Since the beginning of our last fiscal year, there has not been, nor is there currently proposed, any transaction or by emailing us at: ir@mellanox.com. All these documents and filingsseries of similar transactions to which we were or are available free of charge. Please note that information contained on our website is not incorporated by reference in, or considered to be a part of, this report. Further, a copy of this report on Form 10-K is located atparty in which the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxyamount involved exceeds $120,000 and information statements and other information regarding our filings at www.sec.gov.
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 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.
Leverage incurred in connection with our acquisition of EZchip in February 2016 could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent the interest rate on our variable rate debt increases and prevent us from meeting our obligations under the terms of the Term Debt.
As a result of the acquisition of EZchip and the related Term Debt, we have become leveraged. As of December 31, 2017, we had $74.0 million outstanding principal under the Term Debt. Our indebtedness could have more important consequences, including:
increasing our vulnerability to adverse general economic and industry conditions;
requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, research and development efforts, the execution of our business strategy, acquisitions and other general corporate purposes;
•limiting our flexibility in planning for, or reacting to, changes in the economy and the semiconductor industry;
•placing us at a competitive disadvantage compared to our competitors with less indebtedness;
•exposing us to interest rate risk to the extent of our variable rate indebtedness; and
making it more difficult to borrow additional funds in the future to fund growth, acquisitions, working capital, capital expenditures and other purposes.
The Term Debt requires payment of principal and accrued interest during the three years after the closing of the acquisition of EZchip. In addition, if we were to experience a change of control, this would trigger an event of default under the Term Debt, which would permit the lenders to immediately declare the loans due and payable in whole or in part. In either such event, we may not have sufficient available cash to repay such debt at the time it becomes due, or be able to refinance such debt on acceptable terms or at all. Any of the foregoing could materially and adversely affect our business, financial condition and results of operations.
Our Term Debt imposes certain restrictions on our business.
The Term Debt contains a number of covenants imposing certain restrictions on our business. These restrictions may affect our ability to operate our business and to take advantage of potential business opportunities as they arise. The restrictions placed on us include limitations on our ability to:
•incur additional indebtedness and issue preferred or redeemable shares;
•incur or create liens;
•consolidate, merge or transfer all or substantially all of our assets;
•make investments, acquisitions, loans or advances or guarantee indebtedness;
•engage in sale and lease back transactions;
•pay dividends or make other distributions;
•redeem or repurchase shares or make other restricted payments; and
•engage in transactions with affiliates.
The foregoing restrictions could limit our ability to plan for, or react to, changes in market conditions or our capital needs. We do not know whether we will be granted waivers under, or amendments to, the Term Debt if for any reason we are unable to meet these requirements, or whether we will be able to refinance our indebtedness on terms acceptable to us, or at all.
The breach of any of these covenants or restrictions could result in a default under the Term Debt. In addition, the Term Debt contains cross-default provisions that could result in an acceleration of amounts outstanding under the Term Debt if certain events of default occur under any of our material debt instruments. If we are unable to repay these amounts, lenders having secured obligations, including the lenders under the Term Debt, could proceed against the collateral securing that debt. Anydirectors, executive officers, holders of the foregoing would have a material adverse effect on our business, financial condition, and results of operations.
Servicing the debt incurred under the Term Debt will require a significant amount of cash, and we may not have sufficient cash flow from our business to pay our debt.
Our ability to make scheduled payments of the principal of, to pay interest on, and to refinance our debt, depends on our future performance, which is subject to economic, financial, competitive, and other factors beyond our control. Our business may not continue to generate cash flow from operations in the future sufficient to satisfy our obligations under the Term Debt and any future indebtedness we may incur and to make necessary capital expenditures. If we are unable to generate such cash flow, we may be required to adopt one or more alternatives, such as reducing or delaying investments or capital expenditures, selling assets, refinancing or obtaining additional equity capital on terms that may be onerous or highly dilutive. Our ability to refinance our outstanding indebtedness or future indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, when needed, which could result in a default on our indebtedness.
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. 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:
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;
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;
possible disruption to the continued expansion of our product lines;
potential changes in our customer base and changes to the total available market for our products;
reduced demand for our products;
potential difficulties in completing projects associated with in-process research and development intangibles;
the use of a substantial portion of our cash resources and incurrence of significant amounts of debt;
significantly increase our interest expense, leverage and debt service requirements as a result of incurring debt;
the impact of any such acquisition on our financial results;
internal controls may become more complex and may require significantly more resources to ensure they remain effective;
negative customer reaction to any such acquisition; and
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.
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 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. 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.
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.
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:
reduced control over product cost, delivery schedules and product quality;
potential price increases;
inability to achieve sufficient production, increase production or test capacity and achieve acceptable yields on a timely basis;
increased exposure to potential misappropriation of our intellectual property;
shortages of materials used to manufacture products;
capacity shortages;
labor shortages or labor strikes;
political instability in the regions where these subcontractors are located; and
natural disasters impacting these subcontractors.
See Part I, Item 1, "Business-Manufacturing” for more information about our subcontractors.
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.
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, 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 price5% of our ordinary shares to decline.
Our quarterly and annual revenues and operating results are difficult to predict and have fluctuated inor any members of 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:
unpredictable volume and timing of customer orders, which are not fixed by contract but vary on a purchase order basis;
the loss of one or more of our customers, or a significant reduction or postponement of orders from our customers;
our customers' sales outlooks, purchasing patterns and inventory levels based on end-user demands and general economic conditions;
seasonal buying trends;
the timing of new product announcements or introductions by us or by our competitors;
our ability to successfully develop, introduce and sell new or enhanced products in a timely manner;
changes in the relative sales mix of our products;
decreases in the overall average selling prices of our products;
changes in the cost of our finished goods; and
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 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 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:
people may not be deterred from misappropriating our technologies despite the existence of laws or contracts prohibiting it;
policing unauthorized use of our intellectual property may be difficult, expensive and time-consuming, and we may be unable to determine the extentimmediate family of any unauthorized use; and
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,foregoing persons, had 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.
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 analyses. We are involved in intellectual property litigation today and 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, CFO 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 and RSUs 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 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:
manage and enhance our relationships with customers, distributors, suppliers, end users and other third parties;
implement additional, and enhance existing, administrative, financial and operations systems, procedures and controls;
address capacity shortages;
expand and upgrade our technological capabilities;
manage the challenges of having U.S., Israeli and other foreign operations; and
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. Price adjustments may be effected by way of credits for future product or by cash payments to the distributor, either in arrears or in advance, using estimates based on historical transactions. Currently we recognize 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 will recognize 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. 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 reserves recognized for these programs 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.
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. Our reserve estimates associated with products stocked by our distributors are based largely on reports that our distributors provide to us on a weekly or monthly basis. To date, we believe this resale and channel inventory data have been generally accurate. To the extent that these data are inaccurate or not received in a timely manner, we may not be able to make reserve estimates for future periods accurately or at all.
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 orindirect material changes may be made to any 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.interest.
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 usaudit committee, pursuant to modify our manufacturing specifications,its written charter 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 dependsis available on our manufacturers' ability to implement our revised product specifications, whichwebsite as described below, is costly, time-consumingresponsible for reviewing and, complex.
We have significant intangible assets and goodwill. Consequently,where required, approving related party transactions on an ongoing basis as required by 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, 2017, we had recorded $700.6 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 amountrules 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. The U.S. recently enacted significant tax reform, and certain provisions of the new law may adversely affect us. See Note 12 to the consolidated financial statements for more details about the U.S. tax reform and its effects.
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,SEC and the
complexityCompanies Law and the regulations promulgated thereunder. For purposes of
global tax and transfer pricingcompliance with U.S. rules and regulations,
itthe audit committee conducts an appropriate review and oversight of all “related party transactions
,” as required to be disclosed pursuant to Item 404 of RegulationS-K
under the Exchange Act, for potential conflict of interest situations on an ongoing basis. The Company follows internal written procedures to review potential related party transactions, bring these potential related party transactions to the attention of the audit committee and review, approve or ratify, as necessary and appropriate, related party transactions. Under the Companies Law, our audit committee must also approve specified actions and transactions with office holders and controlling shareholders or in which an office holder or controlling shareholder has
become increasingly difficulta Personal Interest. The audit committee is also required to
estimate earnings within each tax jurisdiction. If actual earnings within a tax jurisdictiondetermine whether any such action is
are designed to maintain compliance, we cannot assure you that we have been or will be at all times in complete compliance withmaterial and whether any such
laws and regulations. If we violatetransaction is an extraordinary transaction 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.non-negligible
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. The implementation of 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.
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 certain areas in the Middle East, 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 62%, 55% and 54% of our revenues in the years ended December 31, 2017, 2016 and 2015, respectively, from sales outside of the United States. As a result, we face additional risks from doing business internationally, including:
reduced protection of intellectual property rights in some countries;
difficulties in staffing and managing foreign operations;
longer sales and payment cycles;
greater difficulties in collecting accounts receivable;
adverse economic conditions;
seasonal reductions in business activity;
potentially adverse tax consequences;
laws and business practices favoring local competition;
costs and difficulties of customizing products for foreign countries;
compliance with a wide variety of complex foreign laws and treaties;
compliance with the United States' Foreign Corrupt Practices Act and similar anti-bribery laws in other jurisdictions;
compliance with export control and regulations;
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;
restrictive governmental actions, such as restrictions on the transfer or repatriation of funds and foreign investments;
foreign currency exchange risks;
fluctuations in freight rates and transportation disruptions;
political and economic instability;
variance and unexpected changes in local laws and regulations;
natural disasters and public health emergencies; and
trade and travel restrictions.
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 officialtransaction, for the purpose of obtainingapproving such action or retaining businesstransaction as required by the Companies Law. Under the Companies Law, a “controlling shareholder” is a shareholder who has the ability to direct the Company’s activity, excluding an ability deriving merely from holding an office of director or another office in the Company, and from engaging in unethical business practices, including kick-backsa person will be presumed to control the Company if he or from purely private parties. However, there can be no assurance that allshe holds 50% or more of (i) our employeesvoting rights 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(ii) the rights 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, andappoint our directors
executive officers and other key employees are located primarily in Israel andor general managers. For the
United States. In addition, we engage sales representatives in various countries throughoutpurpose of “transactions with an interested party
,” 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.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. Two of our executive officers and four of our directors, one of whom isCompanies Law definition 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 forincludes 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.
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 generally 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 holdowns 25% or more of the voting rights in the company (unlessgeneral meeting of the Company, if there is already a 25% or greater shareholder of the company) orno other person who holds more than 45%50% of the voting rights in the company (unless there is already a shareholder that holdsCompany. Two or more than 45% of thepersons holding voting rights in the company). If, asCompany each of which has 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 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, even if such an acquisition would be considered beneficial by some of our shareholders.
Exchange rate fluctuations between the U.S. dollar and the NIS may negatively affect our earnings.
We derive all of our revenuesPersonal Interest 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.
The results of the United Kingdom’s referendum on 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”). In March 2017, the U.K. began the process to exit the European Union. Negotiations are in progress to determine the future terms of the U.K.’s relationship with the European Union, including, among other things, the terms of trade between the U.K. and the European Union. The effects of Brexit will depend on any agreements the U.K. reaches to retain access to European Union markets either during a transitional period or more permanently. In addition, the exit of the U.K from the European Union could lead to legal and regulatory uncertainty and potentially divergent treaties, laws and regulations as the U.K. determines which European Union treaties, laws and regulations to replace or replicate, including those governing manufacturing, labor, environmental, data protection/privacy, competition and other matters applicable to the semiconductor industry. The referendum 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.
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 Law"), 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 by the Israeli Income Tax Authority. The Company is eligible for tax benefits under the 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, 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.
If we elect to distribute dividends out of exempt income derived from "Approved/Beneficiary Enterprise" income, 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. 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 is subject to withholding tax at the source at the reduced rate applicable to dividends from Approved Enterprises, which is 15% if the dividend is distributed 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 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 several 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 National Authority for Technological Innovation, formerly known as the Office of the Chief Scientist of Israel's Ministry of Economy and Industry ("OCS") for the financing of a portion of our research and development expenditures in Israel. When know-how is developed using or in connection with OCS grants, we are subject to restrictions on the transfer of the know-how outside of Israel. Transfer of know-how outside of Israel requires pre-approval by the OCS which may at its sole discretion grant such approval and impose certain conditions, and is subject to the payment of a transfer fee calculated according to the formula provided in 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 OCS, requires us to obtain the approval of the OCS and may result in increased amounts to be paid to the OCS. These restrictions may impair our ability to enter into agreementstransaction being brought for those products or technologies without the approval of the OCS. We cannot be certain that any approval of the OCSCompany 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 OCS 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 OCS. Any approval, if given, will generally be subject to additional financial obligations. If we fail to comply with the conditions imposed by the OCS, 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.
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 continueconsidered to be volatile, and the value of an investment in our ordinary shares may decline.
During 2017, our shares traded as low as $40.70 per share and as high as $65.90 per share. Factors that could cause volatility in the market price of our ordinary shares include, but arejoint holders. The Company is not limited to:
quarterly variations in our results of operations or those of our competitors;
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;
our ability to develop and market new and enhanced products on a timely basis;
disruption to our operations;
geopolitical instability;
the emergence of new sales channels in which we are unable to compete effectively;
any major change in our board of directors or management;
changes in financial estimates, including our ability to meet our future revenue and operating profit or loss projections;
changes in governmental regulations or in the status of our regulatory approvals;
general economic conditions and slow or negative growth of related markets;
anticompetitive practices of our competitors;
commencement of, or our involvement in, litigation;
whether our operating results meet our guidance or the expectations of investors or securities analysts;
continuing international conflicts and acts of terrorism; and
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. 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, ordinary shareholders 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, our ordinary shareholders would experience immediate dilution upon the purchasecurrently aware 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.
The ownership of our ordinary shares may continue to be concentrated, and certain shareholders may have significant influence over the outcome of corporate actions requiringcontrolling shareholder, approval.
As of December 31, 2017, based on information filed with the SEC or reported to us, Starboard Value LP beneficially owned an aggregate of approximately 10.7% of our outstanding ordinary shares, Capital Research Global Investors beneficially owned an aggregate of approximately 5.9% of our outstanding ordinary shares, FMR, LLC beneficially owned an aggregate of approximately 5.5% of our outstanding ordinary shares, and DNB Asset Management AS owned an aggregate of approximately 5.4% of our outstanding ordinary shares. These shareholders and any other shareholders acquiring beneficial ownership of a significant amount of our outstanding ordinary shares may have significant influence over the outcome of corporate actions requiring shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction.
Our business could be negatively affected as a result of a proxy contest.
On January 17, 2018, Starboard Value and Opportunity Master Fund Ltd delivered a letter to us notifying us of its intention to nominate director candidates for election to our board of directors at our 2018 Annual General Meeting of Shareholders and solicit proxies from stockholders in support of its nominees. Responding to any proxy contest may be disruptive and costly for our business.
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. 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 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:
no cumulative voting;
a requirement for any merger involving the Company shall require the approval of the shareholders of at least a majority of the voting power of the Company;
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
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 Tax Authority, Israeli tax law generally provides that a shareholder who exchanges our shares for shares that are listed for trading on an 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. 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 the Board 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. 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—UNRESOLVED STAFF COMMENTS
None.
ITEM 2—PROPERTIES
As of December 31, 2017, our major facilities consisted of:
|
| | | | | | | |
| Israel | | United States | | Other | | Total |
Leased facilities (in thousands of square feet) | 1,002 | | 120 | | 63 | | 1,185 |
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—LEGAL PROCEEDINGS
See Note 9 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—MINE SAFETY DISCLOSURES
Not applicable.
PART II
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.
The following table summarizes the high and low sales prices for our ordinary shares as reported by The NASDAQ Global Select Market.
|
| | | | | | | |
2017 | High | | Low |
First quarter | $ | 52.80 |
| | $ | 40.70 |
|
Second quarter | $ | 52.65 |
| | $ | 41.55 |
|
Third quarter | $ | 47.95 |
| | $ | 42.05 |
|
Fourth quarter | $ | 65.90 |
| | $ | 42.25 |
|
| | | |
2016 | High | | Low |
First quarter | $ | 55.80 |
| | $ | 37.54 |
|
Second quarter | $ | 55.45 |
| | $ | 40.54 |
|
Third quarter | $ | 52.15 |
| | $ | 39.53 |
|
Fourth quarter | $ | 46.20 |
| | $ | 38.75 |
|
As of February 10, 2018, we had approximately 232 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, 2012 and ends on December 31, 2017, the end date of our last fiscal year. The graph assumes an investment of $100 on December 31, 2012, 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.
|
| | | | | | | | | | | | | | | | | |
| 12/31/2012 * |
| | 12/31/2013 |
| | 12/31/2014 |
| | 12/31/2015 |
| | 12/31/2016 |
| | 12/31/2017 |
|
Mellanox Technologies | 100.00 |
| | 67.31 |
| | 71.96 |
| | 70.97 |
| | 68.88 |
| | 108.96 |
|
NASDAQ Composite Index | 100.00 |
| | 138.32 |
| | 156.85 |
| | 165.84 |
| | 178.28 |
| | 228.63 |
|
Philadelphia Semiconductor Index | 100.00 |
| | 139.31 |
| | 178.84 |
| | 172.75 |
| | 236.02 |
| | 326.26 |
|
* $100 invested on December 31, 2012 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 income derived from "Approved 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 to the consolidated financial statements.
Recent Sales of Unregistered Securities
None.
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, 2015, 2014, and 2013 and our consolidated statements of operations data for the years ended December 31, 2014 and 2013, 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, 2017, as well the consolidated balance sheet data as of December 31, 2017 and 2016, 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.
|
| | | | | | | | | | | | | | | | | | | |
| Year ended December 31, |
| 2017 | | 2016 (1) | | 2015 | | 2014 | | 2013 |
| (In thousands, except per share data) |
Consolidated Statement of Operations Data: | | |
| | |
| | |
|
Total revenues | $ | 863,893 |
| | $ | 857,498 |
| | $ | 658,140 |
| | $ | 463,649 |
| | $ | 390,436 |
|
Cost of revenues | 300,450 |
| | 301,986 |
| | 189,209 |
| | 148,672 |
| | 134,282 |
|
Gross profit | 563,443 |
| | 555,512 |
| | 468,931 |
| | 314,977 |
| | 256,154 |
|
Operating expenses: | | | | | |
| | |
| | |
|
Research and development | 365,878 |
| | 322,620 |
| | 252,175 |
| | 208,877 |
| | 169,382 |
|
Sales and marketing | 150,457 |
| | 133,780 |
| | 97,438 |
| | 76,860 |
| | 70,544 |
|
General and administrative | 52,170 |
| | 68,522 |
| | 44,212 |
| | 36,431 |
| | 37,046 |
|
Impairment of long-lived assets | 12,019 |
| | — |
| | — |
| | — |
| | — |
|
Total operating expenses | 580,524 |
| | 524,922 |
| | 393,825 |
| | 322,168 |
| | 276,972 |
|
Income (loss) from operations | (17,081 | ) | | 30,590 |
| | 75,106 |
| | (7,191 | ) | | (20,818 | ) |
Interest expense | (7,937 | ) | | (7,352 | ) | | — |
| | — |
| | — |
|
Other income (loss), net | 3,115 |
| | 1,090 |
| | (524 | ) | | 1,449 |
| | 1,228 |
|
Interest and other, net | (4,822 | ) | | (6,262 | ) | | (524 | ) | | 1,449 |
| | 1,228 |
|
Income (loss) before taxes on income | (21,903 | ) | | 24,328 |
| | 74,582 |
| | (5,742 | ) | | (19,590 | ) |
Provision for (benefit from) taxes on income | (2,478 | ) | | 5,810 |
| | (18,312 | ) | | 18,267 |
| | 3,752 |
|
Net income (loss) | $ | (19,425 | ) | | $ | 18,518 |
| | $ | 92,894 |
| | $ | (24,009 | ) | | $ | (23,342 | ) |
Net income (loss) per share — basic | $ | (0.39 | ) | | $ | 0.38 |
| | $ | 2.00 |
| | $ | (0.54 | ) | | $ | (0.54 | ) |
Net income (loss) per share — diluted | $ | (0.39 | ) | | $ | 0.37 |
| | $ | 1.94 |
| | $ | (0.54 | ) | | $ | (0.54 | ) |
Shares used in computing net income (loss) per share: | | | | | | | | | |
Basic | 50,310 |
| | 48,145 |
| | 46,365 |
| | 44,831 |
| | 43,421 |
|
Diluted | 50,310 |
| | 49,526 |
| | 47,778 |
| | 44,831 |
| | 43,421 |
|
|
| | | | | | | | | | | | | | | | | | | |
| December 31, |
| 2017 | | 2016 (1) | | 2015 | | 2014 (2) | | 2013 (2) |
| (In thousands) |
Consolidated Balance Sheet Data: | | | | | |
| | |
| | |
|
Cash and cash equivalents | $ | 62,473 |
| | $ | 56,780 |
| | $ | 263,199 |
| | $ | 51,326 |
| | $ | 63,164 |
|
Short-term investments | 211,281 |
| | 271,661 |
| | 247,314 |
| | 334,038 |
| | 263,528 |
|
Working capital | 310,286 |
| | 340,511 |
| | 540,108 |
| | 396,591 |
| | 344,825 |
|
Long-term assets | 895,015 |
| | 920,427 |
| | 376,144 |
| | 348,982 |
| | 363,939 |
|
Total assets | 1,401,934 |
| | 1,473,505 |
| | 1,053,382 |
| | 863,218 |
| | 806,826 |
|
Current liabilities | 196,633 |
| | 212,567 |
| | 137,130 |
| | 117,645 |
| | 98,062 |
|
Long-term liabilities | 147,853 |
| | 285,208 |
| | 49,571 |
| | 43,821 |
| | 41,953 |
|
Total liabilities | 344,486 |
| | 497,775 |
| | 186,701 |
| | 161,466 |
| | 140,015 |
|
Total shareholders' equity | $ | 1,057,448 |
| | $ | 975,730 |
| | $ | 866,681 |
| | $ | 701,752 |
| | $ | 666,811 |
|
(1) 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.
(2) In November 2015, the Financial Accounting Standards Board issued guidance requiring current deferred tax assets, current deferred tax liabilities and related current valuation allowances to be reclassified as non-current. As a result of adoption of this guidance, we made the following adjustments to selected consolidated financial data:
|
| | | | | | | |
| Year ended December 31, |
| 2014 | | 2013 |
| (in thousands) |
Working capital decrease | $ | (2,271 | ) | | $ | (7,336 | ) |
Long-term assets increase | 2,271 |
| | 7,336 |
|
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, 2017, 2016 and 2015 were $863.9 million, $857.5 million, and $658.1 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.
EZchip Acquisition
On February 23, 2016, we completed our acquisition of EZchip, a public company formed under the laws of the State of Israel, at which time EZchip became our wholly owned subsidiary. Under the terms of the Merger Agreement, the net cash purchase price of $693.7 million consisted of a $781.2 million cash payment for all outstanding common shares of EZchip at the price of $25.50 per share, net of $87.5 million of cash acquired. We also assumed 891,822 EZchip RSUs and converted them to 499,894 equivalent Mellanox RSU awards. The fair value of the converted RSUs was determined based on the per share value of the underlying Mellanox ordinary shares of $46.40 per share as of the acquisition date. The 499,894 RSUs had a total aggregate value of $23.2 million, of which $1.0 million was recorded as a component of the purchase price for service rendered prior to the acquisition date and $22.2 million will be recognized as share-based compensation expense over the remaining required service period of up to 2.25 years from the acquisition date.
In connection with the acquisition, we entered into a $280.0 million variable interest rate Term Debt maturing February 21, 2019. For additional information on the Term Debt, see Note 15 to the consolidated financial statements.
We accounted for the transaction using the acquisition method, which requires, among other things, that the assets acquired and liabilities assumed in a business combination be recognized at their respective fair values as of the acquisition date.
Acquisition-related expenses for the EZchip acquisition for the years ended December 31, 2017 and 2016 were $0.3 million and $8.3 million, respectively, and primarily consisted of investment banking, consulting, and other professional fees.
Amortization of Intangible Assets from Acquisitions
Intangible assets from acquisitions subject to amortization are comprised of trade names, customer relationships, backlog, and developed technology. In connection with the EZchip acquisition, we recognized $254.5 million of finite-lived intangible assets subject to amortization over their useful lives of 1 to 9 years. Amortization of intangible assets, including acquired intangible assets, was $61.3 million, $59.2 million and $10.1 million for the years ended December 31, 2017, 2016 and 2015, respectively. The increased amortization is primarily associated with the EZchip acquisition. For additional information about intangible assets from acquisitions, see Note 6 to the consolidated financial statements.
Patent Settlement
On March 7, 2016, we entered into a settlement and patent license agreement that resolved all litigation matters between Avago (now Broadcom), IPtronics, Inc., IPtronics A/S (now Mellanox Technologies Denmark Aps) and Mellanox. Under the settlement, both parties agreed not to sue each other for a period of 5 years. The settlement was deemed not contributory to our operations or products sold. As a result, we recorded a settlement expense in our operating expenses in the amount of $5.1 million in our first quarter ended March 31, 2016.
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 56%, 55% and 57% of our total revenues for the years ended December 31, 2017, 2016 and 2015, respectively. Sales to customers representing 10% or more of revenues accounted for 24%, 16% and 14% of our total revenues for the years ended December 31, 2017, 2016 and 2015, 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 eight to ten weeks, lead times for delivery from our cable and transceiver manufacturing subcontractor are approximately ten to twelve weeks, and lead times for delivery from our switch systems manufacturing subcontractors are approximately twelve 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.
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.
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.
Taxes on Income
On December 22, 2017, the Tax Cuts and Jobs Acts was enacted into law. The new legislation contains several key tax provisions that will impact us. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, a one-time repatriation tax on accumulated foreign earnings, a limitation on the tax deductibility of interest expense, an acceleration of business asset expensing, and a reduction in the amount of executive pay that could qualify as a tax deduction. The lower corporate income tax rate will require us to remeasure our U.S. deferred tax assets and liabilities as well as reassess the realizability of our deferred tax assets and liabilities. ASC 740 requires us to recognize the effect of the tax law changes in the period of enactment. However, the SEC staff has issued SAB 118 which will allow us to record provisional amounts during a measurement period.
We have concluded that a reasonable estimate could be developed for the effects of the tax reform. However, due to the short time frame between the enactment of the reform and the year end, its fundamental changes, the accounting complexity, and the expected ongoing guidance and accounting interpretations over the next 12 months, we consider the accounting of the deferred tax remeasurement and other items to be incomplete. These effects have been included in the consolidated financial statements for the year ended December 31, 2017 as provisional amounts, which had no effect on the benefit from taxes on income due to the valuation allowance.
During the measurement period, we might need to reflect adjustments to the provisional amounts upon obtaining, preparing, or analyzing additional information about facts and circumstances that existed as of the enactment date that, if known, would have affected the income tax effects initially reported as provisional amounts.
The measurement period will end when we obtain, prepare, and analyze the information needed in order to complete the accounting requirements under ASC Topic 740 or on December 22, 2018, whichever is earlier. We expect to complete our analysis within the measurement period in accordance with SAB 118.
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 Israeli Law for Encouragement of Capital Investments, 1959. 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.
On January 4, 2016 the Israeli Government legislated a reduction in corporate income tax rates from 26.5% to 25.0%, effective in 2016. On December 29, 2016, the Israeli Government legislated a reduction in corporate income tax rates from 25.0% to 24.0% in 2017 and to 23.0% in 2018 and thereafter.
On June 14, 2017, the Israeli government legislated new regulations regarding 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 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. from fiscal year 2022 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 to the consolidated financial statements.
Revenue recognition
We recognize revenue from the sales of products when all of the following criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the price is fixed or determinable; and (4) collection is reasonably assured. We use a binding purchase order or a signed agreement as evidence of an arrangement. Delivery occurs when goods are shipped and title and risk of loss transfer to the customer. Our standard arrangement with our customers typically includes freight-on-board shipping point, no right of return and no customer acceptance provisions. The revenues from fixed-price support or maintenance contracts, including extended warranty contracts and software post-contract customer support agreements, are recognized ratably over the contract period and the costs associated with these contracts are recognized as incurred. The customer's obligation to pay and the payment terms are set at the time of shipment and are not dependent on the subsequent resale of the product. The Company determines whether collectability is reasonably assured on a customer-by-customer basis. We determine whether collectability is reasonably assured on a customer-by-customer basis. When assessing the probability of collection, we consider the number of years the customer has been in business and the history of our collections. Customers are subject to a credit review process that evaluates the customers' financial positions and ultimately their ability to pay. If it is determined at the outset of an arrangement that collection is not reasonably assured, no product is shipped and no revenue is recognized unless cash is received in advance.
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.
Multiple Element Arrangements
For revenue arrangements that contain multiple deliverables, judgment is required to properly identify the accounting units of the transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met for each deliverable in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the arrangement consideration between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could affect our results of operations.
For multiple element arrangements that include a combination of hardware, services, such as post-contract customer support, and software, the arrangement consideration is first allocated among the accounting units before revenue recognition criteria are applied. The allocation is derived based on vendor specific objective evidence ("VSOE"). When VSOE or third party evidence is unavailable, we use management's best estimate of selling price.
Distributor Revenue
A portion of our sales are made to distributors under agreements which contain price protection provisions. Currently, we recognize revenues from sales to distributors based on the sell-through method using inventory and point of sale information provided by the distributors, net of estimated allowances for price adjustments. Upon the adoption of the new revenue standards effective January 1, 2018, we will recognize revenues from sales to distributors upon shipment and transfer of control (known as “sell-in” revenue recognition), net of the estimated allowances for price adjustments.
Short-term investments
We classify short-term investments as available-for-sale securities. We view our available-for-sale-portfolio as available for use in current operations. Available-for-sale securities are recorded at fair value, and we record temporary unrealized gains and losses as a separate component of accumulated other comprehensive income (loss). We regularly review our investment portfolio and charge unrealized losses against net income when a decline in fair value is determined to be other-than-temporary. We review 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
Our financial instruments consist of cash, cash equivalents, restricted cash, short-term investments and foreign currency derivative contracts. When there is no readily available market data, we may make fair value estimates, which may not necessarily represent the amounts that could be realized in a current or future sale of these assets.
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 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.
Property and equipment
Property and equipment are stated at cost, net of accumulated depreciation. Depreciation and amortization 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.
We capitalize certain costs incurred in connection with internal use of inventory items in our 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.
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, 2017, 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, 2017, 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 account for these investments under the cost method, reduced by any impairment write-downs, because we do not have the ability to exercise significant influence over the operating and financial policies of these companies. 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.
Impairment of long-lived assets
Long-lived assets include equipment and furniture and fixtures 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.
While performing our review for impairment for the fourth quarter of 2017, we noted an impairment indicator associated with the potential sale or discontinuation of the 1550nm silicon photonics line of business. As a result, we recorded impairment charges totaling $12.0 million in the fourth quarter of 2017, of which $7.7 million were related to property and equipment and $4.3 million were related to intangible assets. See Note 16 to the consolidated financial statements for more details about the impairment charges.
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:
|
| | | | | | | | | | | |
| Year ended December 31, | |
| 2017 | | 2016 | | 2015 |
Total revenues | 100 |
| % | | 100 |
| % | | 100 |
| % |
Cost of revenues | (35 | ) | | | (35 | ) | | | (29 | ) | |
Gross profit | 65 |
| | | 65 |
| | | 71 |
| |
Operating expenses: | | | | | | | | |
Research and development | 42 |
| | | 38 |
| | | 38 |
| |
Sales and marketing | 17 |
| | | 16 |
| | | 15 |
| |
General and administrative | 6 |
| | | 7 |
| | | 7 |
| |
Impairment of long-lived assets | 2 |
| | | — |
| | | — |
| |
Total operating expenses | 67 |
| | | 61 |
| | | 60 |
| |
Income (loss) from operations | (2 | ) | | | 4 |
| | | 11 |
| |
Interest expense | (1 | ) | | | (1 | ) | | | — |
| |
Other income (loss), net | — |
| | | — |
| | | — |
| |
Interest and other, net | (1 | ) | | | (1 | ) | | | — |
| |
Income (loss) before taxes on income | (3 | ) | | | 3 |
| | | 11 |
| |
Provision for (benefit from) taxes on income | (1 | ) | | | 1 |
| | | (3 | ) | |
Net income (loss) | (2 | ) | % | | 2 |
| % | | 14 |
| % |
Comparison of the Year Ended December 31, 2017 to the Year Ended December 31, 2016 and the Year Ended December 31, 2016 to the Year Ended December 31, 2015
Revenues.
The following tables represent our total revenues for the years ended December 31, 2017 and 2016 by product type and interconnect protocol:
|
| | | | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | % of Revenues | | 2016 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | |
ICs | $ | 161,216 |
| | 18.7 | % | | $ | 170,641 |
| | 19.9 | % |
Boards | 325,845 |
| | 37.7 | % | | 337,304 |
| | 39.3 | % |
Switch systems | 222,836 |
| | 25.8 | % | | 204,083 |
| | 23.8 | % |
Cables, accessories and other | 153,996 |
| | 17.8 | % | | 145,470 |
| | 17.0 | % |
Total Revenue | $ | 863,893 |
| | 100.0 | % | | $ | 857,498 |
| | 100.0 | % |
|
| | | | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | % of Revenues | | 2016 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | |
InfiniBand: | | | |
| | |
| | |
|
EDR | $ | 194,261 |
| | 22.5 | % | | $ | 125,249 |
| | 14.6 | % |
FDR | 181,465 |
| | 21.0 | % | | 302,093 |
| | 35.2 | % |
QDR/DDR/SDR | 31,599 |
| | 3.6 | % | | 49,987 |
| | 5.9 | % |
Total | 407,325 |
| | 47.1 | % | | 477,329 |
| | 55.7 | % |
Ethernet | 401,005 |
| | 46.4 | % | | 317,241 |
| | 37.0 | % |
Other | 55,563 |
| | 6.5 | % | | 62,928 |
| | 7.3 | % |
Total revenue | $ | 863,893 |
| | 100.0 | % | | $ | 857,498 |
| | 100.0 | % |
Revenues were $863.9 million for the year ended December 31, 2017 compared to $857.5 million for the year ended December 31, 2016, representing an increase of $6.4 million, or approximately 0.7%. The year-over-year revenue increase in 2017 from 2016
was primarily attributable to increased demand for our 25, 50, and 100Gb/s Ethernet solutions. Revenues from our InfiniBand products decreased primarily due to declines in storage and embedded customers, driven by customer product transitions and customer M&A activity and lower average selling prices as a result of competition in the HPC market. Revenues from InfiniBand EDR products increased as customers continued transitioning from FDR and lower data rate products to the EDR product generation. Our 2017 revenues are not necessarily indicative of future results.
The following tables represent our total revenues for the years ended December 31, 2016 and 2015 by product type and interconnect protocol:
|
| | | | | | | | | | | | | |
| Year Ended December 31, |
| 2016 | | % of Revenues | | 2015 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | |
ICs | $ | 170,641 |
| | 19.9 | % | | $ | 92,214 |
| | 14.0 | % |
Boards | 337,304 |
| | 39.3 | % | | 265,249 |
| | 40.3 | % |
Switch systems | 204,083 |
| | 23.8 | % | | 179,977 |
| | 27.3 | % |
Cables, accessories and other | 145,470 |
| | 17.0 | % | | 120,700 |
| | 18.4 | % |
Total Revenue | $ | 857,498 |
| | 100.0 | % | | $ | 658,140 |
| | 100.0 | % |
|
| | | | | | | | | | | | | |
| Year Ended December 31, |
| 2016 | | % of Revenues | | 2015 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | |
InfiniBand: | |
| | |
| | |
| | |
|
EDR | $ | 125,249 |
| | 14.6 | % | | $ | 39,009 |
| | 5.9 | % |
FDR | 302,093 |
| | 35.2 | % | | 347,760 |
| | 52.8 | % |
QDR/DDR/SDR | 49,987 |
| | 5.9 | % | | 63,745 |
| | 9.8 | % |
Total | 477,329 |
| | 55.7 | % | | 450,514 |
| | 68.5 | % |
Ethernet | 317,241 |
| | 37.0 | % | | 155,221 |
| | 23.6 | % |
Other | 62,928 |
| | 7.3 | % | | 52,405 |
| | 7.9 | % |
Total revenue | $ | 857,498 |
| | 100.0 | % | | $ | 658,140 |
| | 100.0 | % |
Revenues were $857.5 million for the year ended December 31, 2016 compared to $658.1 million for the year ended December 31, 2015, representing an increase of $199.4 million, or approximately 30.3%. The year-over-year Ethernet revenue increase in 2016 from 2015 was primarily attributable to increased demand for our adapters at 25Gb/s and above and incremental revenues from the EZchip acquisition derived from sales of ICs. Revenues from our InfiniBand products also increased primarily due to increased sales into HPC and cloud markets. Revenues from InfiniBand EDR products increased as customers continued transitioning from FDR and lower data rate products to the EDR product generation. The increase in other revenues was primarily due to higher revenue from support.
Gross Profit and Margin. Gross profit was $563.4 million for the year ended December 31, 2017 compared to $555.5 million for the year ended December 31, 2016, representing an increase of $7.9 million, or approximately 1.4%. As a percentage of revenues, gross margin increased to 65.2% in the year ended December 31, 2017 from approximately 64.8% in the year ended December 31, 2016. The increase in gross margin was primarily due to a decrease in intangible asset amortization costs of $5.6 million and inventory step-up amortization costs of $8.3 million, both related to the EZchip acquisition, partially offset by the lower margins due to product mix. Gross margin for 2017 is not necessarily indicative of future results.
Gross profit was $555.5 million for the year ended December 31, 2016 compared to $468.9 million for the year ended December 31, 2015, representing an increase of $86.6 million, or approximately 18.5%. As a percentage of revenues, gross margin decreased to 64.8% in the year ended December 31, 2016 from approximately 71.3% in the year ended December 31, 2015. The decrease in gross margin was primarily due to an increase in intangible asset amortization costs of $39.7 million and inventory step-up amortization costs of $8.3 million, both related to the EZchip acquisition.
Research and Development.
The following table presents details of our research and development expenses for the periods indicated:
|
| | | | | | | | | | | | | | | | | | | | |
| Year ended December 31, |
| 2017 | | % of Revenues | | 2016 | | % of Revenues | | 2015 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | | | (In thousands) | | |
Salaries and benefits | $ | 200,125 |
| | 23.2 | % | | $ | 174,462 |
| | 20.3 | % | | $ | 130,255 |
| | 19.8 | % |
Share-based compensation | 40,278 |
| | 4.7 | % | | 40,475 |
| | 4.7 | % | | 28,821 |
| | 4.4 | % |
Development and tape-out costs | 39,001 |
| | 4.5 | % | | 36,091 |
| | 4.2 | % | | 36,305 |
| | 5.5 | % |
Other | 86,474 |
| | 10.0 | % | | 71,592 |
| | 8.4 | % | | 56,794 |
| | 8.6 | % |
Total Research and development | $ | 365,878 |
| | 42.4 | % | | $ | 322,620 |
| | 37.6 | % | | $ | 252,175 |
| | 38.3 | % |
Research and development expenses were $365.9 million for the year ended December 31, 2017 compared to $322.6 million for the year ended December 31, 2016, representing an increase of $43.3 million, or approximately 13.4%. The increase in salaries and benefits expenses was primarily attributable to headcount additions and merit increases. The increase in development and tape-out costs reflects continued investments in new products. The increase in other expenses was primarily due to higher depreciation expense and facilities costs.
Research and development expenses were $322.6 million for the year ended December 31, 2016 compared to $252.2 million for the year ended December 31, 2015, representing an increase of $70.4 million, or approximately 27.9%. The increase in salaries and benefits expenses was primarily attributable to headcount additions, including those associated with the EZchip acquisition, merit increases and higher accrued bonuses under our annual discretionary bonus award program. The increase in other expenses reflects higher outsourced services expenses, depreciation expense, and facilities costs.
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:
|
| | | | | | | | | | | | | | | | | | | | |
| Year ended December 31, |
| 2017 | | % of Revenues | | 2016 | | % of Revenues | | 2015 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | | | (In thousands) | | |
Salaries and benefits | $ | 90,419 |
| | 10.5 | % | | $ | 76,774 |
| | 9.0 | % | | $ | 58,204 |
| | 8.8 | % |
Share-based compensation | 15,693 |
| | 1.8 | % | | 15,183 |
| | 1.8 | % | | 10,309 |
| | 1.6 | % |
Trade shows and promotions | 19,593 |
| | 2.3 | % | | 19,893 |
| | 2.3 | % | | 15,996 |
| | 2.4 | % |
Other | 24,752 |
| | 2.8 | % | | 21,930 |
| | 2.5 | % | | 12,929 |
| | 2.0 | % |
Total Sales and marketing | $ | 150,457 |
| | 17.4 | % | | $ | 133,780 |
| | 15.6 | % | | $ | 97,438 |
| | 14.8 | % |
Sales and marketing expenses were $150.5 million for the year ended December 31, 2017 compared to $133.8 million for the year ended December 31, 2016, representing an increase of $16.7 million, or approximately 12.5%. The increase in salaries and benefits expenses was primarily related to headcount additions and merit increases. The increase in other expenses primarily reflects higher depreciation expense, amortization costs related to acquired intangible assets associated with the EZchip acquisition and facilities costs.
Sales and marketing expenses were $133.8 million for the year ended December 31, 2016 compared to $97.4 million for the year ended December 31, 2015, representing an increase of $36.4 million, or approximately 37.3%. The increase in salaries and benefits was primarily attributable to headcount additions, including those associated with the EZchip acquisition, and merit increases. The increase in trade shows and promotions was due primarily to higher trade show exhibit costs and related travel costs. The increase in other expenses primarily reflects higher depreciation expense, amortization costs related to acquired intangible assets associated with the EZchip acquisition and facilities costs.
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:
|
| | | | | | | | | | | | | | | | | | | | |
| Year Ended December 31, |
| 2017 | | % of Revenues | | 2016 | | % of Revenues | | 2015 | | % of Revenues |
| (In thousands) | | | | (In thousands) | | | | (In thousands) | | |
Salaries and benefits | $ | 21,476 |
| | 2.5 | % | | $ | 20,976 |
| | 2.4 | % | | $ | 16,050 |
| | 2.4 | % |
Share-based compensation | 10,893 |
| | 1.3 | % | | 13,085 |
| | 1.5 | % | | 9,268 |
| | 1.4 | % |
Professional services | 13,179 |
| | 1.5 | % | | 26,602 |
| | 3.1 | % | | 12,348 |
| | 1.9 | % |
Other | 6,622 |
| | 0.7 | % | | 7,859 |
| | 1.0 | % | | 6,546 |
| | 1.0 | % |
Total General and administrative | $ | 52,170 |
| | 6.0 | % | | $ | 68,522 |
| | 8.0 | % | | $ | 44,212 |
| | 6.7 | % |
General and administrative expenses were $52.2 million for the year ended December 31, 2017 compared to $68.5 million for the year ended December 31, 2016, representing a decrease of $16.3 million, or approximately 23.8%. The decrease in professional services expenses was primarily due to the fact that during 2016 we incurred $8.3 million of investment banking, consulting and other professional fees related to the EZchip acquisition, and $5.1 million of litigation settlement costs and legal fees.
General and administrative expenses were $68.5 million for the year ended December 31, 2016 compared to $44.2 million for the year ended December 31, 2015, representing an increase of $24.3 million, or approximately 55.0%. The increase in salaries and benefits was primarily attributable to headcount additions, including those associated with the EZchip acquisition, merit increases and higher accrued bonuses under our annual discretionary bonus award program. The increase in professional services expenses was related to investment banking costs, consulting expenses and other professional fees related to the EZchip acquisition, litigation settlement costs and legal fees. The increase in other expenses was primarily related to higher depreciation and facilities costs.
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:
|
| | | | | | | | | | | |
| Year ended December 31, |
| 2017 | | 2016 | | 2015 |
| (in thousands) |
Cost of goods sold | $ | 2,000 |
| | $ | 2,375 |
| | $ | 2,366 |
|
Research and development | 40,278 |
| | 40,475 |
| | 28,821 |
|
Sales and marketing | 15,693 |
| | 15,183 |
| | 10,309 |
|
General and administrative | 10,893 |
| | 13,085 |
| | 9,268 |
|
| $ | 68,864 |
| | $ | 71,118 |
| | $ | 50,764 |
|
Share-based compensation expenses were $68.9 million for the year ended December 31, 2017, compared to $71.1 million for the year ended December 31, 2016, representing a decrease of $2.2 million, or approximately 3%. The decrease was primarily related to $4.8 million of cash payments made during 2016 related to accelerated RSUs that were paid to individuals who were terminated on the closing date of the EZchip acquisition, partially offset by the additional expense due to new hires and focal grants.
Share-based compensation expenses were $71.1 million for the year ended December 31, 2016, compared to $50.8 million for the year ended December 31, 2015, representing an increase of $20.3 million, or approximately 40%. The increase was primarily attributable to RSUs granted to existing employees during 2016 as part of our annual review process, RSUs assumed and granted to employees in conjunction with the acquisition of EZchip, RSUs granted to new hires, and expenses related to the acceleration of EZchip RSUs for employees terminated on the closing date.
Impairment of long-lived assets. While performing our review for impairment for the fourth quarter of 2017, we noted an impairment indicator associated with the potential sale or discontinuation of the 1550nm silicon photonics line of business. As a result, we recorded impairment charges totaling $12.0 million in the fourth quarter of 2017, of which $7.7 million were related to property and equipment and $4.3 million were related to intangible assets.
Interest and other, net. Interest and other, net was $4.8 million for the year ended December 31, 2017 compared to $6.3 million for the year ended December 31, 2016. The change was primarily attributable to a $1.5 million increase in interest income and gains on short-term investments.
Interest and other, net was $6.3 million for the year ended December 31, 2016 compared to $0.5 million for the year ended December 31, 2015. The change was primarily attributable to $7.4 million in interest expense associated with the Term Debt, a $0.7 million increase in foreign exchange loss, and a $0.8 million decrease in interest income and gains on short-term investments due to lower invested balances post EZchip acquisition, partially offset by a $3.2 million impairment loss of investment in a privately-held company in the year ended December 31, 2015.
Provision for or Benefit from Taxes on Income. Our benefit from taxes on income was $2.5 million for the year ended December 31, 2017 as compared to a provision for taxes on income of $5.8 million for the year ended December 31, 2016. Our effective tax rate was 11.3% and 23.9% for 2017 and 2016, respectively. For the year ended December 31, 2017, the difference between the 11.3% effective tax rate and the 35% federal statutory rate resulted primarily from a decrease of $15.7 million in deferred tax assets due to the effects of the recently enacted U.S. tax reform, partially offset by a $10.4 million decrease in the valuation allowance primarily due to the same effects.
Our provision for taxes on income was $5.8 million for the year ended December 31, 2016 as compared to a benefit from taxes on income of $18.3 million for the year ended December 31, 2015. Our effective tax rate was 23.9% and (24.6)% for 2016 and 2015, respectively. For the year ended December 31, 2016, the difference between the 23.9% effective tax rate and the 35% federal statutory rate resulted primarily from the tax holiday in Israel and foreign earnings taxed at rates lower than the federal statutory rates which resulted in a reduction of approximately $20.6 million, partially offset by the accrual of unrecognized tax benefits, interest and penalties associated with unrecognized tax positions in the amount of $4.2 million, changes in valuation allowance in the amount of $9.9 million mainly due to losses generated from subsidiaries without tax benefit and the reduction of deferred tax assets in the amount of $2.7 million resulting from the reduction in the Israeli corporate income tax rates.
Liquidity and Capital Resources
On February 23, 2016, we completed the acquisition of EZchip and acquired its cash of approximately $87.5 million and short term investments of $108.9 million. We financed the acquisition purchase price of approximately $782.2 million and related transaction expenses with cash on hand, and with $280.0 million in term debt. The Term Debt agreement includes customary liquidity covenants and consists of a variable interest rate senior secured loan for the term of three years at an annualized variable interest rate based on, at our option, either (a) the London Interbank Offered Rate ("LIBOR") for Eurocurrency borrowing, or (b) an Alternate Base Rate (“ABR”), which is the highest of (i) the administrative agent’s prime rate, (ii) one-half of 1.00% in excess of the overnight U.S. Federal Funds rate, and (iii) 1.00% in excess of the one-month LIBOR), plus in each case, an applicable margin. The Term Debt provides for an additional term loan borrowing under certain conditions. During the year ended December 31, 2017, we made principal payments of $172.0 million, which included prepayments of $146.5 million which were applied to future payment requirements. As of December 31, 2017, the outstanding principal amount of the Term Debt was $74.0 million.
Historically, we have financed our operations through a combination of sales of equity securities and cash generated by operations. As of December 31, 2017, our principal source of liquidity consisted of cash and cash equivalents of $62.5 million and short-term investments of $211.3 million. After taking into consideration our forecasted operating expenses, including the restructuring charges as discussed in Note 17 to the consolidated financial statements, 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 and both our short-term and long-term liquidity requirements arising from interest and principal payments related to the Term Debt.
We are an Israeli company and as of December 31, 2017 our subsidiaries outside of Israel held approximately $14.9 million in cash and cash equivalents and short term investments.
Our cash and cash equivalents, short-term investments, and working capital at December 31, 2017 and December 31, 2016 were as follows:
|
| | | | | | | |
| Year ended December 31, |
| 2017 | | 2016 |
| (in thousands) |
Cash and cash equivalents | $ | 62,473 |
| | $ | 56,780 |
|
Short-term investments | 211,281 |
| | 271,661 |
|
Total | $ | 273,754 |
| | $ | 328,441 |
|
Working capital | $ | 310,286 |
| | $ | 340,511 |
|
Our ratio of current assets to current liabilities was 2.6:1 at December 31, 2017 and 2016.
Operating Activities
Net cash provided by our operating activities amounted to $161.3 million in the year ended December 31, 2017. Net cash provided by operating activities was attributable to net loss of $19.4 million adjusted by net non-cash items of $182.6 million, gain on short-term investments of $3.5 million, and changes in assets and liabilities of $1.6 million. Non-cash expenses consisted primarily of $103.8 million of depreciation and amortization, $68.9 million of share-based compensation, and $12.0 million of impairment charges, partially offset by an increase in deferred income taxes of $2.2 million. The $1.6 million cash inflow from changes in assets and liabilities resulted from increases in accrued liabilities and other liabilities of $15.2 million, primarily due to higher accrued salaries, benefits and severance liabilities, partially offset by, among other things, an increase in accounts receivable of $12.2 million primarily due to the timing of sales.
Net cash provided by our operating activities amounted to $196.1 million in the year ended December 31, 2016. Net cash provided by operating activities was attributable to net income of $18.5 million adjusted by net non-cash items of $163.1 million and changes in assets and liabilities of $14.5 million (excluding the changes to assets and liabilities as a result of the EZchip acquisition). Non-cash expenses consisted primarily of $66.3 million of share-based compensation, $97.7 million of depreciation and amortization, and decreases in deferred income taxes of $0.8 million, partially offset by a gain on investments of $1.8 million. The $14.5 million cash inflow from changes in assets and liabilities (excluding the changes to assets and liabilities as a result of the EZchip acquisition), resulted from decreases in inventories of $8.3 million as a result of our effort to manage the inventory level, decreases in prepaid expenses and other assets of $6.9 million, increases in accounts payable of $13.3 million primarily due to the timing of payments, and increases in accrued and other liabilities of $27.3 million primarily related to deferred revenue and salaries and benefits expenses, partially offset by an increase in accounts receivable of $41.3 million primarily due to the timing of sales.
Investing Activities
Net cash provided by investing activities was $2.0 million in the year ended December 31, 2017. Cash provided by investing activities was primarily attributable to net proceeds from sales, maturities and purchases of short-term investments of $63.5 million, partially offset by $41.4 million for purchases of property and equipment, $15.0 million for purchases of investments in privately-held companies, $2.8 million for purchases of intangible assets, $1.3 million for purchases of severance-related insurance policies, and $0.9 million of cash used for acquisitions.
Net cash used in investing activities was $664.2 million in the year ended December 31, 2016. Cash used in investing activities was primarily attributable to $693.7 million of net cash used to acquire EZchip, $43.0 million for purchases of property and equipment, $8.0 million for purchases of intangible assets, $5.0 million for purchases of investments in privately-held companies, partially offset by net proceeds from sales, maturities and purchases of short-term investments of $86.6 million.
Financing Activities
Net cash used in financing activities was $149.6 million in the year ended December 31, 2017. Cash used in financing activities was primarily due to $172.0 million of principal payments on the Term Debt and $7.4 million of payments on intangible asset obligations, partially offset by $29.7 million of proceeds from issuances of ordinary shares through our employee equity incentive plans.
Net cash provided by financing activities was $261.6 million in the year ended December 31, 2016. Cash provided by financing activities was primarily due to $280.0 million of proceeds from the Term Debt and $22.6 million of proceeds from issuances of ordinary shares through employee equity incentive plans, partially offset by $34.0 million of principal payments on the Term Debt and debt issuance costs of $5.5 million.
Contractual Obligations
The following table summarizes our contractual obligations at December 31, 2017 and the effect those obligations are expected to have on our liquidity and cash flow in future periods:
|
| | | | | | | | | | | | | | | |
| Contractual Obligations |
| Total | | Non-cancelable operating lease commitments | | Purchase commitments | | Term debt including interest |
| (in thousands) |
2018 | $ | 178,682 |
| | $ | 23,028 |
| | $ | 153,358 |
| | $ | 2,296 |
|
2019 | 95,220 |
| | 18,453 |
| | 2,447 |
| | 74,320 |
|
2020 | 15,284 |
| | 14,740 |
| | 544 |
| | — |
|
2021 | 13,492 |
| | 12,950 |
| | 542 |
| | — |
|
2022 | 10,184 |
| | 9,648 |
| | 536 |
| | — |
|
Thereafter | 60,091 |
| | 60,091 |
| | — |
| | — |
|
Total | $ | 372,953 |
| | $ | 138,910 |
| | $ | 157,427 |
| | $ | 76,616 |
|
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
Operating lease
On May 3, 2016, we entered into a lease agreement for additional office space expected to be built in Yokneam, Israel. The lease term expires 10 years after lease inception with no options to extend the lease term. Our occupancy of the additional office space and our obligation under the lease agreement are contingent on the lessor's attainment of stated milestones in the lease agreement. As such, we cannot make a reliable estimate as to the timing of cash payments under the lease. At December 31, 2017, the estimated total future lease obligation is approximately $30.7 million. Over a twelve month period the estimated rental expense is approximately $3.1 million.
Royalty-bearing grants
We are obliged to pay royalties to the Israeli National Authority for Technological Innovation or the OCS for research and development efforts partially funded through grants from the OCS and under approved plans in accordance with the Israeli Law for Encouragement of Research and Development in the Industry, 1984 (the "R&D Law"). Royalties are payable to the Israeli government at the rate of 4.5% on the revenues of the Company's products incorporating OCS funded know-hows, and up to the amount of the grants received. Our obligation to pay these royalties is contingent on actual sales of the products, at which time a liability is recorded. In the absence of such sales, we cannot make a reliable estimate as to the timing of cash settlement of the royalties. At December 31, 2017, we estimated a total future royalty obligation of approximately $36.4 million, and if recognized, would increase the cost of revenues in our consolidated statement of operations.
Unrecognized tax benefits
The contractual obligation table excludes our unrecognized tax benefit liabilities because we cannot make a reliable estimate of the timing of cash payments. As of December 31, 2017, our unrecognized tax benefits liabilities totaled $45.2 million, out of which an amount of $24.6 million would reduce our income tax expense and effective tax rate, if recognized.
Recent accounting pronouncements
See Note 1 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, 2017, 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 other income (loss), net. See Note 7 to the consolidated financial statements.
ITEM 7A—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate fluctuation risk
As of December 31, 2017, the outstanding principal amount of the Term Debt was $74.0 million. A hypothetical 1.0% increase in the applicable interest rate would increase the interest expense on our outstanding debt by $0.7 million for the following 12 months.
Our investments consist of cash, money market funds, certificates of deposit, and interest bearing investments in government debt securities, commercial paper, corporate bonds, municipal bonds and foreign government bonds with an average maturity of 0.8 years. 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 F-1, 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 1% change in interest rates would have a $1.4 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 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. 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 protect against foreign exchange risks associated with forecasted future cash flows and existing assets and liabilities, we have established a balance sheet and anticipated transaction risk management program. 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 $0.1 million at December 31, 2017. There would also be an impact on future operating expenses denominated in NIS. For the month ending December 31, 2017, approximately $20.5 million of our monthly expenses were denominated in NIS. As of December 31, 2017, we had derivative contracts designated as cash flow hedges in the notional amount of approximately 181.6 million NIS, or approximately $52.4 million based upon the exchange rate on that day. In addition, as of December 31, 2017, we had derivative contracts hedging against NIS denominated assets and liabilities in the notional amount of approximately 163.0 million NIS, or approximately $47.0 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.
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—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
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Q4 | | Q3 | | Q2 | | Q1 | | Q4 | | Q3 | | Q2 | | Q1 (1) |
| 2017 | | 2017 | | 2017 | | 2017 | | 2016 | | 2016 | | 2016 | | 2016 |
| (in thousands, except per share data) |
Total revenues | $ | 237,581 |
| | $ | 225,699 |
| | $ | 211,962 |
| | $ | 188,651 |
| | $ | 221,676 |
| | $ | 224,211 |
| | $ | 214,801 |
| | $ | 196,810 |
|
Cost of revenues | 85,238 |
| | 77,335 |
| | 73,427 |
| | 64,450 |
| | 73,507 |
| | 78,191 |
| | 79,807 |
| | 70,481 |
|
Gross profit | 152,343 |
| | 148,364 |
| | 138,535 |
| | 124,201 |
| | 148,169 |
| | 146,020 |
| | 134,994 |
| | 126,329 |
|
Operating expenses: | |
| | |
| | |
| | |
| | |
| | |
| | |
| | |
|
Research and development | 94,123 |
| | 90,916 |
| | 92,348 |
| | 88,491 |
| | 85,651 |
| | 83,611 |
| | 82,324 |
| | 71,034 |
|
Sales and marketing | 38,761 |
| | 37,829 |
| | 38,110 |
| | 35,757 |
| | 35,568 |
| | 34,408 |
| | 32,576 |
| | 31,228 |
|
General and administrative | 14,136 |
| | 13,039 |
| | 12,476 |
| | 12,519 |
| | 13,589 |
| | 13,501 |
| | 13,494 |
| | 27,938 |
|
Impairment of long-lived assets | 12,019 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
|
Total operating expenses | 159,039 |
| | 141,784 |
| | 142,934 |
| | 136,767 |
| | 134,808 |
| | 131,520 |
| | 128,394 |
| | 130,200 |
|
Income (loss) from operations | (6,696 | ) | | 6,580 |
| | (4,399 | ) | | (12,566 | ) | | 13,361 |
| | 14,500 |
| | 6,600 |
| | (3,871 | ) |
Interest expense | (1,932 | ) | | (2,016 | ) | | (1,996 | ) | | (1,993 | ) | | (1,944 | ) | | (2,195 | ) | | (2,215 | ) | | (998 | ) |
Other income (loss), net | 649 |
| | 956 |
| | 827 |
| | 683 |
| | 108 |
| | 606 |
| | 315 |
| | 61 |
|
Interest and other, net | (1,283 | ) | | (1,060 | ) | | (1,169 | ) | | (1,310 | ) | | (1,836 | ) | | (1,589 | ) | | (1,900 | ) | | (937 | ) |
Income (loss) before taxes on income | (7,979 | ) | | 5,520 |
| | (5,568 | ) | | (13,876 | ) | | 11,525 |
| | 12,911 |
| | 4,700 |
| | (4,808 | ) |
Provision for (benefit from) taxes on income | (5,386 | ) | | 2,117 |
| | 2,423 |
| | (1,632 | ) | | 2,530 |
| | 874 |
| | 46 |
| | 2,360 |
|
Net income (loss) | $ | (2,593 | ) | | $ | 3,403 |
| | $ | (7,991 | ) | | $ | (12,244 | ) | | $ | 8,995 |
| | $ | 12,037 |
| | $ | 4,654 |
| | $ | (7,168 | ) |
Net income (loss) per share — basic | $ | (0.05 | ) | | $ | 0.07 |
| | $ | (0.16 | ) | | $ | (0.25 | ) | | $ | 0.18 |
| | $ | 0.25 |
| | $ | 0.10 |
| | $ | (0.15 | ) |
Net income (loss) per share — diluted | $ | (0.05 | ) | | $ | 0.07 |
| | $ | (0.16 | ) | | $ | (0.25 | ) | | $ | 0.18 |
| | $ | 0.24 |
| | $ | 0.09 |
| | $ | (0.15 | ) |
(1) On February 23, 2016, we acquired EZchip. EZchip's results of operations have been included in our consolidated financial statements beginning February 23, 2016.
ITEM 9—CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The information required by this Item 9 was previously reported in the company’s Current Report on Form 8-K that was filed with the Securities and Exchange Commission on February 24, 2017.
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, 2017. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of December 31, 2017 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, 2017 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)the Companies Law. A copy 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, 2017 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, 2017.
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, 2017, as stated in their report which appears under Item 8.
ITEM 9B—OTHER INFORMATION
None.
PART III
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 Ethicsaudit committee charter is available on our website at http://www.mellanox.com. Any changeswww.mellanox.com under “Company—Investor Relations—Corporate Governance.”
The Board currently consists of ten directors. Our Corporate Governance Guidelines require that the Board be comprised of a majority of directors who qualify as independent directors as required under the rules of Nasdaq. The Board has determined that each of our directors, other than Mr. Waldman, our president and CEO, is independent under the director independence standards of Nasdaq.
The Companies Law provides that the Board is required to or waiversdetermine how many of our members of the CodeBoard should be required to have financial and accounting expertise. The Board has determined that at least one member of Business Conductthe Board should be required to have financial and Ethics will be disclosed onaccounting expertise. Each member of the same website.audit committee of the Board has financial and accounting expertise as defined under the Companies Law.
The other information required by this item will be contained in our definitive proxy statementItem 14—Principal Accountant Fees and Services
Audit andNon-Audit
Services Subject to
be filed withshareholder approval of the
SEC in connection withaudit committee’s authority to determine remuneration for their services, the
Annual General Meetingaudit committee is directly responsible for the appointment, compensation and oversight of our
Shareholders, orindependent auditors. In addition to its retention of Kost Forer Gabbay & Kasierer, the
Proxy Statement, which is expectedIsrael-based member of Ernst & Young Global (“”) to
be filed no later than 120 days afteraudit our consolidated financial statements for the
end of our fiscal year ended December 31,
2017, under2019, the
sections titled “Proposal - Electionaudit committee retained EY Israel to provide othernon-audit
and advisory services in 2019. The audit committee has reviewed allnon-audit
services provided by EY Israel in 2019 and has concluded that the provision of
Directors,” “Security Ownership,”suchnon-audit
services was compatible with maintaining EY Israel’s independence and
“Corporate Governancethat such independence has not been impaired. Set forth below are the aggregate fees billed for professional services rendered for the fiscal years ended December 31, 2018 and Board2019 by EY Israel.
| | | | | | | | |
| | Fiscal Year Ended December 31, | |
| | | | | | |
| | $ | | | | $ | | |
| | | | | | | | |
| | | | | | | | |
| | | | | | | | |
| | | | | | | | |
| | $ | | | | $ | | |
| | | | | | | | |
In the above table, in accordance with the SEC’s definitions and rules, “audit fees” are fees for professional services for the audit and review of Director Matters”our annual consolidated financial statements, as well as fees for issuance of consents and is incorporatedfor services that are normally provided by the accountant in this reportconnection with statutory and regulatory filings or engagements except those not required by reference.statute or regulation; “audit-related fees” are fees for assurance and related services that were reasonably related to the performance of the audit or review of our financial statements, including attestation services that are not required by statute or regulation, due diligence and any services related to acquisitions; “tax fees” are fees for tax compliance, tax advice and tax planning; and “all other fees” are fees for any services not included in the first three categories.
The Sarbanes-Oxley Act of 2002 and the auditor independence rules of the SEC require all issuers to obtainpre-approval
from their respective audit committees in order for their independent registered public accounting firms to provide professional services without impairing independence. As such, the audit committee has a policy and has established procedures by which itpre-approves
all audit and other permitted professional services to be provided by the Company’s independent registered public accounting firm. From time to time, the Company may desire additional permitted professional services for which specificpre-approval
is obtained from the audit committee before provision of such services commences. The audit committee has considered and determined that the provision of the services other than audit services referenced above is compatible with maintenance of the auditors’ independence.