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MELLANOX TECHNOLOGIES, LTD. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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 and sells high-performance interconnect products and solutions primarily based on the InfiniBand and Ethernet standards. Our products facilitate efficient data transmission between servers, storage systems, communications infrastructure equipment and other embedded systems. We operate our business globally and offer products to customers at various levels of integration. The products we offer include integrated circuits ("ICs"), adapter cards, switch systems, cables, modules, software, services and accessories, as an integral part of a total end-to-end networking solution focused on computing, storage and communication applications used in multiple markets, including high-performance computing, ("HPC"), Web 2.0, storage, financial services, enterprise data center, ("EDC") and cloud. Our adapters and switch ICs provide per port bandwidth up to 10Gb/s, 40Gb/s and 56Gb/s Ethernet, and 10Gb/s (Single Data Rate or SDR), 20Gb/s (Double Data Rate or DDR), 40Gb/s (Quad Data Rate or QDR) and 56Gb/s (Fourteen Data Rate or FDR) InfiniBand. Our switch systems range in port density from 8, 12, 18, 36, 48 and 64 port top-of-rack switches to director-class switches ranging in size from 108 to 648 ports. Connectivity between the adapters and switches is supported with our short reach copper cables and 42-------------------------------------------------------------------------------- Table of Contents long reach active optical cables, and our management software provides visibility, monitoring and diagnostics for the system. 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 four largest server vendors, IBM, HP, Dell and Oracle, which collectively shipped the majority of servers in 2013, according to industry research firm Gartner. We supply our products to leading storage and communications infrastructure equipment vendors such as Data Direct Networks, Fujitsu, Hewlett Packard, IBM, EMC/Isilon, NetApp, Nimbus Data, Oracle, Teradata, Toshiba and Seagate/Xyratex. Additionally, our products are used as embedded solutions by companies such as Fujitsu, GE Fanuc, Mercury, and Toshiba Medical. 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 InfiniBand and Ethernet solutions with leading performance. We also believe that we are one of the early suppliers of 40Gb/s Ethernet adapters and switches to the market, and the only end-to-end 40Gb/s and 56Gb/s Ethernet supplier on the market today, which provides us with the opportunity to gain additional share in the Ethernet market as users upgrade from 1Gb/s or 10Gb/s directly to 40Gb/s or 56Gb/s. Our revenues for the year ended December 31, 2013 were $390.9 million, a decrease from $500.8 million in the year ended December 31, 2012. Our revenues increased from $154.6 million for the year ended December 31, 2010 to $259.3 million to $500.8 million for the years ended December 31, 2011 and 2012, respectively. The year-over-year revenue decrease from sales of Infiniband products was primarily due to increased revenues in 2012 related to pent-up demand associated with the launch of Romley and Sandy Bridge platforms by Intel Corporation. In addition, our revenues in 2013 were negatively impacted by the weaker demand environment and a build-up of inventory at an OEM customer.. In order to increase our annual revenues, we must continue to achieve design wins over other InfiniBand and 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. 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, 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 67%, 74% and 70% of our total revenues for the years ended December 31, 2013, 2012 and 2011, respectively. Sales to customers representing 10% or more of revenues accounted for 30%, 39% and 36% of our total revenues for the years ended December 31, 2013, 2012 and 2011, 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. 43-------------------------------------------------------------------------------- Table of Contents 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, 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. In addition, our customers are seeking opportunities to minimize their inventory on hand while demanding shorter lead times for orders placed. As a result, we have increased our inventory levels over the past year to meet this demand. 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, which generally yield higher gross margins. 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, costs associated with computer aided design software tools, depreciation, amortization of intangibles, allocable facilities related and administrative expenses and tape-out costs. Tape-out costs are expenses related to the manufacture of new ICs, including charges for mask sets, prototype wafers, mask set revisions and testing incurred before releasing new ICs into production. We anticipate these expenses will increase in future periods based on an increase in personnel to support our product development activities and the introduction of new products. 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, marketing and customer support, commission payments to third party sales representatives, advertising, trade shows and promotions, travel, amortization of intangibles, and allocable facilities related and administrative expenses. We expect these expenses will increase in absolute dollars in future periods based on an increase in sales and marketing personnel and increased marketing activities. General and Administrative Expenses. General and administrative expenses consist primarily of salaries, share-based compensation and associated costs for employees engaged in finance, legal, human resources and administrative activities, professional service expenses for accounting, corporate legal fees and allocable facilities related expenses. We expect these expenses will increase in absolute dollars in future periods based on an increase in personnel and professional services required to support our business activities. 44-------------------------------------------------------------------------------- Table of Contents Taxes on Income Our operations in Israel have been granted "Approved Enterprise" status by the Investment Center of the Israeli 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 Beneficiary Enterprise program, income that is attributable to our operations in Yokneam, Israel will be exempt from income tax for a period of ten years commencing fiscal year 2011. 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) for five to eight years beginning fiscal year 2013. The Yokneam tax holiday is expected to expire in 2020 and the Tel Aviv tax holiday is expected to expire between 2017 and 2020. The corporate tax rate was 25% in 2013 and will be 26.5% in 2014. In the first quarter of 2013, we realigned some of our business activities and, as a result, may start utilizing carryforward net operating losses in one of our subsidiaries in the future. The valuation allowance established for deferred tax assets will be released if it becomes more likely than not that we will generate sufficient future taxable income in that subsidiary. 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 revenue recognition, allowance for doubtful accounts, fair value of financial instruments, inventory valuation, valuation and impairment of goodwill and acquired intangibles, warranty provision, share-based compensation, contingent liabilities, and income taxes have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. For further information on all of our significant accounting policies, please see Note 1, "The Company and Summary of Significant Accounting Policies," of the Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. 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 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. We determine whether collectibility is probable 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 probable, no product is shipped and no revenue is recognized unless cash is received in advance. 45-------------------------------------------------------------------------------- Table of Contents 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 Excluding Software 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. When we enter into an arrangement that includes multiple elements, the allocation of value to each element is derived based on management's best estimate of selling price when vendor specific evidence or third party evidence is unavailable. Multiple Element Arrangements Including Software For multiple element arrangements that include a combination of hardware, software and services, such as post-contract customer support, the arrangement consideration is first allocated among the accounting units before revenue recognition criteria are applied. If an arrangement includes undelivered elements that are not essential to the functionality of the delivered elements, we defer revenue for the undelivered elements based on their fair value. The fair value for undelivered software elements is based on vendor specific evidence. If the undelivered elements are essential to the functionality of the delivered elements, no revenue is recognized. 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. Distributor Revenue A portion of our sales are made to distributors under agreements which contain a limited right to return unsold product and price protection provisions. We recognize revenue from these distributors based on the sell-through method using inventory and point of sale information provided by the distributor. Additionally, we maintain accruals and allowances for price protection and cooperative marketing programs. We classify the costs of these programs based on the identifiable benefit received as either a reduction of revenue, a cost of revenues or an operating expense. Deferred Revenue and Income We defer revenue and income when advance payments are received from customers before performance obligations have been completed and/or services have been performed. Shipping and Handling Costs incurred for shipping and handling expenses to customers are recorded as cost of revenues. To the extent these amounts are billed to the customer in a sales transaction, we record the shipping and handling fees as revenue. 46-------------------------------------------------------------------------------- Table of Contents Allowance for doubtful accounts We estimate the allowance for doubtful accounts based on an assessment of the collectibility of specific customer accounts. If we determine that a specific customer is unable to meet its financial obligations, we provide a specific allowance for credit losses to reduce the net recognized receivable to the amount we reasonably believe will be collected. Probability of collection is assessed on a customer-by-customer basis and our historical experience with each customer. Customers are subject to an ongoing credit review process that evaluates their respective financial positions. We review and update our estimates for allowance for doubtful accounts on a quarterly basis. Our allowance for doubtful accounts totaled approximately $0.6 million at December 31, 2013 and 2012. Our bad debt expense totaled approximately less than $0.1 million, $0.1 million and $0.2 million for the years ended December 31, 2013, 2012 and 2011, respectively. Fair value of financial instruments Our financial instruments consist of cash, cash equivalents, short-term investments and foreign currency derivative contracts. We believe that the carrying amounts of the financial instruments approximate their respective fair values. 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. Short-term investments We classify short-term investment 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. We 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. Inventory valuation We value our inventory at the lower of cost or market. Market is determined based on net realizable value. Cost is determined for raw materials on a "first-in, first-out" basis, for work in process based on actual costs and for finished goods based on standard cost, which approximates actual cost on a first-in, first-out basis. We reserve for excess and obsolete inventory based on market conditions and forecasted demand generally over a six to twelve months period. Inventory reserves are not reversed and permanently reduce the cost basis of the affected inventory until it is either sold or scrapped. 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 to five years for computers, software license rights and other electronic equipment, and seven to fifteen years for office furniture and equipment. 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 47-------------------------------------------------------------------------------- Table of Contents We incur costs for the fabrication of masks used by our contract manufacturers to manufacture wafers that incorporate our products. We capitalize the costs of fabrication masks that are reasonably expected to be used during production manufacturing. These amounts are included within property and equipment and are generally depreciated over a period of 12 months to cost of revenue. If we do not reasonably expect to use the fabrication mask during production manufacturing, we expense the related mask costs to research and development in the period in which the costs are incurred. 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. The "step one" goodwill impairment test requires us to estimate the fair value of the business and certain assets and liabilities. "Step two" of the process is only performed if a potential impairment exists in "step one" and it involves determining the difference between the fair value of the reporting unit's net assets other than goodwill to the fair value of the reporting unit. If the difference is less than the net book value of goodwill, an impairment exists and is recorded. As of December 31, 2013, our assessment of goodwill impairment indicated that goodwill was not impaired. Intangible assets primarily represent acquired intangible assets including developed technology, customer relationships and in-process research and development, ("IPR&D"). We amortize the 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. 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. Intangible assets are tested for impairment 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, 2013, our assessment of intangibles indicated that intangible assets were not impaired. Investments in privately-held companies As of December 31, 2013, we held $7.5 million investments in privately-held companies. We account for these investments under the cost method, reduced by any impairment write-downs because 48-------------------------------------------------------------------------------- Table of Contents 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. Warranty provision We provide a limited warranty for periods of up to three years from the date of delivery against defects in materials and workmanship. If a customer has a defective product, we will either repair the goods or provide replacement products at no charge. We record estimated warranty expenses at the time we recognize the associated product revenues based on our historical rates of return and costs of repair over the preceding 36-month period. In addition, we recognize estimated warranty expenses for specific defects that are expected to result in warranty claims in excess of our historical rates of return at the time those defects are identified. Share-based compensation We account for share-based compensation expense based on the estimated fair value of the equity awards as of the grant dates. The fair value of restricted share units ("RSUs") is based on the closing market price of our ordinary shares on the date of grant. We estimate the fair value of share option awards using the Black-Scholes option valuation model, which requires the input of subjective assumptions including the expected share price volatility and the calculation of expected term as well as and the fair value of the underlying ordinary share on the date of grant, among other inputs. We base our estimate of expected volatility the historical volatility of our shares. We calculate the expected term of our options using the simplified method as prescribed by the authoritative guidance. The expected term for newly granted options is approximately 6.25 years. Share compensation expense is recognized on a straight-line basis over each recipient's requisite service period, which is generally the vesting period. Share-based compensation expense is recorded net of estimated forfeitures. Forfeitures are estimated at the time of grant and this estimate is revised, if necessary, in subsequent periods. If the actual number of forfeitures differs from that estimated, adjustments may be required to share-based compensation expense 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 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 49-------------------------------------------------------------------------------- Table of Contents 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. 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, 2013 2012 2011 Total revenues 100 % 100 % 100 % Cost of revenues (35 ) (32 ) (35 ) Gross profit 65 68 65 Operating expenses: Research and development 43 27 36 Sales and marketing 18 12 16 General and administrative 9 5 8 Total operating expenses 70 44 60 Income (loss) from operations (5 ) 24 5 Other income, net - - - Provision for taxes on income (1 ) (2 ) (1 ) Net income (loss) (6 ) 22 4 Comparison of the Year Ended December 31, 2013 to the Year Ended December 31, 2012 and Year Ended December 31, 2012 to the Year Ended December 31, 2011 Revenues. The following tables represent our total revenues for the years ended December 31, 2013 and 2012 by product type and interconnect protocol: Year Ended December 31, % of % of 2013 Revenues 2012 Revenues (In thousands) (In thousands) ICs $ 56,817 14.5 $ 95,103 19.0 Boards 119,399 30.6 155,670 31.1 Switch systems 145,184 37.1 168,231 33.6 Cables, accessories and other 69,459 17.8 81,795 16.3 Total revenue $ 390,859 100.0 $ 500,799 100.0 50 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, % of % of 2013 Revenues 2012 Revenues (In thousands) (In thousands) InfiniBand: FDR $ 200,300 51.3 $ 236,728 47.3 QDR 86,784 22.2 175,650 35.1 DDR/SDR 21,211 5.4 33,457 6.7 Total 308,295 78.9 445,835 89.0 Ethernet 52,908 13.5 42,523 8.5 Other 29,656 7.6 12,441 2.5 Total revenue $ 390,859 100.0 $ 500,799 100.0 Revenues were $390.9 million for the year ended December 31, 2013 compared to $500.8 million for the year ended December 31, 2012, representing a decrease of approximately 22%. The year-over-year revenue decrease from sales of Infiniband products was primarily due to increased revenues in 2012 related to pent-up demand associated with the launch of Romley and Sandy Bridge platforms by Intel Corporation. In addition, our revenues in 2013 were negatively impacted by the weaker demand environment and a build-up of inventory at an OEM customer. Revenues in all of our product types declined. The revenues for the higher bandwidth FDR InfiniBand products as a percentage of revenue increased to 51% while the lower bandwidth InfiniBand products revenues declined as the percentage of revenues due to increased adoption of the fastest product generation. Our Ethernet revenues also grew year-over-year primarily due to increased adoption of our products within the Web 2.0 market. The increase in revenues from other products category is explained by higher software and services revenues as well as sales by Kotura and IPtronics products from their respective acquisition dates. The 2013 revenues are not necessarily indicative of future results. The following tables represent our total revenues for the years ended December 31, 2012 and 2011 by product type and interconnect protocol: Year Ended December 31, % of % of 2012 Revenues 2011 Revenues (In thousands) (In thousands) ICs $ 95,103 19.0 $ 46,564 18.0 Boards 155,670 31.1 98,004 37.8 Switch systems 168,231 33.6 76,398 29.5 Cables, accessories and other 81,795 16.3 38,285 14.7 Total revenue $ 500,799 100.0 $ 259,251 100.0 Year Ended December 31, % of % of 2012 Revenues 2011 Revenues (In thousands) (In thousands) InfiniBand: FDR $ 236,728 47.3 $ 13,853 5.3 QDR 175,650 35.1 173,412 66.9 DDR/SDR 33,457 6.6 34,157 13.2 Total 445,835 89.0 221,422 85.4 Ethernet 42,523 8.5 24,252 9.4 Other 12,441 2.5 13,577 5.2 Total revenue $ 500,799 100.0 $ 259,251 100.0 51 -------------------------------------------------------------------------------- Table of Contents Revenues were $500.8 million for the year ended December 31, 2012 compared to $259.3 million for the year ended December 31, 2011, representing an increase of approximately 93%. Following the introduction of Romley and Sandy Bridge server and storage platforms by Intel Corporation in March 2012, end users had begun to upgrade their systems, placing an increased emphasis on the interconnects and associated performance. The year-over-year growth was primarily due to pent-up demand for our higher bandwidth FDR InfiniBand products in the HPC and Web 2.0 markets. Our Ethernet revenues also grew year-over-year primarily due to increased adoption of our products within the Web 2.0 market. Revenues in all of our product types increased with higher growth rates achieved in switch system and cable product families due to increased adoption of our end-to-end solutions. Gross Profit and Margin. Gross profit was $255.6 million for the year ended December 31, 2013 compared to $342.9 million for the year ended December 31, 2012, representing a decrease of approximately 25%. As a percentage of revenues, gross margin decreased to 65% in the year ended December 31, 2013 from approximately 68% in the year ended December 31, 2012. The gross margin percentage decrease was mainly due to product mix and increased warranty expenses associated with our expansion into new markets. Specifically, the portion of revenues attributed to ICs and boards declined in 2013 while the portion of revenues attributable to switch systems, cables and other product types increased. We garnish higher gross margins on sales of ICs and boards than the other product types. In addition, gross profit in 2013 was impacted by higher amortization of acquired intangible assets from the Kotura and IPtronics acquisitions in the amount of $3.4 million and acquisition related charges of $0.9 million. Gross margin for 2013 is not necessarily indicative of future results. Gross profit was $342.9 million for the year ended December 31, 2012 compared to $167.2 million for the year ended December 31, 2011, representing an increase of approximately 105%. As a percentage of revenues, gross margin increased to 68% in the year ended December 31, 2012 from approximately 65% in the year ended December 31, 2011. The gross margin percentage improvement was across all product categories and due primarily to the increased shipments of our FDR InfiniBand products, which typically yield higher gross margins, compared to our lower data rate products, and was partially offset by an increase in warranty expenses associated with our expansion into new markets. Research and Development. The following table presents details of our research and development expenses for the periods indicated: Year Ended December 31, % of % of % of 2013 Revenues 2012 Revenues 2011 Revenues (in thousands) (in thousands) (in thousands) Salaries and benefits $ 84,261 21.6 % $ 76,194 15.2 % $ 48,437 18.7 % Share-based compensation 25,956 6.6 % 19,356 3.9 % 11,906 4.6 % Development and tape-out costs 21,337 5.5 % 16,545 3.3 % 13,888 5.4 % Other 37,167 9.5 % 26,851 5.3 % 18,277 7.0 % Total Research and development $ 168,721 43.2 % $ 138,946 27.7 % $ 92,508 35.7 % Research and development expenses were $168.7 million for the year ended December 31, 2013 compared to $138.9 million for the year ended December 31, 2012, representing an increase of approximately 21%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions, including those associated with the Kotura and IPtronics acquisitions, partially offset by lower accrued bonuses under our annual discretionary bonus award 52-------------------------------------------------------------------------------- Table of Contents program. The increase in development and tape-out costs was attributable due to higher equipment expense, increased non-recurring engineering expenses, higher software expenses, increased outsourcing expenses and higher tape-out costs. The increase in other research and development costs was primarily attributable to higher depreciation and amortization expenses due to amortization of acquired intangibles, as well as increased facilities and maintenance expenses and acquisition related charges. We expect that research and development expenses will increase in absolute dollars in future periods as we continue to devote more resources to develop new products, meet the changing requirements of our customers, expand into new markets and technologies and hire additional personnel. Research and development expenses were $138.9 million for the year ended December 31, 2012 compared to $92.5 million for the year ended December 31, 2011, representing an increase of approximately 50%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions, merit increases and higher accrued bonuses under our annual discretionary bonus award program. The increase in development and tape-out costs was attributable to higher product test, qualification and software expenses, partially offset by lower tape-out costs. The increase in other research and development costs was primarily attributable to an increase in facilities and depreciation expenses. Sales and Marketing. The following table presents details of our sales and marketing expenses for the periods indicated: Year Ended December 31, % of % of % of 2013 Revenues 2012 Revenues 2011 Revenues (in thousands) (in thousands) (in thousands) Salaries and benefits $ 39,252 10.0 % $ 31,433 6.3 % $ 20,884 8.1 % Share-based compensation 9,198 2.4 % 8,055 1.6 % 4,894 1.9 % Trade shows and promotions 10,456 2.7 % 11,111 2.2 % 7,309 2.8 % Other 11,412 2.9 % 10,469 2.1 % 7,279 2.8 % Total Sales and marketing $ 70,318 18.0 % $ 61,068 12.2 % $ 40,366 15.6 % Sales and marketing expenses were $70.3 million for the year ended December 31, 2013 compared to $61.1 million for the year ended December 31, 2012, representing an increase of approximately 15%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions, including those associated with the Kotura and IPtronics acquisitions, partially offset by lower accrued bonuses under our annual discretionary bonus award program. The decrease in trade show and promotion costs was primarily due to lower advertising expenses, lower external sales commission and decreased equipment expenses. The increase in other sales and marketing costs was primarily attributable to higher facilities depreciation, higher amortization expenses of acquired intangible assets and acquisition related charges. Sales and marketing expenses were $61.1 million for the year ended December 31, 2012 compared to $40.4 million for the year ended December 31, 2011, representing an increase of approximately 51%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions, merit increases and higher incentive compensation. The increase in trade show and promotion costs was primarily due to higher advertising and travel expenses. The increase in other sales and marketing costs was primarily attributable to higher facilities and maintenance related costs. 53-------------------------------------------------------------------------------- Table of Contents General and Administrative. The following table presents details of our general and administrative expenses for the periods indicated: Year Ended December 31, % of % of % of 2013 Revenues 2012 Revenues 2011 Revenues (in thousands) (in thousands) (in thousands) Salaries and benefits $ 11,617 3.0 % $ 10,343 2.1 % $ 7,883 3.0 % Share-based compensation 8,156 2.0 % 5,987 1.2 % 3,632 1.4 % Professional services 13,964 3.6 % 5,232 1.0 % 7,433 2.9 % Other 3,181 0.8 % 2,979 0.6 % 2,821 1.1 % Total General and administrative $ 36,918 9.4 % $ 24,541 4.9 % $ 21,769 8.4 % General and administrative expenses were $36.9 million for the year ended December 31, 2013 compared to $24.5 million for the year ended December 31, 2012, representing an increase of approximately 50%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions including those associated with the Kotura and IPtronics acquisitions, partially offset by lower accrued bonuses under our annual discretionary bonus award program. The increase in professional services costs was primarily due to $6.2 million of legal, accounting and other consulting fees associated with the acquisitions of Kotura and IPtronics, as well as legal expenses related to the legal proceedings in which we are currently involved. General and administrative expenses were $24.5 million for the year ended December 31, 2012 compared to $21.8 million for the year ended December 31, 2011, representing an increase of approximately 13%. The increase in salaries and benefits and share-based compensation was attributable to headcount additions, merit increases and higher accrued bonuses under our annual discretionary bonus award program. The decrease in professional services costs was primarily due to $3.6 million of consulting fees associated with the Voltaire acquisition recognized in 2011, partially offset by an increase in legal and consulting 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 income: Year Ended December 31, 2013 2012 2011 (in thousands) Cost of goods sold $ 1,828 $ 1,621 $ 980 Research and development 25,956 19,356 11,906 Sales and marketing 9,198 8,055 4,894 General and administrative 8,156 5,987 3,632 $ 45,138 $ 35,019 $ 21,412 The amount of unearned share-based compensation currently estimated to be expensed from 2014 through 2017 related to unvested share-based payment awards at December 31, 2013 is $89.8 million. Of this amount, $37.2 million, $30.8 million, $17.5 million and $4.3 million are currently estimated to be recorded in 2014, 2015, 2016 and 2017, respectively. The weighted-average period over which the unearned share-based compensation is expected to be recognized is approximately 2.32 years. If there are any modifications or cancellations of the underlying unvested awards, we may be required to 54-------------------------------------------------------------------------------- Table of Contents accelerate, increase or cancel any remaining unearned share-based compensation expense. Future share-based compensation expense and unearned share-based compensation will increase to the extent that we grant additional equity awards to employees or assume unvested equity awards in connection with other acquisitions. Other Income (Loss), Net. Other income, net consists of interest earned on cash and cash equivalents and short-term investments and foreign currency exchange gains and losses. Other income, net was $1.2 million for the year ended December 31, 2013 compared to $1.3 million for the year ended December 31, 2012. The change was primarily attributable to higher foreign currency exchange losses and bank fees of $0.1 million. Other income, net was $1.3 million for the year ended December 31, 2012 compared to $0.8 million for the year ended December 31, 2011. The change was primarily attributable to an increase of $1.1 million in interest income and gains on investments due to higher cash and investment balances, partially offset by higher foreign currency exchange losses of $0.7 million. Provision for Taxes on Income. Our tax expense was $3.8 million for the year ended December 31, 2013 as compared to $8.2 million for the year ended December 31, 2012. Our effective tax rates were (19.6)% and 6.8% for 2013 and 2012, respectively. The difference between the Company's effective tax rates for the year ended December, 2013 and the 35% federal statutory rate resulted primarily from losses of $17.0 million generated from non-US subsidiaries without tax benefit, along with non-tax-deductible expenses of $1.2 million, and the accrual of unrecognized tax benefits along with interest and penalties associated with unrecognized tax positions in amount of the $2.4 million, partially offset by foreign earnings taxed at rates lower than the federal statutory rates. The Israeli tax holidays resulted in cash tax savings of $6.4 million and 33.2 million in 2013 and 2012, respectively. Our tax expense was $8.2 million for the year ended December 31, 2012 as compared to $3.4 million for the year ended December 31, 2011. The U.S. federal statutory rate was 35% for 2012 and 34% for 2011. Our effective tax rates were 6.8% and 25.2% for 2012 and 2011, respectively. The difference between our effective tax rate in 2012 and the federal statutory tax rate is primarily due to profits earned in Israel where the tax rate is lower than the U.S. tax rate, partially offset by non-tax-deductible expenses such as share-based compensation expense and the accrual of unrecognized tax benefits, interest and penalties associated with unrecognized tax positions. The profits earned in Israel that were subject to tax holiday in the years ended December 31, 2012 and 2011 were $125.6 million and $17.4 million, respectively. Liquidity and Capital Resources Historically, we have financed our operations through a combination of sales of equity securities and cash generated by operations. As of December 31, 2013, our principal source of liquidity consisted of cash and cash equivalents of $63.2 million and short-term investments of $263.5 million. During the year 2013, we completed acquisitions of IPtronics and Kotura and paid the total net cash purchase price of approximately $123.5 million from our existing capital resources. We expect that our current cash and cash equivalents and short-term investments and our cash flows from operating activities will be sufficient to fund our operations over the next twelve months after taking into account expected increases in research and development expenses, including tape out costs, higher sales and marketing and general and administrative expenses, capital expenditures to support our infrastructure and growth, and potential acquisitions. 55 -------------------------------------------------------------------------------- Table of Contents Our cash position, short-term investments, restricted cash and working capital at December 31, 2013 and December 31, 2012 were as follows: Year Ended December 31, 2013 2012 (in thousands) Cash and cash equivalents $ 63,164 $ 117,054 Short-term investments 263,528 302,593 Restricted cash, current - 3,229 Restricted cash, long-term 3,514 3,388 Total $ 330,206 $ 426,264 Working capital $ 351,156 $ 431,745 Our ratio of current assets to current liabilities decreased to 4.5:1 at December 31, 2013 from 5.0:1 at December 31, 2012. Operating Activities Net cash provided by our operating activities amounted to $52.0 million in the year ended December 31, 2013. Net cash provided by operating activities was primarily attributable to net non-cash items of $75.9 million partially offset by changes in assets and liabilities of $1.0 million and net loss of $22.9 million. Non-cash expenses consisted primarily of $42.5 million of share-based compensation, net of excess tax benefits, and $35.9 million for depreciation and amortization, partially offset by deferred income taxes of $1.2 million and gains on investments of $1.2 million. The $1.0 million cash outflow from changes in assets and liabilities resulted from an increase in accounts receivable of $8.9 million primarily due to higher sales in the last month of the year and a decrease in accounts payable of $4.4 million primarily due to timing of payments during the year, partially offset by a decrease in inventories of $9.3 million as a result of our effort to reduce inventory levels, an increase of $1.6 million in accrued liabilities and a decrease in prepaid expenses and other assets of $1.4 million. Net cash provided by our operating activities amounted to $182.5 million in the year ended December 31, 2012. Net cash provided by operating activities was primarily attributable to net income of $111.4 million adjusted by net non-cash items of $49.4 million and changes in assets and liabilities of $21.7 million. Non-cash expenses consisted primarily of $29.9 million for share-based compensation, net of the excess tax benefits, $23.9 million for depreciation and amortization and were partially offset by deferred income taxes of $3.5 million. The $21.7 million cash inflow from changes in assets and liabilities resulted from an increase of $51.3 million in accrued liabilities primarily due to higher payroll obligations and an increase in accounts payable of $3.4 million due to the higher volume of purchases during the period, and was partially offset by an increase in inventories of $19.4 million due to higher expected sales volumes, an increase in accounts receivable of $10.3 million and an increase in prepaid expenses and other assets of $3.2 million. Investing Activities Net cash used in investing activities was $121.9 million in the year ended December 31, 2013. Cash used in investing activities was primarily attributable to the acquisitions of Kotura and IPtronics in the amount of $123.5 million, purchases of property and equipment of $30.9 million, purchases of intangible assets of $7.4 million and an equity investment of $3.1 million in private companies partially offset by net sales and maturities of short-term investments of $40.4 million and a decrease in restricted cash deposits by $3.5 million. 56-------------------------------------------------------------------------------- Table of Contents Net cash used in investing activities was $280.9 million in the year ended December 31, 2012. Cash used in investing activities was primarily attributable to net purchases of short-term investments of $249.5 million, purchases of property and equipment of $30.5 million and an equity investment of $1.4 million in a private company, partially offset by a decrease in restricted cash of $1.3 million. Financing Activities Net cash provided by financing activities was $16.1 million in the year ended December 31, 2013. Cash provided by financing activities was primarily due to proceeds of $14.6 million from share option exercises and purchases pursuant to our employee share purchase plan, and an excess tax benefit from share-based compensation of $2.7 million, and was partially offset by principal payments on capital lease obligations of $1.2 million. Net cash provided by financing activities was $34.2 million in the year ended December 31, 2012. Cash provided by financing activities was primarily due to proceeds of $30.0 million from share option exercises and purchases pursuant to our employee share purchase plan, and an excess tax benefit from share-based compensation of $5.1 million, and was partially offset by principal payments on capital lease obligations of $0.9 million. Contractual Obligations The following table summarizes our contractual obligations at December 31, 2013 and the effect those obligations are expected to have on our liquidity and cash flow in future periods: Payments Due by Period Less Than Beyond Contractual Obligations: Total 1 Year 1 - 3 Years 3 - 5 Years 5 Years (in thousands) Commitments under capital lease $ 2,845 $ 1,256 $ 1,589 $ - $ - Non-cancelable operating lease commitments 53,351 16,300 19,789 10,835 6,427 Purchase commitments 45,975 45,150 825 - - Total $ 102,171 $ 62,706 $ 22,203 $ 10,835 $ 6,427 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. 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, 2013, our unrecognized tax benefits totaled $23.6 million, which would reduce our income tax expense and effective tax rate, if recognized. Recent accounting pronouncements See Note 1, "The Company and Summary of Significant Accounting Policies-Recent accounting pronouncements" of the Notes to the Consolidated Financial Statements, included in Part IV, Item 15 of this report, for a full description of recent accounting standards, including the respective dates of adoption and effects on our consolidated financial position, results of operations and cash flows. 57-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements As of December 31, 2013, 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 new Israeli shekel, ("NIS"). We do not enter into derivative transactions for speculative or trading purposes. In fiscal year 2013, we used foreign currency derivative contracts to hedge a portion of operating expenses denominated in NIS. Our derivative instruments are recorded at fair value in assets or liabilities with gains or losses 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. The ineffective portion of a derivative's change in fair value is immediately recognized in other income, net. See Note 7, "Derivatives and Hedging Activities," of the Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this report. |