100 million to $200 million by the end of 2021 in revenue, and let's hope we can do better. In terms of segments, I think it's too early to call a breakdown but we're very comfortable with the annual consensus for 2021. Ita, do you want to answer that?

[Ita Brennan, Chief Financial Officer]

I think, Paul, we're not going to try to do it by vertical at this point. We feel like there is -- between the campus stuff that you talked about, between the growth and services, cloud has resumed growth and then the rest of the business has also been performing well. I think between all of those drivers, you have multiple different ways to get there, and we'll see exactly how it plays out. And I think we're not going to try to take which verticals we're going to do what at this point.

[Paul Silverstein, Cowen and Company]

Can I ask you this, I trust that you get there, cloud has to be healthy by definition…

[Jayshree Ullal, President and Chief Executive Officer]

No, I think -- I hope you noticed our upbeat tone, especially Anshul's. We started the year saying it will be flat to down and then we’ve said it will be flattish. And at this point, I think we're feeling like cloud can be a growth -- cloud titans can also grow next year.

[Operator]

Your next question comes from the line of Jeff Kvaal from Wolfe Research.

[Jeff Kvaal, Wolfe Research]

I was wondering if you two wouldn't mind giving us a little bit of some of the thought process behind the guidance. I guess, one part is there's another partner in the supply chain at one of your customers that cast a pall over 2020. And I'm wondering if that particular issue in semi was resolved. And then the other question is, could you help us a little bit with the assumption of 400 and when that starts to layer in to the 2021 outlook. Thanks.

[Ita Brennan, Chief Financial Officer]

Again, the rationale for the guidance, I think if you look at the various pieces, pretty much what we talked about with Paul a few minutes ago. I mean there are multiple different pieces of the business, and we've seen positive trends across those sectors, not all of those reflected in revenue today. But in the enterprise vertical being good, solid wins that will drive some revenue traction into 2021. And then for cloud, I think we feel like we've got -- we're in the window of starting to understand their plans for next year and feeling more confident around those drivers as well. And then obviously, the rest of the business continues to grow, looking at service software, et cetera, the more ratable piece of the business. So I think those are the building blocks and we like to put those building blocks together in multiple different ways and feel good about the guidance, and that's kind of where we come out for next year.

[Jayshree Ullal, President and Chief Executive Officer]

Jeff, I think Ita said this best. We expect cloud titan trends to improve in 2021, based on both the CapEx projections, which for us isn't a huge indicator because we're a small number. But bulk of these deployments will be 25-gig, 100-gig and even some 400-gig. I think the white box and the overall competitive landscape, much as everyone fears it, is unchanged. And we're seeing a status quo and look forward to share gains in new roles in campus, data center routing and cloud.

[Operator]

Your next question comes from the line of George Notter from Jefferies.

[George Notter, Jefferies]

Very interested to hear the commentary about routing and all the different use cases you're pursuing in that space. Maybe you could kind of talk about your definition of success in routing? And also, could you give us a sense for where you are now in routing applications, percentage of sales or amount of revenue you're driving there? And then maybe looking forward, what use cases are you in today? And what use cases will you be in going forward?

[Jayshree Ullal, President and Chief Executive Officer]

It's difficult to break it down, as I've always told you, because routing and switching off go together. But what we saw as a trend is we've always sort of aimed for the big elephants or the Tier 1 service providers, and those take time. But we started winning, particularly this year, we turned the corner on winning a lot of Tier 2 and Tier 3 providers, not only in the US, but internationally. And these use cases tended to be telco cloud. Some of them were just very happy with the multi-vendor combination of EVPN, BGP stack from us. Some of them were peering use cases. So these are all classical routing use cases with better disruptive economics, programmability, resilience and routing features that they have come to know and love from others but that they could get better from us. And then also, we're doing very, very well in the cloud customer base as well. We have been for some time. So the combination of all this to say that routing is not just with the service providers, it is now permeating all our five verticals.

[George Notter, Jefferies]

And is there one product delivery or feature delivery that has allowed you to turn the quarter in the service provider space, or anything you can attribute that to?

[Jayshree Ullal, President and Chief Executive Officer]

If we know the service providers as well as you do, it's never one feature. It's a long list of them. So we've been working it for four to five years, and I think the combination of it has led to more success. But there's always one more feature to do, George, as you know.

[Operator]

Your next question comes from the line of Rod Hall from Goldman Sachs.

[Rod Hall, Goldman Sachs]

I wanted to just ask kind of a housekeeping question and then the main one. The housekeeping is, do you guys think deferred revenue will become an issue in '21 because of 400-gig rollout? Do you think we'll see product deferred revenue building up again? And then I also wanted to go back to enterprise. It seems like a time when enterprises, if anything, would be slow spending that you guys have really accelerated at least sequential growth there. And there's a lot of absolute additional revenue in Q3. So just curious, do you think you're pulling any revenue forward on enterprise, or how does that look like continues the next few quarters for you? Thanks.

[Ita Brennan, Chief Financial Officer]

I think on the deferred, it's always difficult to forecast when we'll have customer requirements, et cetera, for acceptance. I mean, it tends to be lastly for some very differentiated or different product set, particularly under the current accounting. So we'll see. It's hard to predict that there would be some of that or not at this point. But it's more difficult to get to a deferred bar. It would have to be a very differentiated product going forward.

[Jayshree Ullal, President and Chief Executive Officer]

Rod, I'll just say it feels good to be back after a tough few quarters. The enterprises love our product and they want to buy more. And if anything, I would say opposite of pull in, we're still slightly supply constrained versus demand and are experiencing some shortages that will hopefully improve by the end of the year. So no pull-in for sure.

[Operator]

Your next question comes from the line of Jim Suva from Citigroup.

[Jim Suva, Citigroup]

And really heartfelt congratulations to you and your team for very strong results and outlook during COVID. My question is regarding the outlook for 2021, when you mentioned consensus up 13% to 14%, you're comfortable with that. Does that bake into the most recent CapEx outlooks that we were provided last week? It's notable that like Facebook gave an outlook of materially up [100%]. And I know that you're wrapping up and getting ready for earnings and things, but I believe their CapEx is supposed to be up 30% to 40%. But would that be additive? Thank you.

[Ita Brennan, Chief Financial Officer]

Yes, Jim, I mean, this is our current view as of today of what we feel comfortable with for 2021, and then we'll see. There's always going to be puts and takes on the CapEx to networking correlation has its challenges, right? So we'll see where it goes from there. That's what we see as of today.

[Jayshree Ullal, President and Chief Executive Officer]

Jim, thank you for the question. As you know, the CapEx includes building leases, capital. So the networking component is very, very small. Ita and I were talking earlier, as I was with Anshul, too, it's generally less than or around 5%. So it's hard to make any specific decision based on CapEx. But as an overall trend, we are pleased that the CapEx is going up next year but then we'll keep watching this quarter-by-quarter because it tends to be lumpy and volatile.

[Operator]

Your next question comes from the line of James Fish from Piper Sandler.

[James Fish, Piper Sandler]

Ita, you went over the negatives of the higher freight cost but also the positives of lower travel. To your best understanding, what was the net impact of COVID-19 on OpEx this last quarter? And then DSOs would imply a more front-end-loaded quarter that either insinuates a slowdown in September or was it just lack of needing to push more business that we have a strong backlog heading into Q4?

[Ita Brennan, Chief Financial Officer]

I mean, the DSO is actually the biggest driver this quarter was just we exited with a high balance at the end of last quarter, right? We were very back-end-loaded last quarter, and then you can collect against that, and that drives some good traction through the quarter. So I think we were -- Jayshree mentioned, we still have some supply chain constraints we were still receiving in inventory, and you saw that in the accounts payable as well. So we were still a little bit back end loaded through the quarter, but we had a good balance to collect against coming into the quarter. I don't know that I'm going to try to size exactly what the COVID impact is. There is a little bit in gross margin and you've seen that in the product margins. And there's travel, some marketing expenses, et cetera, probably a couple of million or so that comes out of the sales and marketing line because of it as well.

[Operator]

Your next question comes from the line of Jason Ader from William Blair.

[Jason Ader, William Blair]

On the campus side, just wondering what types of customers are actually buying this stuff and then the stuff working from home. It's just surprising to me that you're winning a lot of new logos there. So that's kind of the first part of the question. Second part of the question is the 750 Series product. Is this a big hole in your portfolio? And do you think that it could actually accelerate some of your traction in the campus market?

[Jayshree Ullal, President and Chief Executive Officer]

First of all, you'll be pleasantly surprised as I am that even though people are not coming back to smart buildings or their headquarters, it's really vertical-dependent, as you know. Some of the logistics and healthcare and some of the business-critical ones do need to go back and do need connectivity and performance in a far more distributed elastic fashion. So I think campus is back, just not the way we thought it would be. The emphasis on unified wire, wireless rather than specific smart buildings is the change we're seeing. And it also gives them -- what we noticed is it's also giving them a chance to plan better, because there's in the building you can't plan but now you can do a lot more proof-of-concept testing. I'm very excited with the 750. There's a whole billion of installed base of some of my old products called the Catalyst that are ripe and old in age. And Anshul, you want to comment on the beauty of that?

[Anshul Sadana, Chief Operating Officer]

Jason, we're very excited with what they're doing, but not a lot of this is driven by feedback from customers. There's immense interest in the 750 Series, and that's broadening our portfolio. When you look at the Fortune 1000 type of enterprises, they absolutely need high density and high performance even in campus. And yes, there are certain companies thinking that since the employees are not in the office, let's not upgrade our refresh but there are also certain companies thinking that there aren't enough employees in the office, so let's go ahead and refresh. And that's really what's driving a lot of the change in the enterprise as well. But the feature set, consistent POS, CloudVision, automation, a lot of the visibility and the benefits to give to people is important to them. If your video conference has jiggered, you don't want to be debugging in the middle of the day, you need to resolve by itself and move on and those are the capabilities we deliver with our products.

[Jason Ader, William Blair]

Anshul, which is the catalyst comparable from Cisco that is…

[Jayshree Ullal, President and Chief Executive Officer]

I think there's a couple of them. There's 4000 series and the 6500 series.

[Anshul Sadana, Chief Operating Officer]

And the CAS 9400.

[Jayshree Ullal, President and Chief Executive Officer]

And the presently shipping one is the 9400, but the older ones are the 4K and the 6500.

[Operator]

Your next question comes from the line of Ryan Koontz from Rosenblatt Securities.

[Ryan Koontz, Rosenblatt Securities]

I wonder if we could circle back to the campus opportunity again and look at the competitive front there. Obviously, you guys have great technology. And how do you feel you're progressing in terms of building out your channels and displacing the big incumbent there in terms of kind of influence over these larger enterprise Global 2000 type customers? Thanks.

[Jayshree Ullal, President and Chief Executive Officer]

I think we have to understand that we are in our second year of campus. And if you look at our competitors, they're in their 10th to 15th or 20th year. They're very mature. So definitely, we've got work to do on go-to-market models. So our first area of focus there is our existing customers. When we have over 6,500 of them, some facilities of them love our EOS and CloudVision and want to use us. The second is we are making more progress on the channel side. We're not signing up everybody, but we certainly see a strong international focus on channels. And I think that will be something we will continue to invest in. And the third is, for the last two, three years, we have been investing in the enterprise go-to-market led by Chris Mit and Ashwin Kohi under Rashman. So we're starting to see the fruits of our labor and just enterprise traction, whether it's in the data center or campus and it's taken us the better part of two to three years to achieve that.

[Operator]

Your next question comes from the line of Ittai Kidron from Oppenheimer.

[Ittai Kidron, Oppenheimer]

A couple from me, maybe just kind of to drill down some of the questions were asked. First, on the cloud, clearly, you're more bullish here. So it's great to hear. Can you clarify whether this includes Facebook sort of refresh? Is that finally back on track and you've got a piece of that? And then pigging back on the question that Jason had on the campus in new 750, congrats there. Cisco just refreshed 9400. I guess when I look at your solution right now online, it looks like you have a couple of cool features there, always on POE, but a supervisor, data plane separation. But it was my impression that this whole chassis campus category is on a massive decline. Customers moving into fixed architectures, not modular at all. So help me understand how much really is the opportunity here? And when you talk about your confidence in doubling the campus business through next year. Is this going to be a material contributor to that or this is really for thereafter?

[Anshul Sadana, Chief Operating Officer]

Ittai, I wouldn't say that the Facebook server refreshes in our guidance model, but all of our cloud titan network plans for the next year are in our models. Let's decouple that a little bit and then we have the data we have today from our customers for using that. So we're confident that there is growth coming back next year on that side.

[Jayshree Ullal, President and Chief Executive Officer]

And on the 750, both Anshul and I have been involved a lot in chassis in our prior lives. I think if there's anything that will be under constraint, it's the stackables. Customers are moving to more and more distributed 1RU. And one of the things that probably got a little unnoticed in our announcement today is our 2RU 96 port, which obviates the need for any stampable. And then for the really high-density distributed buildings, which have large employees, large headquarters, you do need 750. You need the investment protection of 100-gig uplinks. You need the density and footprint and power. You need the operational power management. You need the security. You need the always on failover time for rolling upgrades. And I think what's happened, at least in our minds, is the chassis has gone from being a physical cable plant discussion to much more of an automation, visibility, security discussion. You need all the properties that you had in the data center. So that market is coming to us. So we feel good that there's -- it's a new product, it will take time to qualify, but it is a contributor to our number in 2021.

[Operator]

Your next question comes from the line of Meta Marshall from Morgan Stanley.

[Meta Marshall, Morgan Stanley]

Maybe wanted to touch on just kind of what sort of traction you're seeing with existing customers from your Big Switch and Awake Security acquisitions and just whether that could be -- I understand it's not material to Q4, but a more material contributor to 2021. Thanks.

[Jayshree Ullal, President and Chief Executive Officer]

I definitely think it's a strategic contributor to 2021 in bookings. As you know, the revenue may follow as multiyear contracts in software, network software and subscription models. So how material will it be in 2021? Probably small. But both those are very strategic to influencing our customers' decisions on the data center and campus. And in general, helping with their operational -- their architectural experience and their operational experience, it's a huge differentiator. So observability, monitoring, in-line data analysis capability and then the autonomous threat hunting. It's so important now because the firewall or the perimeter of the firewall is just collapsed. So the ability to do that is we just closed the Awake acquisition in October. So it's too early to tell. But the one thing we can tell is everyone's interested in it. Anshul, you want to add to that?

[Anshul Sadana, Chief Operating Officer]

Jayshree, you actually are right. With IoT and sensors and campuses and work environments, the monitoring is going to be very, very different. And there's an unmet need in this space today and I think a way with a very well with the AI technology as well as Big Switch in the market side.

[Operator]

Your next question comes from the line of Aaron Rakers from Wells Fargo.

[Aaron Rakers, Wells Fargo]

I want to go back to one of Ittai's question. And I can appreciate that you're not factoring in kind of Facebook and server refresh cycle in the context of your guidance. But if you go back in time, how do you think about the context of server cycles and how that pulls through your business just to give a historical backdrop? Because as we look into '21, you've got, obviously, a big refresh for Intel. You've got A&D pushed into service CPU cycle. I'm just curious to how you think about that pull-through effect on Arista's business? Thank you.

[Jayshree Ullal, President and Chief Executive Officer]

Aaron, I don't think it's changed much. Of course what happens is you got to get the buildings and the power and the cooling in, then you got to get the servers. And there's typically a one to two quarter lag on the network. And so clearly, the service cycle comes ahead of us, which is why we felt the pain we did last year. Hopefully, we'll feel the gain of it next year.

[Operator]

Your next question comes from the line of Pierre Ferragu from New Street Research.

[Pierre Ferragu, New Street Research]

Jayshree, you mentioned in your opening remarks that outside of your core switching market, you had growth opportunities in routing, campus and software and services. And I was wondering over like a three, maybe to five year time horizon, how much of your growth do you think is going to come from these additional segments versus how much is still going to come from switching, your core switching market?

[Jayshree Ullal, President and Chief Executive Officer]

Well, Ita is telling me not to answer this question. [Multiple Speakers] From a vision perspective, we think those two segments, the new markets where we're underpenetrated, we're in the early innings in both network adjacencies and software and services will grow faster than our core market. How about I leave it at that? Is that a good enough answer?

[Ita Brennan, Chief Financial Officer]

That's a good enough answer.

[Operator]

Your next question comes from the line of Tim Long from Barclays.

[Tim Long, Barclays]

Can we just hit on the telco vertical? It seems like it's still towards the bottom of the pecking order, at least in your results. So what's going on there? What do you think you get that going? Is it just increasing the routing use cases and further penetrating on that regard or maybe the addition of more security features, which often do well in the telco networks? Thank you.

[Jayshree Ullal, President and Chief Executive Officer]

I think unlike the cloud, where they will adopt our routing features, even if we're missing one or two and then operationalize it, you know very well, service providers want every bell and whistle. And as I said in my opening remarks, it's taking us the better part of four, five years. We're making very good traction in Tier 2 or 3. Tier 1 is still taking time. But in this year, we have won some early design wins in Tier 1 as well. So the numbers are small. So I think in order to make them break, they need to spend more from us.

[Operator]

Your next question comes from the line of Amit Daryanani from Evercore.

[Amit Daryanani, Evercore]

I guess, maybe if I just go back to this double-digit sales growth expectation for calendar '21. Just trying to understand, is that an organic statement, is that a total revenue growth statement, how do we think about that? And then broadly, when I hear you talk about calendar '21, it sounds like the growth vectors are getting much more diversified than they historically have been. And I'm wondering how does that play out into your operating expenses and perhaps the need to expanding infrastructure further in calendar '21?

[Jayshree Ullal, President and Chief Executive Officer]

Amit, just to take the question upfront, it is absolutely based on products as we have now organically. We're not factoring any future products or M&A in that discussion. And maybe, Ita, you want to talk about the…

[Ita Brennan, Chief Financial Officer]

Yes. I think on the investment side, with the top line returning to growth, that gives us a lot of room to make those investments and maybe a little bit more than that, we'll see. But we certainly have the growth on the top line to do that. My script did remind everybody that our target model is 35% operating margin. And we're reserving the right to do that, should we find the right investments to make. And we'll be very metric-driven around that as we go forward. But that's kind of the target model longer term. In the meantime, we'll have the benefit of top line growth to help with the investments in the near term.

[Operator]

Your next question comes from the line of Simon Leopold from Raymond James.

[Simon Leopold, Raymond James]

I wanted to take your sense on a scenario. If we assume an existing Arista customer wants to upgrade a data center to 200-gig, not 400 but 200-gig, what does that mean for Arista? Is it a line card change for a swap of chassis? And if it is a swap of chassis, you risk losing share in that kind of upgrade scenario for one of your customers? Thank you.

[Anshul Sadana, Chief Operating Officer]

Simon, while we haven't talked about 200-gig broadly, there are certain customers looking at these types of technologies. And since we're staying with the four lean architecture at [4550]. The good news is all of the products we mentioned, the R3 series, some in the [7060] series, some in the 7300 series, all of them support not just 400-gig but also 200 gig. So we are aware of the need in certain cases of 200-gig now very, very well poised to actually grow or benefit from that as well.

[Operator]

Your next question comes from the line of Woo Jin Ho from Bloomberg Intelligence.

[Woo Jin Ho, Bloomberg Intelligence]

So an intermediate-term technology question here. So the question has been asked. So NVIDIA and Marvell has been talking a lot about DPUs in the data center. It sounds like if we given starting to get a little bit more complex of the architectures at least. Does DPUs present a growth opportunity for you in the cloud that we may not have considered in the past?

[Anshul Sadana, Chief Operating Officer]

This is a bit too early to say where the DPUs will come disrupt or is there a lot of marketing in terms of offload engines. Remember, offload engines, especially on servers, have been around for many, many years and this might have special instruction sets for the new types of outlooks the world is looking at. But so far, we don't see any major impact to networking like us, maybe even a benefit because that drives the change in architecture and actually helps us compare from the incumbency.

[Jayshree Ullal, President and Chief Executive Officer]

I think they generally have been co-processors, they don't take away the need for a CPU.

[Operator]

Your final question comes from the line of Jon Lopez from Vertical Group.

[Jon Lopez, Vertical Group]

I just had one clarification for Ita on the deferred side. Ita, the deferred has gone marginally lower sequentially each of the last two quarters. And I just want to make sure I understand. Are there puts and takes in that? Is that now more, say, dependent on larger renewals that happen periodically through the course of the year? So if you can just talk a second about that? And also, is there anything in that trending that we should think about as we think about services revenue in 2021?

[Ita Brennan, Chief Financial Officer]

Yes. No, that's exactly what it is. I mean, it's almost all services now and it's really going to move around more by the term and the timing of just those renewals, whether I renew one year or three years, it doesn't really make any difference in the business but it will show up in that deferred revenue line item. The revenue will still be pretty consistent, because you're recognizing it over time. But the deferred line will move around. So if we have a big renewal on a multiyear contract, that number is going to go up. As we renew just one year and come back to do the next later, it won't increase or it might decline slightly because we're recognizing some of that revenue. So it's going to move around a bit but it's not a business driver. It's just more how are we negotiating and closing out.

[Curtis McKee, Director of Corporate and Investor Development]

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

[Operator]

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