News Column

ARISTA NETWORKS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 8, 2014

You should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q and our prospectus filed on June 6, 2014 (the "Prospectus"), pursuant to Rule 424(b) under the Securities Act of 1933, as amended ("the Securities Act"), with the U.S. Securities and Exchange Commission (the "SEC"). This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q.



Overview

We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation data centers for enterprises, based on market share. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our 10/40/100 Gigabit Ethernet switches. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. Since we began shipping our products, we have grown rapidly, and, according to Crehan Research, we have achieved the second largest market share in data center 10/40/100 Gigabit Ethernet switch ports, excluding blade switching, sold in 2013. At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services. We were founded in 2004 to address the limitations of legacy networking products and to create a cloud networking platform that is open and programmable. From 2004 to 2008, our activities were focused on the development of our software, which resulted in the commercial release of our first product, the 7100 Series switches based on our EOS software, in 2008. Since then, we have continued to introduce new products utilizing EOS, including our 7500 Series switch and our 7050 Series switch in 2010, the second generation of our 7500 Series switch, called the 7500E modular switch, in May 2013 and our 7300 Series switch in November 2013. As of June 30, 2014, we have shipped more than two million switch ports. We have experienced rapid revenue growth over the last several years, increasing our revenue at a compound annual growth rate of 71.4% from 2010 to 2013. As we have grown the functionality of our EOS software, expanded the range of our switching portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. To support revenue growth, we have increased our international presence to include offices in nine countries as of June 30, 2014, including Canada, China, India, Ireland, Japan, South Korea, Malaysia, Singapore and Taiwan. Our 2013 revenue grew 86.8% when compared to 2012. Our revenue for the three and six months ended June 30, 2014 was $137.9 million and $255.2 million, an increase of 65.2% and 76.2%, respectively, when compared to the same period in 2013. We have been profitable and cash flow positive for each year since 2010. We believe that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of adoption. We expect to continue rapidly growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. We intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We also intend to continue to expand our sales and marketing teams and programs, with a particular focus on expanding our network of international channel partners and carrying out associated marketing activities in key geographies. In order to support our strong growth, we have accelerated our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations. As a result, we expect our levels of operating profit could decline in the short to medium term. For a description of factors that may impact our future performance, see the disclosure in the section titled "Factors Affecting Our Performance" below. 26 --------------------------------------------------------------------------------



Our Business Model

We derive revenue from sales of products and services. We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also generate services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products.

Since shipping our first products in 2008, our cumulative end-customer base has grown rapidly. Between December 31, 2010 and June 30, 2014, our cumulative end-customer base grew from approximately 570 to approximately 2,700. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others.



To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. For example during the year ended December 31, 2013, approximately 85.2% of our revenue was received from our existing end customers.

Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. We work closely with third parties to manufacture and deliver our products. Our third-party silicon vendors deliver these components directly to our contract manufacturers, who manufacture and assemble our products and deliver them to us for labeling, quality assurance testing, final configuration and shipment to our customers. We market and sell our products through our direct sales force and in partnership with channel partners, including distributors, value-added resellers, systems integrators, original equipment manufacturer, or OEM, partners and in conjunction with various technology partners, depending on the application. To facilitate channel coordination and increase productivity, we have created a partner program, the Arista Partner Program, to engage partners who provide value-added services and extend our reach into the marketplace. Authorized training partners provide technical training to our channel partners. Our partners commonly receive an order from an end customer prior to placing an order with us, and we confirm the identification of the end customer prior to accepting such orders. Our partners generally do not stock inventory received from us. Our sales organization is supported by systems engineers with deep technical expertise and responsibility for pre-sales technical support and engineering for our end customers. Each sales team is responsible for a geographic territory, has responsibility for a number of major direct end-customer accounts or has assigned accounts in a specific vertical market. During three and six months ended June 30, 2014, 74.8% and 78.1% of our revenue was generated from the Americas, substantially all from the United States, 15.0% and 12.7% from Europe, the Middle East and Africa and 10.2% and 9.2% from the Asia-Pacific region, respectively.



Factors Affecting Our Performance

We believe that our future success will depend on many factors, including our ability to expand sales to our existing customers as well as to add new end customers. While these areas present significant opportunity, they also present risks that we must manage to ensure successful results. See the section titled "Risk Factors." Additionally, we face intense competition especially from larger, well-established companies, and we must continue to expand the capabilities of our cloud networking platform to succeed in our market. If we are unable to address these challenges, our business could be adversely affected. Increasing Adoption of Cloud Networks. Networks are subject to increasing performance requirements due to growing numbers of connected devices as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We believe that cloud networks will continue to replace legacy network technologies. Our business and results of operations will be significantly affected by the speed with which organizations implement cloud networks. Expanding Sales to Existing Customer Base. We expect that a substantial portion of our future sales will be follow-on sales to existing end customers. As noted above, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our cloud networking solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing and expected infrastructure spend. Our business and results of operations will depend on our ability to sell additional products to our growing base of customers. 27 -------------------------------------------------------------------------------- Adding New End Customers. We believe that the cloud networking market is still in the early stages of adoption. We intend to target new end customers by continuing to invest in our field sales force and extending our relationships with channel partners. To date, we have primarily targeted end customers with the largest cloud data centers. A typical initial order involves the education of prospective customers about the technical merits and capabilities and potential cost savings of our products as compared to our competitors' products. Our results of operations will depend on our ability to continue to add new customers. We believe that customer references have been, and will continue to be, an important factor in winning new business. Selling More Complex and Higher-Performance Configurations. Our results of operations have been, and we believe will continue to be, affected by our ability to sell more complex and higher-performance configurations of our products. Going forward, we aim to grow our revenue by enabling end customers to transition from previously deployed 1 Gigabit Ethernet switches to 10, 40 and eventually 100 Gigabit Ethernet switches. Our ability to sustain our revenue growth will depend, in part, upon our continued sales of more robust configurations of our products, and quarterly results of operations can be significantly impacted by the mix of products and product configurations sold during the period. Leveraging Channel Partners. We expect to continue to derive a growing portion of our sales through our channel partners as they develop new end customers and expand sales to our existing end customers. We plan to continue to invest in our network of channel partners to empower them to reach new end customers more effectively, increase sales to existing customers and provide services and support effectively. We believe that increasing channel leverage will extend and improve our engagement with a broad set of customers. Our business and results of operations will be materially affected by our success in leveraging our channel partners. Investing in Research and Development for Growth. We believe that the market for cloud networking is still in the early stages of adoption and we intend to continue investing for long-term growth. We expect to continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products including new releases and upgrades to our EOS software and new applications and build upon our technology leadership. We believe one of our greatest strengths lies in the speed of our product development efforts. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these investments. Customer Concentration and Timing of Large Orders. During the years ended December 31, 2011, 2012 and 2013, sales to our 10 largest end customers accounted for approximately 32.4%, 39.3% and 43.0% of our revenue, respectively. During the years ended December 31, 2011, 2012 and 2013, our largest end customer accounted for 10.4%, 15.3% and 21.9% of our revenue, respectively. We have also experienced and continue to experience customer concentration on a quarterly basis. In addition, we have experienced increases in the size of our orders, including orders from existing customers, which could result in future increased customer concentration, depending on the timing of the fulfillment of those orders. We have also experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test and qualify our products and factors specific to our end customers. Due to these factors, we expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers. Basis of Presentation Revenue We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also derive a small but growing portion of our revenue from sales of PCS. We generate PCS revenue from sales of technical support services contracts that are typically purchased in conjunction with our products and subsequent renewals of those contracts. We offer PCS services under renewable, fee-based contracts, which include 24-hour technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if available basis. We expect our revenue may vary from period to period based on, among other things, the timing and size of orders and delivery of products, the impact of significant transactions with unique terms and conditions that may require deferral of revenue and cyclicality of orders being placed by our customers. Additionally, we expect our PCS revenue to increase in absolute dollars as we expand our installed base. Our ability to expand our installed base and increase our revenue is subject to numerous risks and uncertainties. See the section titled "Risk Factors." We report revenue net of sales taxes. Cost of Revenue Cost of revenue primarily consists of amounts paid to our third-party contract manufacturers and merchant silicon vendors, warranty expenses, excess inventory write-offs and personnel and other costs in our manufacturing operations department. Our cost of product revenue also includes product testing costs, allocated costs and shipping costs. We expect our cost of product revenue to 28 --------------------------------------------------------------------------------



increase as our product revenue increases. Cost of providing PCS services consists of personnel costs for our global customer support organization. We expect our cost of service revenue to increase as our PCS revenue increases.

Gross Margin

Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, the average sales price of our offerings, manufacturing costs, merchant silicon costs and the mix of products sold. We expect our gross margins to fluctuate over time, depending on the factors described above and others. See the section titled "Risk Factors."



Operating Expenses

Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. We expect operating expenses to continue to increase in absolute dollars as well as a percentage of revenue in the near term as we continue to invest in the growth of our business.



Research and Development Expenses

Research and development expenses consist primarily of personnel costs, with the remainder being prototype expenses, third-party engineering and contractor support costs, an allocated portion of facility and IT costs and depreciation. Our research and development efforts are focused on maintaining and developing additional functionality for our existing products and on new product development, including new releases and upgrades to our EOS software and applications. We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as well as a percentage of revenue as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.



Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel costs and also include costs related to marketing and promotional activities, with the remainder being an allocated portion of facility and IT costs and depreciation. We expect our sales and marketing expenses to increase in absolute dollars and may fluctuate as a percentage of revenue from period to period as we expand our sales and marketing efforts worldwide and expand our relationships with current and future channel partners and end customers.



General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs, professional fees, an allocated portion of facility and IT costs and depreciation. General and administrative personnel costs include those for our executive, finance, IT, human resources and legal functions. Our professional fees consist primarily of accounting, external legal and IT and other consulting costs. We expect our general and administrative expenses to increase in absolute dollars as well as a percentage of revenue to support our growing infrastructure needs and as we assume the reporting requirements and compliance obligations of a public company. Other Income (Expense), Net Interest Expense



Interest expense consists of interest expense on our subordinated convertible promissory notes, including our related party subordinated convertible promissory notes.

Interest and Other Income (Expense)

Interest and other income (expense) consist of interest expense from our lease financing obligation, gain on our notes receivable, write-off of debt discount on notes payable and foreign currency exchange gains and losses. Our foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates. 29 --------------------------------------------------------------------------------



Provision for Income Taxes

We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, the U.S. taxes are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations. Results of Operations The following table summarizes historical results of operations for the periods presented and as a percentage of revenue for those periods. We have derived the data for the three and six months ended June 30, 2014 and 2013 from our unaudited condensed consolidated financial statements (in thousands, except for percentage of revenue). Three Months Ended June 30,



Six Months Ended June 30,

2014 2013 2014 2013 Revenue $ 137,947$ 83,485$ 255,154$ 144,833 Cost of revenue (1) 44,567 29,584 80,460 48,804 Gross profit 93,380 53,901 174,694 96,029 Operating expenses (1): Research and development 34,888 21,086 68,334 40,600 Sales and marketing 20,711 13,045 39,366 23,180 General and administrative 7,126 3,506 14,357 7,242 Total operating expenses 62,725 37,637 122,057 71,022 Income from operations 30,655 16,264 52,637 25,007 Other income (expense), net: Interest expense (1,435 ) (1,772 ) (3,206 ) (3,523 ) Interest and other income (expense), net 2,472 (1 ) 1,708 (100 ) Total other income (expense), net 1,037 (1,773 ) (1,498 ) (3,623 ) Income before provision for income taxes 31,692 14,491 51,139 21,384 Provision for income taxes 10,074 4,240 17,192 4,522 Net income $ 21,618$ 10,251$ 33,947$ 16,862 30

-------------------------------------------------------------------------------- Three Months Ended June 30, Six Months Ended June 30, 2014 2013 2014 2013 (as a percentage of revenue) Revenue 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenue 32.3 35.4 31.5 33.7 Gross margin 67.7 64.6 68.5 66.3 Operating expenses: Research and development 25.3 25.3 26.8 28.0 Sales and marketing 15.0 15.6 15.4 16.0 General and administrative 5.2 4.2 5.6 5.0 Total operating expenses 45.5 45.1 47.8 49.0 Income from operations 22.2 19.5 20.7 17.3 Other income (expense), net: Interest expense (1.0 ) (2.1 ) (1.3 ) (2.4 ) Interest and other income (expense), net 1.8 - 0.7 (0.1 ) Total other income (expense), net 0.8 (2.1 ) (0.6 ) (2.5 ) Income before provision for income taxes 23.0 17.4 20.1 14.8 Provision for income taxes 7.3 5.1 6.7 3.1 Net income 15.7 % 12.3 % 13.4 % 11.7 %



(1) Includes stock-based compensation expense as follows:

Three Months Ended June



30, Six Months Ended June 30,

2014 2013 2014 2013 Cost of revenue $ 301 $ 83 $ 512 $ 150 Research and development 3,527 1,134 5,994 2,130 Sales and marketing 1,931 612 3,359 1,094 General and administrative 946 244 1,622 441 Total stock-based compensation $ 6,705 $



2,073 $ 11,487$ 3,815

Three and Six Months Ended June 30, 2014 Compared to Three and Six Months Ended June 30, 2013

Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)

Three Months Ended June 30, Six Months Ended June 30, 2014 2013 Change 2014 2013 Change $ $ $ % $ $ $ % Revenue $ 137,947$ 83,485$ 54,462 65.2 % $



255,154 $ 144,833$ 110,321 76.2 % Cost of Revenue 44,567 29,584 14,983 50.6 80,460 48,804 31,656 64.9

Gross profit $ 93,380$ 53,901$ 39,479 73.2 % $ 174,694$ 96,029$ 78,665 81.9 %

Gross margin 67.7 % 64.6 %

68.5 % 66.3 % 31

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Revenue

Revenue increased $54.5 million, or 65.2% for the three months ended June 30, 2014 compared to the same period in 2013. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $48.7 million, or 63.2%, primarily to existing customers, and, to a lesser extent, new customers. The increase in product revenue was largely driven by the number of switch ports shipped, which increased by 51.6% during the three months ended June 30, 2014 compared to the same period in 2013, partially offset by a reduction of 4.0% in the average selling price per port shipped. In addition, we had an increase in revenue of $13.1 million related to changes in deferred product revenue. During the second quarter ended June 30, 2013, we had net product deferrals totaling $7.6 million, primarily from the deferral of a few large customer orders, while in the second quarter ended June 30, 2014 we recognized $5.5 million, net of product deferrals, primarily from the recognition of two large customer orders that were previously deferred. Revenue increased $110.3 million, or 76.2%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $97.2 million, or 72.4%, primarily to existing customers, and, to a lesser extent, new customers. The increase in product revenue was largely driven by the number of switch ports shipped which increased by 59.2%, partially offset by a reduction of 2.7% in average selling price per port shipped. In addition, we had an increase in revenue of $22.5 million related to changes in deferred product revenue. During the six months ended June 30, 2013, we had net product deferrals totaling $8.6 million, primarily from the deferral of a few large customer orders, while in the six months ended June 30, 2014 we recognized $13.9 million, net of product deferrals, primarily from the recognition of a few large customer orders that were previously deferred.



Cost of Revenue

Cost of revenue increased $15.0 million, or 50.6%, for the three months ended June 30, 2014 compared to the same period in 2013. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the three months ended June 30, 2014 resulting in an increase in product costs of $14.3 million in the three months ended June 30, 2014 compared to the same period in 2013.



Cost of revenue increased $31.7 million, or 64.9%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the six months ended June 30, 2014 resulting in an increase in product costs of $29.7 million in the six months ended June 30, 2014 compared to the same period in 2013.

Gross Margin

Gross margin increased from 64.6% for the three months ended June 30, 2013 to 67.7% for the three months ended June 30, 2014. The increase in gross margins was primarily the result of a decrease in product warranty and inventory obsolescence charges totaling $3.5 million from significant charges during the second quarter of 2013 from product defect issues and the impairment of obsolete products due to the introduction of new products. This increase was partially offset by a decrease in product margins due to an increase in the size of contracts with large end customers having higher volume discounts. Gross margin increased from 66.3% for the six months ended June 30, 2013 to 68.5% for the six months ended June 30, 2014. The increase in gross margins was primarily the result of a decrease in product warranty charges of $5.1 million resulting from improved product quality and from a benefit of $2.2 million resulting from a cash settlement received from one of our suppliers due to a product defect issue. This increase was partially offset by a decrease in product margins due to an increase in the size of contracts with large end customers having higher volume discounts. 32 --------------------------------------------------------------------------------



Operating Expenses (in thousands, except percentages)

Three Months Ended June 30,



Six Months Ended June 30,

2014 2013 Change 2014 2013 Change in $ $ $ % $ $ $ % Operating expenses: Research and development $ 34,888$ 21,086$ 13,802 65.5 % $ 68,334$ 40,600$ 27,734 68.3 % Sales and marketing 20,711 13,045 7,666 58.8 39,366 23,180 $ 16,186 69.8 General and administrative 7,126 3,506 3,620 103.3 14,357 7,242 $ 7,115 98.2 Total operating expenses $ 62,725$ 37,637$ 25,088 66.7 % $ 122,057$ 71,022$ 51,035 71.9 %



Research and development

Research and development expenses increased $13.8 million, or 65.5%, for the three months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $9.8 million, resulting from an increase of 226 employees from June 30, 2013 to June 30, 2014, as well as the introduction of our corporate bonus plan in 2014. The increase was also due to a $1.7 million increase in research and development related facilities and IT infrastructure costs and a $1.1 million increase in third-party engineering costs as we continued to expand and support our research and development activities. Research and development expenses increased $27.7 million, or 68.3%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $18.3 million, resulting from an increase in headcount as discussed above as well as the introduction of our corporate bonus plan in 2014. The increase was also due to a $4.0 million increase in research and development related facilities and IT infrastructure costs and a $2.1 million increase in third-party engineering costs as we continued to expand and support our research and development activities.



Sales and marketing

Sales and marketing expenses increased $7.7 million, or 58.8%, for the three months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $5.9 million, resulting from an increase of 65 employees from June 30, 2013 to June 30, 2014. The increase was also due to higher costs associated with trade show activities, conferences and other marketing activities of $0.5 million. Sales and marketing expenses increased $16.2 million, or 69.8%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $12.7 million, resulting from an increase in headcount as discussed above. The increase was also due to higher costs associated with trade show activities, conferences and other marketing activities of $0.9 million. General and administrative General and administrative expenses increased $3.6 million, or 103.3%, for the three months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $1.4 million, resulting from an increase of 32 employees from June 30, 2013 to June 30, 2014, as well as the introduction of our corporate bonus plan in 2014. We also incurred higher professional service fees of $1.1 million related to outside legal, accounting and consulting services to support increased business activity and preparations for becoming a public company as well as an increase of $0.6 million in provision for bad debt and insurance costs. General and administrative expenses increased $7.1 million, or 98.2%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $3.0 million, resulting from an increase in headcount as discussed above as well as the introduction of our corporate bonus plan in 2014. We also incurred higher professional service fees of $3.0 million related to outside legal, accounting and consulting services to support increased business activity and preparations for becoming a public company. 33 --------------------------------------------------------------------------------



Other Income (Expense), Net (in thousands, except percentages)

Three Months Ended June 30,



Six Months Ended June 30,

2014 2013 Change 2014 2013 Change in $ $ $ % $ $ $ % Other income (expense), net:



Interest expense $ (1,435 )$ (1,772 )$ 337 (19.0 )% $ (3,206 )$ (3,523 )$ 317 (9.0 )%

Interest and other income (expense), net 2,472 (1 ) 2,473 N/M



1,708 (100 ) 1,808 N/M

Total other income (expense), net $ 1,037$ (1,773 )$ 2,810$ (1,498 )$ (3,623 )$ 2,125



Interest expense

Interest expense decreased slightly for the three and six months ended June 30, 2014 compared to the same period in 2013 as a result of the repayment and conversion of all our notes payable upon our IPO.

Interest and other income (expense), net

Other income (expense), net increased $2.5 million for the three months ended June 30, 2014, compared to the same period in 2013 largely due to the gain on our notes receivable of $4.0 million partially offset by $0.8 million of interest expense primarily related to our lease financing obligation and $0.7 million of write-off of debt discount on notes payable upon our IPO. Other income (expense), net increased $1.8 million for the six months ended June 30, 2014, compared to the same period in 2013 largely due to the gain on our notes receivable of $4.0 million partially offset by $1.5 million of interest expense primarily related to our lease financing obligation and $0.7 million of write-off of debt discount on notes payable upon our IPO.



Provision for Income Taxes (in thousands, except percentages)

Three Months Ended June 30,



Six Months Ended June 30,

2014 2013 Change 2014 2013 Change $ $ $ % $ $ $ % Provision for income taxes $ 10,074$ 4,240$ 5,834 137.6 % $ 17,192$ 4,522$ 12,670 280.2 % Effective tax rate 31.8 % 29.3 %



33.6 % 21.1 %

Provision for income taxes was approximately $10.1 million and $4.2 million for the three months ended June 30, 2014 and 2013 respectively, and $17.2 million and $4.5 million for the six months ended June 30, 2014 and 2013 respectively. The change in our provision for income taxes and effective tax rate was primarily due to an increase in profit before income tax, the geographical distribution of the earnings, and the expiration of the federal research and development credit as of December 31, 2013. The effective tax rate as of December 31, 2013 included the impact of the passage of the American Tax Relief Act of 2012 signed into law on January 2, 2013, which reinstated 2012 and 2013 federal research and development credit. The impact of the 2012 federal research and development tax credit benefit was recorded in the three months ended March 31, 2013.



Liquidity and Capital Resources

As of June 30, 2014, cash and cash equivalents were $397.2 million, including $31.8 million held outside the United States in our foreign subsidiaries. If we were to repatriate cash held outside of the United States, it could be subject to U.S. income taxes less any previously paid foreign income taxes. Since inception, we have primarily financed our operations and capital expenditures through debt, cash flows from our operations and sales of capital stock. As of December 31, 2013, we had outstanding $75.0 million aggregate principal amount of subordinated convertible promissory notes and $25.0 million aggregate principal amount of related party subordinated convertible promissory notes. 34 -------------------------------------------------------------------------------- On June 6, 2014, we completed our initial public offering (the "IPO") in which we sold 6,037,500 shares of our common stock at a public offering price of $43.00 per share, which included 787,500 shares of common stock issued pursuant to the exercise in full of the over-allotment option by the underwriters. The IPO resulted in proceeds of $238.7 million, net of underwriting discounts and commissions of $15.6 million and other estimated issuance costs of $5.3 million. In connection with the closing of the IPO, all of our outstanding convertible preferred stock automatically converted into 24,000,000 shares of common stock on a one-to-one basis. Upon the closing of our IPO, all noteholders with the exception of one noteholder converted the principal and accrued interest amount outstanding under their subordinated convertible promissory notes into shares of our common stock at the IPO price of $43.00 per share. The noteholder, who did not elect to so convert, was paid a total of $23.6 million which included principal and accrued interest less applicable withholding taxes of $1.1 million. The remainder of the noteholders converted the remaining debt balance of approximately $96.5 million including principal and accrued interest into 2.2 million shares of our common stock. We plan to continue to invest for long-term growth. One of the principal purposes of the IPO was to obtain additional capital to fund the growth of our business. We believe that our existing cash and cash equivalents balance together with cash proceeds from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced products and services offerings, our costs of outsourcing, our manufacturing and possible acquisitions or investments. We expect to incur a total of $17.3 million in capital expenditures in 2014 due to investment in our research and development and manufacturing processes. If we are unable to raise additional capital when we need it, our business, results of operations and financial condition would be adversely affected. The sale of additional equity could result in additional dilution to our stockholders. If we raise additional funds by borrowing from third parties, the terms of those financing arrangements may include negative covenants or other restrictions on our business that could impair our operating flexibility and would require us to incur interest expense. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain financing on terms favorable to us. We consider the undistributed earnings of our foreign subsidiaries as of June 30, 2014 and December 31, 2013 to be indefinitely reinvested, and, accordingly, no U.S. income taxes have been provided thereon. As of June 30, 2014 and December 31, 2013, the amount of cash associated with indefinitely reinvested foreign earnings was approximately $31.8 million and $33.4 million, respectively. If these funds are needed for our operations in the United States, we would be required to accrue and pay U.S. income taxes to repatriate these funds. However, we have not repatriated nor do we anticipate the need to repatriate funds to the United States to satisfy domestic liquidity needs arising in the ordinary course of business, including liquidity needs associated with our domestic debt service requirements. Cash Flows June 30, 2014December 31, 2013

Cash and cash equivalents $ 397,198 $ 113,664 Six Months Ended June 30, 2014 2013



Cash provided by operating activities $ 63,946$ 8,748 Cash used in investing activities

(4,539 ) (12,212 ) Cash provided by financing activities 224,064 5,495 Effect of exchange rate changes 63 (54 )



Net increase in cash and cash equivalents $ 283,534$ 1,977

Cash Flows from Operating Activities

Our primary source of cash from operating activities has been from cash collections from our customers. We expect cash inflows from operating activities to be affected by increases in sales and timing of collections. Our primary uses of cash from operating activities have been for personnel costs and investment in sales and marketing and research and development. We expect cash outflows from operating activities to increase as a result of further investment in sales and marketing and increases in personnel costs as we grow our business. During the six months ended June 30, 2014, cash provided by operating activities was $63.9 million primarily from net income of $33.9 million, net non-cash charges of $14.0 million and a net increase in our operating assets and liabilities of $16.0 million. The change in our operating assets and liabilities was primarily due to a decrease in our accounts receivable of $9.7 million 35 -------------------------------------------------------------------------------- resulting from an increase in our collection efforts, an increase in our accounts payables of $4.8 million from the timing of our payments, an increase in our deferred revenue of $2.8 million resulting from the increase in sales. Inventories also decreased by $2.3 million as a result of improvements in the management of our consigned and finished goods inventory. These changes were partially offset by an increase in our prepaid expenses and other current assets of $5.6 million primarily from the prepayments for taxes and renewals of our insurance and licenses and a $1.0 million net decrease in interest payable attributable to our outstanding subordinated convertible promissory notes, including our related party subordinated convertible promissory notes before their conversion or repayment upon the completion of our IPO. During the six months ended June 30, 2013, cash provided by operating activities was $8.7 million primarily from net income of $16.9 million, net non-cash charges of $3.9 million and a net decrease in our operating assets and liabilities of $12.0 million. The change in our operating assets and liabilities was primarily due to an increase in accounts receivable of $27.5 million due to an increase in sales, an increase in inventories of $12.7 million for anticipated growth in our business and higher prepaid and other assets of $1.9 million. These changes were partially offset by higher deferred revenue of $14.8 million due to increase in sales, an increase in accrued liabilities of $8.0 million which were primarily related higher warranty liabilities and higher compensation related costs from increased headcount and a $3.0 million increase in interest payable attributable to our outstanding promissory notes, including our related party subordinated convertible promissory notes. Additionally, our accounts payable and other liabilities also increased by $4.3 million primarily attributable to the timing of payments.



Cash Flows from Investing Activities

Our investing activities have consisted primarily of purchases of property and equipment. We expect to continue to make purchases of property and equipment to support continued growth of our business. During the six months ended June 30, 2014, cash used in investing activities was $4.5 million, which primarily consisted of purchases of property and equipment of $8.6 million partially offset by the release of our restricted cash into cash and cash equivalents of $4.0 million.



During the six months ended June 30, 2013, cash used in investing activities was $12.2 million, all of which was for purchases of property and equipment.

Cash Flows from Financing Activities

Our cash flows provided by financing activities primarily consisted of proceeds from the for IPO and exercises of stock options partially offset by repayment of our subordinated convertible promissory notes. During the six months ended June 30, 2014, cash provided by financing activities was $224.1 million, consisting primarily of net proceeds raised from our IPO of $241.9 million and proceeds from the exercise of stock options, net of repurchases of $2.1 million. These proceeds were partially offset by the repayment of our notes payable of $20.0 million. During the six months ended June 30, 2013, cash provided by financing activities was $5.5 million, consisting primarily of proceeds from the exercise of stock options, net of repurchases, amounting to $5.3 million and excess tax benefits realized from our equity incentive plans amounting to $0.2 million. 36 --------------------------------------------------------------------------------



Debt Obligations

In January 2011, we sold $55.0 million aggregate principal amount of subordinated convertible promissory notes, or Convertible Notes, to outside investors and $25.0 million aggregate principal amount of Convertible Notes to two trusts that are related to two of our co-founders. In June 2011, we sold an additional $20.0 million aggregate principal amount of Convertible Notes to outside investors. The interest rate on the Convertible Notes was 6.0% per annum, computed on the basis of the actual number of days elapsed and a year of 365 days. All unpaid principal and accrued interest on the Convertible Notes was due and payable on the earlier of December 31, 2014 or upon the occurrence of an event of default, defined as: (i) failure to pay principal or interest when due; (ii) breaches of covenants; (iii) breaches of representations and warranties; (iv) failure to make other payment obligations resulting in the acceleration of maturity of indebtedness in excess of $10.0 million; (v) voluntary bankruptcy; (vi) involuntary bankruptcy; or (vii) certain adverse judgments. We could voluntarily prepay the Convertible Notes, in whole or in part, before the maturity date by giving each investor 10 days' prior written notice. Upon the closing of our IPO, all noteholders with the exception of one noteholder converted the principal and accrued interest amount outstanding under their subordinated convertible promissory notes into shares of our common stock at the IPO price of $43.00 per share. The noteholder, who did not elect to so convert, was paid a total of $23.6 million which included principal and accrued interest less applicable withholding taxes of $1.1 million. The remainder of the noteholders converted the remaining debt balance of approximately $96.5 million including principal and accrued interest into 2.2 million shares of our common stock.



Off-Balance Sheet Arrangements

As of June 30, 2014, we did not have any relationships with any unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.



Contractual Obligations and Commitments

There has been no significant changes during the six months ended June 30, 2014 to our contractual obligations disclosed in our "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Prospectus.



Critical Accounting Policies and Estimates

Our unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. We believe the critical accounting policies and estimates discussed in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our Prospectus that was filed with the SEC on June 6, 2014, reflect our more significant judgments and estimates used in the preparation of the condensed consolidated financial statements. There have been no significant changes to our critical accounting policies and estimates as disclosed in our Prospectus.



Recent Accounting Pronouncements

Refer to "Recent Accounting Pronouncements" in Note 1 to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.


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