ITEM 1 - BUSINESS
We are a fabless semiconductor company that designs, manufactures (through subcontractors) and sells high-performance interconnect products and solutions primarily based on the Ethernet and InfiniBand standards. Our products facilitate efficient data transmission between servers, storage systems, communications infrastructure equipment and other embedded systems. We operate our business globally and offer products to customers at various levels of integration. The products we offer include integrated circuits ("ICs"), adapter cards, switch systems, cables, modules, software, services and accessories. Together these products form a total end-to-end integrated networking solution focused on computing, storage and communication applications used in multiple markets, including cloud, Web 2.0, High Performance Computing ("HPC"), Big Data, machine learning, storage, telecommunications, financial services, and enterprise data centers ("EDC"). These solutions increase performance, application efficiency and improve return on investment. Through the successful development and implementation of multiple generations of our products, we have established significant expertise and competitive advantages.
As a leader in developing multiple generations of high-speed interconnect solutions, we have established strong relationships with our customers. Our products are incorporated in servers and associated networking solutions produced by the largest server vendors. We supply our products to leading storage and communications infrastructure equipment vendors. Additionally, our products are used in embedded solutions.
We are a leader in high-performance Ethernet interconnects, including adapters, switches, and optical and copper cables and transceivers. We have gained significant share in the 25Gb/s and greater market segment and are the leading provider of adapters at these speeds. We work closely with key cloud, Web 2.0, server, storage, machine learning and telco customers to develop hardware and software that accelerate workloads and make data centers more efficient. This deep engagement with our customers enables us to deliver unique acceleration capabilities and thereby differentiate our products from our competitors. This provides us with the opportunity to gain share in the Ethernet market as users upgrade from 1Gb/s or 10Gb/s directly to 25/40/50, 100 or 200Gb/s.
We are one of the pioneers of InfiniBand, an industry-standard architecture for high-performance interconnects. We believe InfiniBand interconnect solutions deliver industry-leading performance, efficiency and scalability for clustered computing and storage systems that incorporate our products. We are the leader in the HPC and machine learning markets and provide the most efficient, highest bandwidth, and lowest latency end to end interconnect solutions for scientific, data intensive, big data, and analytics applications.
We have been shipping our InfiniBand products since 2001 and our Ethernet products since 2007. During 2008, we introduced Virtual Protocol Interconnect, ("VPI"), into our ConnectX family of adapter ICs and cards. VPI provides the ability for an adapter to automatically sense whether a communications port is connected to Ethernet or InfiniBand. We also offer the Spectrum family of Ethernet switches at speeds from 10 to 400Gb/s and smart InfiniBand switches at speeds from 10 to 200Gb/s.
In order to accelerate the adoption of our high-performance interconnect solutions and our products, we work with leading vendors across related industries, including:
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processor and accelerator vendors such as AMD, ARM, Huawei, IBM, Intel, Marvell, and NVIDIA;
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operating system vendors such as Microsoft and Red Hat; and
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software applications vendors such as Oracle, IBM and VMware.
We are a Steering Committee member of the InfiniBand Trade Association, ("IBTA") which is an industry trade organization that maintains and promotes InfiniBand and RoCE (RDMA over Converged Ethernet) technology. We are a founding member of the 25 Gigabit Ethernet consortium. We also participate in the Institute of Electrical and Electronic Engineers ("IEEE"), an organization that facilitates the advancement of the Ethernet standard, Storage Networking Industry Alliance ("SNIA") and other industry organizations advancing multi-vendor interoperable ecosystems for various networking and storage related standards.
Our business headquarters are in Sunnyvale, California, and our engineering and manufacturing headquarters are in Yokneam, Israel. Our total assets as of December 31, 2019 and 2018 were approximately $2,119.8 million and $1,587.2 million, respectively. During the years ended December 31, 2019, 2018 and 2017, we generated approximately $1,330.6 million, $1,088.7 million and $863.9 million in revenues, respectively, and approximately $205.1 million, $134.3 million and $(19.4) million in net income (loss), respectively.
We manage our business based on one reportable segment: the development, manufacturing, marketing and sales of interconnect products. Additional information required by this item is incorporated herein by reference to our consolidated financial statements and Note 2, "Revenue" in the notes to consolidated financial statements, included in Part IV, Item 15 of this report.
Industry Background
High-Performance Interconnect Market Overview and Trends
Computing and storage systems such as servers, supercomputers and storage arrays in today's data centers face a critical challenge of handling exponentially expanding volumes of transactions and data while delivering improved application performance, high scalability and reliability within economic and power constraints. High-performance interconnect solutions remove bottlenecks in communications between compute and storage resources through fast transfer of data, latency reduction, improved application processing by central processing unit ("CPU") utilization and efficient sharing of resources. The result is higher efficiency and better resource utilization, thereby delivering higher application performance with lower capital expenditures and operating expenses. Leading companies in HPC, cloud, Web 2.0, Big Data, machine learning, storage, telecommunications, financial services, and EDCs utilize these technologies to develop distributed applications and services which are able to scale to serve millions of end customers.
Demand for computing power and data storage capacity continues to rise, fueled by the increasing reliance by enterprises on information technology ("IT") for everyday operations. Due to greater amounts of information to be processed, stored and retrieved, data centers rely on high-performance computing and high-capacity storage systems to optimize price/performance, minimize total cost of ownership, utilize power efficiently and simplify management. We believe that several IT trends impact the demand for interconnect solutions and the performance required from these solutions. These trends include:
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Transition to clustered computing and storage using connections among multiple standard components;
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Transition to multiple and multi-core processors in servers;
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Use of solid state Flash memory drives for data storage;
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Increasing deployments of software defined scale out storage;
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EDC infrastructure consolidation;
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Increasing deployments of mission critical, latency, or response time sensitive applications;
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Increasing deployments of converged and hyperconverged infrastructure;
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Increasing deployment of virtualized computing and virtualized networking resources to improve server utilization;
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Requirements by cloud providers to perform system provisioning, workload migrations and support multiple users' requests faster and more efficiently;
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Requirements by Web 2.0 data centers to increase their hardware utilization and to instantly scale up to large capacities;
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Big Data Analytics requirements for faster data access and processing to analyze increasingly large datasets and to provide real-time analysis; and
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Increasing deployment of artificial intelligence and machine learning applications that utilize massive amounts of data and compute resources and often require generating real-time results.
A number of semiconductor-based interconnect solutions have been developed to address different application requirements. These solutions include proprietary technologies as well as standard technologies, including Fibre Channel, Ethernet and InfiniBand.
Challenges Addressed by High-Performance Interconnect
The trends described above indicate that high-performance interconnect solutions will play an increasingly important role in IT infrastructures and will drive strong growth in unit demand. Performance requirements for interconnect solutions, however, continue to evolve and lead to high demand for solutions that are capable of resolving the following challenges to facilitate broad adoption:
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Performance limitations. In clustered computing, cloud computing and storage environments, high bandwidth and low latency are key requirements to capture the full performance capabilities of a cluster. With the usage of multiple multi-core processors in server, storage and embedded systems, I/O bandwidth has not been able to keep pace with processor advances, creating performance bottlenecks. Fast data access has become a critical requirement to take advantage of the increased compute power of microprocessors. In addition, interconnect latency has become a limiting factor in a cluster's overall performance.
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Increasing complexity. The increasing usage of clustered servers and storage systems as a critical IT tool has led to an increase in complexity of interconnect configurations. The number of configurations and connections has also proliferated
in EDC, making systems increasingly complicated to manage and expensive to operate. Additionally, managing multiple software applications utilizing disparate interconnect infrastructures has become increasingly complex.
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Interconnect inefficiency. The deployment of clustered computing and storage has created additional interconnect implementation challenges. As additional computing and storage systems, or nodes, are added to a cluster, the interconnect must be able to scale in order to provide the expected increase in cluster performance. Additionally, increased attention on data center energy efficiency is causing IT managers to look for ways to adopt more energy-efficient implementations.
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Limited reliability and stability of connections. Most interconnect solutions are not designed to provide reliable connections when utilized in a large clustered environment, causing data transmission interruption. As more applications in EDCs share the same interconnect, advanced traffic management and application partitioning become necessary to maintain stability and reduce system down time. Such capabilities are not offered by most interconnect solutions.
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Poor price/performance economics. In order to provide the required system bandwidth and efficiency, most high-performance interconnects are implemented with complex, multi-chip semiconductor solutions. These implementations have traditionally been extremely expensive.
In addition to Ethernet and InfiniBand, proprietary and other standards-based interconnect solutions, including Fibre Channel, are currently used in EDC, HPC and embedded markets. Performance and usage requirements, however, continue to evolve and are now challenging the capabilities of these interconnect solutions.
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Proprietary interconnect solutions have been designed for use in supercomputer applications by supporting low latency and increased reliability. These solutions are only supported by a single vendor for product and software support, and there is no standard organization maintaining and facilitating improvements and changes to the technology. The number of supercomputers that use proprietary interconnect solutions has been declining largely due to the required use of proprietary software solutions, a lack of compatible storage systems and the availability of industry standards-based interconnects that offer superior price/performance.
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Fibre Channel is an industry standard interconnect solution limited to storage applications. The majority of Fibre Channel deployments support 2, 4, 8, 16, and 32Gb/s. Fibre Channel lacks a standard software interface, does not provide server cluster capabilities and remains more expensive relative to other standards-based interconnects. There have been industry efforts to support the Fibre Channel data transmission protocol over interconnect technologies including Ethernet (Fibre Channel over Ethernet) and InfiniBand (Fibre Channel over InfiniBand) however, none of these has gained wide adoption. The Fibre Channel market is declining as legacy storage area network moves to more modern Web 2.0 and cloud architectures based on converged, software defined, and scale out storage.
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Ethernet is an industry-standard interconnect solution that was initially designed to enable basic connectivity between a local area network of computers or over a wide area network, where latency, connection reliability and performance limitations due to communication processing are non-critical. While Ethernet has a broad installed base at 1/10Gb/s and lower data rates, its overall efficiency, scalability and reliability have been less optimal than other interconnect solutions in high-performance computing, storage and communication applications. An increase to 25/40/50/100Gb/s bandwidth, a significant reduction in application latency and more efficient software solutions have improved Ethernet's capabilities to address specific high-performance applications that do not demand the highest performance or scalability.
Advantages of InfiniBand
We believe that InfiniBand-based solutions have advantages compared to solutions based on alternative interconnect architectures. InfiniBand addresses the significant challenges within IT infrastructures by providing solutions for more demanding requirements of the high-performance interconnect market. More specifically, we believe that InfiniBand has the following advantages:
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Superior performance. Compared to other interconnect technologies that were architected to have a heavy reliance on communication processing, InfiniBand was designed for implementation in an IC that relieves the CPU of communication processing functions. InfiniBand is able to provide superior latency relative to other existing interconnect technologies and has maintained this advantage with each successive generation of products. For example, our current InfiniBand adapters and switches provide bandwidth up to 200Gb/s, with end-to-end latency lower than a microsecond. In addition, InfiniBand fully leverages the I/O capabilities of PCI Express, a high-speed system bus interface standard.
The following table provides a bandwidth comparison of the various high-performance interconnect solutions:
Performance in terms of latency varies depending on system configurations and applications. Typical benchmark testing reports show latency of InfiniBand solutions is appreciably lower than that of Ethernet solutions. Fibre Channel, which is used only as a storage interconnect, is typically not benchmarked on latency performance. HPC typically demands low latency interconnect solutions. In addition, there are increasing numbers of latency-sensitive applications in the cloud, Web 2.0, storage, machine learning and embedded markets, and, therefore, there is a trend towards using industry-standard Ethernet and InfiniBand solutions of 10Gb/s and faster, which are able to deliver lower latency than 1Gb/s Ethernet.
InfiniBand also includes smart In-Network Computing engines, engines that enable processing of data while they are being transferred within the data center. This capability enables faster data processing and therefore higher performance with compute and data intensive applications.
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Reduced complexity. While other interconnects require use of separate cables to connect servers, storage and communications infrastructure equipment, InfiniBand allows for the consolidation of multiple I/Os on a single cable or backplane interconnect, which is critical for blade servers and embedded systems. InfiniBand also consolidates the transmission of clustering, communications, storage and management data types over a single connection.
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Highest interconnect efficiency. InfiniBand was developed to provide efficient scalability of multiple systems. InfiniBand provides communication processing functions in hardware, relieving the CPU of this task, and enables the full resource utilization of each node added to the cluster.
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Reliable and stable connections. InfiniBand is one of the only industry standard high-performance interconnect solutions which provides reliable end-to-end data connections within the silicon hardware. In addition, InfiniBand facilitates the deployment of virtualization solutions, which allow multiple applications to run on the same interconnect with dedicated application partitions. As a result, multiple applications run concurrently over stable connections, thereby minimizing down time.
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Superior price/performance economics. In addition to providing superior performance and capabilities, standards-based InfiniBand solutions are generally available at a lower cost than other high-performance interconnects.
Our InfiniBand Solutions
We provide comprehensive end-to-end 40/56/100/200Gb/s InfiniBand solutions, including switch and gateway ICs, adapter cards, switch, gateway and long-haul systems, cables, modules and software. We introduced our 200Gb/s solutions in 2018. InfiniBand enables us to provide products that we believe offer superior performance and meet the needs of the most compute and data demanding applications, while also offering significant improvements in total cost of ownership compared to alternative interconnect technologies. As part of our comprehensive solution, we perform validation and interoperability testing from the physical interface to the applications software. Our expertise in performing validation and testing reduces time to market for our customers and improves the reliability of the fabric solution.
Our Ethernet Solutions
Advances in server virtualization, network storage and compute clusters have driven the need for faster network throughput to address application latency and availability problems in the Enterprise. To service this need, we provide a complete industry leading, end-to-end 10/25/40/50/100/200Gb/s Ethernet product portfolio for use in EDC, HPC, embedded environments, hyperscale, Web 2.0, and cloud data centers. Our portfolio of advanced Ethernet switch products supports the latest generation of Ethernet speeds and deliver wire speed forwarding for telco and data center environments. In addition, we provide a full range of Ethernet adapters at these speeds which incorporate the latest in Ethernet technology, including support for virtualization and RoCE. These solutions remove I/O bottlenecks in mainstream servers that limit application performance and support hardware-based I/O virtualization, providing dedicated adapter resources and guaranteed isolation and protection for virtual machines within the server.
VPI: Providing Connectivity to Ethernet and InfiniBand
Our VPI technology enables us to offer fabric-flexible products that concurrently support both Ethernet and InfiniBand with network ports having the ability to auto sense the type of switch to which it is connected and then take on the characteristics of that fabric. In addition, these products extend certain InfiniBand advantages to Ethernet fabrics, such as reduced complexity and superior price/performance, by utilizing existing, field-proven InfiniBand software solutions.
Our Strengths
We apply our strengths to enhance our position as a leading supplier of semiconductor-based, high-performance interconnect products. We consider our key strengths to include the following:
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We have expertise in developing high-performance interconnect solutions. We were founded by a team with an extensive background in designing and marketing semiconductor solutions. Since our founding, we have been focused on high-performance interconnect and have successfully launched several generations of Ethernet and InfiniBand products. We believe we have developed strong competencies in integrating mixed-signal design and developing complex ICs. We also consider our software development capability as a key strength, and we believe that our software allows us to offer complete solutions. We have developed a significant portfolio of intellectual property ("IP"), and have 783 issued patents, 10 registered designs, and 255 pending patent applications. We believe our experience, competencies and IP will enable us to remain a leading supplier of high-performance interconnect solutions.
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We have expertise in developing high speed analog and optical components. We have unique design expertise and manufacturing capabilities required to build state of the art optical components, modules, and cable assemblies. We have developed significant know-how related to building advanced electrical and electro-optical components and sub-assemblies which combine electrical and optical components. In addition, we have design expertise to enable advanced transceiver chipsets for driving and receiving multimode optical signals and interfacing to low cost lasers and optical sensor technologies. We have developed significant manufacturing know how and automated assembly techniques to combine these optical and electrical components and build complete optical module and cables that are high-performance, cost effective, high quality, and offer high reliability.
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We believe we are the leading merchant supplier of InfiniBand ICs. We have gained in-depth knowledge of the InfiniBand standard through active participation in its development. We were first to market with InfiniBand products (in 2001) and InfiniBand products that support the latest version of the PCI Express interface standard. We have sustained our leadership position through the introduction of several generations of products. Because of our market leadership, vendors have developed and continue to optimize their software products based on our semiconductor solutions. We believe that this places us in an advantageous position to benefit from continuing market adoption of our InfiniBand products.
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We believe we are a leading merchant supplier of end to end Ethernet solutions and the leading merchant supplier of high-performance Ethernet Adapters. We have gained significant expertise in Ethernet adapters and are the leading supplier of adapters with speeds of 25Gb/s and above with over 60% market share of adapters with speeds greater than 10Gb/s. We have developed significant expertise in Ethernet switch hardware and software and are gaining market share with our top of rack switch products and optical and copper cables and transceivers. Nine out of the top ten hyperscale, cloud and Web 2.0 data centers are using our products. Our engagement with these customers through several generations of designs has allowed us to understand the challenges faced by large scale deployments, and to develop features that solve these problems. We are the first to market with a complete end-to-end product portfolio of adapters, switches, and cables for the latest 25, 50, 100, and 200Gb/s speeds of Ethernet. Our leading time to market, customer engagements, advanced feature set, and rapid development cadence provides a significant competitive advantage over other vendors. We believe that this places us in an advantageous position to benefit from continuing market adoption of our Ethernet products.
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We have a comprehensive set of technical capabilities to deliver innovative and reliable products. In addition to designing our ICs, we design standard and customized adapter card products, switch products, and optical cables and transceivers - providing us a deep understanding of the associated circuitry and component characteristics. We believe this knowledge enables us to develop solutions that are innovative and can be efficiently implemented in target applications. We have devoted significant resources to develop our in-house test development capabilities, which enables us to rapidly finalize our mass production test programs, thus reducing time to market. We have synchronized our test platform with our outsourced testing provider and are able to conduct quality control tests with minimal disruption. We believe that because our capabilities extend from product definition, through IC design, and ultimately management of our high-volume manufacturing partners, we have better control over our production cycle and are able to improve the quality, availability and reliability of our products.
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We have extensive relationships with our key original equipment manufacturers ("OEM") and hyperscale customers and many end users. Since our inception, we have worked closely with major hyperscale customers and OEMs, including leading server, storage, communications infrastructure equipment and embedded systems vendors, to develop products that accelerate market adoption of our Ethernet and InfiniBand products. During this process, we have obtained valuable insight into the challenges and objectives of our customers, and gained visibility into their product development plans. We also have established end-user relationships with influential IT executives who allow us access to firsthand information about evolving market trends. We believe that our OEM customer and end-user relationships allow us to stay at the forefront of developments and improve our ability to provide compelling solutions to address their needs.
Our Strategy
Our goal is to be the leading supplier of end-to-end interconnect solutions for servers and storage that optimize data center performance for computing, storage and communications applications. To accomplish this goal, we intend to:
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Continue to develop leading, high-performance interconnect products. We will continue to expand our technical expertise and customer relationships to develop leading interconnect products. We are focused on extending our leadership position in high-performance interconnect technology and pursuing a product development plan that addresses emerging customer and end-user demands and industry standards. Our unified software strategy is to use a single software stack to support connectivity to Ethernet and InfiniBand with the same VPI enabled hardware adapter device.
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Capture Ethernet market share with our adapter, switch, and cable products. We believe we are the market leader in Ethernet adapters with performance greater than 10Gb/s and the only provider of end-to-end solutions of adapters, switches, and cables at the latest 25, 40, 50, 100, and 200Gb/s speeds. We plan to capture Ethernet market share as data centers transition from 10Gb/s to 25/40/50/100/200/400Gb/s. We believe we will be able to leverage our strength in the Ethernet adapter business to grow our Ethernet switch and cable business during the market transition to these advanced speeds.
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Facilitate and increase the continued adoption of InfiniBand. We will facilitate and increase the continued adoption of InfiniBand in the high-performance interconnect marketplace by expanding our partnerships with key vendors that drive high-performance interconnect adoption, such as suppliers of processors, operating systems and other associated software. In conjunction with our OEM customers, we will expand our efforts to promote the benefits of InfiniBand and VPI directly to end users to increase demand for high-performance interconnect solutions.
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Expand our presence with existing server OEM customers. We believe the leading server vendors are influential drivers of high-performance interconnect technologies to end users. We plan to continue working with and expanding our relationships with server OEMs to increase our presence in their current and future product platforms.
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Broaden our customer base with storage, communications infrastructure and embedded systems OEMs. We believe there is a significant opportunity to expand our global customer base with storage, communications infrastructure and embedded systems OEMs. In storage solutions specifically, we believe our products are well suited to replace existing technologies such as Fibre Channel. We believe our adapter, SOC, and switch products are the basis of superior interconnect fabrics for unifying disparate storage interconnects, including back-end, clustering and front-end connections, primarily due to their ability to be a unified fabric and superior price/performance economics.
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Leverage our fabless business model to deliver strong financial performance. We intend to continue operating as a fabless semiconductor company and consider outsourced manufacturing of our ICs, adapter cards, switches and cables to be a key element of our strategy. Our fabless business model offers flexibility to meet market demand and allows us to focus on delivering innovative solutions to our customers. We plan to continue to leverage the flexibility and efficiency offered by our business.
Our Products
We provide complete solutions which are based on and meet the specifications of the Ethernet and InfiniBand standards. Our products include adapter ICs and cards (ConnectX® and Connect-IB™ product family) and switch ICs (InfiniScale®, SwitchX®, SwitchX®-2, Mellanox Spectrum®, Switch-IB® and Mellanox Quantum™ product families) and systems, gateway ICs (BridgeX® product family) and gateway systems (Mellanox Skyway™), long-haul systems (MetroX®), Bluefield family SOC multicore and SmartNIC processors, software, and LinkX® cables and transceivers. Our ConnectX® family of adapters and cards support both the Ethernet and InfiniBand interconnect standards. Our SwitchX and SwitchX-2 family of silicon and systems supports both Ethernet and InfiniBand, and includes gateways that support bridging from InfiniBand to Ethernet. Our Spectrum switches support Ethernet standard and our Switch-IB and Quantum switches support InfiniBand standard. Our long-haul systems expand the reach of InfiniBand and lossless Ethernet up to 80 kilometers.
We have registered "Mellanox" and its logo, "Bluefield", "BridgeX", "Connect-IB", "ConnectX", "CoolBox", "CORE-Direct", "GPUDirect", "InfiniBridge", "InfiniHost", "InfiniScale", "Kotura" and its logo, "Mellanox Federal Systems", "Mellanox Hostdirect", "Mellanox Open Ethernet", "Mellanox Peerdirect", "Mellanox ScalableHPC", "Mellanox Technologies Connect. Accelerate. Outperform", "Mellanox Virtual Modular Switch", "MetroDX", "MetroX", "MLNX-OS", "Open Ethernet" logo, "PhyX", "SwitchX", "TestX", "The Generation of Open Ethernet" and its logo, "UFM", "Virtual Protocol Interconnect", "Quantum", "EZchip", "Tilera", and "Voltaire" and its logo as trademarks in the United States. "25 is the New 10®", "Accelio®", "CloudX®" logo, "CompustorX®"," "HPC-X®", "LinkX®", "Mellanox Care®", "Mellanox CloudX®" and its logo, "Mellanox Multi-host®", "Mellanox NEO®", "Mellanox Opencloud®" and its logo, "Mellanox OpenHPC®", "Mellanox Socket Direct®", "Mellanox Spectrum®", "Mellanox StorageX®", "Mellanox TuneX®, "Mellanox NVMEDirect®", "One Switch. A world of options®" slogan, "PlatformX®", "PSiPHY®", "SiPhy®", "Mellanox Spectrum®", "StoreX®", Switch-IB®", "TuneX®", "UCX®", "UCX Unified Communication X®" and "Unbreakable-Link®".
We have trademark applications pending in the United States to register "FPGADirect™", BlueOS™, CLOUD OF THINGS™, DYNAMIX QSA™, ETHERNET STORAGE FABRIC™ (LOGO), MELLANOX INDIGO™, Mellanox Innova™, MELLANOX NVMEDIRECT™, MELLANOX ONYX™, MELLANOX QUANTUM™ (LOGO), NVMe SNAP™, RIVERMAX™, SHIELD™, WHAT JUST HAPPENED™ (LOGO).
We provide adapters to server, storage, communications infrastructure and embedded systems OEMs as ICs or standard card form factors with PCI Express interfaces. Adapter ICs or cards are incorporated into OEMs' server and storage systems to provide Ethernet and/or InfiniBand connectivity. All of our adapter products interoperate with standard programming interfaces and are compatible with previous generations, providing broad industry support. We support leading server operating systems including Linux, Windows and VMware.
We provide our switch ICs and systems to server, storage, communications infrastructure and embedded systems OEMs to create switching equipment. To deploy an Ethernet or InfiniBand fabric, any number of server or storage systems that contain an adapter can be connected to a communications infrastructure system such as an Ethernet or InfiniBand switch. Our Spectrum family of Ethernet switches supports 10, 25, 40, 50, and 100Gb/s Ethernet throughput while Spectrum-2 is designed to support 200 and 400Gb/s Ethernet throughput. Our Quantum InfiniBand switch IC supports up to 200Gb/s InfiniBand throughput per port. We have introduced switch systems that include 8-port, 12-port, 18-port, 36-port, 48-port, 64-port, 108-port, 216-port, 324-port, 648-port, and 800-port. Our family of multicore processors and the new Bluefield SOC device combine multiple processing cores together with advanced networking connectivity and accelerators for security, storage, and other intelligent networking applications.
Our products generally vary by the number and performance of Ethernet or InfiniBand ports, and the number of processor cores supported.
We also offer custom products that incorporate our ICs to select server and storage OEMs that meet their special system requirements. Through these custom product engagements we gain insight into the OEMs' technologies and product strategies.
We also provide our OEM customers software and tools that facilitate the use and management of our products. Our Linux, Windows, and VMware-based software enables applications to efficiently utilize the features of the interconnect. We have expertise in optimizing the performance of software that spans the entire range of upper layer protocols down through the lower level drivers that interface to our products. We provide a suite of software tools and a comprehensive management software solution, Unified Fabric Manager ("UFM"), Network Orchestration ("NEO"), and ONYX and MLNX- OS network operating systems, for managing, optimizing, testing and verifying the operation of Ethernet and InfiniBand switch fabrics. In addition, we provide a full suite of acceleration software (Messaging Accelerator ("VMA"), Fabric Collective Accelerator ("FCA"), and Unstructured Data Accelerator ("UDA")) that further reduce latency, increase throughput, and offload CPU cycles, enhancing the performance of applications in multiple markets while eliminating the need for large investments in hardware infrastructure.
We provide an extensive selection of passive and active copper and optical cables and modules to enable Ethernet and InfiniBand connectivity at speeds up to 400Gb/s.
Technology
We have technological core competencies in the design of high-performance interconnect ICs that enable us to provide a high level of integration, efficiency, flexibility and performance for our adapter and switch ICs. Our products integrate multiple complex components onto a single IC, including high-performance mixed-signal design, specialized communication processing functions and advanced interfaces.
High-performance mixed-signal design
One of the key technology differentiators of our ICs is our mixed-signal data transmission SerDes technology. SerDes I/O directly drives the interconnect interface, which provides signaling and transmission of data over copper cables or fiber optic interfaces for longer distance connections. Additionally, we are able to integrate several of these high-performance SerDes onto a single, low-power IC, enabling us to provide the highest bandwidth, merchant switch ICs based on an industry-standard specification. We have developed a 25Gb/s SerDes I/O that is used in our ConnectX-4 adapter and Switch-IB and Spectrum switch silicon. Our 25Gb/s SerDes enables our ConnectX adapters to support 100Gb/s bandwidth (four 25Gb/s SerDes operating in parallel) in addition to providing a direct 10Gb/s connection to standard XFP and SFP+ fiber modules to provide long range Ethernet connectivity without the requirement of additional components, which saves power, cost and board space. We have extended our SerDes with PAM-4 technology to operate at 50G/s per lane in our ConnectX-6 adapters, Quantum-2 switches, and Spectrum-2 switches. This enables us to scale these platforms to 200 and 400Gb/s links.
Specialized communication processing and switching functions
We specialize in high-performance, low-latency design architectures that incorporate significant memory and logic areas requiring proficient synthesis and verification. Our adapter ICs are specifically designed to perform communication processing,
effectively offloading this very intensive task from server and storage processors in a cost-effective manner. Our switch ICs are specifically designed to switch cluster interconnect data transmissions from one port to another with high bandwidth and low latency, and we have developed a packet switching engine and non-blocking crossbar switch fabric to address this.
We have developed a custom embedded Reduced Instruction Set Computer processor called InfiniRISC® that specializes in offloading network processing from the host server or storage system and adds flexibility, product differentiation and customization. We integrate a different number of these processors in a device depending on the application and feature targets of the particular product. Integration of these processors also shortens development cycles as additional features can be added by providing new programming packages after the ICs are manufactured, and even after they are deployed in the field.
Advanced interfaces
In addition to Ethernet and InfiniBand interfaces, we also support other industry-standard, high-performance advanced interfaces, such as PCI Express, which also utilize our mixed-signal SerDes I/O technology. PCI Express is a high-speed, chip-to-chip interface which provides a high-performance interface between the adapter and processor in server and storage systems. PCI Express and our high-performance interconnect interfaces are complementary technologies that facilitate optimal bandwidth for data transmissions along the entire connection starting from a processor of one system in the cluster to another processor in a different system.
System hardware technology
In addition to silicon technology, we also provide system hardware technology that enables us to build high-density, high-performance network adapters and switch systems. Our technology delivers end-to-end solutions that maximize data throughput through a given media at minimal hardware or power cost at very low Bit Error Rate.
Software technology
In addition to hardware products, we develop and provide software stacks to expose standard I/O interfaces to the consumer applications on the host and to network management applications within the network. We also provide advanced interfaces and capabilities to enable application acceleration, efficient resource management and utilization in data centers, factoring cost, power and performance into the efficiency equation.
Customers
HPC, cloud, Web 2.0 and embedded end-user markets for systems utilizing our products are mainly served by leading server, storage and communications infrastructure OEMs and original design manufacturer ("ODMs"). In addition, our customer base includes leading embedded systems OEMs that integrate computing, storage and communication functions that use high-performance interconnect solutions contained in a chassis which has been optimized for a particular environment.
Our products have broad adoption with multiple end customers across HPC, Web 2.0, cloud, EDC, financial services and storage markets; however, these markets are mainly served by leading server, storage, communications infrastructure and embedded system OEMs and ODMs. Therefore, we have derived a substantial portion of our revenues from a relatively small number of OEM and ODM customers. In the years ended December 31, 2019, 2018 and 2017, sales to Hewlett Packard Enterprise ("HPE") accounted for 11%, 12% and 13%, respectively, of our total revenues and sales to Dell Technologies ("Dell") accounted for 10%, 12% and 11%, respectively, of our total revenues.
Backlog
Our sales are primarily made through standard purchase orders for delivery of products. Our manufacturing production is based on estimates and advance non-binding commitments from customers as to future purchases. We follow industry practice that allows customers to cancel, change or defer orders with limited advance notice prior to shipment. Given this practice, we do not believe that backlog is a reliable indicator of future revenue levels.
Sales and Marketing
We sell our products worldwide through multiple channels, including our direct sales force, our network of domestic and international sales representatives and independent distributors. We have strategically located marketing and sales personnel in the United States, Europe, China, Japan, India, Singapore, Taiwan and Australia. Our sales directors focus their efforts on leading OEMs and target key decision makers. We are also in frequent communication with our customers' and partners' sales organizations to jointly promote our products and partner solutions into end-user markets. We have expanded our sales and business development teams to engage directly with end users promoting the benefits of our products which we believe creates additional demand for our customers' products that incorporate our products.
Our sales support organization is responsible for supporting our sales channels and managing the logistics from order entry to the delivery of products to our customers. In addition, our sales support organization is responsible for customer and revenue forecasts, customer agreements and program management for our large, multi-national customers.
To accelerate design and qualification of our products into our OEM customers' systems, and ultimately the deployment of our technology by our customers to end users, we have a field applications engineering ("FAE") team and a sales engineering team that provide direct technical assistance during the design-in process. In certain situations, our OEM customers will utilize our expertise to support their end-user customers jointly. Our technical support personnel have expertise in hardware and software, and have access to our development team to ensure proper technical expertise is provided to our OEM customers. Our FAE team provides OEM customers with design reviews of their systems in addition to technical training on the technology we have implemented in our products.
Our marketing team is responsible for creating and growing the brand of our company, product strategy and management, competitive analysis, marketing communications and raising the overall visibility of our company. The marketing team works closely with both the sales and research and development organizations to properly align development programs and product launches with market demands.
Our marketing team leads our efforts to promote our interconnect technology and our products to the entire industry by:
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assuming leadership roles within IBTA, OFA and other industry trade organizations;
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participating in tradeshows, press and analyst briefings, conference presentations and seminars for end-user education; and
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building and maintaining active partnerships with industry leaders whose products are important in driving Ethernet and InfiniBand adoption, including vendors of processors, operating systems and software applications.
Research and Development
Our research and development team is composed of experienced semiconductor designers, software developers and system designers. Our semiconductor design team has extensive experience in all phases of complex, high-volume design, including product definition and architecture specification, hardware code development, mixed-signal and analog design and verification. Our software team has extensive experience in development, verification, interoperability testing and performance optimization of software for use in computing and storage applications. Our systems design team has extensive experience in all phases of high-volume adapter card, switch, and interconnect designs including product definition and architectural specification, product design, design verification and transfer to production. Our software is driven by an open-source approach which is fundamental for achieving high quality and performance.
We design our products with careful attention to quality, reliability, cost and performance requirements. We utilize a methodology called Customer Owned Tooling ("COT"), where we control and manage a significant portion of timing, layout design and verification in-house, before sending the semiconductor design to our third-party manufacturer. Although COT requires a significant up-front investment in tools and personnel, it provides us with greater control over the quality and reliability of our IC products, better product cost and superior time to market as opposed to relying on third-party verification services.
We choose first-tier technology vendors for our design tools and continue to maintain long-term relationships with our vendors to ensure timely support and updates. We also select a mainstream silicon manufacturing process only after it has proven its production worthiness. We verify that actual silicon characterization and performance measurements strongly correlate to models that were used to simulate the device while in design, and that our products meet frequency, power and thermal targets with good margins. Furthermore, we insert Design-for-Test circuitry into our IC products which increases product quality, provides expanded debugging capabilities and ultimately enhances system-level testing and characterization capabilities once the device is integrated into our customers' products.
Frequent interaction between our silicon, software and systems design teams gives us a comprehensive view of the requirements necessary to deliver quality, high-performance products to our OEM customers.
Manufacturing
We depend on third-party vendors to manufacture, package, assemble and production test our products as we do not own or operate facilities for semiconductor fabrication, packaging or production testing, or for board, cable or system assembly. By outsourcing manufacturing, we are able to avoid the high cost associated with owning and operating our own facilities while managing flexible capacity. This allows us to focus our efforts on the design and marketing of our products.
We own our test infrastructure in ICs, boards and cables. To keep high utilization and flexibility, most of our equipment is common between product families. For fiber cables, we also own some of the machines in the production line.
Manufacturing and Testing. We use Taiwan Semiconductor Manufacturing Company ("TSMC") for our CMOS process ICs and STMicroelectronics for our BiCMOS process ICs. We use Advanced Semiconductor Engineering ("ASE") and Amkor Technology Korea Inc. (“Amkor”) to assemble, package and production test our IC products. We use Flextronics International Ltd. ("Flextronics") and Universal Scientific Industrial Co., Ltd. ("USI") to manufacture our standard and custom adapter card products and switch systems. In addition, we also use Comtel Electronics to manufacture some of our switch systems. We use several sub-contractors to manufacture our cables. We maintain close relationships with our suppliers, which improves the efficiency of our supply chain. We focus on mainstream processes, materials, packaging and testing platforms, and have a continuous technology assessment program in place to choose the appropriate technologies to use for future products. We provide all of our suppliers a 6-month rolling forecast, and generally receive their confirmation that they are able to accommodate our needs on a monthly basis. We have access to online production reports that provide up-to-date status information of our products as they flow through the manufacturing process. On a quarterly basis, we generally review lead-time, yield enhancements and pricing with all of our suppliers to obtain the optimal cost for our products.
Quality Assurance. We maintain an ongoing review of product manufacturing and testing processes. Our IC products are subjected to extensive testing to assess whether their performance exceeds the design specifications. We own Teradyne IC in-house testers providing immediate test data and the ability to generate characterization reports that are made available to our customers. Our adapter cards, switch system and cable products are subject to similar levels of testing and characterization, and are additionally tested for regulatory agency certifications such as Safety and EMC (radiation test) which are made available to our customers. We only use components on these products that are qualified to be on our approved vendor list.
Employees
As of December 31, 2019, we had 2,660 full-time employees and 117 part-time employees, including 1,776 full-time employees in research and development, 474 in sales and marketing, 284 in general and administrative and 126 in operations. 1,995 of our full-time employees and 115 of the part-time employees are located in Israel.
Certain provisions of the collective bargaining agreements between the Histadrut (General Federation of Labor in Israel) and the Coordination Bureau of Economic Organizations (including the Industrialists' Associations) are applicable to our employees in Israel by order of the Israeli Ministry of Economy and Industry, which extends such collective bargaining agreements to Israeli employers. These provisions primarily concern the length of the workweek, travel expended, and pension fund benefits for all employees. We generally provide our employees with benefits and working conditions above the required minimums.
We have never experienced any employment-related work stoppages and believe our relationship with our employees is good.
Intellectual Property
One of the key values and drivers for future growth of our high-performance interconnect IC, system hardware and software products is the IP we develop and use to improve them. We believe that the main value proposition of our high-performance interconnect products and success of our future growth will depend on our ability to protect our IP. We rely on a combination of trade secret, patent, trademark, design, copyright and other IP laws, both in the United States and internationally, as well as confidentiality, non-disclosure and inventions assignment agreements with our employees, customers, partners, suppliers and consultants to protect and otherwise seek to control access to, and distribution of, our proprietary information and processes. In addition, we have developed technical knowledge, which, although not patented, we consider to be significant in enabling us to compete. The proprietary nature of such knowledge, however, may be difficult to protect and we may be exposed to competitors who independently develop the same or similar technology or gain access to our knowledge.
The semiconductor industry is characterized by frequent claims of infringement and litigation regarding patent and other IP rights. We, like other companies in the semiconductor industry, believe it is important to aggressively protect and pursue our IP rights. Accordingly, to protect our rights, we may file suit against parties whom we believe are infringing or misappropriating our IP rights. In addition, we may engage in litigation with parties that claim that we infringed their patents or misappropriated or misused their trade secrets. Such litigations could result in substantial cost and may divert management's attention away from day-to-day operations. We may not prevail in these lawsuits. If any party infringes or misappropriates our IP rights, this infringement or misappropriation could materially adversely affect our business and competitive position.
As of December 31, 2019, we had 681 issued patents and six registered designs in the United States, six issued patents in Israel, and 96 issued patents and four registered designs in other countries. We had 175 patent applications pending in the United States and 80 patent applications pending in other countries, which cover aspects of the technology in our products. The term of any issued patent in the United States and Israel is 20 years from its priority date and if our applications are pending for a long time period, we may have a correspondingly shorter term for any patent that may be issued. In addition, the lives of acquired patents may also have a shorter term depending upon their acquisition date and the issue date of respective patent. Our present
and future patents may provide only limited protection for our technology and may not be sufficient to provide competitive advantages to us. Furthermore, we cannot assure you that any patents will be issued to us as a result of our patent applications.
The risks associated with patents and intellectual property are more fully discussed under the section entitled "Risk Factors" under Part I, Item 1A
ITEM 1A - RISK FACTORS
Investing in our ordinary shares involves a high degree of risk. You should carefully consider the following risk factors, in addition to the other information set forth in this report, before purchasing our ordinary shares. Each of these risk factors could harm our business, financial condition and results of operations, as well as decrease the value of an investment in our ordinary shares.
Risks Related to Our Business
The announcement and pendency of our agreement to be acquired by a wholly-owned subsidiary of NVIDIA may adversely affect our business, results of operations and share price.
Our pending acquisition by NVIDIA International Holdings Inc., a wholly-owned subsidiary of NVIDIA, could have an adverse effect on our revenue in the near term if our customers delay, defer or cancel purchases pending completion of the Merger. While we are attempting to address this risk through communications with our customers, current and prospective customers may be reluctant to purchase our products due to uncertainty about the direction of our product offerings and the support and service of our products after the Merger is consummated. Additionally, we are subject to additional risks in connection with the announcement and pendency of the Merger, including:
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various conditions to the closing of the Merger, including required approval by the State Administration for Market Regulation, the China regulatory agency, may not be satisfied or waived;
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the pendency and outcome of any legal proceedings that may be instituted against us, our directors and others relating to the transactions contemplated by the Merger Agreement;
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potential adverse effects on our business and operations under the Merger Agreement, which may prevent us from pursuing opportunities without NVIDIA’s approval or taking other actions, whether in the form of dividend payments, share repurchases, restructurings, asset dispositions or otherwise, that we might have undertaken in the absence of this transaction;
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that the Merger Agreement contains customary provisions that may limit our ability to pursue alternative sale proposals;
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that we may forego opportunities we might otherwise have pursued absent the Merger Agreement;
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the required regulatory approvals from governmental entities may delay the Merger or result in the imposition of conditions that could cause NVIDIA to abandon the Merger;
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potential adverse effects on our ability to attract, recruit, retain and motivate current and prospective employees who may be uncertain about their future roles and relationships with us following the completion of the Merger; and
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the significant diversion of our employees’ and management’s attention resulting from the transactions contemplated by the Merger Agreement.
The failure of our pending acquisition by a wholly-owned subsidiary of NVIDIA to be completed may adversely affect our business, results of operations and share price.
Each of our and NVIDIA’s obligations to consummate the Merger is subject to a number of conditions specified in the Merger Agreement, including the following: (a) approval of the Merger Agreement by the requisite affirmative vote of our shareholders, which was received at our extraordinary general meeting of shareholders held on June 20, 2019, (b) no governmental authority in any jurisdiction has by any law or order restrained, enjoined or otherwise prohibited the consummation of the Merger that remains in effect, (c) expiration or termination of the applicable Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act"), waiting period, clearance or approval, as applicable, by the Anti-Monopoly Bureau of the State Administration for Market Regulation ("SAMR") in the People’s Republic of China, and clearance or affirmative approval by or expiration of the mandatory waiting period with respect to certain specified antitrust jurisdictions, (d) at least fifty (50) days shall have elapsed after the filing of the Merger proposal with the Companies Registrar of the Israeli Corporations Authority and at least thirty (30) days shall have elapsed after the approval of the Merger by our shareholders has been received, (e) with specified qualifications and exceptions, the truth and correctness of the representations and warranties of Mellanox, NVIDIA International Holdings Inc., Teal Barvaz Ltd. and NVIDIA and compliance in all material respects by Mellanox, NVIDIA International Holdings Inc. and Teal Barvaz Ltd. with their respective covenants contained in the Merger Agreement, and (f) the absence of a material adverse effect on Mellanox’s business, except any effects that, individually or in the aggregate, would prevent or materially impair Mellanox from consummating the Merger or performing any of its material obligations under the Merger Agreement. There can be no assurance that these conditions to the completion of the Merger will be satisfied in a timely manner or at all.
If the Merger is not completed our share price could fall to the extent that our current share price reflects an assumption that the Merger will be completed. Furthermore, if the Merger is not completed, we may suffer other consequences that could adversely affect our business, results of operations and share price, including the following:
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we could be required to pay a termination fee of up to $225.0 million to NVIDIA under certain circumstances as described in the Merger Agreement;
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we have incurred, and will continue to incur, significant costs, expenses and fees for professional services and other transaction costs in connection with the Merger, and these fees and costs are payable by us regardless of whether the Merger is consummated;
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the failure of the Merger to be consummated may result in adverse publicity and a negative impression of us in the investment community;
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the pendency and outcome of any legal proceedings that may be instituted against us, our directors and others relating to the transactions contemplated by the Merger Agreement;
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any disruptions to our business resulting from the announcement and pendency of the acquisition, including any adverse changes in our relationships with our customers, vendors and employees, may continue or intensify in the event the Merger is not consummated;
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we may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; and
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we may experience employee departures.
Any delay in completing the Merger may significantly reduce the benefits expected to be obtained from the Merger.
In addition to the required regulatory clearances and approvals described above under "The failure of our pending acquisition by a wholly-owned subsidiary of NVIDIA to be completed may adversely affect our business, results of operations and share price," the Merger is subject to a number of other conditions described in the Merger Agreement that are beyond our control. We cannot predict whether and when these conditions, and the other required regulatory clearances and approvals, will be satisfied.
The semiconductor industry may be adversely impacted by worldwide economic uncertainties which may cause our revenues and profitability to decline.
We operate primarily in the semiconductor industry, which is cyclical and subject to rapid change and evolving industry standards. From time to time, the semiconductor industry has experienced significant downturns characterized by decreases in product demand and excess customer inventories. Economic volatility can cause extreme difficulties for our customers and vendors to accurately forecast and plan future business activities. This unpredictability could cause our customers to reduce spending on our products and services, which would delay and lengthen sales cycles. Furthermore, during challenging economic times our customers and vendors may face issues gaining timely access to sufficient credit, which could affect their ability to make timely payments to us. As a result, we may experience growth patterns that are different than the end demand for products, particularly during periods of high volatility.
We cannot predict the timing, strength or duration of any economic slowdown or recovery or the impact of such events on our customers, our vendors or us. The combination of our lengthy sales cycle coupled with challenging macroeconomic conditions could have a compound impact on our business. The impact of market volatility is not limited to revenue but may also affect our product gross margins and other financial metrics. Any downturn in the semiconductor industry may be severe and prolonged, and any failure of the industry to fully recover from downturns could seriously impact our revenue and harm our business, financial condition and results of operations.
The adoption of InfiniBand is largely dependent on third-party vendors and end users and InfiniBand may not be adopted at prior rates or to the extent that we anticipate.
While the usage of InfiniBand has increased since its first specifications were completed in October 2000, continued adoption of InfiniBand is dependent on continued collaboration and cooperation among IT vendors. In addition, the end users that purchase IT products and services from vendors must find InfiniBand to be a compelling solution to their IT system requirements. We cannot control third-party participation in the development of InfiniBand as an industry standard technology. We rely on server, storage, communications infrastructure equipment and embedded systems vendors to incorporate and deploy InfiniBand ICs in their systems. InfiniBand may fail to effectively compete with other technologies, which may be adopted by vendors and their customers in place of InfiniBand. The adoption of InfiniBand is also affected by the general replacement cycle of IT equipment by end users, which is dependent on factors unrelated to InfiniBand. These factors may reduce the rate at which InfiniBand is incorporated by
our current server vendor customers and impede its adoption in the storage, communications infrastructure and embedded systems markets, which in turn would harm our ability to sell our InfiniBand products.
We face intense competition and may not be able to compete effectively, which could reduce our market share, net revenues and profit margin.
The markets in which we operate are extremely competitive and are characterized by rapid technological change, continuously evolving customer requirements and fluctuating average selling prices. We may not be able to compete successfully against current or potential competitors.
Some of our customers are also IC and switch suppliers and already have in-house expertise and internal development capabilities similar to ours. Licensing our technology and supporting such customers entails the transfer of intellectual property rights that may enable such customers to develop their own products and solutions to replace those we are currently providing to them. Consequently, these customers may become competitors to us. Further, each new design by a customer presents a competitive situation. In the past, we have lost design wins to divisions within our customers and this may occur again in the future. We cannot predict whether these customers will continue to compete with us, whether they will continue to be our customers or whether they will continue to buy products from us at the same volumes. Competition could increase pressure on us to lower our prices and could negatively affect our profit margins.
Many of our current and potential competitors have longer operating histories, significantly greater resources, greater economies of scale, stronger name recognition and larger customer bases than we have. This may allow them to respond more quickly to new or emerging technologies or changes in customer requirements. In addition, these competitors may have greater credibility with our existing and potential customers. If we do not compete successfully, our market share, revenues and profit margin may decline, and, as a result, our business may be adversely affected.
There has been a trend toward industry consolidation in our markets for several years, as companies attempt to improve the leverage of growing research and development costs, strengthen or hold their market positions in an evolving industry or are unable to continue operations. Companies that are strategic alliance partners in some areas of our business may acquire or form alliances with our competitors, thereby reducing their business with us. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. This could lead to more variability in our operating results and could have a material adverse effect on our business, financial condition and results of operations.
See Part I, Item 1, "Business-Competition” for more information about our competitors.
We have limited visibility into customer and end-user demand for our products and generally have short inventory cycles, which introduce uncertainty into our revenue and production forecasts and business planning and could negatively impact our financial results.
Our sales are made on the basis of purchase orders rather than long-term purchase commitments. In addition, our customers may defer purchase orders. We place orders with the manufacturers of our products according to our estimates of customer demand. This process requires us to make multiple demand forecast assumptions with respect to both our customers' and end users' demands. It is more difficult for us to accurately forecast end-user demand because we do not sell our products directly to end users. In addition, the majority of our adapter card, switch system and cable businesses are conducted on a short order fulfillment basis, introducing more uncertainty into our forecasts. Because of the lead time associated with fabrication of our semiconductors, forecasts of demand for our products must be made in advance of customer orders. In addition, we base business decisions regarding our growth on our forecasts for customer demand. As we grow, anticipating customer demand may become increasingly difficult. If we overestimate customer demand, we may purchase products from our manufacturers that we may not be able to sell and may over-burden our operations. Conversely, if we underestimate customer demand or if sufficient manufacturing capacity were unavailable, we would forego revenue opportunities and could lose market share or damage our customer relationships.
In addition, the majority of our revenues are derived from customer orders received and fulfilled in the same quarterly period. If we overestimate customer demand, we could miss our quarterly revenue targets, which could have a material adverse effect on our financial results.
We depend on a small number of customers for a significant portion of our sales, and the loss of any one of these customers will adversely affect our revenues.
A small number of customers account for a significant portion of our revenues. For the years ended December 31, 2019, 2018 and 2017, sales to HPE accounted for 11%, 12% and 13% of our total revenues, respectively; and sales to Dell accounted for 10%, 12% and 11% of our total revenues, respectively. Sales to our top 10 customers represented 48%, 53% and 56% for the years ended December 31, 2019, 2018 and 2017, respectively. Because the majority of servers, storage, communications infrastructure equipment and embedded systems are sold by a relatively small number of vendors, we expect that we will continue
to depend on a small number of customers to account for a significant percentage of our revenues for the foreseeable future. Our customers, including our most significant customers, are not obligated by long-term contracts to purchase our products and may cancel orders with limited potential penalties. If any of our large customers reduces or cancels its purchases from us for any reason, it could have an adverse effect on our revenues and results of operations. See Part I, Item 1, "Business-Customers" for more information about our customers.
Winning business is subject to lengthy, competitive selection processes that often require us to incur significant expense, from which we may ultimately generate no revenues.
Our business is dependent on us winning competitive bid selection processes, known as "design wins," to develop semiconductors for use in our customers' products. These selection processes are typically lengthy and can require us to incur significant design and development expenditures and to dedicate scarce engineering resources in pursuit of a single customer opportunity. We may not win the competitive selection process and may never generate any revenue despite incurring such expenditures.
Furthermore, winning a product design does not guarantee sales to a customer. We may experience delays in generating revenue as a result of the lengthy development cycle typically required, or we may not realize as much revenue as anticipated. In addition, a delay or cancellation of a customer's plans could materially and adversely affect our financial results, as we may have incurred significant expense in the design process and generated little or no revenue. Customers could choose at any time to stop using our products or may fail to successfully market and sell their products, which could reduce the demand for our products and cause us to hold excess inventory, thereby materially adversely affecting our business, financial condition and results of operations.
The timing of design wins is unpredictable and implementing production for a major design win, or multiple design wins occurring at or around the same time, may strain our resources and those of our contract manufacturers. In such instances, we may be forced to dedicate significant additional resources and incur additional, unanticipated costs and expenses, which may have a material adverse effect on our results of operations.
Finally, some customers will not purchase any products from us, other than limited numbers of evaluation units, until they qualify the products and/or the manufacturing line for the products. The qualification process can take significant time and resources and we may not always be able to satisfy the qualification requirements of these customers. Delays in qualification or failure to qualify our products may cause a customer to discontinue use of our products and result in a significant loss of revenue.
If we fail to develop new products or enhance our existing products to react to rapid technological change and market demands in a timely and cost-effective manner, our business will suffer.
We must develop new products or enhance our existing products with improved technologies to meet rapidly evolving customer requirements. We are currently engaged in the development process for our next generation of products in order to meet the demands of our customers who continually require higher performance and functionality at lower costs. The development process for these advancements is lengthy and will require us to accurately anticipate technological innovations and market trends. Developing and enhancing these products can be time-consuming, costly and complex. Our ability to fund product development and enhancements partially depends on our ability to generate revenues from our existing products.
We may be unable to successfully develop additional next generation products, new products or product enhancements. There is a risk that these developments or enhancements will be late, have technical problems, fail to meet customer or market specifications or otherwise be uncompetitive with other products using alternative technologies that offer comparable performance and functionality. Our next generation products or any new products or product enhancements may not be accepted in new or existing markets. Our business, financial condition and results of operations may be adversely affected if we fail to develop and introduce new products or product enhancements in a timely manner or on a cost-effective basis.
We rely on a limited number of subcontractors to manufacture, assemble, package and production test our products, and the failure of any of these third-party subcontractors to deliver products or otherwise perform as requested could damage our relationships with our customers, decrease our sales and limit our growth.
While we design and market our products and conduct test development in-house, we do not manufacture, assemble, package and production test the vast majority of our products, and we must rely on third-party subcontractors to perform these services. If these subcontractors do not provide us with high-quality products, services and production and production test capacity in a timely manner, or if one or more of these subcontractors terminates its relationship with us, we may be unable to obtain satisfactory replacements to fulfill customer orders on a timely basis, our relationships with our customers could suffer, our sales could decrease and our growth could be limited. In particular, there are significant challenges associated with moving our IC production from our existing manufacturer to another manufacturer with whom we do not have a pre-existing relationship.
In addition, the consolidation of foundry subcontractors, as well as the increasing capital intensity and complexity associated with fabrication in smaller process geometries has limited the diversity of our suppliers and increased our risk of a "single point of failure." Specifically, as we move to smaller geometries, we have become increasingly reliant on IC manufacturers. The lack of diversity of suppliers could also drive increased prices and adversely affect our results of operations, including our product gross margins.
We currently do not have long-term supply contracts with any of our third-party subcontractors. Therefore, they are not obligated to perform services or supply products to us for any specific period, in any specific quantities or at any specific price, except as may be provided in a particular purchase order. None of our third-party subcontractors has provided contractual assurances to us that adequate capacity will be available to us to meet future demand for our products. Our subcontractors may allocate capacity to the production of other companies' products while reducing deliveries to us on short notice. Other customers that are larger and better financed than we are or that have long-term agreements with these subcontractors may cause these subcontractors to reallocate capacity to those customers, thereby decreasing the capacity available to us.
Other significant risks associated with relying on these third-party subcontractors include:
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reduced control over product cost, delivery schedules and product quality;
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potential price increases;
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inability to achieve sufficient production, increase production or test capacity and achieve acceptable yields on a timely basis;
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increased exposure to potential misappropriation of our intellectual property;
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shortages of materials used to manufacture products;
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capacity shortages;
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labor shortages or labor strikes;
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political instability in the regions where these subcontractors are located; and
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natural disasters impacting these subcontractors.
See Part I, Item 1, "Business-Manufacturing" for more information about our subcontractors.
The average selling prices of our products have decreased in the past and may do so in the future, which could harm our financial results.
The products we develop and sell are subject to declines in average selling prices. We have had to reduce our prices in the past and we may be required to reduce prices in the future. Reductions in our average selling prices to one customer could impact our average selling prices to other customers. If we are unable to reduce our associated manufacturing costs this reduction in average selling prices would cause our gross margin to decline. Our financial results will suffer if we are unable to offset any reductions in our average selling prices by increasing our sales volumes, reducing our costs or developing new or enhanced products with higher selling prices or gross margins.
We expect gross margin to vary over time, and our recent level of product gross margin may not be sustainable.
Our product gross margins vary from quarter to quarter, and our recent level of gross margins may not be sustainable and may be adversely affected in the future by numerous factors, including product mix shifts, product transitions, increased price competition in one or more of the markets in which we compete, increases in material or labor costs, excess product component or obsolescence charges from our contract manufacturers, inventory reserve levels, warranty related issues, or the introduction of new products or entry into new markets with different pricing and cost structures.
Fluctuations in our revenues and operating results on a quarterly and annual basis could cause the market price of our ordinary shares to decline.
Our quarterly and annual revenues and operating results are difficult to predict and have fluctuated in the past, and may fluctuate in the future, from quarter to quarter and year to year. It is possible that our operating results in some quarters and years will be below market expectations. This would likely cause the market price of our ordinary shares to decline. Our quarterly and annual operating results are affected by a number of factors, many of which are outside of our control, including:
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unpredictable volume and timing of customer orders, which are not fixed by contract but vary on a purchase order basis;
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the loss of one or more of our customers, or a significant reduction or postponement of orders from our customers;
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our customers' sales outlooks, purchasing patterns and inventory levels based on end-user demands and general economic conditions;
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seasonal buying trends;
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the timing of new product announcements or introductions by us or by our competitors;
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our ability to successfully develop, introduce and sell new or enhanced products in a timely manner;
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changes in the relative sales mix of our products;
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decreases in the overall average selling prices of our products;
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changes in the cost of our finished goods; and
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the availability, pricing and timeliness of delivery of other components used in our customers' products.
We base our planned operating expenses in part on our expectations of future revenues, and a significant portion of our expenses is relatively fixed in the short-term. We have limited visibility into customer demand from which to predict future sales of our products. As a result, it may be difficult for us to forecast our future revenues and budget our operating expenses accordingly. Our operating results would be adversely affected to the extent customer orders are cancelled or rescheduled. If revenues for a particular quarter are lower than we expect, we may not be able to proportionately reduce our operating expenses.
We rely on our ecosystem partners to enhance and drive demand for our product offerings. Our inability to continue to develop or maintain such relationships in the future or our partners' inability to timely deliver technology or product offerings to the market may harm our revenues and ability to remain competitive.
We have developed relationships with third parties, which we refer to as ecosystem partners. Such partners provide their technology products, operating systems, tool support, reference designs and other elements necessary for the sale of our products into our markets. In addition, introduction of new products into the market by these partners may increase demand for our products. If we are unable to continue to develop or maintain these relationships, or if our ecosystem partners delay or fail to timely deliver their technology or products or other elements to the market, our revenues may be adversely impacted and we might not be able to enhance our customers' ability to commercialize their products in a timely manner and our ability to remain competitive may be harmed.
We rely primarily upon trade secret, patent, trademark, design and copyright laws and contractual restrictions to protect our proprietary rights, and, if these rights are not sufficiently protected, our ability to compete and generate revenues could suffer.
We seek to protect our proprietary manufacturing specifications, documentation and other written materials primarily under trade secret, patent, trademark, design and copyright laws. We also typically require employees and consultants with access to our proprietary information to execute confidentiality agreements. The steps taken by us to protect our proprietary information may not be adequate to prevent misappropriation of our technology. In addition, our proprietary rights may not be adequately protected because:
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people may not be deterred from misappropriating our technologies despite the existence of laws or contracts prohibiting it;
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policing unauthorized use of our intellectual property may be difficult, expensive and time-consuming, and we may be unable to determine the extent of any unauthorized use; and
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the laws of other countries in which we market our products, such as some countries in the Asia/Pacific region, may offer little or no protection for our proprietary technologies.
Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for doing so. Any inability to adequately protect our proprietary rights could harm our ability to compete, generate revenues and grow our business.
We may not obtain sufficient patent protection on the technology embodied in our products, which could harm our competitive position and increase our expenses.
Our success and ability to compete in the future may depend to a significant degree upon obtaining sufficient patent protection for our proprietary technology. Patents that we currently own do not cover all of the products that we presently sell as we have
patent applications pending with respect to certain products, while we have not been able to obtain, or choose not to seek, patent protection for other products. Our patent applications may not result in issued patents, and even if they result in issued patents, the patents may not have claims of the scope we seek. Furthermore, any issued patents may be challenged, invalidated or declared unenforceable. Whether or not these patents are issued, the applications may become publicly available and the proprietary information disclosed in the applications will become available to others. The lives of acquired patents may also be of a shorter term depending upon their acquisition dates and the issue dates. The term of any issued patent in the United States and Israel is typically 20 years from its filing date, and if our applications are pending for a long time period, we may have a correspondingly shorter term for any patent that may be issued. Our present and future patents may provide only limited protection for our technology and may not be sufficient to provide competitive advantages to us. For example, competitors could be successful in challenging any issued patents or, alternatively, could develop similar or more advantageous technologies on their own or design around our patents. Also, patent protection in certain foreign countries may not be available or may be limited in scope and any patents obtained may not be as readily enforceable as in the United States and Israel, making it difficult for us to effectively protect our intellectual property from misuse or infringement by other companies in these countries. Our inability to obtain and enforce our intellectual property rights in some countries may harm our business, financial condition and results of operations. In addition, given the costs of obtaining patent protection, we may choose not to protect certain innovations that later on turn out to be important. In such cases, our lack of intellectual property rights may have a material adverse impact on our business, financial condition and results of operations.
If we fail to carefully manage the use of "open source" software in our products, we may be required to license key portions of our products on a royalty-free basis or expose key parts of source code.
Some portion of our software may be derived from "open source" software that is generally made available to the public by its authors and/or other third parties. Such open source software is often made available to us under licenses, such as the GNU General Public License, which impose certain obligations on us in the event we were to create and distribute derivative works of the open source software. These obligations may require us to make source code for the derivative works available to the public and/or license such derivative works under a particular type of license, rather than the forms of licenses customarily used to protect our intellectual property. In the event that we inadvertently use open source software without the correct license form or a copyright holder of any open source software were to successfully establish in court that we had not complied with the terms of a license for a particular work, we could be required to release the source code of that work to the public and/or stop distribution of that work.
Intellectual property litigation, which is common in our industry, could be costly, harm our reputation, limit our ability to sell our products and divert the attention of management and technical personnel.
The semiconductor industry is characterized by frequent litigation regarding patent and other intellectual property rights. From time to time, we receive notices from competitors and other third parties that claim we have infringed upon, misappropriated or misused other parties' proprietary rights. We may also be required to indemnify some customers and strategic partners under our agreements if a third party alleges or if a court finds that our products or activities have infringed upon, misappropriated or misused another party's proprietary rights. We have received requests from certain customers and strategic partners to include increasingly broad indemnification provisions in our agreements with them. Additionally, our products may contain technology provided to us by other parties such as contractors, suppliers or customers. We may have little or no ability to determine in advance whether such technology infringes upon the intellectual property rights of a third party. Our contractors, suppliers and licensors may not be required to indemnify us in the event that a claim of infringement is asserted against us, or they may be required to indemnify us only up to a maximum amount, above which we would be responsible for any further costs or damages.
Questions of infringement in the markets we serve involve highly technical and subjective analysis. We are not involved in intellectual property litigation today, but litigation may be necessary in the future to enforce any patents we may receive and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity, and we may not prevail in any such future litigation. Litigation, whether or not determined in our favor or settled, could be costly, could harm our reputation and could divert the efforts and attention of our management and technical personnel from normal business operations. In addition, adverse determinations in litigation could result in the loss of our proprietary rights, subject us to significant liabilities, and require us to seek licenses from third parties or prevent us from licensing our technology or selling our products, any of which could seriously harm our business.
In the normal course of business, we enter into agreements with terms and conditions that require us to indemnify the other party against third-party claims alleging that one of our products infringes or misappropriates intellectual property rights, as well as against certain claims relating to property damage, personal injury or acts or omissions relating to supplied products or technologies, or acts or omissions made by us or our agents or representatives. In addition, we are obligated pursuant to indemnification undertakings with our officers and directors to indemnify them to the fullest extent permitted by law and to indemnify venture capital funds that were affiliated with or represented by such officers or directors. If we receive demands for indemnification under these agreements and terms and conditions, they will likely be very expensive to settle or defend, and we
may incur substantial legal fees in connection with any indemnity demands. Our indemnification obligations under these agreements and terms and conditions may be unlimited in duration and amount, and could have an adverse effect on our business, financial condition and results of operations.
We depend on key and highly skilled personnel to operate our business, and if we are unable to retain our current personnel and hire additional personnel, our ability to develop and successfully market our products could be harmed.
Our business is particularly dependent on the interdisciplinary expertise of our personnel, and we believe our future success will depend in large part upon our ability to attract and retain highly skilled managerial, engineering, finance and sales and marketing personnel. The loss of any key employees or the inability to attract or retain qualified personnel could delay the development and introduction of, and harm our ability to sell our products and harm the market's perception of us. Competition for qualified engineers in the markets in which we operate is intense and accordingly, we may not be able to retain or hire all of the engineers required to meet our ongoing and future business needs. If we are unable to attract and retain the highly skilled professionals we need, we may have to forego projects for lack of resources or be unable to staff projects optimally. We believe that our future success is highly dependent on the contributions of our president and CEO and other senior executives. We do not have long-term employment contracts with our president and CEO or any other key personnel, and their knowledge of our business and industry would be extremely difficult to replace.
In an effort to retain key employees, we may modify our compensation policies by, for example, increasing cash compensation to certain employees and/or modifying existing share options. These modifications of our compensation policies and the requirement to expense the fair value of share options, restricted share units, and performance share units awarded to employees and officers may increase our operating expenses and result in the dilution of the holders of our ordinary shares. We cannot be certain that these and any other changes in our compensation policies will or would improve our ability to attract, retain and motivate employees. Our inability to attract and retain additional key employees and the increase in share-based compensation expense could each have an adverse effect on our business, financial condition and results of operations.
We may pursue acquisitions of other companies or new or complementary products, technologies and businesses, which could harm our operating results, may disrupt our business and could result in unanticipated accounting charges.
Our growth depends upon market growth, our ability to enhance our existing products, and our ability to introduce new products on a timely basis. Consistent with the terms of the Merger Agreement, we intend to continue to address the need to develop new products and enhance existing products through acquisitions of other companies, product lines, technologies, and personnel.
Acquisitions create additional material risk factors for our business that could cause our results to differ materially and adversely from our expected or projected results. Such risk factors include:
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difficulties in integrating the operations, systems, technologies, products, and personnel of the acquired companies, particularly companies with large and widespread operations and/or complex products;
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the diversion of management's attention from normal daily operations of the business and the challenges of managing larger and more widespread operations resulting from acquisitions;
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possible disruption to the continued expansion of our product lines;
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potential changes in our customer base and changes to the total available market for our products;
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reduced demand for our products;
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potential difficulties in completing projects associated with in-process research and development intangibles;
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the use of a substantial portion of our cash resources and incurrence of significant amounts of debt;
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significantly increase our interest expense, leverage and debt service requirements as a result of incurring debt;
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the impact of any such acquisition on our financial results;
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internal controls may become more complex and may require significantly more resources to ensure they remain effective;
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negative customer reaction to any such acquisition; and
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assuming the liabilities of the acquired company.
Acquisitions present a number of other potential risks and challenges that could disrupt our business operations. For example, we may not be able to successfully negotiate or finance the acquisition on favorable terms. If an acquired company also has
inventory that we assume, we will be required to write up the carrying value of that inventory to its fair value. When that inventory is sold, the gross margins for those products are reduced and our gross margins for that period are negatively affected. Furthermore, the purchase price of any acquired businesses may exceed the current fair values of the net tangible assets of such acquired businesses. As a result, we would be required to record material amounts of goodwill, acquired in-process research and development and other intangible assets, which could result in significant impairment and acquired in-process research and development charges and amortization expense in future periods. These charges, in addition to the results of operations of such acquired businesses and potential restructuring costs associated with an acquisition, could have a material adverse effect on our business, financial condition and results of operations. We cannot forecast the number, timing or size of future acquisitions, or the effect that any such acquisitions might have on our operating or financial results. Furthermore, potential acquisitions, whether or not consummated, will divert our management's attention and may require considerable cash outlays at the expense of our existing operations. In addition, to complete future acquisitions, we may issue equity securities, incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets, which could adversely affect our profitability.
We have made and may in the future pursue investments in other companies, which could harm our operating results.
We have made, and could make in the future, investments in technology companies, including privately-held companies in the development stage. Many of these private equity investments are inherently risky because these businesses may never develop, and we may incur losses related to these investments. In addition, we have written down the carrying value of these investments in the past and may be required to write down the carrying value of these investments in the future to reflect other-than-temporary declines in their value, which could have a material adverse effect on our business, financial position and results of operations.
We may not be able to manage our future growth effectively, and we may need to incur significant expenditures to address the additional operational and control requirements of our growth.
We are experiencing a period of company growth and expansion. This expansion has placed, and any future expansion will continue to place, a significant strain on our management, personnel, systems and financial resources. We plan to hire additional employees to support an increase in research and development and strengthen our sales and marketing and general and administrative efforts. To successfully manage our growth, we believe we must effectively:
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manage and enhance our relationships with customers, distributors, suppliers, end users and other third parties;
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implement additional, and enhance existing, administrative, financial and operations systems, procedures and controls;
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address capacity shortages;
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manage inventory levels;
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expand and upgrade our technological capabilities;
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manage the challenges of having U.S., Israeli and other foreign operations; and
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hire, train, integrate and manage additional qualified engineers for research and development activities as well as additional personnel to strengthen our sales and marketing, financial and IT functions.
Managing our growth may require substantial managerial and financial resources and may increase our operating costs even though these efforts may not be successful. If we are unable to manage our growth effectively, we may not be able to take advantage of market opportunities, develop new products, satisfy customer requirements, execute our business plan or respond to competitive pressures, in which case our business, financial conditions and results of operations may be adversely affected.
We are subject to risks associated with our distributors' product inventories.
We sell many of our products to customers through distributors who maintain their own inventory of our products for sale to dealers and end customers. We allow limited price adjustments on sales to distributors. We have extended these programs to certain distributors in the United States, Asia and Europe and may extend them on a selective basis to some of our other distributors in these geographies. The allowances for distributor price adjustments are based on judgments and estimates, using historical experience rates, inventory levels in distribution, current trends and other factors, and there could be material differences between actual amounts and our estimates. Prior to January 1, 2018, we recognized revenues for sales to distributors upon sell through by the distributors, net of estimated allowances for price adjustments. Upon the adoption of the new revenue standards effective January 1, 2018, we began recognizing revenue on sales to distributors upon shipment and transfer of control (known as "sell-in" revenue recognition), net of the estimated allowances for price adjustments.
If our distributors are unable to sell an adequate amount of their inventory of our products in a given quarter to dealers and end customers or if they decide to decrease their inventories for any reason, such as adverse global economic conditions or a downturn in technology spending, our sales to these distributors and our revenues may decline. We also face the risk that our
distributors may purchase, or for other reasons accumulate, inventory levels of our products in any particular quarter in excess of future anticipated sales to end customers. If such sales do not occur in the time frame anticipated by these distributors for any reason, these distributors may substantially decrease the amount of product they order from us in subsequent periods until their inventory levels realign with end-customer demand, which would harm our business and could adversely affect our revenues in such subsequent periods.
We do not always have a direct relationship with the end customers of our products sold through distributors. As a result, our products may be used in applications for which they were not necessarily designed or tested, and they may not perform as anticipated in such applications. In such event, failure of even a small number of parts could result in significant liabilities to us, damage our reputation and harm our business and results of operations.
Certain of our customers and suppliers require us to comply with their codes of conduct, which may include certain restrictions that may substantially increase our cost of doing business as well as have an adverse effect on our operating efficiencies, operating results and financial condition.
Certain of our customers and suppliers require us to agree to comply with the Electronic Industry Code of Conduct ("EICC") or their own codes of conduct, which may include detailed provisions on labor, human rights, health and safety, environment, corporate ethics and management systems. Certain of these provisions are not requirements under the laws of the countries in which we operate and may be burdensome to comply with on a regular basis. Moreover, new provisions may be added or material changes may be made to any of these codes of conduct, and we may have to promptly implement such new provisions or changes, which may substantially further increase the cost of our business, be burdensome to implement and adversely affect our operational efficiencies and operating results. If we violate any such codes of conduct, we may lose further business with the customer or supplier and, in addition, we may be subject to fines from the customer or supplier. While we believe that we are currently in compliance with our customers and suppliers' codes of conduct, there can be no assurance that, from time to time, if any one of our customers and suppliers audits our compliance with such code of conduct, we would be found to be in full compliance. A loss of business from these customers or suppliers could have a material adverse effect on our business, financial condition and results of operations.
We may experience defects in our products, unforeseen delays, higher than expected expenses or lower than expected manufacturing yields of our products, which could result in increased customer warranty claims, delays of our product shipments and prevent us from recognizing the benefits of new technologies we develop.
Our products may contain defects and errors. Product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased warranty-related returns, including wide-scale product recalls, warranty expenses and product liability claims against us which may not be fully covered by insurance. Our products are complex and our quality control tests and procedures may fail to detect any such defects or errors. Delivery of products with defects or reliability, quality or compatibility problems may damage our reputation and our ability to retain existing customers and attract new customers. As a result, defects in our products could have an adverse effect on our business, financial condition and results of operations.
In addition, our production of existing and development of new products can involve multiple iterations and unforeseen manufacturing difficulties, resulting in reduced manufacturing yields, delays and increased expenses. The evolving nature of our products requires us to modify our manufacturing specifications, which may result in delays in manufacturing output and product deliveries. We rely on a limited number of third parties to manufacture our products. Our ability to offer new products depends on our manufacturers' ability to implement our revised product specifications, which is costly, time-consuming and complex.
We have significant intangible assets and goodwill. Consequently, the future impairment of our intangible assets and goodwill, if any, may significantly impact our profitability.
Our intangible assets and goodwill are significant. As of December 31, 2019, we had recorded $626.0 million of intangible assets, net and goodwill primarily related to our past acquisitions. Intangible assets and goodwill are subject to an impairment analysis whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. Additionally, goodwill and indefinite-lived assets are subject to an impairment test at least annually. The impairment of any goodwill and other intangible assets may have a negative impact on our consolidated results of operations.
Unanticipated changes in our tax provisions or adverse outcomes resulting from examination of our income tax returns could adversely affect our results of operations.
We are subject to income taxes in Israel, the United States and various foreign jurisdictions. Our effective income tax rate could be adversely affected by changes in tax laws or interpretations of those tax laws, by changes in the mix of earnings in countries with differing statutory tax rates, or by changes in the valuation of our deferred tax assets and liabilities.
Our effective income tax rates are also affected by intercompany transactions for sales, services, funding and other items. Given the increased global scope of our operations, and the complexity of global tax and transfer pricing rules and regulations, it has become increasingly difficult to estimate earnings within each tax jurisdiction. If actual earnings within a tax jurisdiction differ materially from our estimates or new information is discovered in the course of our tax return preparation process, we may not achieve our expected effective tax rate. Additionally, our effective tax rate may be affected by the tax effects of acquisitions, restructuring activities, newly enacted tax legislation, share-based compensation and uncertain tax positions. Finally, we are subject to the examination of our income tax returns by the Internal Revenue Service and other tax authorities which may result in the assessment of additional income taxes. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. However, unanticipated outcomes from these examinations could have a material adverse effect on our business, financial condition and results of operations.
Changes to financial accounting standards may affect our results of operations and cause us to change our business practices.
We prepare our financial statements to conform to GAAP in the United States. These accounting principles are subject to interpretation by the FASB, the American Institute of Certified Public Accountants, the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business.
We must comply with a variety of existing and future laws and regulations that could impose substantial costs on us and may adversely affect our business.
We are subject to various state, federal and international laws and regulations governing the environment, including restricting the presence of certain substances in electronic products and making producers of those products financially responsible for the collection, treatment, recycling and disposal of those products. In addition, we are also subject to various industry requirements restricting the presence of certain substances in electronic products. Although our management systems are designed to maintain compliance, we cannot assure you that we have been or will be at all times in complete compliance with such laws and regulations. If we violate or fail to comply with any of them, a range of consequences could result, including fines, import/export restrictions, sales limitations, criminal and civil liabilities or other sanctions.
We and our customers are also subject to various import and export laws and regulations. Government export regulations apply to the encryption or other features contained in some of our products. If we fail to continue to receive licenses or otherwise comply with these regulations, we may be unable to manufacture the affected products or ship these products to certain customers, or we may incur penalties or fines.
We are also subject to regulations concerning the supply of certain minerals coming from the conflict zones in and around the Democratic Republic of Congo ("DRC"). The Dodd-Frank Wall Street Reform and Consumer Protection Act includes disclosure requirements regarding the use of certain minerals mined from the DRC and adjoining countries and procedures regarding a manufacturer's efforts to identify sourcing of such conflict minerals. These requirements could affect the sourcing and availability of minerals used in the manufacture of semiconductor devices.
As a result, this could limit the pool of suppliers who can provide us confirmation that the components and parts we source are considered DRC "conflict free," and we may not be able to confirm that we have obtained products or supplies that can be confirmed as DRC "conflict free" in sufficient quantities for our operations. Also, because our supply chain is complex, we may face reputational challenges with our customers, shareholders and other stakeholders if we are unable to sufficiently verify the origins for the minerals used in our products.
The costs of complying with these laws could adversely affect our current or future business. In addition, future regulations may become more stringent or costly and our compliance costs and potential liabilities could increase, which may harm our current or future business.
If we fail to maintain an effective system of internal controls, we may not be able to report accurately our financial results or prevent material fraud. As a result, current and potential shareholders could lose confidence in our financial reporting, which could harm our business and the trading price of our ordinary shares.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent material fraud. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our internal control structure and procedures for financial reporting. We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements. We have incurred, and expect to continue to incur significant expenses and to devote significant management resources to Section 404 compliance.
Furthermore, as we grow our business or acquire businesses, our internal controls may become more complex and we may require significantly more resources to ensure they remain effective. Failure to implement required new or improved controls, or difficulties encountered in their implementation, either in our existing business or in businesses that we may acquire could harm our operating results or cause us to fail to meet our reporting obligations. In the event that our CEO, CFO or independent registered public accounting firm determine that our internal controls over financial reporting are not effective as defined under Section 404, investor perceptions of our company may be adversely affected and may cause a decline in the market price of our ordinary shares.
We may be subject to disruptions or failures in information technology systems and network infrastructures, including theft, misuse of our electronic data or cyber-attacks that could have a material adverse effect on us.
We rely on the efficient and uninterrupted operation of complex information technology systems and network infrastructures to operate our business. We also hold large amounts of data in various data center facilities upon which our business depends. A disruption, infiltration or failure of our information technology systems or any of our data centers as a result of software or hardware malfunctions, system implementations or upgrades, computer viruses, third-party security breaches, attempts by others that try to gain unauthorized access through the Internet to our information technology systems, employee error, theft or misuse, malfeasance, power disruptions, natural disasters or accidents could cause breaches of data security, loss of intellectual property and critical data and the release and misappropriation of sensitive competitive information and partner, customer and employee personal data. These attempts may be the result of industrial or other espionage, or actions by hackers seeking to harm us, our products, or our end users. Any of these events could harm our competitive position, result in a loss of customer confidence, cause us to incur significant costs to remedy any damages and ultimately materially adversely affect our business, financial condition and results of operations.
While we have implemented a number of protective measures, including firewalls, antivirus, patches, log monitors, routine back-ups, system audits, routine password modifications and disaster recovery procedures, such measures may not be adequate or implemented properly to prevent or fully address the adverse effect of such events, and in some cases we may be unaware of an incident or its magnitude and effects.
In addition, our third-party subcontractors, including our foundries, test and assembly houses and distributors, have access to certain portions of our sensitive data. In the event that these subcontractors do not properly safeguard our data that they hold, security breaches and loss of our data could result. Any such loss of data by our third-party service providers, or theft, unauthorized use or publication of our trade secrets and other confidential business information as a result of such cyber threats, could adversely affect our competitive position and reduce marketplace acceptance of our products; the value of our investment in research and development and marketing could be reduced; and third parties may assert against us or our customers claims related to resulting losses of confidential or proprietary information or end-user data, or system reliability. Any such event could have a material adverse effect on our business, financial condition and results of operations.
Our business is subject to the risks of earthquakes, fires, floods and other natural catastrophic events.
Our operations take place across the globe, including in areas such as the San Francisco Bay Area and Asia Pacific nations that are known for seismic activity. A significant natural disaster, such as an earthquake, fire, flood or tsunami, or a human health epidemic or pandemic - such as the recent strain of COVID-19 virus - affecting any location in which our operations or the operations of our customers or suppliers take place could have a material adverse impact on our business, financial condition and results of operations. To the extent that such disruptions result in delays or cancellations of customer orders, or the deployment of our products, our business, financial condition and results of operations would be adversely affected.
Risks Related to Operations in Israel and Other Foreign Countries
Regional instability in Israel may adversely affect business conditions and may disrupt our operations and negatively affect our revenues and profitability.
We have engineering facilities, corporate and sales support operations located in Israel. A significant number of our employees and a material amount of assets are located in Israel. Accordingly, political, economic and military conditions in Israel may directly affect our business. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its Arab neighbors, as well as incidents of civil unrest. These conflicts negatively affected business conditions in Israel. In addition, Israel and companies doing business with Israel have, in the past, been the subject of an economic boycott. In addition, there has been recent civil unrest in the Middle East and surrounding areas, including Egypt, Jordan, Iraq, Syria and Libya. Any future armed conflicts or political instability in the region may negatively affect business conditions and adversely affect our results of operations. Parties with whom we do business have sometimes declined to travel to Israel during periods of heightened unrest or tension, forcing us to make alternative arrangements when necessary. In addition, the political and security situation in Israel may result in parties with whom we have agreements involving performance in Israel claiming that they are not obligated to perform their commitments under those agreements pursuant to force majeure provisions in the agreements.
The security and political conditions may have an impact on our business in the future. Hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could adversely affect our operations and could make it more difficult for us to raise capital. Our Israeli operations are within range of Hezbollah or Hamas missiles and we or our immediate surroundings may sustain damages in a missile attack, which could adversely affect our operations.
In addition, our business insurance does not cover losses that may occur as a result of events associated with the security situation in the Middle East. Although the Israeli government currently covers the reinstatement value of direct damages that are caused by terrorist attacks or acts of war, we cannot assure you that this government coverage will be maintained. Any losses or damages incurred by us as a result of such events could have a material adverse effect on our business, financial condition and results of operations.
Our operations may be negatively affected by the obligations of our personnel to perform military service.
Generally, all non-exempt male adult citizens and permanent residents of Israel under the age of 45 (or older, for citizens with certain occupations), including some of our employees, are obligated to perform military reserve duty for Israel annually, and are subject to being called to active duty at any time under emergency circumstances. In the event of severe unrest or other conflict, individuals could be required to serve in the military for extended periods of time. In response to increases in terrorist activity, there have been periods of significant call-ups of military reservists, and some of our employees, including those in key positions, have been called upon in connection with armed conflicts. It is possible that there will be additional call-ups in the future. Our operations could be disrupted by the absence for a significant period of one or more of our officers, directors or key employees due to military service. Any such disruption could adversely affect our operations.
Our operations may be affected by labor unrest in Israel.
In the past, there have been several general strikes and work stoppages in Israel affecting all banks, airports and ports. These strikes had an adverse effect on the Israeli economy and on business, including our ability to deliver products to our customers and to receive raw materials from our suppliers in a timely manner. From time to time, the Israeli trade unions threaten strikes or work stoppages, which, if carried out, may have a material adverse effect on the Israeli economy and our business.
We are susceptible to additional risks from our international operations.
We derived 61%, 63% and 62% of our revenues in the years ended December 31, 2019, 2018 and 2017, respectively, from sales outside of the United States. As a result, we face additional risks from doing business internationally, including:
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reduced protection of intellectual property rights in some countries;
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difficulties in staffing and managing foreign operations;
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longer sales and payment cycles;
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greater difficulties in collecting accounts receivable;
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adverse economic conditions;
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seasonal reductions in business activity;
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potentially adverse tax consequences;
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laws and business practices favoring local competition;
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costs and difficulties of customizing products for foreign countries;
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compliance with a wide variety of complex foreign laws and treaties;
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compliance with the United States' Foreign Corrupt Practices Act and similar anti-bribery laws in other jurisdictions;
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compliance with export control and regulations;
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licenses, tariffs, other trade barriers, transit restrictions and other regulatory or contractual limitations on our ability to sell or develop our products in certain foreign markets, including the tariffs recently enacted and proposed by the U.S. government on various imports from China and by the Chinese government on certain U.S. goods, the scope and duration of which remain uncertain;
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restrictive governmental actions, such as restrictions on the transfer or repatriation of funds and foreign investments;
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foreign currency exchange risks;
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fluctuations in freight rates and transportation disruptions;
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political and economic instability;
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variance and unexpected changes in local laws and regulations;
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natural disasters and public health emergencies; and
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trade and travel restrictions.
We sell our products into many countries and we also source many components and materials for our products from various countries. Such global resourcing enables us to minimize or mitigate the impact of tariffs and other regulatory taxes or duties. Nonetheless, the recently imposed U.S. tariffs and other trade restrictions could have a negative impact on our business, financial condition or results of operations. Further, an increase in tariffs or the imposition of additional tariffs or other trade restrictions and the potential escalation of a trade war and retaliatory measures could adversely affect our business, financial condition or results of operations.
A significant legal risk associated with conducting business internationally is compliance with various and differing anti-corruption and anti-bribery laws and regulations of the countries in which we do business, including the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act and similar laws in China. In addition, the anti-corruption laws in various countries are constantly evolving and may, in some cases, conflict with each other. Our Code of Ethics and Business Conduct and other policies prohibit us and our employees from offering or giving anything of value to a government official for the purpose of obtaining or retaining business and from engaging in unethical business practices, including kick-backs to or from purely private parties. However, there can be no assurance that all of our employees or agents will refrain from acting in violation of such laws and our related anti-corruption policies and procedures. Any violations of these anti-corruption or trade control laws, or even allegations of such violations, can lead to an investigation, which could disrupt our operations, involve significant management distraction, and lead to significant costs and expenses, including legal fees. If we, or our employees or agents acting on our behalf, are found to have engaged in practices that violate these laws and regulations, we could suffer severe fines and penalties, profit disgorgement, injunctions on future conduct, securities litigation, and other consequences that may have a material adverse effect on our business, financial condition and results of operations. In addition, our reputation, sales activities or stock price could be adversely affected if we become the subject of any negative publicity related to actual or potential violations of anti-corruption, anti-bribery, or trade control laws and regulations.
Our principal research and development facilities are located in Israel, and our directors, executive officers and other key employees are located primarily in Israel and the United States. In addition, we engage sales representatives in various countries throughout the world to market and sell our products in those countries and surrounding regions. If we encounter any of the above risks in our international operations, we could experience slower than expected revenue growth and our business could be harmed.
The results of the United Kingdom's withdrawal from the European Union may have a negative effect on global economic conditions, financial markets and our business.
The United Kingdom ("U.K.") held a referendum in June 2016 in which a majority of voters approved an exit from the European Union ("Brexit"). On January 31, 2020, the UK officially left the European Union and entered into a transitional period running through December 31, 2020, during which period the UK and the European Union will attempt to negotiate their future relationship. Significant political and economic uncertainty remains about whether the terms of the relationship will differ materially from the terms before withdrawal, as well as about the possibility that a so-called “no deal” separation will occur if negotiations are not completed by the end of the transition period. The laws and regulations effected could include those governing manufacturing, labor, environmental, data protection/privacy, competition and other matters applicable to the semiconductor industry.
Brexit has also given rise to calls for the governments of other European Union member states to consider withdrawal. These developments, or the perception that any of them could occur, may have a material adverse effect on global economic conditions and the stability of global financial markets, and may significantly reduce global market liquidity and restrict the ability of key market participants to operate in certain financial markets. Any of these factors could depress economic activity and restrict our access to capital, which could have a material adverse effect on our business, financial condition and results of operations and reduce the price of our ordinary shares.
Provisions of Israeli law may delay, prevent or make difficult an acquisition of our company, which could prevent a change of control and therefore depress the price of our shares.
The Israeli Companies Law, 1999 (the "Companies Law") generally requires that a merger be approved by the board of directors and by the general meeting of the shareholders. Upon the request of any creditor of a merging company, a court may delay or prevent the merger if it concludes that there is a reasonable concern that, as a result of the merger, the surviving company will be unable to satisfy its obligations. In addition, a merger may not be completed unless at least (i) 50 days have passed since the filing of the merger proposal with the Israeli Registrar of Companies and (ii) 30 days have passed since the merger was approved by the shareholders of each of the merging companies.
Also, in certain circumstances, an acquisition of shares in a public company must be made by means of a tender offer if, as a result of the acquisition, the purchaser would hold 25% or more of the voting rights in the company (unless there is already a 25% or greater shareholder of the company) or more than 45% of the voting rights in the company (unless there is already a shareholder that holds more than 45% of the voting rights in the company). If, as a result of an acquisition, the acquirer would hold more than 90% of a company's shares or voting rights, the acquisition must be made by means of a tender offer for all of the shares.
In addition, the Companies Law allows us to create and issue shares having rights different from those attached to our ordinary shares, including rights that may delay or prevent a takeover or otherwise prevent our shareholders from realizing a potential premium over the market value of their ordinary shares. The authorization of a new class of shares would require an amendment to our amended and restated articles of association, which requires the prior approval of the holders of a majority of our shares at a general meeting.
These provisions could delay, prevent or impede an acquisition of us, including the planned acquisition by NVIDIA, even if such an acquisition would be considered beneficial by some of our shareholders.
Exchange rate fluctuations between the U.S. dollar and the New Israeli Shekels ("NIS") may negatively affect our earnings.
We derive all of our revenues in U.S. dollars. The U.S. dollar is our functional and reporting currency in all of our foreign locations. However, a significant portion of our liabilities, as well as our operating expenses, consisting principally of salaries and related personnel costs and facilities expenses, are denominated in NIS. This foreign currency exposure gives rise to market risk associated with exchange rate movements of the U.S. dollar against the NIS. To the extent that the value of the NIS increases against the U.S. dollar, our expenses on a U.S. dollar cost basis will increase. We cannot predict any future trends in the rate of appreciation of the NIS against the U.S. dollar. If the U.S. dollar cost of our salaries and related personnel costs and facilities expenses in Israel increases, our dollar-measured results of operations will be adversely affected. Our operations also could be adversely affected if we are unable to hedge against currency fluctuations in the future. Further, because all of our international revenues are denominated in U.S. dollars, a strengthening of the dollar versus other currencies could make our products less competitive in foreign markets and the collection of our receivables more difficult. To help manage this risk we have been engaged in foreign currency hedging activities, comprised of currency derivative instruments and natural hedges.
Our cost in Israel in U.S. dollar terms will also increase if inflation in Israel exceeds the devaluation of the NIS against the U.S. dollar or if the timing of such devaluation lags behind inflation in Israel.
In addition, a material portion of our leases are denominated in currencies other than the U.S. Dollar, mainly in NIS. In accordance with the new lease accounting standard, which became effective on January 1, 2019, the associated lease liabilities are remeasured using the current exchange rate in the future reporting periods, which may result in material foreign exchange gains or losses. See Note 1, "The Company and Summary of Significant Accounting Policies" in the notes to the consolidated financial statements for more details.
The government tax benefits that we currently receive require us to meet several conditions and may be terminated or reduced in the future, which would increase our costs.
According to the Israeli Law for Encouragement of Capital Investments, 1959 (the "Encouragement Law"), the Company's operations in Israel were granted "Approved Enterprise" status by the Investment Center in the Israeli Ministry of Economy and Industry and "Beneficiary Enterprise" status by the Israeli Income Tax Authority. The Company is eligible for tax benefits under the Encouragement Law with respect to its income derived from its Approved and Beneficiary Enterprises. The availability of these tax benefits is subject to certain requirements, including, among other things, making specified investments in fixed assets and equipment, financing a percentage of those investments with our capital contributions, complying with our marketing program which was submitted to the Investment Center, filing of certain reports with the Investment Center, export requirements, limiting manufacturing outside of Israel and complying with Israeli intellectual property laws. If we do not meet these requirements in the future, these tax benefits may be cancelled and we could be required to refund any tax benefits that we have already received plus
interest and penalties thereon. The tax benefits that our current "Approved Enterprise" and "Beneficiary Enterprise" program receives may not be continued in the future at their current levels or at all. If these tax benefits were reduced or eliminated, the amount of taxes that we pay would likely increase, which could adversely affect our results of operations. Additionally, if we increase our activities outside of Israel, for example, by acquisitions, our increased activities may not be eligible for inclusion in Israeli tax benefit programs.
On December 29, 2016, the Israeli government amended the Encouragement Law and legislated a new tax regime; the "Preferred Technological Enterprise" regime, under which a company that complies with the terms may be entitled to certain tax benefits. We expect that our operation in Israel will comply with the terms of the Preferred Technological Enterprise regime. Therefore, we may utilize the tax benefits under this regime after the end of the benefit period of its Approved and Beneficiary Enterprise statuses (i.e., prior to fiscal year 2022, based on our decision, and for fiscal year 2022 and onwards). The tax rates under the new regime will be higher than those under our current regime. See Note 12, "Income taxes" for more details.
If we elect to distribute dividends or buy back our shares using exempt income derived from "Approved/Beneficiary Enterprise" income, we will be subject to tax on the gross amount distributed or used in a buyback. The tax rate will be the rate at which the income would have been subject to tax had it not been exempt. This rate is generally between 10% and the corporate tax rate in Israel, depending on the percentage of our shares held by foreign shareholders. The dividend recipient or the shareholder from whom we buy back the shares is subject to withholding tax at the source at the reduced rate applicable to dividends or buybacks from Approved Enterprises, which is 15% if we distribute dividends or buy back shares during the tax exemption period (subject to the applicable double tax treaty) or within 12 years after the period. This 12-year limitation does not apply to foreign investment companies. The Encouragement Law has defined certain actions that are deemed as dividend distributions and would trigger the recapture of tax benefits.
The Israeli government grants that we received require us to meet various conditions and restrict our ability to manufacture and engineer products and transfer know-how outside of Israel and require us to satisfy specified conditions.
We have received grants from the Israeli Innovation Authority (the "IIA"), formerly known as the Office of the Chief Scientist of Israel's Ministry of Economy and Industry, for the financing of a portion of our research and development expenditures in Israel. When know-how is developed using or in connection with IIA grants, we are subject to restrictions on transfer of the know-how, including outside of Israel. Transfer of know-how outside of Israel requires pre-approval by the IIA which may at its sole discretion grant such approval and impose certain conditions, and is subject to the payment to IIA of a transfer fee or license fees, calculated according to the formulas provided in the Israeli Law for Encouragement of Research, Development and Technological Innovation in Industry, 1984 (the "R&D Law") which takes into account, inter alia, the consideration for such know-how paid to us in the transaction in which the technology is transferred. In general, transfer fees are no less than the funding received plus interest less the royalties already paid for the transferred know-how and are not higher than six times the amount of the grants received by the company. In addition, any decrease of the percentage of manufacturing performed in Israel, as originally declared in the application to the IIA, requires us to obtain the approval of the IIA and may result in increased amounts to be paid to the IIA as well as in increased royalty rate. Transfer of know-how to another Israeli entity requires the approval of IIA as well as full or partial assumption of the liabilities to IIA by the other entity. These restrictions may impair our ability to enter into agreements for those products or technologies without the approval of the IIA. We cannot be certain that any approval of the IIA will be obtained on terms that are acceptable to us, or at all. Furthermore, in the event that we undertake a transaction involving the transfer to a non-Israeli entity of technology developed with IIA funding pursuant to a merger or similar transaction, the consideration available to our shareholders may be reduced by the amounts we are required to pay to the IIA. Any approval, if given, will generally be subject to additional financial obligations. If we fail to comply with the conditions imposed by the IIA, we may be required to refund any payments previously received, together with interest and penalties as well as tax benefits. Also, failure to meet the restrictions concerning transfer of know-how outside of Israel may trigger criminal liability. The restrictions regarding the use and transfer of know-how (including for the purpose of manufacturing) apply also to any IIA programs that are under a royalty payments agreement and to non-royalty-bearing programs. Under the R&D Law and the applicable regulations, the execution and delivery of the Merger Agreement by the company requires the filing of: (i) a written notice to the IIA regarding the change in our ownership effected as a result of the Merger, which was submitted to the IIA on June 27, 2019; and (ii) a written undertaking of Parent. to the IIA, to observe the requirements of the R&D Law and the applicable regulation (including, in particular, those requirements relating to the prohibitions of the transfer of know-how and/or productions rights), which is expected to be filed to the IIA following the closing of the Merger Agreement.
It may be difficult to enforce a U.S. judgment against us, our officers and directors or to assert U.S. securities law claims in Israel.
We are incorporated in Israel. Three of our executive officers and two of our directors, one of whom is also an executive officer, are non-residents of the United States and are located in Israel, and a significant amount of our assets and the assets of these persons are located outside the United States. Therefore, it may be difficult to enforce a judgment obtained in the United States against us or any of the above persons in Israel.
In addition, it may be difficult for a shareholder to enforce civil liabilities under U.S. securities law claims in original actions instituted in Israel. Israeli courts may refuse to hear a claim based on a violation of U.S. securities laws because Israel is not the most appropriate forum to bring such a claim. If U.S. law is found to be applicable, the content of applicable U.S. law must be proved in an Israeli court as a fact, which can be a time-consuming and costly process. Certain matters of procedure will also be governed by Israeli law.
Your rights and responsibilities as a shareholder will be governed by Israeli law and differ in some respects from the rights and responsibilities of shareholders under U.S. law.
We are incorporated under Israeli law. The rights and responsibilities of holders of our ordinary shares are governed by our amended and restated articles of association and by Israeli law. These rights and responsibilities differ in some respects from the rights and responsibilities of shareholders in typical U.S. corporations. In particular, a shareholder of an Israeli company has a duty to act in good faith toward the company and other shareholders and to refrain from abusing his, her or its power in the company, including, among other things, in voting at the general meeting of shareholders on certain matters.
Risks Related to Our Ordinary Shares
The price of our ordinary shares may become volatile, and the value of an investment in our ordinary shares may decline.
Factors that could cause volatility in the market price of our ordinary shares include, but are not limited to:
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development regarding our planned Merger with NVIDIA;
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quarterly variations in our results of operations or those of our competitors;
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announcements by us, our competitors, our customers or rumors from sources other than our company related to acquisitions, new products, significant contracts, commercial relationships, capital commitments or changes in the competitive landscape;
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our ability to develop and market new and enhanced products on a timely basis;
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disruption to our operations;
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geopolitical instability;
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the emergence of new sales channels in which we are unable to compete effectively;
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any major change in our board of directors or management;
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changes in financial estimates, including our ability to meet our future revenue and operating profit or loss projections;
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changes in governmental regulations or in the status of our regulatory approvals;
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general economic conditions and slow or negative growth of related markets;
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anticompetitive practices of our competitors;
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commencement of, or our involvement in, litigation;
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whether our operating results meet our guidance or the expectations of investors or securities analysts;
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continuing international conflicts and acts of terrorism; and
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changes in accounting rules.
We may need to raise additional capital, which might not be available or which, if available, may be on terms that are not favorable to us.
We may need to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. If we issue equity securities to raise additional funds, the ownership percentage of our shareholders would be diluted, and the new equity securities may have rights, preferences or privileges senior to those of existing holders of our
ordinary shares. If we borrow money, we may incur significant interest charges, which could harm our profitability. Holders of debt may also have certain rights, preferences or privileges senior to those of existing holders of our ordinary shares. In addition, any additional funds would need to be raised consistent with the terms of the Merger Agreement. If we cannot raise needed funds on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could harm our business, financial condition and results of operations.
If we sell our ordinary shares in future financings, holders of ordinary shares could experience immediate dilution and, as a result, the market price of our ordinary shares may decline.
We may from time to time issue additional ordinary shares at a discount from the current trading price of our ordinary shares. As a result, holders of our ordinary shares would experience immediate dilution upon the purchase of any ordinary shares sold at such discount. In addition, as opportunities present themselves, we may enter into equity or debt financings or similar arrangements in the future, including the issuance of convertible debt securities, preferred shares or ordinary shares. If we issue ordinary shares or securities convertible into ordinary shares, holders of our ordinary shares could experience dilution. In addition, any equity or debt financings or similar arrangements would need to be made consistent with the terms of the Merger Agreement.
If securities or industry analysts do not publish research or reports about our business, if they adversely change their recommendations regarding our ordinary shares or if our operating results do not meet their expectations, the market price of our ordinary shares could decline.
The trading market for our ordinary shares could be influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause the price of our ordinary shares or trading volume in our ordinary shares to decline. Following the announcement of the Merger, some analysts suspended their coverage of our company and are no longer providing extended coverage. If we do not complete the Merger, these analysts may not resume their coverage. Moreover, if one or more of the analysts who cover our company downgrades our ordinary shares or if our operating results do not meet their expectations, the market price of our ordinary shares could decline.
Provisions of our amended and restated articles of association could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our shareholders, and could make it more difficult for shareholders to change management.
Provisions of our amended and restated articles of association may discourage, delay or prevent a merger, acquisition or other change in control that shareholders may consider favorable, including transactions in which shareholders might otherwise receive a premium for their shares. In addition, these provisions may frustrate or prevent any attempt by our shareholders to replace or remove our current management by making it more difficult to replace or remove our board of directors. These provisions include:
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no cumulative voting;
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a requirement for the approval of the shareholders of at least a majority of the voting power of the Company for any merger involving the Company;
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a requirement for the approval of at least 75% of the voting power represented at the general meeting of the shareholders for the removal of any director from office, and election of any director instead of the director so removed; and
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an advance notice requirement for shareholder proposals and nominations.
Furthermore, Israeli tax law treats some acquisitions, particularly share-for-share swaps between an Israeli company and a foreign company, less favorably than U.S. tax law. Under certain circumstances and subject to receiving a ruling from the Israeli Income Tax Authority, Israeli tax law generally provides that a shareholder who exchanges our shares for shares that are listed for trading on a securities exchange in a foreign corporation is treated as if the shareholder has sold the shares. In such a case, the shareholder will generally be subject to Israeli taxation on any capital gains from the sale of shares (after two years, with respect to one half of the shares, and after four years, with respect to the balance of the shares, in each case unless the shareholder sells such shares at an earlier date), unless a relevant tax treaty between Israel and the country of the shareholder's residence exempts the shareholder from Israeli tax, resulting in taxation before disposition of the investment in the foreign corporation. For a further discussion of Israeli laws relating to mergers and acquisitions, please see "Risk Factors - Risks Related to Operations in Israel and Other Foreign Countries - Provisions of Israeli law may delay, prevent or make difficult an acquisition of our company, which could prevent a change of control and therefore depress the price of our shares." These provisions in our amended and restated articles of association and other provisions of Israeli law could limit the price that investors are willing to pay in the future for our ordinary shares.
We have never paid cash dividends on our share capital, and, while our board of directors regularly reviews our cash position and uses for cash, we do not anticipate paying any cash dividends in the foreseeable future.
We currently intend to retain all available funds and any future earnings to fund the development and growth of our business. Furthermore, the Merger Agreement with NVIDIA limits our ability to pay dividends. As a result, capital appreciation, if any, of our ordinary shares will be your sole source of gain for the foreseeable future.
We may incur increased costs as a result of changes in laws and regulations relating to corporate governance matters.
Changes in the laws and regulations affecting public companies, including Israeli laws, rules adopted by the SEC, the Nasdaq Stock Market, the FASB and the Public Company Accounting Oversight Board, may result in increased costs to us as we respond to their requirements. These laws and regulations could make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these requirements could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We cannot predict or estimate the amount or timing of additional costs we may incur to respond to these requirements.
ITEM 1B
ITEM 1B - UNRESOLVED STAFF COMMENTS
None.
ITEM 2
ITEM 2 - PROPERTIES
As of December 31, 2019, our major facilities consisted of:
Our United States business headquarters are located in Sunnyvale, California, and our engineering headquarters are located in Yokneam, Israel. We believe that our existing facilities will be adequate to meet our current requirements and that suitable additional or substitute space will be available on acceptable terms to accommodate our foreseeable needs.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
See Note 9, “Commitments and Contingencies” to the consolidated financial statements for a full description of legal proceedings and related contingencies and their effects on our consolidated financial position, results of operations and cash flows.
We may, from time to time, become a party to various other legal proceedings arising in the ordinary course of business. We may also be indirectly affected by administrative or court proceedings or actions in which we are not involved, but which have general applicability to the semiconductor industry.
ITEM 4
ITEM 4 - MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S ORDINARY SHARES, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our ordinary shares began trading on The Nasdaq Global Market on February 8, 2007 under the symbol "MLNX". Prior to that date, our ordinary shares were not traded on any public exchange.
As of February 14, 2020, we had approximately 348 holders of record of our ordinary shares. This number does not include the number of persons whose shares are in nominee or in "street name" accounts through brokers.
Share Performance Graph
The graph below compares the five-year cumulative total shareholder return on our ordinary shares with the cumulative total return on The Nasdaq Composite Index and The Philadelphia Semiconductor Index. The period shown commences on December 31, 2014 and ends on December 31, 2019, the end date of our last fiscal year. The graph assumes an investment of $100 on December 31, 2014, and the reinvestment of any dividends. No cash dividends have been declared or paid on our ordinary shares during such period. Shareholder returns over the indicated periods should not be considered indicative of future share prices or shareholder returns.
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* $100 invested on December 31, 2014 in shares or index, including reinvestment of dividends.
Dividends
We have not declared or paid any cash dividends on our ordinary shares in the past, and we do not anticipate declaring or paying cash dividends in the foreseeable future. The Companies Law also restricts our ability to declare dividends. We can only distribute dividends from profits (the "Profit Test") (as defined in the Companies Law) and only if there is no reasonable concern that the dividend distribution will prevent us from meeting our existing and foreseeable obligations as they come due (the "Insolvency Test"); provided that, with court approval, we may distribute dividends if we do not meet the Profit Test so long as we meet the Insolvency Test.
If we elect to distribute dividends out of exempt income derived from "Approved/Beneficiary Enterprise" operations, we will be subject to tax on the gross amount distributed. The tax rate will be the rate which would have been applicable had we not been granted the beneficial status. These dividend tax rules may also apply to our acquisitions outside Israel if they are made with cash from tax benefited income.
Securities Authorized for Issuance under Equity Compensation Plans
Our equity compensation plan information required by this item is incorporated by reference to the information in Part III, Item 12 of this report. For additional information on our share incentive plans and activity, see Note 10, "Share Incentive Plans" to the consolidated financial statements.
Recent Sales of Unregistered Securities
None.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and related notes included elsewhere in this report. We derived the consolidated balance sheet data for the years ended December 31, 2017, 2016, and 2015 and our consolidated statements of operations data for the years ended December 31, 2016 and 2015, from our audited consolidated financial statements not included in this report. We derived the consolidated statements of operations data for each of the three years in the period ended December 31, 2019, as well the consolidated balance sheet data as of December 31, 2019 and 2018, from our audited consolidated financial statements included elsewhere in this report. Our historical results are not necessarily indicative of results to be expected in any future period.
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(1) On January 1, 2019, we adopted the new lease standard (Topic 842). The consolidated financial statements for the year ended December 31, 2018 and prior years are reported under Topic 840. See Note 15, "Leases" to the consolidated financial statements for more details.
(2) On January 1, 2018, we adopted the new revenue standards (Topic 606) using a modified retrospective method with the cumulative effect recognized in the beginning retained earnings. The consolidated financial statements for the year ended December 31, 2017 and prior years are reported under Topic 605. See Note 2, "Revenue" to the consolidated financial statements for more details.
(3) On February 23, 2016, we acquired EZchip. EZchip's results of operations and estimated fair value of assets acquired and liabilities assumed were included in our consolidated financial statements beginning February 23, 2016.
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the financial statements and the notes thereto included elsewhere in this report. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in the section entitled "Risk Factors".
Overview
General
We are a fabless semiconductor company that designs, manufactures (through subcontractors) and sells high-performance interconnect products and solutions primarily based on the Ethernet and InfiniBand standards. Our products facilitate efficient data transmission between servers, storage systems, communications infrastructure equipment and other embedded systems. We operate our business globally and offer products to customers at various levels of integration. The products we offer include ICs, adapter cards, switch systems, cables, modules, software, services and accessories. Together these products form a total end-to-end integrated networking solution focused on computing, storage and communication applications used in multiple markets, including HPC, cloud, Web 2.0, Big Data, machine learning, storage, telecommunications, financial services, and EDC. These solutions increase performance, application efficiency and improve return on investment. Through the successful development and implementation of multiple generations of our products, we have established significant expertise and competitive advantages.
As a leader in developing multiple generations of high-speed interconnect solutions, we have established strong relationships with our customers. Our products are incorporated in servers and associated networking solutions produced by the largest server vendors. We supply our products to leading storage and communications infrastructure equipment vendors. Additionally, our products are used in embedded solutions.
We are one of the pioneers of InfiniBand, an industry-standard architecture for high-performance interconnects. We believe InfiniBand interconnect solutions deliver industry-leading performance, efficiency and scalability for clustered computing and storage systems that incorporate our products. In addition to supporting InfiniBand, our products also support industry-standard Ethernet transmission protocols providing unique product differentiation and connectivity flexibility. Our products serve as building blocks for creating reliable and scalable Ethernet and InfiniBand solutions with leading performance. We also believe that we are one of the early suppliers of 25/50/100Gb/s Ethernet adapters, switches, and cables to the market. This provides us with the opportunity to gain share in the Ethernet market as users upgrade from one or 10Gb/s directly to 25/40/50 or 100Gb/s.
Our revenues for the years ended December 31, 2019, 2018 and 2017 were $1,330.6 million, $1,088.7 million, and $863.9 million, respectively. In order to increase our annual revenues, we must continue to achieve design wins over other Ethernet providers and providers of competing interconnect technologies. We consider a design win to occur when an original equipment manufacturer ("OEM"), or contract manufacturer notifies us that it has selected our products to be incorporated into a product or system under development. Because the life cycles for our customers' products can last for several years if these products have successful commercial introductions, we expect to continue to generate revenues over an extended period of time for each successful design win.
Pending Merger with NVIDIA Corporation
On March 10, 2019, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with NVIDIA Corporation, a Delaware corporation ("NVIDIA"), NVIDIA International Holdings Inc., a Delaware corporation and wholly owned subsidiary of NVIDIA ("Parent") and Teal Barvaz Ltd., a wholly owned subsidiary of Parent organized under the laws of the State of Israel and wholly owned subsidiary of Parent ("Merger Sub"). NVIDIA has agreed to guarantee the payment and performance obligations of Parent under the Merger Agreement. The Merger Agreement and the Merger (as defined below) have been approved by our board of directors and the boards of directors of NVIDIA, Parent and Merger Sub.
The Merger Agreement provides that, upon the terms and subject to the satisfaction or waiver of the conditions set forth therein, Merger Sub will be merged with and into Mellanox (the "Merger") in accordance with Sections 314-327 of the Companies Law 5759-1999 of the State of Israel, with Mellanox continuing as the surviving corporation and a wholly owned subsidiary of Parent.
At the effective time of the Merger (the "Effective Time"), each ordinary share, par value NIS 0.0175 per share, of Mellanox (a "Company Share") issued and outstanding immediately prior to the Effective Time, other than any shares owned by Mellanox, Parent and their respective subsidiaries or any shares held in Mellanox’s treasury, will be deemed to have been transferred to the Parent in exchange for the right to receive $125.00 in cash, without interest and subject to applicable withholding taxes.
The Merger Agreement contains customary representations, warranties and covenants. The consummation of the Merger is conditioned on the receipt of the approval of our shareholders, as well as the satisfaction of other customary closing conditions, including domestic and foreign regulatory approvals and performance in all material respects by each party of its obligations under the Merger Agreement. In June 2019, our shareholders approved the consummation of the Merger, and we received regulatory approvals for the Merger from Mexico in July 2019 and from the European Commission in December 2019. In addition, the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, in connection with the proposed acquisition expired in May 2019. Discussions with State Administration for Market Regulation, the China regulatory agency, are progressing and we believe the closing will likely occur in the early part of calendar 2020.
The Merger Agreement contains certain customary termination rights by either us or Parent, including if the Merger is not consummated by December 10, 2019 (the "Outside Date"), subject to two three-month extensions in order to obtain required regulatory approvals. Pursuant to the first of those three-month extensions, the Outside Date has been extended to March 10, 2020. If the Merger Agreement is terminated under certain circumstances, including termination by us to enter into a superior proposal, a termination by Parent following a change of our board of directors’ recommendation or a termination by Parent as a result of a willful material breach of the Merger Agreement’s no-solicitation obligations by us, we will be obligated to pay to Parent a termination fee equal to $225.0 million in cash. If the Merger Agreement is terminated under certain circumstances involving the failure to obtain certain regulatory approvals, Parent will be obligated to pay us a termination fee equal to $350.0 million in cash.
The foregoing description of the Merger Agreement and the Merger does not purport to be complete and is subject to, and qualified in its entirety by, the full text of the Merger Agreement. For additional details on the transaction, please refer to the copy of the Merger Agreement attached as Exhibit 2.1 to our Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on March 11, 2019.
During the year ended December 31, 2019, we recorded transaction-related costs of $15.5 million, principally for investment banking and legal fees associated with the pending acquisition, under general and administrative expenses included in the consolidated statement of operations. Additional transaction-related costs are expected to be incurred through the closing of the Merger.
The pending transaction with NVIDIA may have significant effects on us, including, among others, deferrals, delays or cancellations of purchase orders by our customers and the significant diversion of management and employee attention from ordinary course matters. For a more extensive discussion of those and other possible effects, please refer to "Risk Factors" in Part I, Item 1A of this report.
Our Business
Revenues. We derive revenues from sales of our ICs, boards, switch systems, cables, modules, software, accessories and other product groups. Our products have broad adoption with multiple end customers across HPC, machine learning, Web 2.0, cloud, EDC, financial services and storage markets; however, these markets are mainly served by leading server, storage and communications infrastructure OEMs. Therefore, we have derived a substantial portion of our revenues from a relatively small number of OEM customers. Sales to our top ten customers represented 48%, 53% and 56% of our total revenues for the years ended December 31, 2019, 2018 and 2017, respectively. Sales to customers representing 10% or more of revenues accounted for 21%, 24% and 24% of our total revenues for the years ended December 31, 2019, 2018 and 2017, respectively. The loss of one or more of our principal customers, the reduction or deferral of purchases, or changes in the mix of our products ordered by any one of these customers could cause our revenues to decline materially if we are unable to increase our revenues from other customers. Our customers, including our most significant customers, are not obligated by long-term contracts to purchase our products and may cancel orders with limited potential penalties. If any of our large customers reduces or cancels its purchases from us for any reason, it could have an adverse effect on our revenues and results of operations.
Cost of revenues and gross profit. The cost of revenues consists primarily of the cost of silicon wafers purchased from our foundry supplier, costs associated with the assembly, packaging and production testing of our ICs, outside processing costs associated with the manufacture of our products, royalties due to third parties, warranty costs, excess and obsolete inventory costs, depreciation and amortization, and costs of personnel associated with production management, quality assurance and services. In addition, after we purchase wafers from our foundries, we also face yield risk related to manufacturing these wafers into semiconductor devices. Manufacturing yield is the percentage of acceptable product resulting from the manufacturing process, as identified when the product is tested as a finished IC. If our manufacturing yields decrease, our cost per unit increases, which could have a significant adverse impact on our cost of revenues. We do not have long-term pricing agreements with foundry suppliers and contract manufacturers. Accordingly, our costs are subject to price fluctuations based on the overall cyclical demand for semiconductors.
We purchase our inventory pursuant to standard purchase orders. We estimate that lead times for delivery of our finished semiconductors from our foundry supplier and assembly, packaging and production testing subcontractor are approximately three to four months, lead times for delivery from our adapter card manufacturing subcontractor are approximately ten to twelve weeks, lead times for delivery from our cable and transceiver manufacturing subcontractor are approximately twelve to sixteen weeks, and lead times for delivery from our switch systems manufacturing subcontractors are approximately twelve to sixteen weeks. We build inventory based on forecasts of customer orders rather than the actual orders themselves.
We expect our cost of revenues as a percentage of sales to increase in the future as a result of a reduction in the average sale price of our products and a lower percentage of revenue deriving from sales of ICs and boards, which generally yield higher gross margins than sales of switches and cables. This trend will depend on overall customer demand for our products, our product mix, competitive product offerings and related pricing and our ability to reduce manufacturing costs.
Operational expenses
Research and development expenses. Our research and development expenses consist primarily of salaries, share-based compensation and associated costs for employees engaged in research and development, depreciation, amortization of intangibles,
allocable facilities and administrative expenses and tape-out costs. Tape-out costs are expenses related to the manufacture of new ICs, including charges for mask sets, prototype wafers, mask set revisions and testing incurred before releasing new ICs into production. We expect these expenses will increase in absolute dollars in the upcoming year as our business expands.
Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, incentive compensation, share-based compensation and associated costs for employees engaged in sales and marketing, field applications engineering and sales engineering, advertising, trade shows and promotions, travel, amortization of intangibles, and allocable facilities and administrative expenses. We expect these expenses will increase in absolute dollars in the upcoming year as our business expands.
General and Administrative Expenses. General and administrative expenses consist primarily of salaries, share-based compensation and associated costs for employees engaged in finance, legal, human resources and administrative activities, professional service expenses for accounting, corporate legal fees and allocable facilities related expenses. We expect these expenses will increase in absolute dollars in the upcoming year as our business expands.
Taxes on Income
In December 2017, the U.S. enacted significant tax reform through the Tax Cuts and Jobs Act ("TCJA"). The TCJA enacted significant changes affecting the year ended December 31, 2017 and forward, including, but not limited to, (1) reducing the U.S. federal corporate income tax rate to 21% effective 2018, and (2) imposing a one-time Transition Tax on certain unrepatriated earnings of foreign subsidiaries of U.S. companies that had not been previously taxed in the U.S. The U.S. Internal Revenue Service continues to release guidance surrounding the TCJA. In the absence of guidance on various uncertainties and ambiguities in the application of certain provisions of the TCJA, we have used what we believe are reasonable interpretations and assumptions in applying the TCJA, but it is possible that the Internal Revenue Service as well as state tax authorities could issue subsequent guidance or take positions on audit that differ from our interpretations and assumptions, which could have a material adverse effect on our cash tax liabilities, results of operations, and financial condition. In addition, the TCJA could be subject to potential amendments and technical corrections, any of which could materially lessen or increase certain adverse impacts of the legislation on us and our business. We will continue to evaluate the effects of the TCJA on us as federal and state tax authorities issue additional regulations and guidance. If and when amendments and technical corrections are enacted with respect to the TCJA, they could cause changes in our previous estimates and could materially affect our financial position and results of operations.
Our operations in Israel have been granted "Approved Enterprise" status by the Investment Center of the Israeli Ministry of Economy and Industry (formerly, the Ministry of Industry, Trade and Labor) and "Beneficiary Enterprise" status by the Israeli Income Tax Authority, which makes us eligible for tax benefits under the Encouragement Law. Under the terms of the Approved and Beneficiary Enterprise programs, income that is attributable to our operations in Yokneam, Israel is exempt from income tax commencing fiscal year 2011 through 2021. Income that is attributable to our operations in Tel Aviv, Israel is subject to a reduced income tax rate (generally between 10% and the current corporate tax rate, depending on the percentage of foreign investment in the Company) commencing fiscal year 2013 through 2021.
In 2017, the Israeli Government legislated a reduction in corporate income tax rates to 24.0%, and to 23.0% in 2018 and thereafter.
On December 29, 2016, the Israeli government amended the Encouragement Law and legislated a new tax regime - "Preferred Technological Enterprise" regime, under which a company that complies with the terms may be entitled to certain tax benefits. On June 14, 2017, the Israeli government legislated new regulations, stipulating the calculation method of the tax benefits under the Preferred Technological Enterprise regime. We expect that our operations in Israel will comply with the terms of the Preferred Technological Enterprise regime. Therefore, we may utilize the tax benefits under this regime after the end of the benefit period of our Approved and Beneficiary Enterprise statuses (i.e. prior to fiscal year 2022, based on our decision, and for fiscal year 2022 and onwards). Under the new legislation, the majority of our income from our operations in Yokneam, Israel, will be subject to a corporate rate of 7.5%, while the majority of the income from our operations in Tel-Aviv, Israel, will be subject to a corporate rate of 12%. As a result of the lower tax rates mentioned above, we recorded a decrease of approximately $0.2 million in deferred tax assets and a corresponding increase in tax expense during the second quarter of 2017.
To prepare our consolidated financial statements, we estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual tax exposure together with assessing temporary differences resulting from the differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our
estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates.
We believe that the assumptions and estimates associated with the following areas would have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. For further information on all of our significant accounting policies, please see Note 1, "The Company and Summary of Significant Accounting Policies" to the consolidated financial statements.
Revenue recognition
We recognize revenue when (or as) we satisfy performance obligations by transferring promised products or services to our customers in an amount that reflects the consideration we expect to receive. We apply the following five steps: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.
We consider customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with a customer. For each contract, we consider the promise to transfer tangible products, extended warranty and post-contract customer support, each of which are distinct, to be the identified performance obligations. In determining the transaction price, we evaluate whether the price is subject to rebates and adjustments to determine the net consideration which we expect to receive. As our standard payment terms are less than one year, the contracts have no significant financing component. We allocate the transaction price to each distinct performance obligation based on its relative standalone selling price. Revenue from tangible products is recognized when control of the product is transferred to the customer (i.e., when our performance obligation is satisfied), which typically occurs at shipment. The revenues from fixed-price support or maintenance contracts, including extended warranty contracts and post-contract customer support agreements, are recognized ratably over the contract period and the costs associated with these contracts are recognized as incurred. Our standard arrangements with our customers do not allow for rights of return.
We maintain inventory, or hub arrangements with certain customers. Pursuant to these arrangements, we deliver products to a customer or a designated third-party warehouse based upon the customer's projected needs, but do not recognize product revenue unless and until the customer reports it has removed our product from the warehouse to be incorporated into its end products.
A portion of our sales are made to distributors under agreements which contain price protection provisions. Revenue from sales to distributors is recognized upon shipment and transfer of control, net of estimated distribution price adjustments (“DPAs”). We calculate the estimated DPAs based on specific earned DPA claims and estimated unearned DPA claims based on an analysis of historical DPA claims, at the distributor level, over a period of time considered adequate to account for current pricing and business trends. The earned DPA claims are recorded as a reduction of revenue and a reduction of gross accounts receivable. We record the estimated unearned DPAs as a reduction of revenue and an increase in the allowance for unearned DPAs.
In addition, we record revenue reserves for rebates as a reduction of revenue and a reduction of gross accounts receivable or as an increase in other current payables. The reserves are recorded in the same period that the related revenue is recorded, and are based on the amounts stated in the contracts. We reverse reserves for unclaimed rebates as specific rebate programs contractually end and when we believe unclaimed rebates are no longer subject to payment and will not be paid. As a result, the reversal of unclaimed rebates may have a positive impact on our net revenue and net income in subsequent periods.
Most of our distributors are entitled to a limited right of return related to stock rotation. Distributors have the right to return a limited amount of product not to exceed a percentage of the distributor’s prior quarter's net purchases. However, a simultaneous, compensating order of equal or greater value must be placed by the distributor within the same quarter of the return.
Derivatives
We enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks, mainly the exposure to changes in the exchange rate of the NIS against the U.S. dollar that are associated with forecasted future cash flows and certain existing assets and liabilities. We account for our derivative instruments as either assets or liabilities and carry them at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gains or losses on the derivative instruments is reported as a component of accumulated other comprehensive income ("AOCI") in shareholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gains or losses on the derivative instruments, if any, is recognized in earnings in the current period. Our derivative instruments that hedge the exposure to variability in the fair value of assets or liabilities are not currently designated as hedges for financial reporting purposes, and thus the gains or losses on such derivative instruments are recognized in earnings in the current period.
Inventory valuation
Inventory includes finished goods, work-in-process and raw materials. Inventory is stated at the lower of cost (principally standard cost which approximates actual cost on a first-in, first-out basis) or net realizable value. Reserves for potentially excess and obsolete inventory are made based on management's analysis of inventory levels, future sales forecasts and market conditions. Once established, the original cost of our inventory less the related inventory reserve represents the new cost basis of such products.
Business combinations
We account for business combinations using the acquisition method of accounting. We determine the recognition of intangible assets based on the following criteria: (i) the intangible asset arises from contractual or other rights; or (ii) the intangible asset is separable or divisible from the acquired entity and capable of being sold, transferred, licensed, returned or exchanged. We allocate the purchase price of business combinations to the tangible assets, liabilities and intangible assets acquired, including in-process research and development ("IPR&D"), based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. The process of estimating the fair values requires significant estimates, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from customer contracts, customer lists and distribution agreements, acquired developed technologies, expected costs to develop IPR&D into commercially viable products, estimated cash flows from projects when completed and discount rates. We estimate fair value based upon assumptions that are believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed.
Goodwill and intangible assets
Goodwill represents the excess of the cost of acquired businesses over the fair market value of their identifiable net assets. We conduct a goodwill impairment qualitative assessment during the fourth quarter of each fiscal year or more frequently if facts and circumstances indicate that goodwill may be impaired. The goodwill impairment qualitative assessment requires us to perform an assessment to determine if it is more likely than not that the fair value of the business is less than its carrying amount. The qualitative assessment considers various factors, including the macroeconomic environment, industry and market specific conditions, market capitalization, stock price, financial performance, earnings multiples, budgeted-to-actual revenue performance from the prior year, gross margin and cash flow from operating activities and issues or events specific to the business. If adverse qualitative trends are identified that could negatively impact the fair value of the business, we perform a "two step" goodwill impairment test. "Step one" is the identification of potential impairment. This involves comparing the fair value of each reporting unit, which we have determined to be the entity itself, with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, the goodwill of the reporting unit is considered not impaired and "Step two" of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, "Step two" is performed and it involves comparing the carrying amount of goodwill to its implied fair value, which is determined to be the excess of the reporting unit's fair value over the fair value of its identifiable net assets other than goodwill. If the carrying amount of goodwill exceeds its implied fair value, an impairment exists and is recorded. As of December 31, 2019, our qualitative assessment of goodwill impairment indicated that goodwill was not impaired.
Intangible assets represent acquired intangible assets including developed technology, customer relationships and IPR&D, as well as licensed technology. We amortize the finite lived intangible assets over their useful lives using a method that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise used, or, if that pattern cannot be reliably determined, using a straight-line amortization method. We capitalize IPR&D projects acquired as part of a business combination as intangible assets with indefinite lives. On completion of each project, IPR&D assets are reclassified to developed technology and amortized over their estimated useful lives. If any of the IPR&D projects are abandoned, we impair the related IPR&D asset.
Indefinite-lived intangible assets are tested for impairment annually or more frequently when indicators of impairment exist. We first assess qualitative factors to determine if it is more likely than not that an indefinite-lived intangible asset is impaired and whether it is necessary to perform a quantitative impairment test. The qualitative assessment considers various factors, including reductions in demand, the abandonment of IPR&D projects or significant economic slowdowns in the semiconductor industry and macroeconomic environment. If adverse qualitative trends are identified that could negatively impact the fair value of the asset, then quantitative impairment tests are performed to compare the carrying value of the asset to its undiscounted expected future cash flows. If this test indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using: (i) quoted market prices or (ii) discounted expected future cash flows utilizing an appropriate discount rate. Impairment is based on the excess of the carrying amount over the fair value of those assets. As of December 31, 2019, there were no indicators that impairment existed or assets were not recoverable. Intangible assets with finite lives are tested for impairment in accordance with our policy for long-lived assets.
Equity investments in privately-held companies
We have made equity investments in privately-held companies. We measure these equity investments at cost, less impairments, adjusted by observable price changes. We record gains or losses on the sale of these investments when the proceeds are greater than or
less than cost, respectively. To determine if an investment is recoverable, we monitor the investments and if facts and circumstances indicate the investment may be impaired, conduct an impairment test. The impairment test considers multiple factors including a review of the privately-held company's revenue and earnings trends relative to pre-defined milestones and overall business prospects, the general market conditions in its industry and other factors related to its ability to remain in business, such as liquidity and receipt of additional funding.
While performing our review for impairment for the first quarter of 2019, we noted an observable price change related to one of our investments in a privately-held company. As a result, we recorded an impairment charge of $1.8 million in the first quarter of 2019.
While performing our review for impairment for the fourth quarter of 2018, we noted an observable price change related to one of our investments in a privately-held company. As a result, we recorded an impairment charge of $1.5 million in the first quarter of 2018.
Impairment of long-lived assets
Long-lived assets include equipment, furniture and fixtures, right-of-use ("ROU") assets, and finite-lived intangible assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. If the sum of the expected future cash flows (undiscounted and without interest charges) from the long-lived assets is less than the carrying amount of such assets, an impairment loss would be recognized, and the assets would be written down to their estimated fair values. We review for possible impairment on a regular basis.
Leases
In January 1, 2019, we adopted the new lease standard ASU No. 2016-02, Leases (Topic 842) and recognized ROU assets and lease liabilities on the balance sheet. The leases are mainly for office buildings. Establishing ROU assets and lease liabilities requires judgments and estimates related to the discount rate to be applied to the future lease payments and, if applicable, renewal options. Renewal options are included in the ROU and liability calculations when we are reasonably assured that we will exercise the option.
Warranty provision
We typically offer a limited warranty for our products for periods up to three years. We accrue for estimated returns of defective products at the time revenue is recognized based on historical activity. The determination of these accruals requires us to make estimates of the frequency and extent of warranty activity and estimated future costs to either replace or repair the products under warranty. If the actual warranty activity and/or repair and replacement costs differ significantly from these estimates, adjustments to record additional cost of revenues may be required in future periods.
Income taxes
To prepare our consolidated financial statements, we estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual tax exposure together with assessing temporary differences resulting from the differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are calculated using tax rates expected to be in effect during the period these temporary differences would reverse, and are included within our consolidated balance sheet.
We must also make judgments regarding the realizability of deferred tax assets. The carrying value of our net deferred tax assets is based on our belief that it is more likely than not that we will generate sufficient future taxable income in certain jurisdictions to realize these deferred tax assets. A valuation allowance has been established for deferred tax assets which we do not believe meet the "more likely than not" criteria. Our judgments regarding future taxable income may change due to changes in market conditions, changes in tax laws, tax planning strategies or other factors. If our assumptions and consequently our estimates change in the future, the valuation allowances we have established may be increased or decreased, resulting in a respective increase or decrease in income tax expense. Our effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies.
We use a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with the guidance on judgments regarding the realizability of deferred taxes. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. We recognize potential accrued interest and penalties related to unrecognized tax benefits within the consolidated statements of income as income tax expense.
Results of Operations
The following table sets forth our consolidated statements of operations as a percentage of revenues for the periods indicated:
Comparison of the Year Ended December 31, 2019 to the Year Ended December 31, 2018
Revenues.
The following tables represent our total revenues for the years ended December 31, 2019 and 2018 by product type and interconnect protocol:
Revenues were $1,330.6 million for the year ended December 31, 2019 compared to $1,088.7 million for the year ended December 31, 2018, representing an increase of $241.9 million, or approximately 22.2%. InfiniBand product sales increased by $127.6 million, which was mainly due to the strong adoption of our 200Gb/s HDR InfiniBand solutions in the high-performance computing, artificial intelligence, cloud, and storage market segments. Ethernet product sales increased by $125.4 million primarily due to the increased
adoption of our 25Gb/s and above solutions. Our revenues for the year ended December 31, 2019 are not necessarily indicative of future results.
Gross Profit and Margin. Gross profit was $866.5 million for the year ended December 31, 2019 compared to $700.2 million for the year ended December 31, 2018, representing an increase of $166.3 million, or approximately 23.7%. As a percentage of revenues, gross margin increased to 65.1% in the year ended December 31, 2019 from approximately 64.3% in the year ended December 31, 2018. The lower gross margin for the year ended December 31, 2018 was primarily due to a $9.3 million settlement of a contingent royalty obligation. Gross margin for the year ended December 31, 2019 is not necessarily indicative of future results.
Research and Development.
The following table presents details of our research and development expenses for the periods indicated:
Research and development expenses were $414.9 million for the year ended December 31, 2019 compared to $360.3 million for the year ended December 31, 2018, representing an increase of $54.6 million, or approximately 15.1%. The increase in salaries and benefits expenses was primarily attributable to headcount increases, merit-based salary increases and higher bonuses. The increase in other expenses was primarily attributable to higher facility expenses and the outsourcing of research and development activities during the year ended December 31, 2019.
Please refer to "Share-based Compensation Expense" below for a discussion of its impact on research and development expenses.
Sales and Marketing.
The following table presents details of our sales and marketing expenses for the periods indicated:
Sales and marketing expenses were $162.7 million for the year ended December 31, 2019 compared to $148.6 million for the year ended December 31, 2018, representing an increase of $14.1 million, or approximately 9.5%. The increase in salaries and benefits expenses was primarily related to headcount increases, higher sales commissions, bonuses and merit-based salary increases. The decrease in Other was mainly due to lower depreciation and amortization.
Please refer to "Share-based Compensation Expense" below for a discussion of its impact on sales and marketing expenses.
General and Administrative.
The following table presents details of our general and administrative expenses for the periods indicated:
General and administrative expenses were $79.5 million for the year ended December 31, 2019 compared to $68.9 million for the year ended December 31, 2018, representing an increase of $10.6 million, or approximately 15.4%. The increase in salaries and benefits expenses was primarily related to merit-based salary increases and higher bonuses.
Please refer to "Share-based Compensation Expense" below for a discussion of its impact on general and administrative expenses.
Share-based Compensation Expense.
The following table presents details of our share-based compensation expense that is included in each functional line item in our consolidated statements of operations:
Share-based compensation expenses were $112.1 million for the year ended December 31, 2019, compared to $71.3 million for the year ended December 31, 2018, representing an increase of $40.8 million, or approximately 57%. Approximately $30.4 million of the increase was primarily due to additional expense related to the 2019 annual focal grant during the first quarter of 2019 and a full year of expense in 2019 related to the 2018 annual focal grant in the third quarter of 2018 (in 2018, the focal grant was deferred from the first quarter to the third quarter due to the timing of the Annual General Meeting) and an additional $8.4 million of expense related to retention grants to employees during the third quarter of 2019 in connection with the proposed acquisition by NVIDIA.
Restructuring and impairment charges were $1.5 million in the year ended December 31, 2019 compared to $10.3 million in the year ended December 31, 2018. The higher amounts in 2018 primarily related to the discontinuation of our 1550nm silicon photonics development activities.
Interest and other, net. Interest and other, net was an income of $16.0 million for the year ended December 31, 2019 compared to an income of $0.1 million for the year ended December 31, 2018. The change was primarily attributable to a $9.6 million gain on sale of investment in a privately-held company for the year ended December 31, 2019, and an increase of $10.0 million in interest income due to higher invested balances and gains on short-term investments, partially offset by an increase of $5.8 million in foreign exchange loss, net, primarily as a result of the lease liabilities denominated in NIS.
Provision for or Benefit from Taxes on Income. Our provision for taxes on income was $18.8 million for the year ended December 31, 2019 compared to a benefit from taxes of $22.0 million for the year ended December 31, 2018. Our effective tax rate was 8.4% and (19.6)% for 2019 and 2018, respectively. For the year ended December 31, 2019, the difference between the 8.4% effective tax rate and the 21% federal statutory rate resulted primarily from foreign earnings taxed at rates lower than the federal statutory rates which resulted in a reduction of approximately $34.5 million, partially offset by the accrual of unrecognized tax positions, and interest and penalties associated with unrecognized tax positions in the amount of $6.3 million. For the year ended December 31, 2018, the difference between the (19.6)% effective tax rate and the 21% federal statutory rate resulted primarily from the release of a valuation allowance of $32.1 million against the deferred tax assets related to our U.S. subsidiaries. The effective tax rate was also affected by foreign earnings taxed
at rates lower than the federal statutory rates which resulted in a reduction of approximately $16.0 million, partially offset by the accrual of unrecognized tax positions, and interest and penalties associated with unrecognized tax positions in the amount of $4.5 million.
Comparison of the Year Ended December 31, 2018 to the Year Ended December 31, 2017
Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located in our 10-K for the fiscal year ended December 31, 2018, filed on February 21, 2019, for the discussion of the comparison of the fiscal year ended December 31, 2018 to the fiscal year ended December 31, 2017, the earliest of the three fiscal years presented in the consolidated statements of operations.
Liquidity and Capital Resources
Comparison of the Year Ended December 31, 2019 to the Year Ended December 31, 2018
Historically, we have financed our operations through a combination of sales of equity securities and cash generated by operations. As of December 31, 2019, our principal source of liquidity consisted of cash and cash equivalents of $77.6 million and short-term investments of $798.3 million. After taking into consideration our forecasted operating expenses, and capital expenditures to support our infrastructure and growth, we expect our current cash and cash equivalents, short-term investments, and our cash flows from operating activities will be sufficient to fund our operations for at least the next 12 months.
We are an Israeli company and as of December 31, 2019 our subsidiaries outside of Israel held approximately $65.4 million in cash and cash equivalents and short-term investments.
Our cash and cash equivalents, short-term investments, and working capital at December 31, 2019 and 2018 were as follows:
Our ratio of current assets to current liabilities was 3.7:1 at December 31, 2019 and 3.3:1 at December 31, 2018.
Operating Activities
Net cash provided by our operating activities amounted to $424.8 million in the year ended December 31, 2019. Net cash provided by operating activities was attributable to net income of $205.1 million adjusted by net non-cash items of $226.4 million, changes in assets and liabilities of $17.9 million, partially offset by gain on short-term investments of $15.0 million and gains on investments in privately-held companies of $9.6 million. Non-cash expenses consisted primarily of $112.1 million of share-based compensation, $96.9 million of depreciation and amortization, a decrease in deferred income taxes of $14.2 million, and $3.2 million of impairment charges and loss on disposal of property and equipment. The $17.9 million net cash inflow from changes in assets and liabilities resulted from increases in accrued liabilities and other liabilities of $44.7 million primarily due to employee related accruals, increases in accounts payable of $33.8 million primarily due to the timing of purchases and payments, increases in prepaid expenses and other assets of $17.3 million, and a decrease in inventories of $1.3 million, partially offset by an increase in accounts receivable of $79.2 million primarily due to higher sales and timing of collections.
Investing Activities
Net cash used in investing activities was $433.5 million in the year ended December 31, 2019. Cash used in investing activities was primarily attributable to net purchases of short-term investments of $399.6 million, $37.8 million for purchases of property and equipment, $8.1 million for purchases of investments in privately-held companies, and $4.9 million for purchases of intangible assets, partially offset by $16.9 million of proceeds from sales of investments in privately-held companies.
Financing Activities
Net cash provided by financing activities was $21.7 million in the year ended December 31, 2019. Cash provided by financing activities was primarily due to $32.0 million of proceeds from issuances of ordinary shares through our employee equity incentive plans, partially offset by $10.4 million of payments on intangible asset obligations.
Comparison of the Year Ended December 31, 2018 to the Year Ended December 31, 2017
Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - "Liquidity and Capital Resources" located in our 10-K for the fiscal year ended December 31, 2018, filed on February 21, 2019, for the discussion of the comparison of the fiscal year ended December 31, 2018 to the fiscal year ended December 31, 2017, the earliest of the three fiscal years presented in the consolidated statements of operations.
Contractual Obligations
The following table summarizes our contractual obligations at December 31, 2019 and the effect those obligations are expected to have on our liquidity and cash flow in future periods:
For purposes of this table, purchase commitments are defined as agreements that are enforceable and legally binding and that specify all significant terms including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are fulfilled by our vendors within relatively short time horizons. In addition, we have purchase orders that represent authorizations to purchase rather than binding agreements. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements.
Other Commitments
For additional information about other commitments, see Note 9, "Commitments and Contingencies" in the notes to the consolidated financial statements.
Recent Accounting Pronouncements
See Note 1, "The Company and Summary of Significant Accounting Policies" in the notes to the consolidated financial statements for a full description of recent accounting standards, including the respective dates of adoption and effects on our consolidated financial statements.
Off-Balance Sheet Arrangements
As of December 31, 2019, we did not have any off-balance sheet arrangements.
Impact of Currency Exchange Rates
Exchange rate fluctuations could have a material adverse effect on our business, financial condition and results of operations. Our most significant foreign currency exposure is the NIS. We do not enter into derivative transactions for speculative or trading purposes. We use foreign currency derivative contracts to hedge assets, liabilities and a significant portion of our operating expenses denominated in NIS. Our derivative instruments are recorded at fair value in assets or liabilities. For the effective portion of derivatives designated as cash flow hedges, the gains or losses are recorded as a component of accumulated other comprehensive income and subsequently reclassified into operating expenses in the same period in which the hedged operating expenses are recognized. For the ineffective portion of derivatives designated as cash flow hedges, if any, as well as derivatives not designated as hedging instruments, the change in fair value is immediately recognized in interest and other, net. See Note 7, "Derivatives and Hedging Activities" to the consolidated financial statements.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate fluctuation risk
Our investments consist of cash, money market funds, certificates of deposit, and interest bearing investments in government debt securities and corporate debt securities with an average maturity of approximately 14 months. The primary objective of our investment activities is to preserve principal and ensure liquidity while maximizing income without significantly increasing risk. By policy, we limit the amount of our credit exposure through diversification and restricting our investments to highly rated securities. At the time of purchase, we do not invest more than 4% of the total investment portfolio in individual securities, except U.S. Treasury or agency securities. Highly rated long-term securities are defined as having a minimum Moody's, Standard & Poor's or Fitch rating of A2 or A, respectively. Highly rated short-term securities are defined as having a minimum Moody's, Standard & Poor's or Fitch rating of P-1, A-1 or, respectively. We have not experienced any significant losses on our cash equivalents or short-term investments. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. An immediate 100 basis points change in interest rates would have a $5.8 million effect on the fair market value of our portfolio.
Foreign currency exchange risk
We derive all of our revenues in U.S. dollars. The U.S. dollar is our functional and reporting currency in all of our foreign locations. However, a significant portion of our liabilities and operating expenses, consisting principally of salaries and related personnel costs, are denominated in NIS. This foreign currency exposure gives rise to market risk associated with exchange rate movements of the U.S. dollar against the NIS. Furthermore, we anticipate that a material portion of our expenses will continue to be denominated in NIS. To the extent the U.S. dollar weakens against the NIS, we will experience a negative impact on our net income.
To reduce the impact of foreign exchange risks associated with forecasted future cash flows and certain existing assets and liabilities, we have established a balance sheet and anticipated transaction risk management program in order to reduce the volatility in our consolidated statement of operations. Currency derivative instruments and natural hedges are generally utilized in this hedging program. We do not enter into derivative instruments for trading or speculative purposes. We account for our derivative instruments as either assets or liabilities and carry them at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.
Our hedging program reduces, but does not eliminate the impact of currency exchange rate movements (see Part I, Item 1A, "Risk Factors"). If we were to experience a strengthening of NIS against USD of 10%, the impact on assets and liabilities denominated in NIS, after taking into account hedges and offsetting positions, would result in a loss before taxes of approximately $11.4 million at December 31, 2019. There would also be an impact on future operating expenses denominated in NIS. For the month ending December 31, 2019, approximately $24.0 million of our monthly expenses were denominated in NIS. As of December 31, 2019, we had derivative contracts designated as cash flow hedges in the notional amount of approximately 296.0 million NIS, or approximately $85.6 million based upon the exchange rate on that day.
Our derivatives expose us to credit risk to the extent that the counterparties may be unable to meet the terms of the agreement. We seek to mitigate such risk by limiting our counterparties to major financial institutions and by spreading the risk across a number of major financial institutions. However, failure of one or more of these financial institutions is possible and could result in incurred losses.
In addition, a material portion of our leases are denominated in currencies other than the U.S. Dollar, mainly in NIS. In accordance with the new lease accounting standard, which became effective on January 1, 2019, the associated lease liabilities will be remeasured using the current exchange rate in the future reporting periods, which may result in material foreign exchange gains or losses. See Note 1, "The Company and Summary of Significant Accounting Policies" in the notes to the consolidated financial statements for more details.
Inflation related risk
We believe that the rate of inflation in Israel has not had a material impact on our business to date. Our cost in Israel in U.S. dollar terms will increase if inflation in Israel exceeds the devaluation of the NIS against the U.S. dollar or if the timing of such devaluation lags behind inflation in Israel.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by Item 8 are submitted as a separate section of this report and are incorporated by reference into this Item 8. See Item 15, "Exhibits and Financial Statement Schedules."
Summary Quarterly Data-Unaudited
______________________________________________________________________________
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934, as amended (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our CEO (principal executive officer) and CFO (principal financial officer), as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of our disclosure controls and procedures as of December 31, 2019. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of December 31, 2019 to provide the reasonable assurance described above.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management's Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Under the supervision and with the participation of our management,
including the CEO and the CFO, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2019 using the criteria established in "Internal Control-Integrated Framework" (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2019.
Kost, Forer, Gabbay and Kasierer, a member of EY Global, our independent registered public accounting firm, audited our consolidated financial statements and has issued a report on the effectiveness of our internal control over financial reporting as of December 31, 2019, as stated in their report which appears under Item 8.
ITEM 9B
ITEM 9B - OTHER INFORMATION
None.
PART III
ITEM 10
ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our written Code of Business Conduct and Ethics applies to all of our directors and employees, including our executive officers. The Code of Business Conduct and Ethics is available on our website at http://www.mellanox.com. Any changes to or waivers of the Code of Business Conduct and Ethics will be disclosed on the same website.
The other information required by this item will be contained in the Proxy Statement or the Amendment, which will be filed no later than 120 days after the end of our fiscal year ended December 31, 2019, under the sections titled “Proposal One - Election of Directors,” “Security Ownership,” and “Corporate Governance and Board of Director Matters” and is incorporated in this report by reference.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this item will be set forth in the Proxy Statement or the Amendment under the sections titled “Compensation Discussion and Analysis,” “Executive Compensation Tables,” “Director Compensation in Fiscal Year 2019,” “Executive Officers” and “Corporate Governance and Board of Director Matters” and is incorporated in this report by reference.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
The information required by this item will be set forth in the Proxy Statement or the Amendment under the sections titled “Compensation Discussion and Analysis,” “Executive Compensation Tables,” “Security Ownership,” “Executive Officers” and “Corporate Governance and Board of Director Matters” and is incorporated in this report by reference.
Equity Compensation Plan Information
The following table provides certain information with respect to all of our equity compensation plans in effect as of December 31, 2019.
____________________________
(1)
Reflects weighted average price of options only.
(2)
Consists of the Fourth Amended and Restated Global Share Incentive Plan (2006), the Global Share Incentive Assumption Plan (2010), the Kotura, Inc. Second Amended and Restated 2003 Stock Plan, the IPtronics, Inc. 2013 Restricted Stock Unit Plan, the EZchip Semiconductor Ltd. 2003 Amended and Restated Equity Incentive Plan, the EZchip Semiconductor Ltd. 2007 U.S. Equity Incentive Plan, the Amended and Restated EZchip Semiconductor Ltd. 2009 Equity Incentive Plan, and the Amended and Restated Employee Share Purchase Plan.
(3)
Consists of 274,005 options and 3,315,348 restricted share units.
(4)
Includes 2,625,623 shares available for issuance under the Amended and Restated Employee Share Purchase Plan as of December 31, 2019, of which up to 2,515,743 shares may be issued with respect to the current purchase period ending February 29, 2020.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item will be set forth in the Proxy Statement or the Amendment under the section titled “Corporate Governance and Board of Directors Matters” and is incorporated in this report by reference.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be set forth in the Proxy Statement or the Amendment under the section titled “Audit Matters” and is incorporated in this report by reference.
PART IV
ITEM 15
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Documents filed as part of this report.
1. Financial Statements. The following financial statements and report of the independent registered public accounting firm are included in Item 8:
Page
Reports of Independent Registered Public Accounting Firms
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Comprehensive Income (Loss)
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
2. Financial Statement Schedules. The following financial statement schedule is filed as part of this report:
Schedule II-Consolidated Valuation and Qualifying Accounts
All other schedules have been omitted because they are not applicable or not required, or the information is included in the Consolidated Financial Statements or Notes thereto.
3. Exhibits. See Item 15(b) below. Each management contract or compensatory plan or arrangement required to be filed has been identified.
(b) Exhibits.
INDEX TO EXHIBITS
______________________________________________________________________________
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors of Mellanox Technologies Ltd.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Mellanox Technologies Ltd. (the Company) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and the financial statement schedule listed in the Index at Item 15(a)(2) (collectively referred to as the "consolidated financial statements"). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the result of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 20, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates.
Valuation of excess and obsolete inventory reserve
Description of the Matter The Company’s inventories totaled $98.0 million as of December 31, 2019. As described
in Note 1 to the consolidated financial statements, the Company values its inventories at the lower of cost or net realizable value. Reserves for potentially excess and obsolete inventory are made based on management's analysis of inventory levels, future sales forecasts and market conditions.
The valuation of inventories requires management to make significant assumptions and judgments about the future salability of the inventory. These assumptions include the assessment by inventory category (finished goods, work-in-process and raw materials) of future usage and market demand for the Company's products. Additionally, management makes qualitative judgments related to slow moving and obsolete inventories.
How We Addressed the Matter
in Our Audit We evaluated and tested the design and operating effectiveness of internal controls over the
valuation of inventories, including those related to the Company's methodology for valuing specific inventory categories.
Our audit procedures included, among others, evaluating the reasonableness of the significant assumptions used by management including those related to forecasted inventory usage. We examined the completeness, accuracy, and relevance of the underlying data used in management's estimate. We re-performed the calculations related to the application of the methodology to specific inventory categories. We performed inquiries with appropriate non-financial personnel including operational employees, regarding slow moving or obsolete inventory items and other factors to corroborate management's assertions regarding qualitative judgments about slow moving and obsolete inventories and performed an examination of historical forecasted sales estimation to actual utilization of inventory.
/s/ Kost Forer Gabbay and Kasierer
KOST FORER GABBAY & KASIERER
A Member of EY Global
We have served as the Company's auditor since 2017.
Tel-Aviv, Israel
February 20, 2020
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors of Mellanox Technologies Ltd.
Opinion on Internal Control over Financial Reporting
We have audited Mellanox Technologies Ltd. (the Company) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and the financial statement schedule listed in the Index at Item 15(a)(2) and our report dated February 20, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Kost Forer Gabbay and Kasierer
KOST FORER GABBAY & KASIERER
A Member of EY Global
Tel-Aviv, Israel
February 20, 2020
MELLANOX TECHNOLOGIES, LTD.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
MELLANOX TECHNOLOGIES, LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
MELLANOX TECHNOLOGIES, LTD.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
The accompanying notes are an integral part of these consolidated financial statements.
MELLANOX TECHNOLOGIES, LTD.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
MELLANOX TECHNOLOGIES, LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
MELLANOX TECHNOLOGIES, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Company
Mellanox Technologies, Ltd., an Israeli corporation (the "Company" or "Mellanox"), was incorporated and commenced operations in March 1999. Mellanox is a supplier of high-performance interconnect products for computing, storage and communications applications.
Pending Merger with NVIDIA Corporation
On March 10, 2019, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with NVIDIA Corporation, a Delaware corporation ("NVIDIA"), NVIDIA International Holdings Inc., a Delaware corporation and wholly owned subsidiary of NVIDIA ("Parent") and Teal Barvaz Ltd., a wholly owned subsidiary of Parent organized under the laws of the State of Israel and wholly owned subsidiary of Parent ("Merger Sub"). NVIDIA has agreed to guarantee the payment and performance obligations of Parent under the Merger Agreement. The Merger Agreement and the Merger (as defined below) have been approved by the boards of directors of the Company, NVIDIA, Parent and Merger Sub.
The Merger Agreement provides that, upon the terms and subject to the satisfaction or waiver of the conditions set forth therein, Merger Sub will be merged with and into the Company (the "Merger") in accordance with Sections 314-327 of the Companies Law 5759-1999 of the State of Israel, with the Company continuing as the surviving corporation and a wholly owned subsidiary of Parent.
At the effective time of the Merger (the "Effective Time"), each ordinary share, par value NIS 0.0175 per share, of the Company (a "Company Share") issued and outstanding immediately prior to the Effective Time, other than any shares owned by the Company, Parent and their respective subsidiaries or any shares held in the Company’s treasury, will be deemed to have been transferred to the Parent in exchange for the right to receive $125.00 in cash, without interest and subject to applicable withholding taxes.
The Merger Agreement contains customary representations, warranties and covenants. The consummation of the Merger is conditioned on the receipt of the approval of the Company’s shareholders, as well as the satisfaction of other customary closing conditions, including domestic and foreign regulatory approvals and performance in all material respects by each party of its obligations under the Merger Agreement. In June 2019, the Company’s shareholders approved the consummation of the Merger and the Company received regulatory approvals for the Merger from Mexico in July 2019 and from the European Commission in December 2019. In addition, the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, in connection with the proposed acquisition expired in May 2019. Discussions with State Administration for Market Regulation, the China regulatory agency, are progressing and the Company believes the closing will likely occur in the early part of calendar 2020.
The Merger Agreement contains certain customary termination rights by either the Company or Parent, including if the Merger is not consummated by December 10, 2019 (the "Outside Date"), subject to two three-month extensions in order to obtain required regulatory approvals. Pursuant to the first of those three-month extensions, the Outside Date has been extended to March 10, 2020. If the Merger Agreement is terminated under certain circumstances, including termination by the Company to enter into a superior proposal, a termination by Parent following a change of the Company’s board of directors’ recommendation or a termination by Parent as a result of a willful material breach of the Merger Agreement’s no-solicitation obligations by the Company, the Company will be obligated to pay to Parent a termination fee equal to $225.0 million in cash. If the Merger Agreement is terminated under certain circumstances involving the failure to obtain certain regulatory approvals, Parent will be obligated to pay the Company a termination fee equal to $350.0 million in cash.
The Company recorded transaction-related costs of $15.5 million, principally for investment banking and legal fees associated with the pending acquisition, during the year ended December 31, 2019 under general and administrative expenses included in the consolidated statement of operations. Additional transaction-related costs are expected to be incurred through the closing of the Merger.
MELLANOX TECHNOLOGIES, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Principles of presentation
The consolidated financial statements include the Company's accounts as well as those of its wholly owned subsidiaries after the elimination of all intercompany balances and transactions.
Certain prior year amounts have been reclassified for consistency with the current year presentation. On the balance sheet, the severance assets were reclassified to deferred taxes and other long-term assets, and the accrued severance was reclassified to other long-term liabilities.
Risks and uncertainties
The Company is subject to all of the risks inherent in a company which operates in the dynamic and competitive semiconductor industry. Significant changes in any of the following areas could have a material adverse impact on the Company's financial position and results of operations; unpredictable volume or timing of customer orders; ordered product mix; the sales outlook and purchasing patterns of the Company's customers based on consumer demands and general economic conditions; loss of one or more of the Company's customers; decreases in the average selling prices of products or increases in the average cost of finished goods; the availability, pricing and timeliness of delivery of components used in the Company's products; reliance on a limited number of subcontractors to manufacture, assemble, package and production test the Company's products; the Company's ability to successfully develop, introduce and sell new or enhanced products in a timely manner; product obsolescence and the Company's ability to manage product transitions; the timing of announcements or introductions of new products by the Company's competitors, and the Company's ability to successfully integrate acquired businesses.
Use of estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of net revenue and expenses in the reporting periods. The Company regularly evaluates estimates and assumptions related to revenue recognition, allowances for doubtful accounts, allowances for price adjustments, investment valuation, warranty reserves, inventory reserves, share-based compensation expense, long-term asset valuations, useful lives of property, equipment, and intangibles, right-of-use ("ROU") assets and liabilities, accounting for business combinations, goodwill and purchased intangible asset valuation, investments in privately-held companies, accounting and fair value of financial instruments and derivatives, deferred income tax asset valuation, uncertain tax positions, litigation and other loss contingencies. These estimates and assumptions are based on current facts, historical experience and various other factors that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses that are not readily apparent from other sources. The actual results that the Company experiences may differ materially and adversely from the Company's original estimates. To the extent there are material differences between the estimates and actual results, the Company's future results of operations will be affected.
Cash and cash equivalents
The Company considers all highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. Cash and cash equivalents consist of cash on deposit with banks and money market funds.
Restricted cash
As of December 31, 2018 and 2017, the Company maintained certain cash amounts that were restricted as to withdrawal or use over the long-term. The cash secured bank guarantees primarily issued against long-term tenancy agreements. The Company did not maintain any restricted cash amounts as of December 31, 2019. The long-term restricted cash balances were reported in deferred taxes and other long-term assets on the balance sheets, and were included in the ending balance of cash, cash equivalents and restricted cash in the statement of cash flows for the years then ended. The following table provides a reconciliation of the cash and cash equivalents balances reported on the balance sheets and the cash, cash equivalents and restricted cash balances reported in the statements of cash flows:
MELLANOX TECHNOLOGIES, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Short-term investments
The Company's short-term investments are classified as available-for-sale securities and are reported at fair value. Unrealized gains or losses are recorded in shareholders' equity and included in other comprehensive income ("OCI"). The Company views its available-for-sale portfolio as available for use in its current operations. Accordingly, the Company has classified all investments in available for sale securities with readily available markets as short-term, even though the stated maturity date may be one year or more beyond the current balance sheet date, because of the intent and ability to sell these securities prior to maturity to meet liquidity needs or as part of a risk management program. The Company regularly reviews its investment portfolio and charges unrealized losses against net income when a decline in fair value is determined to be other-than-temporary. The Company reviews several factors to determine whether a loss is other-than-temporary. These factors include but are not limited to: (1) the length of time a security is in an unrealized loss position, (2) the extent to which fair value is less than cost, (3) the financial condition and near term prospects of the issuer and (4) our intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.
Fair value of financial instruments
The Company's financial instruments consist of cash equivalents, short-term investments and foreign currency derivative contracts. The fair value of a financial instrument is the amount that would be received in an asset sale or paid to transfer a liability in an orderly transaction between unaffiliated market participants. When there is no readily available market data, fair value estimates may be made by the Company, which may not necessarily represent the amounts that could be realized in a current or future sale of these assets.
Derivatives
The Company enters into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks, mainly the exposure to changes in the exchange rate of the NIS against the U.S. dollar that are associated with forecasted future cash flows and certain existing assets and liabilities. The Company's primary objective in entering into these arrangements is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. The program is not designated for trading or speculative purposes. The Company's derivative instruments expose the Company to credit risk to the extent that the counter-parties may be unable to meet the terms of the agreement. The Company seeks to mitigate such risk by limiting its counter-parties to major financial institutions and by spreading the risk across a number of major financial institutions. In addition, the potential risk of loss with any one counter-party resulting from this type of credit risk is monitored on an ongoing basis.
The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the unrealized gains or losses on the derivative instruments is reported as a component of accumulated other comprehensive income ("AOCI") in shareholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gains or losses on the derivative instruments, if any, is recognized in earnings in the current period. The derivative instruments that hedge the exposure to variability in the fair value of assets or liabilities are not currently designated as hedges for financial reporting purposes, and thus the gains or losses on such derivative instruments are recognized in earnings in the current period.
MELLANOX TECHNOLOGIES, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Concentration of credit risk
Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash, cash equivalents, short-term investments and accounts receivable. Cash, cash equivalents and short-term investment balances are maintained with high quality financial institutions, the composition and maturities of which are regularly monitored by management. The Company's accounts receivable are derived from revenue earned from customers primarily located in North America, Europe and Asia. The Company performs ongoing credit evaluations of its customers' financial condition and, generally, requires no collateral from its customers. The Company maintains an allowance for doubtful accounts receivable based upon the expected collectability of accounts receivable. The Company reviews its allowance for doubtful accounts quarterly by assessing individual accounts receivable over a specific aging and amount, and all other balances based on historical collection experience and an economic risk assessment. If the Company determines that a specific customer is unable to meet its financial obligations to the Company, the Company provides an allowance for credit losses to reduce the receivable to the amount management reasonably believes will be collected. In addition, the Company maintains credit insurance for the majority of its accounts receivable balances.
The following table summarizes the revenues from customers (including original equipment manufacturers) in excess of 10% of the total revenues:
There were no accounts receivable balances in excess of 10% of total accounts receivable for the years ended December 31, 2019 and 2018.
Inventory
Inventory includes finished goods, work-in-process and raw materials. Inventory is stated at the lower of cost (principally standard cost which approximates actual cost on a first-in, first-out basis) or net realizable value. Reserves for potentially excess and obsolete inventory are made based on management's analysis of inventory levels, future sales forecasts and market conditions. Once established, the original cost of the Company's inventory less the related inventory reserve represents the new cost basis of such products.
Property and equipment
Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is generally calculated using the straight-line method over the estimated useful lives of the related assets, which is three years for computer equipment and software, seven years for lab equipment, and seven years for office furniture and fixtures. Leasehold improvements and assets acquired under capital leases are amortized on a straight-line basis over the term of the lease, or the useful lives of the assets, whichever is shorter. Maintenance and repairs are charged to expense as incurred, and improvements are capitalized. When assets are retired or otherwise disposed of, the cost and accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is reflected in the results of operations in the period realized. The Company retires fully depreciated assets when they are no longer in use. As a result, $26.7 million and $16.6 million of cost and accumulated depreciation were removed from the accounts during the years ended December 31, 2019 and 2018, respectively. No gain or loss was recognized.
The Company capitalizes certain costs incurred in connection with internal use of inventory items in the Company's data centers and laboratories. Capitalized inventory costs are included in Property and equipment, net and amortized on a straight-line basis over the estimated useful life of the asset.
MELLANOX TECHNOLOGIES, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Business combinations
The Company accounts for business combinations using the acquisition method of accounting. The Company determines the recognition of intangible assets based on the following criteria: (i) the intangible asset arises from contractual or other rights; or (ii) the intangible asset is separable or divisible from the acquired entity and capable of being sold, transferred, licensed, returned or exchanged. The Company allocates the purchase price of business combinations to the tangible assets, liabilities and intangible assets acquired, including in-process research and development ("IPR&D"), based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. The process of estimating the fair values requires significant estimates, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from customer contracts, customer lists and distribution agreements, acquired developed technologies, expected costs to develop IPR&D into commercially viable products, estimated cash flows from projects when completed and discount rates. The Company estimates fair value based upon assumptions that are believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates.
Goodwill and intangible assets
Goodwill represents the excess of the cost of acquired businesses over the fair market value of their identifiable net assets. The Company conducts a goodwill impairment qualitative assessment during the fourth quarter of each fiscal year or more frequently if facts and circumstances indicate that goodwill may be impaired. The goodwill impairment qualitative assessment requires the Company to perform an assessment to determine if it is more likely than not that the fair value of the business is less than its carrying amount. The qualitative assessment considers various factors, including the macroeconomic environment, industry and market specific conditions, market capitalization, stock price, financial performance, earnings multiples, budgeted-to-actual revenue performance from prior year, gross margin and cash flow from operating activities and issues or events specific to the business. If adverse qualitative trends are identified that could negatively impact the fair value of the business, the Company performs a "two step" goodwill impairment test. "Step one" is the identification of potential impairment. This involves comparing the fair value of each reporting unit, which the Company has determined to be the entity itself as one reporting unit, with its carrying amount including goodwill. If the fair value of a reporting unit exceeds its carrying amount, the goodwill of the reporting unit is considered not impaired and "Step two" of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, "Step two" is performed. This involves comparing the carrying amount of goodwill to its implied fair value, which is determined to be the excess of the reporting unit's fair value over the fair value of its identifiable net assets other than goodwill. If the carrying amount of goodwill exceeds its implied fair value, an impairment exists and is recorded. As of December 31, 2019, the Company's qualitative assessment of goodwill impairment indicated that goodwill was not impaired.
Intangible assets represent acquired intangible assets including developed technology, customer relationships and IPR&D, as well as licensed technology. The Company amortizes its finite lived intangible assets over their useful lives using a method that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise used, or, if that pattern cannot be reliably determined, using a straight-line amortization method. The Company capitalizes IPR&D projects acquired as part of a business combination as intangible assets with indefinite lives. On completion of each project, IPR&D assets are reclassified to developed technology and amortized over their estimated useful lives. If any of the IPR&D projects are abandoned, the Company would impair the related IPR&D asset. Intangible assets with finite lives are tested for impairment in accordance with our policy for long-lived assets.
Indefinite-lived intangible assets are tested for impairment annually or more frequently when indicators of impairment exist. The Company first assesses qualitative factors to determine if it is more likely than not that an indefinite-lived intangible asset is impaired and whether it is necessary to perform a quantitative impairment test. The qualitative assessment considers various factors, including reductions in demand, the abandonment of IPR&D projects or significant economic slowdowns in the semiconductor industry and macroeconomic environment. If adverse qualitative trends are identified that could negatively impact the fair value of the asset, then quantitative impairment tests are performed to compare the carrying value of the asset to its undiscounted expected future cash flows. If this test indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using: (i) quoted market prices or (ii) discounted expected future cash flows utilizing an appropriate discount rate. Impairment is based on the excess of the carrying amount over the fair value of those assets.
Equity investments in privately-held companies
The Company has equity investments in privately-held companies. These investments are recorded at cost, less impairments, adjusted by observable price changes. The Company records gains or losses on the sale of these investments when the proceeds are greater than or less than cost, respectively. The investments are included in deferred taxes and other long-term assets on the
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accompanying balance sheets. The Company monitors the investments and if facts and circumstances indicate an investment may be impaired, then it conducts an impairment test of its investment. To determine if the investment is recoverable, it reviews the privately-held company's revenue and earnings trends relative to pre-defined milestones and overall business prospects, the general market conditions in its industry and other factors related to its ability to remain in business, such as liquidity and receipt of additional funding.
While performing its review for impairment for the first quarter of 2019, the Company noted an observable price change related to one of its investments in a privately-held company. As a result, the Company recorded an impairment charge of $1.8 million in the first quarter of 2019.
While performing its review for impairment for the fourth quarter of 2018, the Company noted an observable price change related to one of its investments in a privately-held company. As a result, the Company recorded an impairment charge of $1.5 million in the fourth quarter of 2018.
Impairment of long-lived assets
Long-lived assets include equipment, furniture and fixtures, ROU assets, and finite-lived intangible assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. If the sum of the expected future cash flows (undiscounted and without interest charges) from the long-lived assets is less than the carrying amount of such assets, an impairment loss would be recognized, and the assets would be written down to their estimated fair values. The Company reviews for possible impairment on a regular basis.
While performing the review for impairment for 2017, the Company noted an impairment indicator associated with the potential sale or discontinuation of the 1550nm silicon photonics line of business. As a result, the Company recorded $12.0 million of impairment charges during the year ended December 31, 2017.
Also, in connection with the discontinuation of the 1550nm silicon photonics development activities, the Company recorded impairment charges and a net loss on disposal of assets of $2.4 million during the year ended December 31, 2018. There was also a $0.9 million impairment charge on fixed assets not related to the 1550nm silicon photonics development activities recorded during the year ended December 31, 2018.
During the year ended December 31, 2019, the Company recorded impairment charges and a net loss on disposal of assets of $1.5 million.
See Note 16, "Restructuring and Impairment Charges" for more details about the impairment charges.
Revenue recognition
The Company recognizes revenue when (or as) it satisfies performance obligations by transferring promised products or services to its customers in an amount that reflects the consideration the Company expects to receive. The Company applies the following five steps: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.
The Company considers customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with a customer. For each contract, the Company considers the promise to transfer tangible products, extended warranty and post-contract customer support, each of which are distinct, to be the identified performance obligations. In determining the transaction price, the Company evaluates whether the price is subject to rebates and adjustments to determine the net consideration to which the Company expects to receive. As the Company’s standard payment terms are less than one year, the contracts have no significant financing component. The Company allocates the transaction price to each distinct performance obligation based on its relative standalone selling price. Revenue from tangible products is recognized when control of the product is transferred to the customer (i.e., when the Company’s performance obligation is satisfied), which typically occurs at shipment. The revenues from fixed-price support or maintenance contracts, including extended warranty contracts and post-contract customer support agreements, are recognized ratably over the contract period and the costs associated with these contracts are recognized as incurred. The Company's standard arrangements with its customers do not allow for rights of return.
The Company maintains inventory, or hub arrangements with certain customers. Pursuant to these arrangements, the Company delivers products to a customer or a designated third party warehouse based upon the customer's projected needs, but does not
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recognize product revenue unless and until the customer reports it has removed the Company's product from the warehouse to be incorporated into its end products.
A portion of the Company's sales are made to distributors under agreements which contain price protection provisions. Revenue from sales to distributors is recognized upon shipment and transfer of control, net of estimated distribution price adjustments (“DPAs”). The Company calculates the estimated DPAs based on specific earned DPA claims and estimated unearned DPA claims based on an analysis of historical DPA claims, at the distributor level, over a period of time considered adequate to account for current pricing and business trends. The earned DPA claims are recorded as a reduction of revenue and a reduction of gross accounts receivable. The Company records the estimated unearned DPAs as a reduction of revenue and an increase in the allowance for unearned DPAs.
In addition, the Company records revenue reserves for rebates as a reduction of revenue and a reduction of gross accounts receivable or as an increase in other current payables. The reserves are recorded in the same period that the related revenue is recorded, and are based on the amounts stated in the contracts. The Company reverses reserves for unclaimed rebates as specific rebate programs contractually end and when it believes unclaimed rebates are no longer subject to payment and will not be paid. As a result, the reversal of unclaimed rebates may have a positive impact on our net revenue and net income in subsequent periods.
Most of the Company’s distributors are entitled to a limited right of return related to stock rotation. Distributors have the right to return a limited amount of product not to exceed a percentage of the distributor’s prior quarter's net purchases. However, a simultaneous, compensating order of equal or greater value must be placed by the distributor within the same quarter of the return.
Product warranty
The Company typically offers a limited warranty for its products for periods up to three years. The Company accrues for estimated returns of defective products at the time revenue is recognized based on historical activity. The determination of these accruals requires the Company to make estimates of the frequency and extent of warranty activity and estimated future costs to either replace or repair the products under warranty. If the actual warranty activity and/or repair and replacement costs differ significantly from these estimates, adjustments to record additional cost of revenues may be required in future periods. Changes in the Company's liability for product warranty were as follows:
Research and development
Costs incurred in research and development are charged to operations as incurred. The Company expenses all costs for internally developed patents as incurred.
Advertising
Costs related to advertising and promotion of products are charged to sales and marketing expense as incurred. Advertising expense was approximately $3.1 million, $2.6 million and $2.9 million for the years ended December 31, 2019, 2018 and 2017, respectively.
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Share-based compensation
The Company accounts for share-based compensation expense based on the estimated fair value of the equity awards as of the grant dates. The fair value of restricted stock units ("RSUs"), is based on the closing market price of our ordinary shares on the date of grant. The Company estimates the fair value of share options and the Employee Share Purchase Plan ("ESPP") using the Black-Scholes option valuation model, which requires the input of subjective assumptions including the expected share price volatility and the calculation of expected term, as well as the fair value of the underlying ordinary share on the date of grant, among other inputs.
The Company bases its estimate of expected volatility on the historical volatility of the Company's shares. The Company did not grant share options in 2019, 2018, and 2017.
Share-based compensation expense is recognized on a straight-line basis over each recipient's requisite service period, which is generally the vesting period. Share-based compensation expense is recorded in full during the vesting period, and the effect of forfeitures will be recorded as they occur.
During the year ended December 31, 2018, the Company granted 36,000 performance share units ("PSUs"). The PSUs will vest and be earned based on the Company’s achievement of relative total shareholder return and average non-GAAP net operating margin over a three-year performance period commencing on January 1, 2018 and ending on December 31, 2020, subject to the continued service to the Company through the end of the performance period. The number of shares that will actually vest range from zero to 175% of the target. The share-based compensation expenses related to these PSUs were $2.1 million and $0.9 million for the year ended December 31, 2019 and 2018, respectively.
Comprehensive income (loss)
Accumulated other comprehensive income (loss), net of tax on the consolidated balance sheets at December 31, 2019 and 2018, represents the accumulated unrealized gains (losses) on available-for-sale securities, and the accumulated unrealized gains (losses) related to derivative instruments accounted for as cash flow hedges. The amount of income tax expense allocated to unrealized gains (losses) on available-for-sale securities and derivative instruments was immaterial at December 31, 2019 and 2018.
Foreign currency translation and remeasurement
The Company uses the U.S. dollar as its functional currency. Foreign currency assets and liabilities are remeasured into U.S. dollars at the end-of-period exchange rates except for non-monetary assets and liabilities, which are remeasured at historical exchange rates. The Company derives all revenues in U.S. dollars. Expenses are remeasured at the exchange rate in effect on the day the transaction occurred, except for those expenses related to non-monetary assets and liabilities, which are remeasured at historical exchange rates. Gains or losses from foreign currency transactions are included in the Consolidated Statements of Operations as part of "Interest and other, net."
Net income (loss) per share
Basic net income (loss) per share is computed by dividing the net income (loss) by the weighted-average number of ordinary shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted-average number of ordinary shares outstanding during the period increased to include the number of additional shares that would have been outstanding if the potentially dilutive shares had been issued. Potentially dilutive shares include unvested RSUs, PSUs, outstanding stock options, and shares to be purchased by employees under the Company’s employee stock purchase plan. The dilutive effect of potentially dilutive shares is reflected in diluted net income (loss) per share by application of the treasury stock method.
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The following table sets forth the computation of basic and diluted net income (loss) per share for the periods indicated:
The Company excluded 0.1 million potentially dilutive share options and RSUs from the computation of diluted net income per share for the year ended December 31, 2019, 0.2 million outstanding share options and RSUs from the computation of diluted net income per share for the year ended December 31, 2018, and 4.5 million potentially dilutive shares options and RSUs from the computation of diluted net loss per share for the year ended December 31, 2017, respectively, because including them would have had an anti-dilutive effect.
Segment reporting
The Company has one reportable segment: the development, manufacturing, marketing and sales of interconnect products.
Income taxes
To prepare the Company's consolidated financial statements, the Company estimates its income taxes in each of the jurisdictions in which it operates. This process involves estimating the Company's actual tax exposure together with assessing temporary differences resulting from the differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are calculated using tax rates expected to be in effect during the period these temporary differences would reverse, and are included within the Company's consolidated balance sheet.
The Company must also make judgments regarding the realizability of deferred tax assets. The carrying value of the Company's net deferred tax assets is based on its belief that it is more likely than not that the Company will generate sufficient future taxable income in certain jurisdictions to realize these deferred tax assets. A valuation allowance has been established for deferred tax assets which the Company does not believe meet the "more likely than not" criteria. The Company's judgments regarding future taxable income may change due to changes in market conditions, changes in tax laws, tax planning strategies or other factors. If the Company's assumptions and consequently its estimates change in the future, the valuation allowances it has established may be increased or decreased, resulting in a respective increase or decrease in income tax expense. The Company's effective tax rate is highly dependent upon the geographic distribution of its worldwide earnings or losses, the tax regulations and tax holidays in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of its tax planning strategies.
The Company uses a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with the guidance on judgments regarding the realizability of deferred taxes. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits within the consolidated statements of income as income tax expense.
Adoption of new accounting principles
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The standard requires lessees to recognize almost all leases on the balance sheet as a ROU asset and a lease liability and requires leases to be classified as either an operating or a finance type lease. The standard excludes leases of intangible assets or inventory.
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The standard became effective for the Company on January 1, 2019. The Company elected the available practical expedients and implemented internal controls to enable the preparation of financial information on adoption. The adoption of the standard had a material impact on the Company's consolidated balance sheet due to the recognition of the ROU assets and lease liabilities related to the Company's operating leases. In addition, a material portion of the Company's leases are denominated in currencies other than the U.S. Dollar, mainly in New Israeli Shekels ("NIS"). As a result, the associated lease liabilities are remeasured using the current exchange rate, which may result in non-operating foreign exchange gains and losses. See Note 15, "Leases" for details about the impact from adopting the new lease standard and other required disclosures.
Recent accounting pronouncements
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments, which modifies the measurement of expected credit losses on certain financial instruments. In addition, for available-for-sale debt securities, the standard eliminates the concept of other-than-temporary impairment and requires the recognition of an allowance for credit losses rather than reductions in the amortized cost of the securities. This standard became effective for the Company beginning January 1, 2020. The Company does not expect this ASU to have a material impact on its consolidated financial statements and related disclosures.
In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU clarifies the accounting treatment for implementation costs for cloud computing arrangements (hosting arrangements) that are service contracts. This standard became effective for the Company beginning January 1, 2020. The Company does not expect this ASU to have a material impact on its consolidated financial statements and related disclosures.
NOTE 2-REVENUE
Revenues by geographic region for the years ended December 31, 2019, 2018 and 2017 were as follows:
The following tables represent our total revenues by product type and interconnect protocol for the years ended December 31, 2019, 2018 and 2017:
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Contract balances
The Company recognizes contract liabilities, or deferred revenues, when it receives advance payments from customers before performance obligations primarily related to extended warranty and post-contract customer support have been performed. Advance payments are received at the beginning of the service period and the related deferred revenues are reclassified to revenue ratably over the service period. The balance of deferred revenues approximates the aggregate amount of the transaction price allocated to the unsatisfied performance obligations at the end of reporting period. The Company expects to recognize the long-term portion of deferred revenue over the remaining service period of up to five years.
The following table presents the significant changes in the deferred revenue balance during the years ended December 31, 2019 and 2018:
(1) Of the total reclassifications from deferred revenue to revenue, $20.6 million and $19.0 million were related to the beginning balance of 2019 and 2018, respectively, and $15.7 million and $8.2 million were related to the new deferred revenue during the years ended December 31, 2019 and 2018, respectively.
Unsatisfied performance obligations, other than extended warranty and post-contract customer support, primarily represent contracts with future delivery dates. As of December 31, 2019, the Company had $41.7 million of unbilled transaction price allocated to performance obligations that were unsatisfied or partially unsatisfied related to contracts with an original duration over one year. The Company expects to invoice and recognize the revenue as it satisfies each performance obligation during a period of three years. The foregoing excludes the value of the remaining unsatisfied performance obligations related to contracts that have original durations of one year or less.
The Company recognizes assets for the material incremental costs of obtaining contracts with customers if it expects the benefit of those costs to be longer than one year. The Company allocates these assets proportionally to the performance obligations in the contracts and amortizes them as the performance obligations are satisfied. During the year ended December 31, 2019, the Company recognized $11.3 million of assets related to costs to obtain contracts, and amortized $7.5 million of these assets during the same period. The unamortized balance of the assets was $3.8 million as of December 31, 2019.
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NOTE 3-BALANCE SHEET COMPONENTS:
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NOTE 4-FAIR VALUE MEASUREMENTS:
Fair value hierarchy:
The Company measures its cash equivalents, restricted cash, marketable securities, and foreign currency contracts at fair value. The Company’s cash equivalents are classified within Level 1. Cash equivalents are valued primarily using quoted market prices utilizing market observable inputs. The Company's restricted cash, investments in debt securities and certificates of deposits are classified within Level 2 as the market inputs to value these instruments consist of market yields, reported trades and broker/dealer quotes. In addition, foreign currency contracts are classified within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments. The Level 3 valuation inputs include the Company's best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument's valuation. As of December 31, 2019 and 2018, the Company did not have any assets or liabilities valued based on Level 3 valuations.
Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis:
The following table represents the fair value hierarchy of the Company's financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2019.
The following table represents the fair value hierarchy of the Company's financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2018.
There were no transfers between Level 1 and Level 2 securities during the years ended December 31, 2019 and 2018.
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NOTE 5-INVESTMENTS:
Cash, cash equivalents and short-term investments:
At December 31, 2019 and 2018, the Company held cash, cash equivalents and short-term investments classified as available-for-sale securities as follows:
The Company does not intend to sell the short-term investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be at maturity.
Interest income and gains on short-term investments, net were $15.6 million and $5.6 million for the years ended December 31, 2019 and 2018, respectively. At December 31, 2019, the unrealized gains and unrealized losses were $1.9 million and $0.3 million, respectively. At December 31, 2018, the unrealized gains and unrealized losses were $0.1 million and $0.5 million, respectively. At December 31, 2019, gross unrealized losses on investments that were in a gross unrealized loss position for greater than 12 months were immaterial. These investments were not deemed to be other-than-temporarily impaired and the gross unrealized losses were recorded in OCI.
The contractual maturities of short-term investments at December 31, 2019 and 2018 were as follows:
Equity investments in privately-held companies:
As of December 31, 2019 and 2018, the Company held a total of $39.3 million and $40.3 million, respectively, in equity investments in privately-held companies. During the first quarter of 2019, one of the investees of the Company's equity investments in privately-held companies was acquired. As a result, the Company recorded a gain on sale of $9.1 million in the first quarter of 2019. In addition, $3.2 million of the consideration owed to the Company was held back in an escrow account as of December 31, 2019. The final amount released from escrow, if any, will be recognized as an additional gain on sale when released. During the second quarter of 2019, the Company recorded a gain of $0.4 million from the conversion of a note receivable to equity in a privately-held company.
While performing its review for impairment for the first quarter of 2019, the Company noted an observable price change related to one of its investments in a privately-held company; as a result, the Company recorded an impairment charge of $1.8 million.
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NOTE 6-GOODWILL AND INTANGIBLE ASSETS:
The following table represents changes in the carrying amount of goodwill:
The carrying amounts of intangible assets as of December 31, 2019 were as follows:
The carrying amounts of intangible assets as of December 31, 2018 were as follows:
Amortization expense of intangible assets totaled approximately $60.4 million, $63.9 million and $61.3 million for the years ended December 31, 2019, 2018 and 2017, respectively.
The estimated future amortization expense is as follows:
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NOTE 7-DERIVATIVES AND HEDGING ACTIVITIES:
Fair Value of Derivative Contracts
The fair value of derivative contracts as of December 31, 2019 and 2018 was as follows:
The gross notional amounts of derivative contracts were NIS denominated. The notional amounts of outstanding derivative contracts in U.S. dollar at December 31, 2019 and 2018 were as follows:
Effect of Derivatives Designated as Hedging Instruments on Accumulated Other Comprehensive Income (Loss)
The following table represents the unrealized gains (losses) of derivatives designated as hedging instruments, net of tax effects, that were recorded in accumulated other comprehensive income (loss) as of December 31, 2019 and 2018, and their effect on OCI for the year ended December 31, 2019 (in thousands):
Foreign exchange contracts designated as hedging instruments primarily relate to operating expenses and the associated gains and losses are expected to be recorded in operating expenses when reclassified out of OCI. See Note 11, "Accumulated Other Comprehensive Income (Loss)" for the amounts recorded in each operating expense account. The Company expects to realize the accumulated OCI balance related to foreign exchange contracts within the next twelve months.
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Effect of Derivative Contracts on the Consolidated Statement of Operations
The effect of derivative contracts on the consolidated statement of operations in the years ended December 31, 2019, 2018, and 2017 was as follows:
NOTE 8-EMPLOYEE BENEFIT PLANS:
The Company has established a pretax savings plan under Section 401(k) of the Internal Revenue Code. The 401(k) Plan allows eligible employees in the United States to voluntarily contribute a portion of their pre-tax or after-tax salary, subject to a maximum limit specified in the Internal Revenue Code. The Company matches employee contributions up to 4% of their annual base salaries. The total expenses for these contributions were $1.8 million for both the years ended December 31, 2019 and 2018, and $2.2 million for the year ended December 31, 2017.
As a general rule, under Israeli law, an employee whose employment has been terminated by an employer or an employee who has resigned under circumstances which entitle him/her to receive statutory severance, in each case after completing at least one year of service with a particular employer or in a particular workplace, is entitled to statutory severance. For Israeli employees hired prior to January 1, 2007 ("Group One"), the severance pay liability is calculated based on the last monthly salary of each employee multiplied by the number of years of such employee's employment and is presented in the Company's balance sheet in other long-term liabilities, as if it was payable at each balance sheet date on an undiscounted basis. This liability is partially funded by the amounts accrued in the severance component of the employees’ pension arrangements (the “Severance Fund”). The surrender value of the Severance Fund is presented in other long-term assets.
The severance pay detail is as follows:
As a general rule, Israeli employees who were hired on or after January 1, 2007 ("Group Two"), are subject to the arrangement pursuant to Section 14 of the Severance Pay Law, 1963 (“Section 14 Arrangement”). When the Company makes the full monthly contribution equal to 8.3% of the employee's salary towards the Severance Fund and undertakes that the amounts accumulated in the Severance Fund will be released to the employee in the event that the employment relationship comes to an end, no additional calculations shall be conducted between the parties regarding the matter of severance pay and no additional payments will be made by the Company to the employee. Further, the related obligation and amounts deposited for the employee by the Company for such obligation are not stated on the balance sheet, as the Company is legally released from the obligation to employees once the deposit amounts have been paid.
During the first quarter of 2019, a significant portion of the employees in Group One elected to move to Group Two under settlement agreements with the Company, which were permitted by a formal approval obtained by the Company from the Israeli Ministry of Labor. In accordance with the Ministry of Labor’s approval (which applied to each of the relevant employees individually), the Company undertook to make the necessary contributions to ensure coverage of severance based on the employees'
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entire salary for the period during which the employees were not subject to the Section 14 Arrangement up to June 30, 2018. The Company reclassified the accumulated amount of severance assets and accrued severance liabilities as of June 30, 2018 related to these employees to accrued and other liabilities as of March 31, 2019. The Company paid the net severance liabilities (i.e., it made the necessary contributions to each of these employees’ Severance Fund) in April 2019.
Severance expenses for the years ended December 31, 2019, 2018 and 2017 were $16.2 million, $13.7 million and $12.6 million, respectively.
In addition, the Company has established a pension contribution plan with respect to its employees in Israel. Under the plan, for the period from January 1 to June 30, 2016, the Company contributed up to 6.0% of employee monthly salary toward the plan. Effective July 1, 2016 the contribution percentage was increased to 6.25% and was further increased to 6.5% effective January 1, 2017. Employees are entitled to amounts accumulated in the plan upon reaching retirement age, subject to any applicable law. Defined contribution pension plan expenses were $11.5 million, $10.6 million and $10.4 million in the years ended December 31, 2019, 2018 and 2017, respectively.
NOTE 9-COMMITMENTS AND CONTINGENCIES:
Leases
See Note 15, "Leases" for lease related commitments as of December 31, 2019.
Purchase commitments
At December 31, 2019, the Company had the following non-cancelable purchase commitments:
Other Commitments
Royalty-bearing grants
In April 2018, the Company entered into a settlement agreement with the IIA, which eliminated the future contingent royalty payment obligations of the Company (approximately $36.4 million at March 31, 2018) and the associated future interest payments. These obligations were related to the funding the Company received from the IIA prior to the date of the agreement under approved plans in accordance with the R&D Law and the regulations and rules of the IIA. As part of the agreement, the Company paid approximately $9.3 million to the IIA and the expense was included in cost of revenues during the second quarter of 2018. The Company could be subject to the payment to the IIA of transfer fees or license fees, if the related know-how is transferred outside of Israel.
Unrecognized tax benefits
Due to the inherent uncertainty with respect to the timing of future cash outflows associated with the Company's unrecognized tax benefits, it is unable to reliably estimate the timing of cash settlement with the respective taxing authorities. As of December 31, 2019, the Company's unrecognized tax benefits totaled $55.5 million, out of which an amount of $28.6 million would reduce the Company's income tax expense and effective tax rate, if recognized.
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Contingencies
Legal proceedings
The Company is involved in a variety of claims, suits, investigations and proceedings that arise from time to time in the ordinary course of its business, including actions with respect to contracts, intellectual property, taxation, employment, benefits, securities, personal injuries and other matters. The results of these proceedings in the ordinary course of business are not expected to have a material adverse effect on the Company’s consolidated financial position or results of operations.
The Company records a liability when it believes that it is both probable that a liability will be incurred, and the amount of loss can be reasonably estimated. The Company evaluates, at least quarterly, developments in its legal matters that could affect the amount of liability that has been previously accrued and makes adjustments as appropriate. Significant judgment is required to determine both the probability and the estimated amount of a loss or potential loss. The Company may be unable to estimate the reasonably possible loss or range of loss for a particular legal contingency. In such instances, there is considerable uncertainty regarding the ultimate resolution of such matters, including a possible eventual loss, if any.
NOTE 10-SHARE INCENTIVE PLANS:
Stock option plans
During the 2016 annual shareholder meeting, the Company's shareholders approved the Mellanox Technologies, Ltd. Amended and Restated Global Share Incentive Plan (2006) (the "First Restated 2006 Plan"), which constituted an amendment and restatement of the Mellanox Technologies, Ltd. Global Share Incentive Plan (2006) and its appendices (the "2006 Plan"). The First Restated 2006 Plan became effective on March 14, 2016 ("Effective Date"). The approval of the First Restated 2006 Plan extended the term to February 2026.
The First Restated 2006 Plan reserved 750,000 ordinary shares for issuance under new equity awards and reduced to zero the shares available for issuance under all of the Company's other equity incentive plans in effect, including the Voltaire Ltd. 2007 Incentive Compensation Plan, the Voltaire Ltd. 2003 Section 102 Stock Option/Stock Purchase Plan, the Voltaire Ltd. 2001 Section 102 Stock Option/Stock Purchase Plan, the Voltaire Ltd. 2001 Stock Option Plan, the Kotura, Inc. Second Amended and Restated 2003 Stock Plan, the IPtronics, Inc. 2013 Restricted Stock Unit Plan, the Global Share Incentive Assumption Plan (2010), the EZchip Semiconductor Ltd. 2003 Amended and Restated Equity Incentive Plan, the EZchip Semiconductor Ltd. 2007 U.S. Equity Incentive Plan, and the Amended and Restated EZchip Semiconductor Ltd. 2009 Equity Incentive Plan (collectively, the "Prior Plans").
As of the Effective Date of the First Restated 2006 Plan, the Company ceased granting awards under the Prior Plans, and began granting new awards only from the First Restated 2006 Plan. Any shares subject to issued and outstanding awards under the Prior Plans that expire, are canceled or otherwise terminate after the Effective Date of the First Restated 2006 Plan will be added back to share reserves under the First Restated 2006 Plan. The share reserve of the 2006 Plan is no longer available for issuance under the First Restated 2006 Plan. In addition, the First Restated 2006 Plan implemented additional amendments to reflect compensation and governance best practices.
On April 25, 2017, the Company's shareholders approved the Mellanox Technologies, Ltd. Second Amended and Restated Global Share Incentive Plan (2006) (the “Second Restated 2006 Plan”), which constituted a second amendment and restatement of the 2006 Plan, as amended and restated by the First Restated 2006 Plan. The Second Restated 2006 Plan became effective on February 14, 2017. The Second Restated 2006 Plan increased the ordinary shares reserved for issuance under the First Restated 2006 Plan by 1,640,000 shares to 2,390,000 shares plus any shares subject to issued and outstanding awards under the other equity incentive plans that existed prior to the First Restated 2006 Plan that expire, are cancelled or otherwise terminated after the effective date of the First Restated 2006 Plan. The Second Restated Plan also extended the term of the First Restated 2006 Plan to February 14, 2027. In addition, the Second Restated Plan implemented additional amendments to reflect compensation and governance best practices.
On July 25, 2018, the Company's shareholders approved the Mellanox Technologies, Ltd. Third Amended and Restated Global Share Incentive Plan (2006) (the “Third Restated Plan”), which constituted an amendment and restatement of the Second Restated 2006 Plan. The Third Restated Plan increased the ordinary shares reserved for issuance under the Second Restated 2006 Plan by 2,077,000 shares to 4,467,000 shares plus any shares subject to issued and outstanding awards under certain of the Company’s prior equity plans that expire, are cancelled or otherwise terminated after March 14, 2016, the effective date of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
First Restated 2006 Plan. The Third Restated Plan also implemented certain additional amendments, including specifically providing for the granting of PSUs.
On July 25, 2019, the Company's shareholders approved the Mellanox Technologies, Ltd. Fourth Amended and Restated Global Share Incentive Plan (2006) (the “Fourth Restated Plan”), which constitutes an amendment and restatement of the Third Restated Plan. The Fourth Restated Plan increased the ordinary shares reserved for issuance under the Third Restated Plan by 1,960,000 shares to 6,427,000 shares plus any shares subject to issued and outstanding awards under certain of the Company’s prior equity plans that expire, are cancelled or otherwise terminated after March 14, 2016, the effective date of the First Restated 2006 Plan. The Fourth Restated Plan also clarifies the treatment of PSU's upon the occurrence of a change in control of the Company.
Share option activity
The following table summarizes the share option activity under all equity incentive plans:
There were no options granted in 2019, 2018 and 2017.
The total pretax intrinsic value of options exercised in 2019 was $15.6 million. This intrinsic value represents the difference between the fair market value of the Company's ordinary shares on the date of exercise and the exercise price of each option. Based on the most recently available closing price of the Company's ordinary shares of $117.18 at December 31, 2019, the total pretax intrinsic value of all outstanding options was $14.7 million. The total pretax intrinsic value of exercisable options at December 31, 2019 was $14.7 million.
The total pretax intrinsic value of options exercised in 2018 was $33.5 million. Based on the most recently available closing price of the Company's ordinary shares of $92.38 prior to December 31, 2018, the total pretax intrinsic value of all outstanding options was $21.8 million. The total pretax intrinsic value of exercisable options at December 31, 2018 was $21.7 million.
The weighted average remaining contractual life of options outstanding at December 31, 2019 was 2.6 years. There were 273,963 options exercisable at December 31, 2019 with a weighted average exercise price $63.47 per share.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Restricted share unit activity
The following table summarizes the restricted share unit activity under all equity incentive plans:
The weighted average fair value of restricted share units granted was $105.42, $80.40 and $49.88 for the years ended December 31, 2019, 2018 and 2017, respectively. The total intrinsic value of all outstanding restricted share units was $388.5 million as of December 31, 2019.
The non-vested restricted share units at December 31, 2019 included 36,000 PSUs. The PSUs will vest and be earned based on the Company’s achievement of relative total shareholder return and average non-GAAP net operating margin over a three-year performance period commencing on January 1, 2018 and ending on December 31, 2020, subject to the continued service to the Company through the end of the performance period. The number of shares that will actually vest range from zero to 175% of the target.
Employee stock purchase plan activity
The ESPP is designed to allow eligible employees to purchase the Company's ordinary shares, at semi-annual intervals, with their accumulated payroll deductions. A participant may contribute up to 15% of his or her base compensation through payroll deductions, and the accumulated deductions will be applied to the purchase of shares on the purchase date, which is the last trading day of the offering period. The purchase price per share will be equal to 85% of the fair market value per share on the start date of the offering period in which the participant is enrolled or, if lower, 85% of the fair market value per share on the purchase date. No participant in the ESPP may be issued or transferred more than $25,000 worth of ordinary shares pursuant to purchase rights under the ESPP per calendar year. During the years ended December 31, 2019, 2018 and 2017, 309,723, 490,123, and 568,876 shares, respectively, were issued under the ESPP at weighted average per share prices of $78.92, $46.62 and $38.83, respectively.
Shares reserved for future issuance
The Company had the following ordinary shares reserved for future issuance under its equity incentive plans as of December 31, 2019:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Share-based compensation
The Company accounts for share-based compensation expense for share option awards and ESPP based on the estimated fair value of the instruments as of the grant dates. There were no employee share options granted in 2019, 2018 and 2017. The following weighted average assumptions were used in the valuation of the ESPP for the years ended December 31, 2019, 2018 and 2017:
The following table summarizes the distribution of total share-based compensation expense in the Consolidated Statements of Operations:
At December 31, 2019, there was $235.4 million of total unrecognized share-based compensation costs related to non-vested share-based compensation arrangements. The costs are expected to be recognized over a weighted average period of approximately 2.69 years.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 11-ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):
The following table summarizes the changes in accumulated other comprehensive income (loss) for the years ended December 31, 2019 and 2018:
The following table provides details about the realized (gains)/losses reclassified from accumulated other comprehensive income for the years ended December 31, 2019 and 2018:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 12-INCOME TAXES:
The components of income (loss) before taxes on income are as follows:
The components of the provision for (benefit from) income taxes are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
At December 31, 2019 and 2018, significant deferred tax assets and liabilities are as follows:
The Company records net deferred tax assets to the extent it believes these assets will more likely than not be realized. As of each reporting date, management considers new evidence, both positive and negative, that could impact management’s view with regards to the future realization of deferred tax assets for each jurisdiction. During the year ended December 31, 2018, the Company released $32.1 million of valuation allowance against the deferred tax assets primarily related to NOL carryforwards and tax credit carryforwards related to its U.S. subsidiaries. After the discontinuation of the Company’s 1550nm silicon photonics development activities in the first quarter of fiscal 2018, the Company expects its U.S. subsidiaries will have sufficient taxable income in the future to utilize the deferred tax assets before they expire. The Company continued to provide a valuation allowance against the deferred tax assets related to capital loss carryforwards on the consolidated balance sheet as of December 31, 2019 due to uncertainty concerning realization of these deferred tax assets.
At December 31, 2019, the Company had NOL carryforwards of approximately $138.4 million in Israel, $56.5 million in the U.S. for federal tax purposes, $46.2 million in the U.S. for state tax purposes and $5.7 million in Denmark. The U.S. NOL carryforwards for federal tax purposes will expire from 2024 to 2037, and the U.S. NOL carryforwards for state tax purposes will expire from 2020 to 2037. The non-U.S. NOL carryforwards have no expiration date.
The Company has not provided for Israeli income and foreign withholding taxes on $40.4 million of its non-Israeli subsidiaries' undistributed earnings as of December 31, 2019. The Company currently has no plans to repatriate those funds and intends to indefinitely reinvest them in its non-Israeli operations. The amount of the unrecognized deferred tax liability for temporary differences related to investments in non-Israeli subsidiaries that were essentially permanent in duration as of December 31, 2019 was $9.3 million.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The reconciliation of the statutory federal income tax rate to the Company's effective tax rate is as follows:
The Company's operations in Israel were granted "Approved Enterprise" status by the Investment Center in the Israeli Ministry of Economy and Industry (formerly, the Ministry of Industry Trade and Labor) and "Beneficiary Enterprise" status from the Israeli Income Tax Authority, which makes the Company eligible for tax benefits under the Encouragement Law. Under the terms of the Approved and Beneficiary Enterprise programs, income that is attributable to the Company's operations in Yokneam, Israel, is exempt from income tax commencing fiscal year 2011 through 2021. Income that is attributable to the Company's operations in Tel Aviv, Israel is subject to a reduced income tax rate (generally between 10% and the current corporate tax rate, depending on the percentage of foreign investment in the Company) commencing fiscal year 2013 through 2021. The tax holiday has resulted in a cash tax savings of approximately $53.7 million, $27.9 million and $11.6 million in 2019, 2018, and 2017, respectively, increasing diluted earnings per share by approximately $0.95, $0.49 and $0.23 in the years ended December 31, 2019, 2018, and 2017, respectively.
The following summarizes the activity related to the Company's unrecognized tax benefits:
As of December 31, 2019, 2018 and 2017, the total amount of gross unrecognized tax benefits was $55.5 million, $46.5 million, and $45.2 million, respectively. Of these amounts as of December 31, 2019, 2018 and 2017, $28.6 million, $25.7 million, and $24.6 million, respectively, would reduce our income tax expense and effective tax rate, if recognized.
It is the Company's policy to classify accrued interest and penalties as part of the accrued unrecognized tax benefits liability and record the expense in the provision for income taxes. As of December 31, 2019, 2018 and 2017, the amount of accrued interest and penalties related to unrecognized tax benefits totaled $2.5 million, $2.6 million, and $2.9 million, respectively, which is not included in the table above. For unrecognized tax benefits that existed at December 31, 2019, the Company does not anticipate any significant changes within the next twelve months.
On December 29, 2016, the Israeli government amended the Encouragement Law and legislated a new tax regime - "Preferred Technological Enterprise" regime, under which a company that complies with the terms may be entitled to certain tax benefits. On June 14, 2017, the Israeli government legislated new regulations, stipulating the calculation method of the tax benefits under the Preferred Technological Enterprise regime. The Company expects that its operation in Israel will comply with the terms of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Preferred Technological Enterprise regime. Therefore, the Company may utilize the tax benefits under this regime after the end of the benefit period of its Approved and Beneficiary Enterprise statuses (i.e., prior to fiscal year 2022, based on the Company’s decision, and for fiscal year 2022 and onwards). Under the new legislation, the majority of the Company’s income from its operations in Yokneam, Israel, will be subject to a corporate rate of 7.5%, while the majority of the income from its operations in Tel-Aviv, Israel, will be subject to a corporate rate of 12%. As a result of the lower tax rates mentioned above, the Company recorded a decrease of approximately $0.2 million in deferred tax assets and a corresponding increase in tax expense during the second quarter of 2017.
As a multinational corporation, the Company conducts business in many countries and is subject to taxation in many jurisdictions. The taxation of the Company's business is subject to the application of multiple and sometimes conflicting tax laws and regulations as well as multinational tax conventions. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation and the evolution of regulations and court rulings. Consequently, taxing authorities may impose tax assessments or judgments against the Company that could materially impact its tax liability and/or its effective income tax rate. As of December 31, 2019, the 2015 through 2018 tax years are open and may be subject to potential examinations in the U.S. The Company has net operating losses in the U.S. from prior tax periods beginning in 2003 which may be subject to examination upon utilization in future tax periods. As of December 31, 2019, the 2014 through 2018 tax years are open and may be subject to potential examinations in Denmark, and the 2015 through 2018 tax years are open and may be subject to potential examinations in Israel. As of December 31, 2019, the income tax returns of the Company and one of its subsidiaries in Israel are under examination by the Israeli Tax Authority for certain years from 2015 to 2018.
NOTE 13-GEOGRAPHIC INFORMATION:
The Company operates in one reportable segment, the development, manufacturing, marketing and sales of interconnect products. The Company's chief operating decision maker is the chief executive officer. Since the Company operates in one segment, all financial segment information can be found in the accompanying Consolidated Financial Statements.
Revenues by geographic region are as follows:
Revenues are attributed to countries based on the geographic location of the customers. Intercompany sales between geographic areas have been eliminated.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Property and equipment, net by geographic location are as follows:
Property and equipment, net is attributed to the geographic location in which it is located.
NOTE 14-INTEREST AND OTHER, NET:
Interest and other, net, is summarized in the following table:
NOTE 15-LEASES:
On January 1, 2019, the Company adopted Topic 842 and elected the available transition-related practical expedient to recognize the cumulative effect of initially adopting Topic 842 as an adjustment to the opening balance sheet in the period of adoption. In addition, the Company elected to not reassess whether contracts are or contain leases, lease classification, or initial direct costs for existing leases as of January 1, 2019. The Company also elected other available practical expedients for existing leases at adoption and new leases post-adoption, and will not record leases with an initial term of 12 months or less on the balance sheet and will not separate lease components from non-lease components. Only the minimum lease payments in accordance with Topic 840 were included in the calculation of the ROU and liability for existing leases as of January 1, 2019. The consolidated balance sheets and results of operations for reporting periods beginning after January 1, 2019 are presented under Topic 842, while prior period amounts are not adjusted and continue to be reported in accordance with the historic accounting under Topic 840.
The Company's leases include office buildings for its facilities worldwide and car leases in Israel, which are all classified as operating leases. Certain lease agreements include rental payments that are adjusted periodically for the consumer price index ("CPI"). The ROU and lease liability were calculated using the CPI as of the adoption date and will not be subsequently adjusted. Certain leases include renewal options that are under the Company's sole discretion. The renewal options were included in the ROU and liability calculation if it was reasonably assured that the Company will exercise the option.
The cumulative effect of the changes made to the consolidated balance sheet as of January 1, 2019 for the adoption of Topic 842 were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The components of lease expense and supplemental cash flow information related to leases for the year ended December 31, 2019 were as follows:
For the year ended December 31, 2019, the weighted average remaining lease term is 6.8 years, and the weighted average discount rate is 3.01 percent. The discount rate was determined based on the estimated collateralized borrowing rate of the Company, adjusted to the specific lease term and location of each lease.
Maturities of lease liabilities as of December 31, 2019 were as follows:
(1) Future lease payments have not been reduced by minimum sublease rental income of $3.6 million owed to the Company in the future under noncancelable subleases.
The lease liabilities as of December 31, 2019 do not include the obligations under a lease agreement related to an office being built in Tel Aviv, Israel. The Company is not involved in the construction and will not be exposed to any risks during the construction period. The lease term expires 10 years after the expected lease inception. In addition, the lease contains a renewal option, which the Company determined is not reasonably assured to be exercised. As of December 31, 2019, the estimated total future lease obligation was approximately $31.8 million.
NOTE 16-RESTRUCTURING AND IMPAIRMENT CHARGES:
While performing the review for impairment for the fourth quarter of 2017, the Company noted an impairment indicator associated with the potential sale or discontinuation of the 1550nm silicon photonics line of business. As a result, the Company recorded $12.0 million of impairment charges for the year ended December 31, 2017, of which $7.7 million was related to property and equipment and $4.3 million was related to intangible assets.
The impairment charges were calculated based on the differences between the net book values of the related assets and their estimated fair values. The Company primarily used the market approach to determine the estimated fair values of the property and equipment. Under this approach we considered various factors, including secondary market comparables, replacement costs, age
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
and condition of the assets and estimated selling costs. The impaired intangible assets represent obsolete technologies that were deemed to have no value, and therefore were fully written off.
In connection with the discontinuation of its 1550nm silicon photonics development activities, the Company initiated a restructuring plan in the first quarter of 2018 to wind down the business operations related to these activities, which primarily included terminating employees, exiting contracts with vendors, selling assets, and exiting facilities. The Company recorded $3.5 million, $3.4 million, and $2.4 million of employee separation and severance costs, contract exit costs, and impairment charges and losses on disposal of assets, respectively, during the year ended December 31, 2018.
There was also a $0.9 million impairment charge on fixed assets not related to the discontinuation of the 1550nm silicon photonics development activities recorded during the year ended December 31, 2018.
During the year ended December 31, 2019, the Company recorded impairment charges and a net loss on disposal of assets of $1.5 million. The Company does not expect any significant restructuring charges in the future.
NOTE 17-RELATED PARTY TRANSACTIONS:
On June 19, 2018, the Company entered into a settlement agreement (the “Settlement Agreement”) with Starboard Value LP and certain of its affiliates (“Starboard”), together holding, on such date, approximately 10.3% of the Company’s outstanding ordinary shares. The Settlement Agreement provided for, among other things, the concurrent resignations of three members of the Company’s Board of Directors (the “Board”) and the concurrent appointment of two independent directors nominated by Starboard and one mutually agreed upon independent nominee to the Board. Starboard also agreed to terminate its proxy contest against the Company and withdraw its notice of shareholder nomination of individuals for election as directors at the Company's 2018 annual general meeting of shareholders. Furthermore, the Company agreed to reimburse Starboard for its reasonable, documented out-of-pocket fees and expenses (including legal expenses) incurred through the date of the Settlement Agreement in connection with Starboard’s interactions with the Company up to a maximum of $2.0 million. On July 11, 2018, the Company paid $2.0 million for such costs to Starboard.
During the year ended December 31, 2019, Starboard sold all its holdings in the Company, and is no longer a related party.
SCHEDULE II-CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
MELLANOX TECHNOLOGIES, LTD.
ITEM 16 - FORM 10-K SUMMARY
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Mellanox Technologies, Ltd. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on February 20, 2020.
MELLANOX TECHNOLOGIES, LTD.
By:
/s/ EYAL WALDMAN
Eyal Waldman
President and Chief Executive Officer
KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Eyal Waldman and Doug Ahrens, and each of them, his or her attorneys-in-fact and agents, each with the power of substitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the U.S. Securities and Exchange Commission, hereby ratifying and confirming all that said attorneys-in-fact, or his or her or their substitute or substitutes, may do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.