Welcome to the second quarter 2019 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. If at any time during the conference you need to reach an operator, please press star followed by zero. As a reminder, this conference is being recorded and will be available for replay from the investor relations section at the Arista website following this call. I will now turn the call over to Mr. Chuck Elliott, Director of Business and Investor Development. Sir, you may begin.
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 second quarter ended June 30, 2019. If you would like a copy of the release, you can access it online at the company's website.
During the course of this conference call, Arista Networks management will make forward-looking statements, including those relating to our financial outlook for the third quarter of the 2019 fiscal year, industry innovation, our market opportunity, the benefits of recent acquisitions, and the impact of litigation, 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.
Thank you, Chuck. Thank you, everyone, for joining us this afternoon for our second quarter 2019 earnings call. Our profitability growth combination was once again demonstrated with a non-GAAP revenue of $608.3 million, while non-GAAP earnings per share grew to a record $2.44. Services contributed 15.6% of revenue. We delivered non-GAAP gross margins of 64.7% influenced by our solid performance from our enterprise vertical. We registered record number of new customers in calendar Q2, continue to drive new customer logo expansion at the rate of one to two per day throughout the quarter. In terms of verticals, the Cloud Titan segment remained our largest vertical. The modern enterprise high-tech segment is now consistently becoming our second largest, with financials in third place, tier 2 specialty cloud providers and service provider coming in at fourth and fifth place.
In terms of geography mix, in Q2 2019, the international contribution was 27%, while the Americas were at 73%. We had a banner quarter for new products in Q2 2019. We launched two 400 Gigabit product families during Q2 with the Arista R3 Series for modular 7500 and 7280 Series models, as well as a brand-new Arista 7800 Series chassis family for 400 Gig switching and routing based on the Broadcom Jericho 2 silicon. This is enabling our flagship Arista EOS and uncompromised multi-terabit capacity and availability. We have now launched 10 400 Gig platforms, and Arista has more 400 Gig products than any other peer. We have begun active product qualification with more meaningful 400 Gig revenue really expected next year in 2020. Given the recent industry news, I wanted to take this opportunity to comment on 400 Gig optics.
To join me on this is Andy Bechtolsheim, our Chief Development Officer and Chairman, who will speak more about this. Andy?
Thanks, Jayshree. The first observation on optics is that in the cloud, pluggable optics have led to a disaggregated business model between the switch and the optics vendors, with virtually all optics in the cloud being purchased directly from optics vendors. Cloud providers typically qualify at least three optics vendors to ensure lowest cost and diversity of supply. We don't see that changing with 400 Gig. In the case of 400 Gig ZR, which is the long-distance optics that won't ship in volume until mid-2020, we are aware of one dozen optics module vendors that plan to offer compatible 400 Gig ZR modules, competing on the basis of price, quality, and volume availability. We do believe that 400 Gig ZR will be a very competitive market with competition that will drive unprecedented price performance improvements for 400 Gig coherent optics.
We work closely with our largest customers to qualify all 400 Gig optics, including 400 Gig ZR, that are relevant to them with the objective to deliver the most cost-effective 400 Gig optic solutions to the market.
Thank you, Andy. Speaking of new products, we also introduced Arista's first entry into the Cognitive Campus edge with our 720XP power over Ethernet switches and our new Wi-Fi 6 offerings, all of which are supporting CloudVision for the campus, flow-based telemetry, and security segmentation services. With this, Arista establishes an exciting and formal complete cognitive portfolio addressing the transitional changes in the campus security and IoT era. We are in early field trials now, and we expect more results in second half 2019. Speaking of second half 2019, as you all know, we experienced some turbulence in Q2 2019 with the pause of a specific Cloud Titan set of orders. They have now resumed spending, and we expect stabilization in second half 2019 for the overall Cloud Titan spend.
Certainly, second half will be an improvement over the first half, but we do not expect the cloud momentum to be a repeat of second half 2018. Naturally, these trends are consistent with the annual cloud CapEx forecast reported in recent weeks. Our enterprise segment is healthy, with growing interest in our campus and multi-cloud migrations. On June 6th, 2019, we celebrated our five-year IPO anniversary at the New York Stock Exchange with both our premier customers and analysts. Our deep collaboration with Microsoft was evidenced with CEO Satya Nadella joining me at our special event as our chief guest. Together, the two companies share a synergistic vision in cloud area networking. We announced Microsoft Azure cloud integration, including vWAN and IoT Central. As our customers migrate to a cloud-led strategy, bringing holistic client to any cloud experience, we are seeing a compelling conviction in Arista as their strategic partner.
I am proud to share that for the fifth consecutive year, we have also attained a status as the leader in Gartner's Magic Quadrant for data center networking, with our strongest showing yet in both vision and ability to execute. With that, I'd like to turn it over to Ita for more financial specifics.
Thanks, Jayshree, and good afternoon. This analysis of our Q2 results and our guidance for Q3 2019 is based on non-GAAP and excludes all non-cash stock-based compensation impacts, certain acquisition-related charges, and other non-recurring items. A full reconciliation of our selected GAAP to non-GAAP results is provided in our earnings release. Total revenues in Q2 were $608.3 million, up 17% year-over-year and above the midpoint of our guidance of $600 million to $610 million. Service revenues remained strong, representing approximately 15.6% of revenue, up from 15.1% last quarter, reflecting a healthy level of renewals activity. International revenues for the quarter came in at $162 million, or 27% of total revenue, up from 26% in the prior period. Overall gross margin in Q2 was 64.7%, above the midpoint of our guidance of 64%-65% and up from 64.5% last quarter.
Gross margin in the period benefited from a lower cloud contribution combined with healthy enterprise and services performance. Operating expenses for the quarter were $158.7 million or 26.1% of revenue, down slightly from last quarter at $160.7 million. R&D spending came in at $101.7 million or 16.7% of revenue, down from $106.5 million last quarter. This reflected lower levels of new product-related NRE and prototype spending in the period. Sales and marketing expense was $45.1 million or 7.4% of revenue, up from last quarter with increased headcount, somewhat offset by some reductions in other sales costs. Our G&A costs were $11.9 million or 2% of revenue, up slightly from last quarter. Our operating income for the quarter was $235.1 million or 38.7% of revenue. Other income and expense for the quarter was a favorable $13.8 million and our effective tax rate was lower at approximately 20%.
This resulted in net income for the quarter of $198.6 million or 32.7% of revenue. Our diluted share number for the quarter was 81.3 million shares, resulting in a diluted earnings per share number for the quarter of $2.44, up 26.4% from the prior year. Turning to the balance sheet. Cash, cash equivalents and investments ended the quarter at approximately $2.3 billion. We repurchased $100 million of our common stock during the quarter at a weighted average price of $246 per share. As a reminder, our board of directors has authorized a three-year, $1 billion stock repurchase program commencing in Q2 2019. The program allows us to repurchase shares of our common stock opportunistically and will be funded from operating cash flows.
We generated $196 million of cash from operations in the second quarter, reflecting strong net income performance, offset by increased working capital requirements and a reduction in deferred revenue. DSOs came in at 51 days, up from 41 days in Q1, reflecting the timing of billings in the period. Inventory turns were 2.4 times, down slightly from 2.5 last quarter. Inventory decreased to $314.2 million in the quarter, down from $347.2 million in the prior period. Our total deferred revenue balance was $502.2 million, down from $536.5 million in Q1. Our product deferred revenue balance decreased by approximately $38 million in the quarter, reflecting customer acceptance of new features. Accounts payable days were 37 days, down from 38 days in Q1, reflecting the timing of inventory receipts and payments. Capital expenditures for the quarter were $3.4 million. Now turning to our outlook for the third quarter and beyond.
As expected, we experienced some softness in demand from our cloud customers in the second quarter. Early indications are for improved demand from these customers in the September period, we believe that second half growth in this business will remain somewhat muted as compared to prior years. We expect our enterprise and financial verticals to continue to perform well, offset by some declines in the service provider business. On the gross margin front, we would reiterate our overall gross margin outlook of 63%-65%, with customer mix being the key driver. We will continue to manage investments in the business carefully, prioritizing growth in sales headcount and resources as we look to expand our market coverage.
With this as a backdrop, our guidance for the third quarter, which is based on non-GAAP results and excludes any non-cash stock-based compensation impacts and other non-recurring items is as follows: revenues of approximately $647 million-$657 million, gross margins of approximately 63%-65%, operating margin of approximately 36%. Our effective tax rate is expected to be approximately 20.5%, with diluted shares of approximately 81.9 million. I will now turn the call back to Chuck. Chuck?
Thank you, Ida. 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.
We will now begin the Q&A portion of the Arista earnings call. In order to ask a question during this time, simply press star, then the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. We ask that you pick up your handset before asking questions in order to ensure optimal sound quality. Your first question comes from Jason Ader with William Blair. Your line is open.
Thank you. Jayshree, on the campus side, can you provide any metrics, customer wins, anything that is worth investment community knowing about in terms of tracking your progress there?
Thanks, Jason. As you know, we introduced the products in June at the Analyst Day on June 6th, and we said most of them would be available in Q3. It's a little early to be giving customer wins, but I can say with confidence that we are in very many early field trials with customers, to the tune of tens of them. Anshul and the team have been having very good interactions, and I fully expect that we'll have more results in Q3, Q4, and certainly much of next year.
How do you respond to somebody that says, "Okay, you guys have done well on the enterprise side with data center switching, but the campus side is a much more complex sale from the standpoint of typically more channels are involved. There's wireless, there's potentially security. There's just a lot more going on with a major campus deployment." How do you help people get comfortable?
Yeah
that you guys will be able to replicate some of the success-
Yeah
you've had on the data center side?
If you step back for a moment and ask, when did we get our success in the data center with enterprise? It was five years after we started shipping products. We didn't even report much on the data center. We mostly focused on the niche of financials and the cloud in the early years, right? I'm pretty sure we won't take five years to enter the campus market, but I'm here to say that the traction with enterprise will really come in three categories. The early adopters who already love our EOS, and therefore, that's going to be the fastest place of attraction. The CloudVision, don't underestimate that, where they're looking for that single point of management and single pane of glass. To your point, the third one will be new channels, new partners, new systems integrators.
If you look at those three segments, we can start playing in two out of the three already. My response would be the campus technology in many ways is no different than the data center. It's very similar in layer two, layer three protocols, and customers who appreciated us for the last five years with EOS and CloudVision are the first points of success for us. The second point of success, which is new customers and new logos, will take longer. Campus for us is a multi-year journey, and, as I said many times before, I'd be very happy if our first deal was $100 million because I think it sows the right seeds for half a billion and billion in the future. None of us should think this is a overnight one-quarter journey. This is a three- to five-year journey.
Thank you.
Thank you, Jason.
Your next question comes from James Fish with Piper Jaffray. Your line is open.
Hey, congrats on the quarter. Just one from me is, Ita, how should we think about the impact of the 25% tariff on the gross margin guide? Obviously, you're reiterating your 63%-65%, but if we were to get a trade deal tomorrow, I guess how much would gross margins be positively impacted? Have you done enough to kind of offset it from a supply chain perspective? Thanks.
Yeah. I think we've been working on improving the supply chain and addressing some of the issues with the supply chain. At the same time, obviously, we've had an adder to customers, which we've also been managing. As the tariff rates have changed, we've been fortunate enough, we've made enough progress that we've been able to kind of hold our margin, the increase that customer adder. I think, with the new news that we heard just before the call, I think that's still the case, right? We believe that we've done enough from a supply chain perspective that we should have minimal impact. I wouldn't think that there's a big swing in gross margin one way or the other, if either it went away completely tomorrow or we continue to see some changes in it.
I think we've done enough work where it's kind of mostly neutral from a gross margin P&L perspective.
Yeah, James, just to add to that, with a 63%-65% range, we think the tariff can have impact on the gross margin, but it will be within that range of 63-65. As Ita said, the manufacturing team has done a tremendous amount of work. We are not immune to the tariff. We absolutely are affected by it. I think the effect will be minimal.
Got it. Appreciate the color. Thank you.
Thank you.
Your next question comes from Rod Hall with Goldman Sachs. Your line is open.
Yeah. Hi, guys. Thanks for the question. I guess I'd just ask you had said that the large Cloud Titan orders had dropped to almost zero in the middle of March, and you didn't really have good visibility on when those might return. It seems like they've resumed spending, per your comments. When would you expect spending there to be back to normal? Is there some new level of normal? Can you just give us some kind of an idea on what sort of visibility you have and how you see that progressing over the next few quarters?
Well, I think, first of all, Rod, the new level of norm has changed. We shouldn't use 2017 and 2018 as our frame of reference, right? First half was a real adjustment for us to the norm in 2017 and 2018. Having said that, I think you've all seen the CapEx reports, and depending on whose CapEx you're talking about, they've all gone from double-digit growth to single digit, and some of them are negative. You can expect that the new norm is no more double-digit growth and is going to hover in the low single digits. Anshul, would you like to add some more to that?
Sure. We mentioned this last time, but I want to reiterate, which is there was no design loss. The Cloud Titan has unpaused or they're back to the normal spending that they do, and the allocations were unchanged.
Is the inventory all utilized that you guys had called out?
Sorry, can you repeat the question, Rod?
You guys had just, To clarify, Jayshree, you guys had said there was inventory, and they were using inventory last quarter. I just wondered where we are in the process of them utilizing that inventory. Is it all done, or they're still utilizing out of inventory as well?
I don't think we made an explicit comment that they had extraordinary inventory levels. It's typical to have some. The real reason for our Q2 turbulence was a very conscious decision on the part of a specific Cloud Titan to put orders on pause. Those have resumed, and they've resumed at levels that are improved over the first half, but nowhere close to the second half of 2018.
Oh, okay. Thank you very much. Appreciate it.
Inventory was not the reason.
Right. Got it. Thank you.
Thanks, Rod.
Your next question comes from Ittai Kidron with Oppenheimer. Your line is open.
Thanks. Congrats, ladies and Andy, and Anshul, I guess. A great quarter.
Wow, there's a broader definition of ladies now.
Yes, that is true. I guess I do want to drill down again on the cloud. I just want to make sure I understand that you claim stabilization. I guess I'm kind of wondering, has there been a change in the way they communicate with you? Because it was a surprise last quarter. I guess, what makes you comfortable that they're not going to surprise you here? I know anything can happen, but has there been a change in the way you communicate with them such that gives you confidence that there is a stabilization?
Ittai, that's a good question. I'm not trying to imply that they couldn't make further changes on their business side, right? What I am trying to say, and again, Anshul can clarify, is we're literally taking this one quarter at a time. At this point, we see stabilization in Q3, and anything can change in Q4, but if we had to predict, I think what the stabilization in Q3 could carry on to Q4. That's what we're saying. Who knows what's going to happen in 2020? Your guess is as good as mine. Maybe Anshul knows better. You want to add something?
Well, I don't know anything about the future.
Good one.
Look, the Q2 communication was sudden, but was a very rare event for them. Otherwise, our communication has been very normal, back and forth, that you expect between a customer and us, and the engineering collaboration as well as planning for next gen designs. Nothing really extraordinary there. Everything is very normal now.
Very good. Ittai, just so you don't feel lonely here, a question on the OpEx. At the midpoint of your guide, there's quite a significant increase quarter-over-quarter in expenses. I know you probably want to be some conservatism built in there, but nonetheless, is there an unusual level of prototyping that's happening in the quarter? Help me get my hands around how would I explain about a $20 million-$24 million quarter-over-quarter increase in OpEx, which is something that you've never really done.
Yeah, I think there's definitely some reserving the right to make some investments if we want to, included in there. I think the rest of it is, we did push hard on R&D. We talked about that on the last call that we would prioritize sales and marketing and maybe push a little bit harder on R&D, just given the quarter that we were heading into. Obviously, the intention is to kind of not to continue to do that. You will see some increase in R&D as we move through this next quarter.
Great. Good luck.
Our R&D cycles, Itay, with new product, right? We can't always time it, and we've got so much new product coming out of our ears. It's one of the things we're very proud of, and that has a natural impact on prototype expense.
Got it. Good stuff. Good luck.
Thank you.
Your next question comes from Alex Kurtz with KeyBanc Capital Markets. Your line is open.
Yeah, thanks. Can you guys hear me okay?
Yep.
Yeah.
Just a clarification and a question. Jayshree, on your comments about the large Cloud Titan and the resumption in the second half, do you see them changing how they use their networks and the capacity and the utilization and "how hot" they run their networks? Because that one Cloud Titan obviously is chasing another Cloud Titan for business, and I think the underlying investor assumption is they will continue to invest to compete. I'm just trying to understand, do you think, given all the understanding of their network that you have, are they making a pivot in how they run their network?
Alex, I'll comment, and Anshul's closer to it, so he can give more detail. We have not seen any appreciable changes on, gosh, I'm going to optimize for the last megabit of bandwidth or anything like that. There has been a general increase in spend due to the 100 gigabit common denominator across all layers of the lease line network, including the data center interconnect. That will vary on 400 gig. Some Cloud Titans may stay on 100 gig longer, some may go to 400 gig faster, some may actually pick 200 gigs. We do see the sort of the personality performance changes, but we don't see any major bandwidth planning down to the megabit at all.
One thing I'll add, and Anshul can comment to that, is one thing we also see is, I've always said we're in the early innings, but that counts on the fact that the Cloud Titan is going to continue to invest in new regions and new locations for data centers. More than your performance standard, I expect we will see more planning around where they put their data centers, and some of them may not open new data centers, and some may rely on a more incremental strategy.
Alex, most of the commentary in the industry right now about optimizations, I believe, is tied more to compiler compute virtualization optimizations. As you know, the networking spend on switches and routers is in the range of 6% to 7% of their total CapEx. They're not going to try and squeeze that and create a bottleneck which impacts the remaining 93%. The network has to run error-free, and no one is trying to optimize beyond what we have managed to do by providing a very competitive offering.
Thank you, Anshul. Ita, on the maintenance and support number, it looked like it missed the consensus estimates by a pretty wide margin. You obviously did well on product. Was there some mix on the balance sheet as far as deferred or that we should understand as far as why there was a disconnect there? Anything that we should be aware of contextually around the maintenance and support execution in the quarter?
I think if you look at the percentage of revenue, it was pretty consistent right quarter-over-quarter. You're talking about the services revenue on the income statement?
Yeah.
Yeah. I don't think there was anything unusual there, right? We don't guide it specifically, right?
Yeah, I know.
Right. It tends to be high in Q1 or Q4, but this is very normal.
Pretty normalized.
Yeah, this is very normal, Alex.
The percentage of revenue, it wasn't that different. I'll go back and look at the consensus numbers, but I think it's not a number we guide, and I don't think the quarter-over-quarter trend looked particularly different to what we would have expected.
Okay. Just checking. Thank you very much.
Yeah. Okay, thank you.
Your next question comes from Aaron Rakers with Wells Fargo. Your line is open. Aaron?
Yes. Can you hear me?
Yeah, now we can.
Can you hear me?
You were a bit choppy. Go ahead.
Yep, I apologize for that. Congratulations again on the quarter.
Thank you.
My question's actually on the enterprise, the traditional enterprise market. There's clearly been some recent signals of a lot of choppiness. We had one of the enterprise system companies pre-announce tonight. We saw Intel's choppy results, et cetera. I'm curious of what you've been seeing in that market, and what gives you confidence that that market will continue to grow, at what sounds to be a very healthy pace through the back half of the calendar year.
Well, I think the enterprise is small. We are new to this market, right? We are a recent entrant. We're not operating off the large base where we're a market leader or anything. We're the newcomer. Because we have a large TAM and because we have highly differentiated products, and I think also because there's an awful lot of enterprise fatigue with existing dominance of one vendor and lack of quality and all of that, we are seeing a unique situation despite the macro. Now, not to say if there's a really bad macro, we wouldn't see it, but I think despite the macro, we're enjoying a little oasis in the desert, if you will.
Thank you.
Thank you, Aaron.
Your next question comes from Jeff Kvaal with Nomura Instinet. Your line is open.
Yes, a question and a clarification, I guess for me, please. On the question, I'm wondering if you all have applied the same methodology to coming up with your guidance as you have in prior quarters. It is sometimes tempting to adopt a more conservative assumption on close rates or what have you, after a guide down. Secondly, the clarification is when you say back to sustainable levels in 3Q, Jayshree, were you meaning over the course of the third quarter we'll be back at sustainable levels, or we're at full run rate August one, game on?
Both your questions are intriguing. I'm still kind of processing them. The first one is, did we guide like we normally do, and were we being conservative? I'm just translating your question. Is that what you asked?
Yes.
Okay. I think this word conservative and the label we have is a little bit of a misnomer. I think we're guiding as best as we can, and there's very little sandbagging going on. Of course, we have customer concentration, but particularly with the enterprise, there's so many more customers and so much more to forecast. We do our best in analyzing that forecast, and this is our best effort. I wouldn't think there's a lot of buffer in that. That would be my caution to you, Jeff. In terms of, is it game on August, or is it going to happen through the quarter? It's very difficult to ever predict a quarter, especially in its weakest, slowest summer months in some parts of the world. I wouldn't say it's game on in August.
I would say it's going to be a process we will need all three months of the quarter to execute on this one.
Okay. Thank you. Thank you all.
Thanks, Jeff.
Your next question comes from Tejas Venkatesh from UBS. Your line is open.
Thank you. I wonder if you can comment on what you expect your largest customer to be as a percentage of sales in 2019. Jayshree, I think earlier in the year, you had indicated it would go back to historical levels, which many of us interpreted as 16% of sales instead of the 27% in 2018. As we get closer to the end of the year, you must have better visibility. I'm curious to hear that.
Yeah, no, that's a good question. I think my prediction of mid to high teens is still what I think is our best estimate. 27 was wonderful, but a rare event. Yeah.
Thank you. A follow-up on 400G. I know you generally said you expect that in 2020. Early part, latter part? Can you parse how you're thinking about 400G between cloud routing and cloud switching? Thank you.
Okay. Good question. Well, 400G, as you can tell from Andy and my talk, we're ready with the products. No problem with that. We have been often slowed down by the optics. As Andy said, I think he's predicting some of the optics to be in 2020. You want to comment on that, Andy?
Yeah. One of the most important use cases for 400G is actually the 400G ZR data center interconnect, and those optics will not be in volume production till mid-2020. We do expect customers to qualify these optics way before that. We cannot predict the exact timing here, but it's going to be in 2020.
Yeah. As for switching versus routing, because a large number of these use cases will be data center interconnect, it'll be both. It'll be hard to parse one versus the other. They'll almost always want an option for routing or start right with routing in the beginning.
Thank you.
Thanks, Tejas.
Your next question comes from James Faucette with Morgan Stanley. Your line is open.
Thank you. I want to follow up on the 400G question. I understand in terms of the availability of optics, but can you help us understand what stage of evaluation of your equipment customers are in or potential customers are in, and can they fully evaluate and qualify the products without the commercial availability of those optics?
Sure. James, the way to look at this is many of the new products for 400G are based on Jericho 2 or Tomahawk 3 or other silicon. The many form factors with 100G ports as well. Customers are busy qualifying them as 100G switches and routers first. They'll use them in existing designs but with more efficiency with these new products, and then they'll wait for optics like the ZR optics or DR or FR optics to show up in volume before they can really use them as 400G. The transition is already starting in qualification, but again, you can expect 100G first. I think from a material impact on revenue in the industry, I would think it's second half 2020.
Great. Then just as a quick follow-up, Jayshree, you talked about your go-to-market on enterprise, but I'm wondering how you're thinking about today your needs for sales and support around those new products. Is that something that you feel like you'll need to ramp up personnel ahead of sales, or can you continue to be really efficient bringing on headcount to support those customers after commitments are already made?
Actually, that's a very good question. I think we will ramp up salespeople ahead of sales, but we can ramp the systems engineers and some of the support engineers post-sales after we get the win. A little bit of both. We're not applying the same discipline and conservatism, James, that you saw us do in the data center. We are definitely adding headcount, and if you look at our sales and marketing as a percentage of revenue, it has increased. Maybe not appreciably, because we're still holding the bar pretty high and making sure that the caliber and quality is not compromised just because we want to hire a bunch of people. The other big thing I think that's going to play a huge part in this is partners.
We've never been viewed as a partner-friendly company, but we're very friendly with partners at the moment, and I think the campus is a key piece of that strategy, and the partners see us as a key piece of that. The two will go hand in hand.
All right. That's good. You shouldn't have any problem being friendly with people, so good luck.
Thank you, James.
Your next question comes from Paul Silverstein with Cowen & Company. Your line is open.
Before I ask my questions, I'd just like to ask you to talk faster on the next call.
I'll see what I can do, Paul. Just for you.
I've got a handful of questions by me.
Yeah. Paul, she's trying to go from 100 gigabit to 400 gigabit speeds.
There, she's doing a good job of it. Most of these questions are clarifications. Let me fire away. First off, regionally, what are you all seeing with respect to the quality of demand on a regional basis? I appreciate that a good chunk of your revenue comes from cloud. Perhaps the regional concept doesn't quite apply. To the extent you have regional exposure, it looks like your non-U.S. and your U.S. were about the same growth rate in the high teens. What are you seeing regionally? I've got some follow-ups.
The growth rate is very good, especially in enterprise customers across all regions. We're seeing better growth rate in terms of new customer acquisition in the international regions. The big bet and larger customers tend to be more U.S.-driven, and the new customer logos tend to be more international-driven, but all regions are growing nicely.
Jayshree, again, I appreciate that you guys are a share gainer, so you're less macro-sensitive, to an extent you are sensitive like any other company to a degree to macro trends. In terms of the quality of budgets, the quality of spend, any thoughts on what you're seeing? We've seen from a number of other companies, most recently NetApp today, in terms of weakness from an in-demand perspective. Any thoughts on that? Once again, I appreciate that you're a share gainer, so maybe you don't see it the same way. Any thoughts you could share with us?
My experience with macro issues is we certainly won't be immune, but the way we will see it is that a lot of the activity we are seeing may not result in fast decisions. Probably prolonged decision-making would be my biggest worry should a macro set in. Usually when a macro sets in, customers tend to get conservative, and then they don't want to make new decisions.
Have you seen that elongation yet? Is that just a concern at this point, or are you already seeing it?
Yeah. I'm addressing a theoretical concern. We have not seen it yet.
All right. Then on service revenue, does it go without saying that the growth in your service revenue is going to slow consistent with the moderation growth in your product revenue?
Yeah, I think there's a linearity associated with that.
Yeah. You'll get some offset just from renewals and stuff, overall it'll trend with the product. Yeah.
All right. Two more clarifications. Jayshree, on your comment or your reiteration, I think from the June analyst event on the $100 million forecast for Enterprise Campus. My sense is that that's drifted out a little bit from a timing perspective. When you talk about $100 million, is that a CY 2020 outlook, or is that the departure point September? I recognize we're not talking about a ton of time in terms of the difference.
Yeah, exactly.
When you talk about $100 million, what period of time?
No. What I said at the Analyst Day, which is only six weeks ago, still holds, which is four quarters starting from Q3. Q3, second half of 2019 and first half of 2020, unless something changes substantially. We're still bullish on that and optimistic that we have the activity to result in that number.
Got it. Edith, going back to the OpEx question that was asked earlier. I would've thought your answer would've been as simple as enterprise costs more money. One of the beautiful things about cloud, not just the concentration spend, but it was a relatively inexpensive market to address. Enterprise, you've got to bulk up your sales force, your channel, and that costs money. Not that you're projecting a dramatic increase, but correct me if I'm wrong, you're projecting an increase from 7.5%-10% on sales and marketing, with operating margin going out of 35%. Are those still the operative numbers going forward, and is that what's going on in terms of the increase in spend?
Yeah, I think quarter-over-quarter, there's other things in there, like we talked about with R&D and stuff, just from the quarterly trend. I think over the longer term, when you think about the model, I think that's what we described at the Analyst Day, and that's the right way to think about it. Again, we're not going to get to 10% overnight, right? We're growing and then we're adding incrementally as a percentage of revenue, but it won't become 10% overnight.
My last question.
The model that we think about longer term.
Oh, we're going to have to move on.
Paul, can we do that in the callback?
Absolutely. No worries. Thank you.
Thank you.
Thanks, Paul.
Your next question comes from Alex Henderson with Needham. Your line is open.
Hey. I'm sure I'm going to ask the question Paul was going to ask. I was hoping you could talk a little bit about the market share trajectory. There's two or three variables that were always the kind of underpinnings of the company's story. One was the cloud growth. Obviously, that slowed quite a bit. The other one was the ability to gain considerable amount of share annually. Your share is fairly low. Can you talk about excluding cloud, what's your expectation for the overall market growth for switching to be, and whether you can continue to pick up a point to two or three on market share annually? A follow-up on that question is there any change in that as we go into the 400G?
I think you've been pretty clear that you think you'll continue to grow based off of your software advantages 400G, but could you address those two together? Thanks.
Sure, Alex. I don't think anything has substantially changed on total available market. Yes, the cloud spend has reduced, we may see some shifting of TAM between one quarter and another. I think our position both in the cloud and in our rate of enterprise design wins is only getting stronger. From a market share gain, since we've gone from zero to the teens rather quickly, probably our rate of gain will be slower, maybe more like one to two rather than two to three on an annual basis. I believe we'll continue to be a share gainer both in overall high-performance switching and especially in 100 Gigabit Ethernet switching.
Great. If I could throw one more question in. The Luxtera and Acacia acquisitions over at Cisco, if Andy's still around.
Yeah, Andy's here.
any thoughts on why they did that and how that might affect you? Is there any concerns that as optics need to get closer to the switch chip, that they may be positioning to have an advantage as we get to the 53 terabit switch chips that require the chips to butt up against the optics? Can you give us any thoughts on where they're going with that? Thanks.
Great. We obviously don't want to speculate on a competitor's motivations or actions here. What I will say is that the optics field is intensely competitive. There's plenty of suppliers, both with silicon photonics technology, the photonic DSPs that you need for the ZR. That we don't see the competitive environment in optics changing at all. The pluggable form factor in particular has just taken over the market, over the last 10, 20 years, and we don't see that changing for all kinds of reasons. In particular, to your question on 51.2T, our plan is to deliver that product with conventional pluggable optics, which are well understood and will be the time to market product. We do understand there's certain people excited about co-packaging, but there's so many problems with co-packaged optics, I wouldn't even know where to start, so I'll leave it at that.
Okay. Thank you very much for your answers.
Thank you, Alex.
Your next question comes from Jim Suva with Citigroup. Your line is open.
Thank you very much. It was great to hear Andy on the call at the beginning as well as pretty recently. Arista does a lot of things very much on purpose, so having Andy on the call, as well as addressing the 400G topic, can you help us just maybe understand a little bit better, are you trying to clarify some misperceptions or show that Arista is likely to gain more share? There was definitely a tempo change to the speaking at the beginning of this call versus previously with Andy, and it's appreciated. I'm just trying to figure out why and the excitement behind it, as far as from a competitive standpoint or share or, figure out the change in tone. Thank you.
Yeah. Jim, if you look at the analyst forecasts for 400G, like at the lower forecast in particular, they make certain projections on where 400G will actually deploy. The vast amount of 400G forecast is in cloud, obviously cloud and large cloud and small cloud. Given our strong footprint in that market, we are very, I shouldn't say optimistic, but confident that we will have a good share of that business going forward. 400G as a technology is actually almost overkill for traditional enterprise. I don't think you're going to see much 400G adoption in the enterprise anytime soon. This is a very much a cloud story, and it's really when the cloud customers, the large cloud customers, are starting to deploy this, when you see the big ramp. We do expect that in 2020.
We have Andy frequently as a guest speaker. I don't think there's any deliberate intent to do it differently than any other quarterly call, except investors love hearing from Andy, and we love Andy. I think sometimes the 400G gets over-hyped. I think bringing a dose of realism that Arista, the market leader in high-performance switching, and especially 100G, has more products than anyone else in 400G and is ready for that transition, but it will take time, is a pragmatic message.
Great. Thanks so much for the detail, Jayshree, Andy. That's all my questions. Thank you.
Thanks, Jim.
Your next question comes from Simon Leopold with Raymond James. Your line is open.
Great. Thanks for taking the question. Maybe to follow up on the 400G theme, understanding that cloud will be the primary adopter. I'd like to hear your thoughts on maybe compare and contrast the 400G cycle, versus the 100G cycle for you, reflecting on time. I guess where I'm coming from is you're now the incumbent with 100G. You're sort of the one everybody wants to be. It's a different position. You're not the underdog anymore. I want to get that perspective, and just as a clarification within this context, my impression is that right now, the 400G switches are being deployed as just really, really good 100G, high density 100G. Not necessarily awaiting the optics. I just want to make sure that understanding is correct. Thank you.
I'm going to kick it off. I'd love Anshul and Andy's detail on it as well. When I step back and look at 10G migration, it took about eight years to happen. Why did it take so long? It was a very long tail because 1G was good enough, and the compute and storage wasn't fast enough or large enough to require any better IO, and the cloud hadn't happened. The advent of cloud really pushed 25G, 40G, 50G, and especially 100G. The 100G cycle, instead of taking eight years, only took two or three years. This is why we became such a market leader so quickly. It all happened between 2016 and 2019. When I look at 400G, I think you have to sort of look at it as split it between the 10G cycle and the 100G cycle.
It will likely take three to four years to happen. It will start first in the cloud, and then it will migrate over time to other high-tech enterprise and cloud specialty providers as well. Hopefully that gives you a sense of why 10G took too long, 100G happened very fast, and 400G may be somewhere in the middle.
If I could add to that. The 100G is still ramping, as you may know.
Exactly.
We're expecting very significant growth into next year, and maybe even into 2021 on 100G ports. No mistake about that. The reason why a cloud company would deploy 400G is because it's more cost-effective than 100G on a per bit basis, right? As you know, our 400G products have typically double the cost performance for 400G than 100G. However, the optics, they are not at that level, right? Because the optics are still too expensive and arguably just not available in volume, a cloud company, even if they wanted to, could not deploy 400G today in volume. It's just not possible. Keep in mind, 100G is deploying in the cloud at a rate of, call it 10 million ports a year. It takes a long time to get to those kind of volumes on the optics.
This is why we've been saying all along that it's a 2020 story until you even get to meaningful revenue in 400G.
How do you see?
7100 is launching.
Sorry, just this real quick.
7100 is launching. One thing I would. Go ahead.
Go ahead, Anshul. Sorry.
This is important for everyone to understand that when we came out with 100G products in 2016 with the 7500R. Our competition had already announced their 100G products. It wasn't as if we had some huge advantage and we are the only one with a product and so on. The market was very competitive. You had to win on your own merit, on software, on partnership with the customer, on solving real-world problems, on quality, on support, and so on. The exact same thing will repeat here, and we feel very good about our position, and you've seen the kind of collaboration we've done with companies like Microsoft and Facebook recently, and I believe that will continue.
Is competition or the competitiveness, the price pressure any different in this cycle? Because your competitors are saying that they're going to take market share in 400G. Should we think this is any different than 100G?
No, we've always competed against tough competitors. That will continue. I don't believe there's any different in dynamics.
I mean, we're not seeing new competition. It's the same competitors being aggressive.
Great. Thank you for taking my questions.
Thank you, Simon.
Your next question comes from Samik Chatterjee with JPMorgan. Your line is open.
Hi. Thanks for taking the question. I just wanted to ask at a higher level, Jayshree, how are you thinking about kind of given the sluggishness in the cloud spend that you're seeing, how are you thinking about diversification in the customer mix, and particularly if you have any views of strategically where you want the customer to mix to be kind of five years from now? Is there more of an effort to steer the business towards a particular customer mix to mitigate some of the volatility around the cloud? Just a quick follow-up for Ita. Maybe you addressed this. There's some headline today about incremental tariffs on products that were exempt earlier. Can you just clarify if there are any products that you're shipping from China that were exempt earlier? Thank you.
Yeah, no, Samik, I think this is a good question. Our sales and go-to-market strategy is really shaping to be one that was on focused verticals to a horizontal enterprise where we will be much broader from a coverage, from a geography, and from addressing a broader enterprise perspective. I think this will provide important diversification. Campus was an important piece of that diversification. Two years ago, we asked our customers, "Should we be in the campus?" They said, "No." This year when we asked them, they said, "You're late." That tells you the thirst and the hunger for Arista technology to go beyond the data center. Addressing a broader TAM and going out of our normal comfort verticals into a horizontal go-to-market's an important piece of this. Ita, you were going to answer the tariff question?
Yeah, I think the way to think about it is, yeah, we'll have some impact, but between the improvements we're making on the supply chain and other stuff, I think from a financials perspective, it kind of balances out, right. It's a pretty minimal impact from a financials perspective, even though we're continuing to churn the supply chain to respond.
Great. Thank you.
Thank you.
Your next question comes from Mitch Steves with RBC Capital Markets. Your line is open.
Hey, just a quick question for me. You guys have talked about the annual numbers in terms of the Street estimates. I just wanted some clarity there. Are you guys comfortable where Street estimates are at this point? Just to get an idea for what seasonality in the back half looks like.
No, I think you guys have been more aggressive than we have in our guidance. We're going one quarter at a time, but you all started the year at 30%, and we at Analyst Day, as you know, Ita guided to a mid to high teens depending on the cloud spend, right? So
Yeah, I think, Mitch, the motto is, look, we're taking this quarter at a time from our perspective. It's difficult for us to go beyond that at this stage. We're just running the business a quarter at a time.
Got it. Just to clarify on the Q4 kind of expectation, I'm trying to just understand the half-on-half commentary. Is it going to be essentially a few points below seasonal trends, or do you think that it's going to be more than that?
Yeah, I think the comments were kind of clear that we think second half over second half. It's a very different environment, right? If you think about where we were at the second half last year, it was very strong demand. We were building deferred, et cetera. I think it's significantly different when you look at where we are in the second half of this year. I think that's what we're trying to communicate, right? To put a specific number on it, we're not ready to do that for Q4 yet, but I think there has been a significant change just in the momentum and the growth in the cloud part of the business.
Got it. Thank you.
Your next question comes from Hendi Susanto with Gabelli Research. Your line is open.
Good evening, and thank you for taking my one and only questions.
Thank you, Hendy. Thank you for following the rules.
All right, Jayshree, your Cognitive Campus will have general availability in Q3 2019. Do you have updates, and would you be able to share goals, timing, and milestone in terms of early trials, early adopters in terms of verticals, integration with Mojo, and building an ecosystem of channel partners?
Yeah, no, I think we'll have more updates and results towards the latter half of 2019. In terms of activity, it's been very high. We've integrated Mojo into the company. Now it's been a year now. We've integrated it into our CloudVision. The combination of our 720XP PoE switch and Mojo is really redefining a new Cognitive Campus layer. The X3 Splines are being very well received. What you're seeing here is Arista's having to position the new architectural shift to the next generation campus in terms of network design and have the products tested at the same time. The activity level is very high. The results we'll definitely share more with you in Q3 and Q4.
Thank you, Jayshree.
Thank you, Hendi.
Your last question comes from Brian Young with Deutsche Bank. Your line is open.
Hey, thanks for squeezing me in. I also had a question on the campus opportunity. I've been hearing more and more that new enterprise campus deals are often led by discussions around Wi-Fi solutions. Is that what you're seeing as well? If so, I know you have the Cognitive Wi-Fi portfolio in Mojo, but is the wireless portfolio right now pretty robust, or is that an area where you are thinking about or would need to expand?
It's a good question. In the smaller enterprise sites, we often see that the conversation is led with Wi-Fi because they want to start with a small configuration of campus, and they don't need to think of all the protocols. We feel we have a very complete portfolio, particularly with the introduction of Wi-Fi 6. In larger enterprises, it's actually the other way around. Often the Wi-Fi has to integrate with other partners like ClearPass, and we lead more with the X3 Spline. It depends on the nature of the enterprise customers, but we see a bit of both.
Thank you.
Thank you, Brian.
This concludes the Arista Q2 2019 earnings call. Thank you for all the good questions and for the opportunity to highlight our financial results and corporate achievements for you. I also want to mention that we have posted a presentation which provides additional information on our fiscal results, which you can access on the investor section of our website. We look forward to continuing the conversation with you during the quarter.
Thank you for joining, ladies and gentlemen. This concludes today's call. You may now disconnect.