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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)



☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended:	June 30, 2019
OR
☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission File Number 001-33299

MELLANOX TECHNOLOGIES, LTD.

(Exact name of registrant as specified in its charter)



Israel		98-0233400
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

Beit Mellanox, Yokneam, Israel 20692

(Address of principal executive offices, including zip code)

+972-4-909-7200

(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Exchange Act:



Title of each class	Trading Symbol	Name of each exchange on which registered
Ordinary Shares, nominal value NIS 0.0175 per share	MLNX	The Nasdaq Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer", "smaller reporting company", and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer	☒	Accelerated filer	☐	Non-accelerated filer	☐	Smaller reporting company	☐
						Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ☐ No ☒

The total number of shares outstanding of the registrant's Ordinary Shares, nominal value NIS 0.0175 per share, as of July 26, 2019, was 54,799,274.

MELLANOX TECHNOLOGIES, LTD.



PART I		Page No.
FINANCIAL INFORMATION

ITEM 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets (Unaudited) — June 30, 2019 and December 31, 2018	3
	Condensed Consolidated Statements of Operations (Unaudited) — Three and Six Months Ended June 30, 2019 and 2018	4
	Condensed Consolidated Statements of Comprehensive Income (Unaudited) — Three and Six Months Ended June 30, 2019 and 2018	5
	Condensed Consolidated Statements of Shareholders' Equity (Unaudited) — Six Months Ended June 30, 2019 and 2018	6
	Condensed Consolidated Statements of Cash Flows (Unaudited) — Six Months Ended June 30, 2019 and 2018	7
	Notes to Unaudited Condensed Consolidated Financial Statements	8
ITEM 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	28
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	40
ITEM 4.	Controls and Procedures	41

	PART II
	OTHER INFORMATION

ITEM 1	Legal Proceedings	42
ITEM 1A.	Risk Factors	42
ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	61
ITEM 3.	Defaults Upon Senior Securities	61
ITEM 4.	Mine Safety Disclosures	61
ITEM 5.	Other Information	61
ITEM 6.	Exhibits	62

PART I. FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

MELLANOX TECHNOLOGIES, LTD.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)



	June 30,		December 31,
	2019		2018
	(in thousands, except par value)
ASSETS
Current assets:
Cash and cash equivalents	$	53,782	$	56,766
Short-term investments	556,806		381,724
Accounts receivable, net	200,351		150,625
Inventories	89,650		104,381
Other current assets	20,895		16,942
Total current assets	921,484		710,438
Property and equipment, net	108,142		105,334
Intangible assets, net	159,046		179,328
Goodwill	473,916		473,916
Other long-term assets	159,520		118,182
Total assets	$	1,822,108	$	1,587,198
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	73,790	$	70,336
Accrued and other liabilities	142,246		121,878
Deferred revenue	22,998		20,558
Total current liabilities	239,034		212,772
Deferred revenue, long-term	20,224		18,665
Other long-term liabilities	100,093		54,113
Total liabilities	359,351		285,550
Commitments and Contingencies - (see Note 9)
Shareholders’ equity:
Ordinary shares: NIS 0.0175 par value, 200,000 shares authorized, 54,795 and 53,918 shares issued and outstanding at June 30, 2019 and December 31, 2018, respectively	237		233
Additional paid-in capital	1,051,985		982,677
Accumulated other comprehensive income (loss)	2,394		(1,051		)
Retained earnings	408,141		319,789
Total shareholders’ equity	1,462,757		1,301,648
Total liabilities and shareholders' equity	$	1,822,108	$	1,587,198

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

MELLANOX TECHNOLOGIES, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)



	Three Months Ended June 30,					Six Months Ended June 30,
	2019		2018			2019		2018
	(in thousands, except per share data)
Total revenues	$	310,324	$	268,462		$	615,541	$	519,462
Cost of revenues	110,034		103,668			218,120		192,666
Gross profit	200,290		164,794			397,421		326,796
Operating expenses:
Research and development	99,329		87,152			191,534		173,578
Sales and marketing	39,302		35,673			79,399		75,167
General and administrative	19,199		23,635			38,470		40,151
Restructuring and impairment charges	275		1,774			1,178		9,361
Total operating expenses	158,105		148,234			310,581		298,257
Income from operations	42,185		16,560			86,840		28,539
Interest and other, net	2,268		(338		)	10,499		(871		)
Income before taxes on income	44,453		16,222			97,339		27,668
Provision for (benefit from) taxes on income	6,024		(304		)	10,290		(26,701		)
Net income	$	38,429	$	16,526		$	87,049	$	54,369
Net income per share — basic	$	0.70	$	0.31		$	1.60	$	1.04
Net income per share — diluted	$	0.68	$	0.30		$	1.55	$	1.00
Shares used in computing net income per share:
Basic	54,707		52,615			54,469		52,219
Diluted	56,480		54,466			56,180		54,149

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

MELLANOX TECHNOLOGIES, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)



	Three Months Ended June 30,					Six Months Ended June 30,
	2019		2018			2019		2018
	(in thousands)
Net income	$	38,429	$	16,526		$	87,049	$	54,369
Other comprehensive income (loss), net of tax:
Change in unrealized gains (losses) on available-for-sale securities, net of tax	1,186		213			1,968		(80		)
Change in unrealized gains (losses) on derivative contracts, net of tax	189		(2,382		)	2,780		(3,720		)
Other comprehensive income (loss), net of tax	1,375		(2,169		)	4,748		(3,800		)
Total comprehensive income, net of tax	$	39,804	$	14,357		$	91,797	$	50,569

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

MELLANOX TECHNOLOGIES, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)



						Accumulated
				Additional		Other					Total
	Ordinary Shares			Paid-in		Comprehensive			Retained		Shareholders'
	Shares	Amount		Capital		Income (Loss)			Earnings		Equity
	(In thousands, except share data)

Balance at December 31, 2018	53,918,208	$	233	$	982,677	$	(1,051	)	$	319,789	$	1,301,648

Net income									48,620		48,620
Unrealized gains on available-for-sale securities and derivative contracts, net of taxes						3,373					3,373
Share-based compensation				24,242							24,242
Issuances of shares through employee equity incentive plans	451,535	2		5,970							5,972
Issuance of shares through employee share purchase plan	162,573	1		11,054							11,055
Balance at March 31, 2019	54,532,316	$	236	$	1,023,943	$	2,322		$	368,409	$	1,394,910
Net income									38,429		38,429
Unrealized gains on available-for-sale securities and derivative contracts, net of taxes						72			1,303		1,375
Share-based compensation				26,949							26,949
Issuances of shares through employee equity incentive plans	262,557	1		1,093							1,094
Balance at June 30, 2019	54,794,873	$	237	$	1,051,985	$	2,394		$	408,141	$	1,462,757

Balance at December 31, 2017	51,487,650	$	221	$	873,979	$	1,618		$	181,630	$	1,057,448

Net income									37,843		37,843
Unrealized losses on available-for-sale securities and derivative contracts, net of taxes						(1,631		)			(1,631		)
Effect of adopting Topic 606									4,501		4,501
Share-based compensation				14,974							14,974
Issuances of shares through employee equity incentive plans	384,523	2		2,708							2,710
Issuance of shares through employee share purchase plan	288,017	1		11,347							11,348
Balance at March 31, 2018	52,160,190	$	224	$	903,008	$	(13	)	$	223,974	$	1,127,193
Net income									16,526		16,526
Unrealized losses on available-for-sale securities and derivative contracts, net of taxes						(2,169		)			(2,169		)
Share-based compensation				14,916							14,916
Issuances of shares through employee equity incentive plans	770,573	5		5,278							5,283
Balance at June 30, 2018	52,930,763	$	229	$	923,202	$	(2,182	)	$	240,500	$	1,161,749

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

MELLANOX TECHNOLOGIES, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)



	Six Months Ended June 30,
	2019			2018
	(in thousands)
Cash flows from operating activities:
Net income	$	87,049		$	54,369
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	47,449			52,674
Deferred income taxes	—			(28,085		)
Share-based compensation	51,191			29,890
Gain on short-term investments, net	(6,558		)	(1,828		)
Gain on investments in privately-held companies	(9,569		)	—
Impairment charges	2,843			1,567
Changes in assets and liabilities:
Accounts receivable	(49,726		)	(1,451		)
Inventories	11,800			(30,598		)
Prepaid expenses and other assets	4,047			718
Accounts payable	1,969			12,530
Accrued and other liabilities	6,509			12,334
Net cash provided by operating activities	147,004			102,120

Cash flows from investing activities:
Purchase of short-term investments	(364,777		)	(82,486		)
Proceeds from sales and maturities of short-term investments	198,221			76,289
Proceeds from sales of property and equipment	—			3,239
Purchase of property and equipment	(15,208		)	(20,078		)
Purchase of intangibles and other assets	(2,850		)	(6,995		)
Proceeds from sale of an investment in a privately-held company	16,887			—
Purchase of investments in privately-held companies	(4,247		)	(6,000		)
Acquisition, net of cash acquired	—			(7,129		)
Net cash used in investing activities	(171,974		)	(43,160		)

Cash flows from financing activities:
Principal payments on term debt	—			(74,000		)
Payments on intangible asset financings	(4,019		)	(3,446		)
Proceeds from share issuances through employee stock plans	18,121			19,341
Net cash provided by (used in) financing activities	14,102			(58,105		)

Net increase (decrease) in cash, cash equivalents, and restricted cash	(10,868		)	855
Cash, cash equivalents, and restricted cash at beginning of period	64,650			70,498
Cash, cash equivalents, and restricted cash at end of period	$	53,782		$	71,353

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1—THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Company

Mellanox Technologies, Ltd., an Israeli corporation (the "Company" or "Mellanox"), was incorporated and commenced operations in March 1999. Mellanox is a supplier of high-performance interconnect products for computing, storage and communications applications.

Pending Merger with NVIDIA Corporation

On March 10, 2019, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement") with NVIDIA Corporation, a Delaware corporation ("NVIDIA"), NVIDIA International Holdings Inc., a Delaware corporation and wholly owned subsidiary of NVIDIA ("Parent") and Teal Barvaz Ltd., a wholly owned subsidiary of Parent organized under the laws of the State of Israel and wholly owned subsidiary of Parent ("Merger Sub"). NVIDIA has agreed to guarantee the payment and performance obligations of Parent under the Merger Agreement. The Merger Agreement and the Merger (as defined below) have been approved by the boards of directors of the Company, NVIDIA, Parent and Merger Sub.

The Merger Agreement provides that, upon the terms and subject to the satisfaction or waiver of the conditions set forth therein, Merger Sub will be merged with and into the Company (the "Merger") in accordance with Sections 314-327 of the Companies Law 5759-1999 of the State of Israel, with the Company continuing as the surviving corporation and a wholly owned subsidiary of Parent.

At the effective time of the Merger (the "Effective Time"), each ordinary share, par value NIS 0.0175 per share, of the Company (a "Company Share") issued and outstanding immediately prior to the Effective Time, other than any shares owned by the Company, Parent and their respective subsidiaries or any shares held in the Company’s treasury, will be deemed to have been transferred to the Parent in exchange for the right to receive $125.00 in cash, without interest and subject to applicable withholding taxes.

The Merger Agreement contains customary representations, warranties and covenants. The consummation of the Merger is conditioned on the receipt of the approval of the Company’s shareholders, as well as the satisfaction of other customary closing conditions, including domestic and foreign regulatory approvals and performance in all material respects by each party of its obligations under the Merger Agreement. At the Company’s extraordinary general meeting held on June 20, 2019, the Company’s shareholders approved the consummation of the Merger. Closing of the Merger is expected by the end of calendar year 2019.

The Merger Agreement contains certain customary termination rights by either the Company or Parent, including if the Merger is not consummated by December 10, 2019, subject to two three-month extensions in order to obtain required regulatory approvals. If the Merger Agreement is terminated under certain circumstances, including termination by the Company to enter into a superior proposal, a termination by Parent following a change of the Company’s board of directors’ recommendation or a termination by Parent as a result of a willful material breach of the Merger Agreement’s no-solicitation obligations by the Company, the Company will be obligated to pay to Parent a termination fee equal to $225 million in cash. If the Merger Agreement is terminated under certain circumstances involving the failure to obtain certain regulatory approvals, Parent will be obligated to pay the Company a termination fee equal to $350 million in cash.

The Company recorded transaction-related costs of $7.8 million, principally for investment banking and legal fees associated with the pending acquisition, during the six months ended June 30, 2019. These costs are recorded in general and administrative expenses included in the condensed consolidated statement of operations for the six months ended June 30, 2019. Additional transaction-related costs are expected to be incurred through the closing of the Merger.

Principles of presentation

The unaudited condensed consolidated financial statements include the Company's accounts as well as those of its wholly owned subsidiaries after the elimination of all intercompany balances and transactions.

The unaudited condensed consolidated financial statements included in this quarterly report on Form 10-Q have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). The year-end balance sheet data were derived from audited consolidated financial statements, but do not include all disclosures required by accounting principles generally accepted in the United States ("GAAP"). Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with GAAP have been

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures contained in this quarterly report comply with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended, for a quarterly report on Form 10-Q and are adequate to make the information presented not misleading. The unaudited condensed consolidated financial statements included herein reflect all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the financial position, results of operations and cash flows for the interim periods presented. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on February 21, 2019. The results of operations for the six months ended June 30, 2019 are not necessarily indicative of the results to be anticipated for the entire year ending December 31, 2019 or thereafter.

Certain prior year amounts have been reclassified for consistency with the current year presentation. On the balance sheet, the severance assets were reclassified to other long-term assets, and the accrued severance was reclassified to other long-term liabilities.

Risks and uncertainties

The Company is subject to all of the risks inherent in a company which operates in the dynamic and competitive semiconductor industry. Significant changes in any of the following areas could have a material adverse impact on the Company's financial position and results of operations: unpredictable volume or timing of customer orders; ordered product mix; the sales outlook and purchasing patterns of the Company's customers based on consumer demands and general economic conditions; loss of one or more of the Company's customers; decreases in the average selling prices of products or increases in the average cost of finished goods; the availability, pricing and timeliness of delivery of components used in the Company's products; reliance on a limited number of subcontractors to manufacture, assemble, package and production test the Company's products; the Company's ability to successfully develop, introduce and sell new or enhanced products in a timely manner; product obsolescence and the Company's ability to manage product transitions; the timing of announcements or introductions of new products by the Company's competitors; and the Company's ability to successfully integrate acquired businesses.

Use of estimates

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of net revenue and expenses in the reporting periods. The Company regularly evaluates estimates and assumptions related to revenue recognition, allowances for doubtful accounts, allowances for price adjustments, investment valuation, warranty reserves, inventory reserves, share-based compensation expense, long-term asset valuations, useful lives of property, equipment, and intangibles, accounting for business combinations, goodwill and purchased intangible asset valuation, investments in privately-held companies, accounting and fair value of financial instruments and derivatives, deferred income tax asset valuation, uncertain tax positions, and litigation and other loss contingencies. These estimates and assumptions are based on current facts, historical experience and various other factors that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs and expenses that are not readily apparent from other sources. The actual results that the Company experiences may differ materially and adversely from the Company's original estimates. To the extent there are material differences between the estimates and actual results, the Company's future results of operations will be affected.

Significant accounting policies

Other than our accounting policy related to the new lease standard (see Note 14, "Leases"), there have been no changes in the Company’s significant accounting policies that were disclosed in its Annual Report on Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on February 21, 2019.

Restricted cash

The Company maintained certain cash amounts that were restricted as to withdrawal or use over the long-term. The cash was securing bank guarantees primarily issued against long-term tenancy agreements. During the second quarter of 2019, the Company renegotiated the guarantee terms with the banks, and all restricted cash was released as of June 30, 2019. The long-term restricted cash balance of $7.9 million was reported in other long-term assets on the balance sheet as of June 30, 2018, and was included in the ending balance of cash, cash equivalents and restricted cash in the statement of cash flows for the six

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

months ended June 30, 2018. The following table provides a reconciliation of the cash and cash equivalents balances reported on the balance sheets and the cash, cash equivalents and restricted cash balances reported in the statements of cash flows:



	June 30,
	2019		2018
	(In thousands)
Cash and cash equivalents, as reported on the balance sheets	$	53,782	$	63,422
Restricted cash in other long-term assets, as reported on the balance sheets	—		7,931
Cash, cash equivalents, and restricted cash, as reported in the statements of cash flows	$	53,782	$	71,353

Concentration of credit risk

The following table summarizes the revenues from customers (including original equipment manufacturers) in excess of 10% of the total revenues:



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
Hewlett Packard Enterprise ("HPE")	13.5	%	13.0	%	10.5	%	15.0	%
Dell Technologies Inc. ("Dell")	*		14.0	%	11.3	%	12.0	%
____________________
* Less than 10%

There was no customer with an accounts receivable balance in excess of 10% of total accounts receivable as of June 30, 2019 and December 31, 2018.

Product warranty

The following table provides changes in the product warranty accrual for the six months ended June 30, 2019 and 2018:



	Six Months Ended June 30,
	2019			2018
	(in thousands)
Balance, beginning of the period	$	1,376		$	889
New warranties issued during the period	2,397			856
Reversal of warranty reserves	(18		)	—
Settlements during the period	(1,934		)	(784		)
Balance, end of the period	1,821			961
Less: long-term portion of product warranty liability	(362		)	(173		)
Current portion, end of the period	$	1,459		$	788

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

Net income per share

The following table sets forth the computation of basic and diluted net income per share for the three and six months ended June 30, 2019 and 2018:



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
	(in thousands, except per share data)
Net income	$	38,429	$	16,526	$	87,049	$	54,369
Basic and diluted shares:
Weighted average ordinary shares outstanding	54,707		52,615		54,469		52,219
Effect of dilutive shares	1,773		1,851		1,711		1,930
Shares used to compute diluted net income per share	56,480		54,466		56,180		54,149
Net income per share — basic	$	0.70	$	0.31	$	1.60	$	1.04
Net income per share — diluted	$	0.68	$	0.30	$	1.55	$	1.00

There were no material amounts of potentially dilutive share options and restricted share units ("RSUs") that had an anti-dilutive effect for the computation of diluted net income per share for both the three and six months ended June 30, 2019. The Company excluded 0.2 million potentially dilutive share options and RSUs from the computation of diluted net income per share for both the three and six months ended June 30, 2018, respectively, because including them would have had an anti-dilutive effect.

Adoption of new accounting principles

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The standard requires lessees to recognize almost all leases on the balance sheet as a right-of-use asset and a lease liability and requires leases to be classified as either an operating or a finance type lease. The standard excludes leases of intangible assets or inventory.

The standard became effective for the Company on January 1, 2019. The Company elected the available practical expedients and implemented internal controls to enable the preparation of financial information on adoption. The adoption of the standard had a material impact on the Company's condensed consolidated balance sheets due to the recognition of the right-of-use ("ROU") assets and lease liabilities related to the Company's operating leases. In addition, a material portion of the Company's leases are denominated in currencies other than the U.S. Dollar, mainly in New Israeli Shekels ("NIS"). As a result, the associated lease liabilities were remeasured using the current exchange rate, which resulted in non-operating foreign exchange losses. The standard did not have a material impact on the Company's results of operations or cash flows. See Note 14, "Leases" for details about the impact from adopting the new lease standard and other required disclosures.

Recent accounting pronouncements

In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. This ASU clarifies the accounting treatment for implementation costs for cloud computing arrangements (hosting arrangements) that are service contracts. This standard becomes effective for the Company beginning January 1, 2020. The Company is currently assessing the effect that this ASU will have on its condensed consolidated financial statements and related disclosures.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 2—REVENUE

Revenues by geographic region for the three and six months ended June 30, 2019 and 2018 were as follows:



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
	(in thousands)
United States	$	121,618	$	101,396	$	231,912	$	197,656
China	91,868		54,182		170,008		110,395
Europe	38,343		41,454		85,589		77,450
Other Americas	28,082		33,112		53,811		60,852
Other Asia	30,413		38,318		74,221		73,109
Total revenues	$	310,324	$	268,462	$	615,541	$	519,462

The following tables represent our total revenues for the three and six months ended June 30, 2019 and 2018 by product type and interconnect protocol:



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
	(in thousands)
ICs	$	53,046	$	28,934	$	113,669	$	57,521
Boards	120,643		136,708		229,073		254,759
Switch systems	73,808		57,074		155,866		112,721
Cables, accessories and other	62,827		45,746		116,933		94,461
Total revenues	$	310,324	$	268,462	$	615,541	$	519,462



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
	(in thousands)
InfiniBand:
HDR	$	28,620	$	—	$	51,813	$	—
EDR	66,643		59,319		$	126,286	$	115,265
FDR	28,972		35,649		69,570		77,397
QDR/DDR/SDR	8,646		7,143		23,350		12,587
Total	132,881		102,111		271,019		205,249
Ethernet	169,131		157,470		330,024		294,418
Other	8,312		8,881		14,498		19,795
Total revenues	$	310,324	$	268,462	$	615,541	$	519,462

Contract balances

The Company recognizes contract liabilities, or deferred revenues, when it receives advance payments from customers before performance obligations primarily related to extended warranty and post-contract customer support have been performed. Advance payments are received at the beginning of the service period and the related deferred revenues are reclassified to revenue ratably over the service period. The balance of deferred revenues approximates the aggregate amount of the transaction price allocated to the unsatisfied performance obligations at the end of reporting period. The Company expects to recognize the long-term portion of deferred revenue over the remaining service period of up to five years.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

The following table presents the significant changes in the deferred revenue balance during the six months ended June 30, 2019:



	(in thousands)
Balance, beginning of the period	$	39,223
New deferred revenue	21,013
Reclassification to revenues during the year (1)	(17,014		)
Balance, end of the period	43,222
Less: long-term portion of deferred revenue	20,224
Current portion, end of the period	$	22,998

(1) Of the total reclassification from deferred revenue to revenues, $11.7 million was related to the beginning balance, and $5.3 million was related to the new deferred revenue during the period.

Unsatisfied performance obligations, other than extended warranty and post-contract customer support, primarily represent contracts with future delivery dates. As of June 30, 2019, the Company had $57.5 million of unbilled transaction price allocated to performance obligations that were unsatisfied or partially unsatisfied related to contracts with an original duration over one year. The Company expects to invoice and recognize the revenue as it satisfies each performance obligation during a period of three years. The foregoing excludes the value of the remaining unsatisfied performance obligations related to contracts that have original durations of one year or less.

The Company recognizes assets for the material incremental costs of obtaining contracts with customers if it expects the benefit of those costs to be longer than one year. The Company allocates these assets proportionally to the performance obligations in the contracts and amortizes them as the performance obligations are satisfied. During the six months ended June 30, 2019, the Company recognized $11.3 million of assets related to costs to obtain contracts, and amortized $6.7 million of these assets during the same period. The unamortized balance of the assets was $4.6 million as of June 30, 2019.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 3—BALANCE SHEET COMPONENTS:



	June 30, 2019			December 31, 2018
	(in thousands)
Accounts receivable, net:
Accounts receivable, gross	$	209,851		$	156,525
Less: unearned distribution price adjustments allowance	(9,000		)	(5,400		)
Less: allowance for doubtful accounts	(500		)	(500		)
	$	200,351		$	150,625
Inventories:
Raw materials	$	19,331		$	19,391
Work-in-process	32,580			39,425
Finished goods	37,739			45,565
	$	89,650		$	104,381
Property and equipment, net:
Computer, equipment, and software	$	189,505		$	180,125
Furniture and fixtures	1,886			2,140
Leasehold improvements	50,057			46,179
	241,448			228,444
Less: Accumulated depreciation and amortization	(133,306		)	(123,110		)
	$	108,142		$	105,334
Other long-term assets:
Right of use assets	$	62,376		$	—
Deferred taxes	50,660			50,660
Equity investments in privately-held companies	35,496			40,300
Long-term restricted cash	—			7,884
Severance assets	5,428			17,043
Other	5,560			2,295
	$	159,520		$	118,182
Accrued and other liabilities:
Payroll and related expenses	$	68,965		$	76,788
Accrued expenses	31,227			28,821
Lease liability, current	17,706			—
Intangible asset financings	5,379			4,488
Other	18,969			11,781
	$	142,246		$	121,878
Other long-term liabilities:
Lease liability, long term	$	51,490		$	—
Income tax payable	36,211			25,600
Accrued severance	6,778			21,645
Deferred rent	—			2,532
Other	5,614			4,336
	$	100,093		$	54,113

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 4—FAIR VALUE MEASUREMENTS:

Fair value hierarchy:

The Company measures its cash equivalents and marketable securities at fair value. The Company’s cash equivalents are classified within Level 1. Cash equivalents are valued primarily using quoted market prices utilizing market observable inputs. The Company's investments in debt securities and certificates of deposits are classified within Level 2 as the market inputs to value these instruments consist of market yields, reported trades and broker/dealer quotes. In addition, foreign currency contracts are classified within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments. The Level 3 valuation inputs include the Company's best estimate of what market participants would use in pricing the asset or liability at the measurement date. The inputs are unobservable in the market and significant to the instrument's valuation. As of June 30, 2019 and December 31, 2018, the Company did not have any assets or liabilities valued based on Level 3 valuations.

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis:

The following table represents the fair value hierarchy of the Company's financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2019:



	Level 1		Level 2		Total
	(in thousands)
Money market funds	$	4,048	$	—	$	4,048
Certificates of deposit	—		149,108		149,108
Government debt securities	—		150,144		150,144
Corporate debt securities	—		257,554		257,554
	4,048		556,806		560,854
Derivative contracts	—		706		706
Total financial assets	$	4,048	$	557,512	$	561,560
Derivative contracts	—		22		22
Total financial liabilities	$	—	$	22	$	22

The following table represents the fair value hierarchy of the Company's financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2018:



	Level 1		Level 2		Total
	(in thousands)
Money market funds	$	1,265			$	1,265
Certificates of deposit			95,038		95,038
Government debt securities			100,478		100,478
Corporate debt securities			186,208		186,208
	1,265		381,724		382,989
Long-term restricted cash	—		7,884		7,884
Derivative contracts	—		96		96
Total financial assets	$	1,265	$	389,704	$	390,969
Derivative contracts	—		2,536		2,536
Total financial liabilities	$	—	$	2,536	$	2,536

There were no transfers between Level 1 and Level 2 securities during the six months ended June 30, 2019 and 2018.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 5—INVESTMENTS:

Cash, cash equivalents and short-term investments:

The short-term investments are classified as available-for-sale securities. The cash, cash equivalents and short-term investments at June 30, 2019 and December 31, 2018 were as follows:



	June 30, 2019
	Amortized Cost			Unrealized Gains		Unrealized Losses			Estimated Fair Value
	(in thousands)
Cash and cash equivalents	$	49,734		$	—	$	—		$	49,734
Money market funds	4,048			—		—			4,048
Certificates of deposit	149,074			39		(5		)	149,108
Government debt securities	149,683			474		(13		)	150,144
Corporate debt securities	256,457			1,124		(27		)	257,554
Total	608,996			1,637		(45		)	610,588
Less amounts classified as cash and cash equivalents	(53,782		)	—		—			(53,782		)
Short-term investments	$	555,214		$	1,637	$	(45	)	$	556,806



	December 31, 2018
	Amortized Cost			Unrealized Gains		Unrealized Losses			Estimated Fair Value
	(in thousands)
Cash and cash equivalents	$	55,501		$	—	$	—		$	55,501
Money market funds	1,265			—		—			1,265
Certificates of deposit	95,080			1		(43		)	95,038
Government debt securities	100,449			92		(63		)	100,478
Corporate debt securities	186,571			27		(390		)	186,208
Total	438,866			120		(496		)	438,490
Less amounts classified as cash and cash equivalents	(56,766		)	—		—			(56,766		)
Short-term investments	$	382,100		$	120	$	(496	)	$	381,724

Interest income and gains on short-term investments, net were $3.8 million and 1.0 million for the three months ended June 30, 2019 and 2018, respectively. Interest income and gains on short-term investments, net were $6.8 million and $1.9 million for the six months ended June 30, 2019 and 2018, respectively. At June 30, 2019, there were no material gross unrealized losses on investments that were in a gross unrealized loss position for a period greater than 12 months. These investments were not deemed to be other-than-temporarily impaired and the gross unrealized losses were recorded in other comprehensive income (loss) ("OCI").

The contractual maturities of short-term investments at June 30, 2019 and December 31, 2018 were as follows:



	June 30, 2019				December 31, 2018
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	(in thousands)
Due in less than one year	$	359,796	$	360,247	$	281,303	$	280,959
Due in one to three years	195,418		196,559		100,797		100,765
	$	555,214	$	556,806	$	382,100	$	381,724

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

Equity investments in privately-held companies:

As of June 30, 2019 and December 31, 2018, the Company held a total of $35.5 million and $40.3 million, respectively, in equity investments in privately-held companies. During the first quarter of 2019, one of the investees of the Company's equity investments in privately-held companies was acquired. As a result, the Company recorded a gain on sale of $9.1 million in the first quarter of 2019. In addition, $3.2 million of the consideration owed to the Company was held back in an escrow account as of June 30, 2019. The final amount released from escrow, if any, will be recognized as an additional gain on sale when released. During the second quarter of 2019, the Company recorded a gain of $0.4 million from the conversion of a note receivable to equity in a privately-held company.

While performing its review for impairment for the first quarter of 2019, the Company noted an observable price change related to one of its investments in a privately-held company. As a result, the Company recorded an impairment charge of $1.8 million in the first quarter of 2019. The gains on the investments and the impairment charge were reported in interest and other, net on the condensed consolidated statement of operations.

NOTE 6—GOODWILL AND INTANGIBLE ASSETS:

There has been no change in the carrying amount of goodwill of $473.9 million during the six months ended June 30, 2019.

The carrying amounts of intangible assets as of June 30, 2019 were as follows:



	Gross Carrying Value		Accumulated Amortization			Net Carrying Value		Useful Life
	(in thousands)							(in years)
Licensed technology	$	56,526	$	(34,470	)	$	22,056	1-8
Developed technology	285,443		(183,849		)	101,594		4-7
Customer relationships	69,776		(34,380		)	35,396		4-9
Trade names	5,600		(5,600		)	—		3
Total intangible assets	$	417,345	$	(258,299	)	$	159,046

The carrying amounts of intangible assets as of December 31, 2018 were as follows:



	Gross Carrying Value		Accumulated Amortization			Net Carrying Value		Useful Life
	(in thousands)							(in years)
Licensed technology	$	49,546	$	(30,062	)	$	19,484	1-8
Developed technology	285,443		(164,406		)	121,037		4-7
Customer relationships	69,776		(31,246		)	38,530		4-9
Trade names	5,600		(5,323		)	277		3
Total intangible assets	$	410,365	$	(231,037	)	$	179,328

Amortization expense of intangible assets totaled approximately $14.6 million and $16.5 million for the three months ended June 30, 2019 and 2018, respectively. Amortization expense of intangible assets totaled approximately $29.6 million and $32.8 million for the six months ended June 30, 2019 and 2018, respectively.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

The estimated future amortization expense from amortizable intangible assets is as follows:



	(in thousands)
2019 (remainder of the year)	$	32,245
2020	53,723
2021	43,113
2022	13,077
2023	8,291
Thereafter	8,597
Total	$	159,046

NOTE 7—DERIVATIVES AND HEDGING ACTIVITIES:

The Company enters into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks, mainly the exposure to changes in the exchange rate of the NIS against the U.S. dollar that are associated with forecasted cash flows and existing assets and liabilities. The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

Fair Value of Derivative Contracts

The fair value of derivative contracts in the unaudited condensed consolidated balance sheets at June 30, 2019 and December 31, 2018 were as follows:



		Other current assets		Accrued liabilities		Other current assets		Accrued liabilities
		June 30, 2019				December 31, 2018
		(in thousands)
Derivatives designated as hedging instruments
	Currency forward and option contracts	$	706	$	22	$	27	$	2,122
Derivatives not designated as hedging instruments
	Currency forward and option contracts	$	—	$	—	$	69	$	414
Total derivatives		$	706	$	22	$	96	$	2,536

The gross notional amounts of derivative contracts were NIS denominated. The notional amounts of outstanding derivative contracts in U.S. dollars at June 30, 2019 and December 31, 2018 were as follows:



	June 30, 2019		December 31, 2018
	(in thousands)
Derivatives designated as hedging instruments
Currency forward and option contracts	$	56,197	$	92,956
Derivatives not designated as hedging instruments
Currency forward and option contracts	$	—	$	57,844

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

Effect of Derivatives Designated as Hedging Instruments on Accumulated Other Comprehensive Income

The following table represents the unrealized gains (losses) of derivatives designated as hedging instruments, net of tax effects, that were recorded in accumulated other comprehensive income as of June 30, 2019 and December 31, 2018 and their effect on OCI for the six months ended June 30, 2019:



	(in thousands)
December 31, 2018	$	(1,978	)
Amount of gain recognized in OCI (effective portion)	3,197
Amount of gain reclassified from OCI to income (effective portion)	(417		)
June 30, 2019	$	802

Effect of Derivative Contracts on the Unaudited Condensed Consolidated Statement of Operations

The effect of derivative contracts on the unaudited condensed consolidated statements of operations for the three months ended June 30, 2019 and 2018 was as follows:



	Derivatives designated as hedging instruments					Derivatives not designated as hedging instruments
	Three Months Ended June 30,					Three Months Ended June 30,
	2019		2018			2019		2018
	(in thousands)
Operating income (expenses)	$	455	$	(1,419	)	$	—	$	—
Interest and other, net	$	—	$	—		$	693	$	(1,814	)

The effect of derivative contracts on the unaudited condensed consolidated statements of operations for the six months ended June 30, 2019 and 2018 was as follows:



	Derivatives designated as hedging instruments					Derivatives not designated as hedging instruments
	Six Months Ended June 30,					Six Months Ended June 30,
	2019		2018			2019		2018
	(in thousands)
Operating income (expenses)	$	417	$	(884	)	$	—	$	—
Interest and other, net	$	—	$	—		$	2,256	$	(2,704	)

NOTE 8—EMPLOYEE BENEFIT PLANS:

As a general rule, under Israeli law, an employee whose employment has been terminated by an employer or an employee who has resigned under circumstances which entitle him/her to receive statutory severance, in each case after completing at least one year of service with a particular employer or in a particular workplace, is entitled to statutory severance. For Israeli employees hired prior to January 1, 2007 ("Group One"), the severance pay liability is calculated based on the last monthly salary of each employee multiplied by the number of years of such employee's employment and is presented in the Company's balance sheet in other long-term liabilities, as if it was payable at each balance sheet date on an undiscounted basis. This liability is partially funded by the amounts accrued in the severance component of the employees’ pension arrangements (the “Severance Fund”). The surrender value of Severance Funds is presented in other long-term assets.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

The severance pay detail is as follows:



	June 30, 2019		December 31, 2018
	(in thousands)
Accrued severance liabilities	$	6,778	$	21,645
Severance assets	5,428		17,043
Unfunded portion	$	1,350	$	4,602

As a general rule, Israeli employees who were hired on or after January 1, 2007 ("Group Two"), are subject to the arrangement pursuant to Section 14 of the Severance Pay Law, 1963 (“Section 14 Arrangement”). When the Company makes the full monthly contribution equal to 8.3% of the employee's salary towards the Severance Fund and undertakes that the amounts accumulated in the Severance Fund will be released to the employee in the event that the employment relationship comes to an end, no additional calculations shall be conducted between the parties regarding the matter of severance pay and no additional payments will be made by the Company to the employee. Further, the related obligation and amounts deposited for the employee by the Company for such obligation are not stated on the balance sheet, as the Company is legally released from the obligation to employees once the deposit amounts have been paid.

During the first quarter of 2019, a significant portion of the employees in Group One elected to move to Group Two under settlement agreements with the Company, which were permitted by a formal approval obtained by the Company from the Israeli Ministry of Labor. In accordance with the Ministry of Labor’s approval (which applied to each of the relevant employees individually), the Company undertook to make the necessary contributions to ensure coverage of severance based on the employees' entire salary for the period during which the employees were not subject to the Section 14 Arrangement up to June 30, 2018. The Company reclassified the accumulated amount of severance assets and accrued severance liabilities as of June 30, 2018 related to these employees to accrued and other liabilities as of March 31, 2019. The Company paid the net severance liabilities (i.e., it made the necessary contributions to each of these employees’ Severance Fund) in April 2019.

NOTE 9—COMMITMENTS AND CONTINGENCIES:

Commitments

Leases

See Note 14 "Leases" for lease-related commitments as of June 30, 2019.

Purchase commitments

At June 30, 2019, the Company had the following non-cancelable purchase commitments:



	(in thousands)
2019 (remainder of the year)	$	145,822
2020	30,001
2021	982
2022	353
Total	$	177,158

Other Commitments

Unrecognized tax benefits

Due to the inherent uncertainty with respect to the timing of future cash outflows associated with the Company's unrecognized tax benefits, it is unable to reliably estimate the timing of cash settlement with the respective taxing authorities. As of June 30, 2019, the Company's unrecognized tax benefits totaled $57.7 million, out of which an amount of $35.1 million would reduce the Company's income tax expense and effective tax rate, if recognized.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

Contingencies

Legal proceedings

On May 1, 2019, a purported class action suit, entitled Marc Henzel v. Mellanox Technologies, Ltd., et al., was filed in the United States District Court for the Northern District of California against the Company and the members of its board of directors. On May 2, 2019, a purported class action suit, entitled Michael Kent v. Mellanox Technologies, Ltd., et al., was filed in the United States District Court for the Southern District of New York. Also on May 2, 2019, a purported class action suit, entitled David Thornton v. Mellanox Technologies, Ltd., et al., was filed in the United States District Court for the Northern District of California. On May 3, 2019, a purported class action suit, entitled Lewis Stein v. Mellanox Technologies, Ltd., et al., was filed in the United States District Court for the Northern District of California against the Company, the members of its board of directors, NVIDIA International Holdings Inc., Teal Barvaz Ltd., and NVIDIA Corporation. Also on May 3, 2019, a lawsuit entitled Elaine Wang v. Mellanox Technologies, Ltd., et al., was filed in the United States District Court for the Northern District of California against the Company and the members of its board of directors. All five suits alleged that the preliminary proxy statement filed by the Company on April 22, 2019 with the SEC in connection with the proposed Merger omits material information with respect to the transactions contemplated by the Merger Agreement, rendering it false and misleading in violation of Sections 14(a) and 20(a) of the Exchange Act. Each plaintiff sought, among other things, injunctive relief, rescission, declaratory relief and unspecified monetary damages. None of the plaintiffs moved for injunctive relief before the shareholder vote, which occurred on June 20, 2019. On June 25, 2019, the plaintiffs of the class action suit entitled Michael Kent v. Mellanox Technologies, Ltd., et al. filed a voluntary dismissal in the United States District Court for the Southern District of New York.

The Company believes that the claims asserted in these lawsuits are without merit and intends to defend vigorously against all claims asserted. The Company is currently unable to estimate the reasonably possible loss or range of loss related to these lawsuits. Additional lawsuits arising out of or relating to the Merger Agreement and the transactions contemplated thereby may be filed in the future.

The Company is involved in a variety of claims, suits, investigations and proceedings that arise from time to time in the ordinary course of its business, including actions with respect to contracts, intellectual property, taxation, employment, benefits, securities, personal injuries and other matters. The results of these proceedings in the ordinary course of business are not expected to have a material adverse effect on the Company’s condensed consolidated financial position or results of operations.

The Company records a liability when it believes that it is both probable that a liability will be incurred, and the amount of loss can be reasonably estimated. The Company evaluates, at least quarterly, developments in its legal matters that could affect the amount of liability that has been previously accrued and makes adjustments as appropriate. Significant judgment is required to determine both the probability and the estimated amount of a loss or potential loss. The Company may be unable to estimate the reasonably possible loss or range of loss for a particular legal contingency for various reasons, including, among others: (i) if the damages sought are indeterminate; (ii) if proceedings are in the early stages; (iii) if there is uncertainty as to the outcome of pending proceedings (including motions and appeals); (iv) if there is uncertainty as to the likelihood of settlement and the outcome of any negotiations with respect thereto; (v) if there are significant factual issues to be determined or resolved; (vi) if the proceedings involve a large number of parties; (vii) if relevant law is unsettled or novel or untested legal theories are presented; or (viii) if the proceedings are taking place in jurisdictions where the laws are complex or unclear. In such instances, there is considerable uncertainty regarding the ultimate resolution of such matters, including a possible eventual loss, if any.

NOTE 10—SHARE INCENTIVE PLANS

Share option plans

On July 25, 2018, the Company's shareholders approved the Mellanox Technologies, Ltd. Third Amended and Restated Global Share Incentive Plan (2006) (the "Third Restated Plan"), which constitutes an amendment and restatement of the Mellanox Technologies, Ltd. Second Amended and Restated Global Share Incentive Plan (2006) (the "Second Restated Plan"). The Third Restated Plan increased the ordinary shares reserved for issuance under the Second Restated Plan by 2,077,000 shares to 4,467,000 shares plus any shares subject to issued and outstanding awards under certain of the Company’s prior equity plans that expire, are cancelled or otherwise terminated after March 14, 2016, the effective date of the first amendment and

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

restatement of the Global Share Incentive Plan (2006). The Third Restated Plan also implements certain additional amendments, including specifically providing for the grant of performance share units.

Share option activity

Share option activity under the Company's equity incentive plans in the six months ended June 30, 2019 is set forth below:



	Options Outstanding
	Number of Shares		Weighted Average Exercise Price
Outstanding at December 31, 2018	494,503		$	50.73
Options exercised	(199,425	)	$	35.43
Options canceled	(1,040	)	$	91.91
Outstanding at June 30, 2019	294,038		$	60.96

The total pretax intrinsic value of options exercised in the six months ended June 30, 2019 and 2018 was $13.9 million and $19.4 million, respectively. This intrinsic value represents the difference between the fair market value of the Company's ordinary shares on the date of exercise and the exercise price of each option. Based on the closing price of the Company's ordinary shares of $110.67 on June 28, 2019, the last trading day of the quarter ended June 30, 2019, the total pretax intrinsic value of options outstanding at June 30, 2019 was $14.6 million. The total pretax intrinsic value of options outstanding at December 31, 2018 was $21.8 million.

There were 293,621 and 493,462 options exercisable at June 30, 2019 and December 31, 2018, respectively. The total pretax intrinsic value of exercisable options at June 30, 2019 was $14.6 million. The total pretax intrinsic value of exercisable options at December 31, 2018 was $21.7 million.

Restricted share unit activity

RSU activity under the Company's equity incentive plans in the six months ended June 30, 2019 is set forth below:



	Restricted Share Units Outstanding
	Number of Shares		Weighted Average Grant Date Fair Value
Non-vested restricted share units at December 31, 2018	3,294,163		$	65.05
Restricted share units granted	1,241,432		$	103.59
Restricted share units vested	(514,667	)	$	50.81
Restricted share units canceled	(147,187	)	$	69.39
Non-vested restricted share units at June 30, 2019	3,873,741		$	79.13

The weighted average fair value of RSUs granted in the six months ended June 30, 2019 and 2018 was $103.59 and $70.32, respectively.

The total intrinsic value of all outstanding RSUs as of June 30, 2019 and December 31, 2018 was $428.7 million and $304.3 million, respectively.

The non-vested restricted share units at June 30, 2019 included 36,000 performance share units. The PSUs will vest and be earned based on the Company’s achievement of relative total shareholder return and average non-GAAP net operating margin over a three-year performance period commencing on January 1, 2018 and ending on December 31, 2020, subject to the continued service to the Company through the end of the performance period. The number of shares that will actually vest ranges from zero to 175% of the target.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

Employee Stock Purchase Plan activity

There were 162,573 and 288,017 shares purchased under the ESPP for the six months ended June 30, 2019 and 2018 at an average price per share of $68.00 and $39.40, respectively.

Shares reserved for future issuance

The Company had the following ordinary shares reserved for future issuance under its equity incentive plans as of June 30, 2019:



	Number of Shares
Share options outstanding	294,038
Restricted share units outstanding	3,873,741
Shares authorized for future issuance	537,246
ESPP shares available for future issuance	2,772,773
Total shares reserved for future issuance as of June 30, 2019	7,477,798

Share-based compensation

The Company accounts for share-based compensation expense based on the estimated fair value of the share equity awards as of the grant dates.

The following weighted average assumptions were used to value ESPP shares issued pursuant to the Company's share incentive plans for the six months ended June 30, 2019 and 2018:



	Six Months Ended June 30,
	2019		2018
Dividend yield	—	%	—	%
Expected volatility	42.6	%	37.2	%
Risk free interest rate	2.44	%	1.20	%
Expected life, years	0.5		0.5

The following table summarizes the distribution of total share-based compensation expense in the unaudited condensed consolidated statements of operations:



	Three Months Ended June 30,				Six Months Ended June 30,
	2019		2018		2019		2018
	(in thousands)
Cost of goods sold	$	829	$	415	$	1,513	$	826
Research and development	14,486		8,340		27,727		16,514
Sales and marketing	6,504		3,646		12,156		7,245
General and administrative	5,130		2,515		9,795		5,305
Total share-based compensation expense	$	26,949	$	14,916	$	51,191	$	29,890

At June 30, 2019, there was $263.4 million of total unrecognized share-based compensation costs related to non-vested share-based compensation arrangements. The costs are expected to be recognized over a weighted average period of approximately 3.14 years.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 11—ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):

The following table summarizes the changes in accumulated balances of other comprehensive income (loss) for the six months ended June 30, 2019 and 2018:



	Unrealized Gains (Losses) on Available-for-Sale Securities			Unrealized Gains (Losses) on Derivatives Designated as Hedging Instruments			Total
	(in thousands)
Balance at December 31, 2018	$	927		$	(1,978	)	$	(1,051	)
Other comprehensive income before reclassifications, net of taxes	1,976			3,197			5,173
Realized gains reclassified from accumulated other comprehensive income	(1,311		)	(417		)	(1,728		)
Net current-period other comprehensive income, net of taxes	665			2,780			3,445
Balance at June 30, 2019	$	1,592		$	802		$	2,394

Balance at December 31, 2017	$	693		$	925		$	1,618
Other comprehensive loss before reclassifications, net of taxes	(81		)	(4,604		)	(4,685		)
Realized loss reclassified from accumulated other comprehensive income	1			884			885
Net current-period other comprehensive loss, net of taxes	(80		)	(3,720		)	(3,800		)
Balance at June 30, 2018	$	613		$	(2,795	)	$	(2,182	)

The following table provides details about reclassifications out of accumulated other comprehensive income (loss) for the six months ended June 30, 2019 and 2018:



	Realized (Gains)/Losses Reclassified from Accumulated Other Comprehensive Income (Loss)					Affected Line Item in the Financial Statements
	Six Months Ended June 30,
	2019			2018
	(in thousands)
Realized (gains)/losses on derivatives designated as hedging instruments	$	(417	)	$	884	Cost of revenues and Operating expenses:
	(21		)	45		Cost of revenues
	(42		)	78		General and administrative
	(38		)	81		Sales and marketing
	(316		)	680		Research and development
Realized (gains)/losses on available-for-sale securities	(1,311		)	1		Retained earnings and interest and other, net
Total reclassifications for the period	$	(1,728	)	$	885	Total

NOTE 12—INCOME TAXES:

As of June 30, 2019 and December 31, 2018, the Company had gross unrecognized tax benefits of $57.7 million and $46.5 million, respectively. It is the Company’s policy to classify accrued interest and penalties as part of the unrecognized tax benefits and record the expense in the provision for income taxes. The amount of accrued interest and penalties related to unrecognized tax benefits totaled $3.2 million at June 30, 2019 and $2.6 million at December 31, 2018.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

As of June 30, 2019, the 2014 through 2018 tax years are open and may be subject to potential examinations in the United States. The Company has NOLs in the United States from prior tax periods beginning in 2003 which may be subject to examination upon utilization in future tax periods. As of June 30, 2019, the 2014 through 2018 tax years are open and may be subject to potential examinations in Denmark and Israel. As of June 30, 2019, the income tax returns of the Company and one of its subsidiaries in Israel are under examination by the Israeli Income Tax Authorities for certain years from 2014 to 2017.

The Company's operations in Israel were granted "Approved Enterprise" status by the Investment Center in the Israeli Ministry of Economy and Industry and "Beneficiary Enterprise" status from the Israeli Income Tax Authority, which makes the Company eligible for tax benefits under the Israeli Law for Encouragement of Capital Investments, 1959 (the "Encouragement Law"). Under the terms of the Beneficiary Enterprise program, income that is attributable to the Company's operations in Yokneam, Israel, is exempt from income tax commencing fiscal year 2011 through 2021. Income that is attributable to the Company's operations in Tel Aviv, Israel is subject to a reduced income tax rate (generally between 10.0% and the current corporate tax rate, depending on the percentage of foreign investment in the Company) commencing fiscal year 2013 through 2021. The tax holiday has resulted in a cash tax savings of $19.7 million for the six months ended June 30, 2019, increasing diluted earnings per share by approximately $0.35 in the six months ended June 30, 2019.

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. The Company expects that its operation in Israel will comply with the terms of the Preferred Technological Enterprise regime. Therefore, the Company may utilize the tax benefits under this regime after the end of the benefit period of its Approved and Beneficiary Enterprise statuses (i.e., from fiscal year 2022 onwards). Under the new legislation, the majority of the Company’s income from its operations in Yokneam, Israel, will be subject to a corporate rate of 7.5%, while the majority of the income from its operations in Tel-Aviv, Israel, will be subject to a corporate rate of 12.0%.

The Company’s effective tax rate is highly dependent upon the geographic distribution of its worldwide earnings or losses, tax regulations and tax holiday benefits in Israel, and the effectiveness of the Company’s tax planning strategies. The Company’s effective tax rates were 10.6% and (96.5)% for the six months ended June 30, 2019 and 2018, respectively. The difference between the Company’s effective tax rate and the 21.0% federal statutory rate for the six months ended June 30, 2019 resulted primarily from the excess benefits related to share-based compensation, the tax holiday in Israel and foreign earnings taxed at rates lower than the federal statutory rates, partially offset by the accrual of unrecognized tax benefits, interest and penalties associated with unrecognized tax positions and non-tax-deductible expenses such as share-based compensation.

The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous, and the Company is required to make many subjective assumptions and judgments regarding its income tax exposures. In addition, interpretations of and guidance surrounding income tax laws and regulations are subject to change over time. Any changes in the Company’s subjective assumptions and judgments could materially affect amounts recognized in its condensed consolidated balance sheets and statements of operations.

At June 30, 2019, the Company maintained a valuation allowance against deferred tax assets related to capital loss carryforwards of certain subsidiaries. The Company assesses its ability to recover its deferred tax assets on an ongoing basis. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferred tax assets, the Company considers available positive and negative evidence including its recent cumulative losses, its ability to carry-back losses against prior taxable income and its projected financial results. The Company also considers, commensurate with its objective verifiability, the forecast of future taxable income including the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. A valuation allowance may be recorded in the event it is deemed to be more-likely-than-not that the deferred tax asset cannot be realized. Previously established valuation allowances may also be released in the event it is deemed to be more-likely-than-not that the deferred tax asset can be realized. Any release of valuation allowance will be recorded as a tax benefit which will positively impact the Company’s operating results. Management has determined on the basis of the quarterly assessment performed at June 30, 2019, that these deferred tax assets are not more-likely-than-not to be realized.

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

NOTE 13—INTEREST AND OTHER, NET:

Interest and other, net is summarized in the following table:



	Three Months Ended June 30,						Six Months Ended June 30,
	2019			2018			2019			2018
	(in thousands)
Interest expense	$	(77	)	$	(871	)	$	(91	)	$	(2,042	)
Interest income and gains on short-term investments, net	3,792			972			6,795			1,939
Foreign exchange loss, net	(1,800		)	(399		)	(4,052		)	(579		)
Gain on investments in privately-held companies	441			—			9,569			—
Impairment of investment in a privately-held company	—			—			(1,755		)	—
Other	(88		)	(40		)	33			(189		)
Interest and other, net	$	2,268		$	(338	)	$	10,499		$	(871	)

NOTE 14—LEASES:

On January 1, 2019, the Company adopted Topic 842 and elected the available practical expedient to recognize the cumulative effect of initially adopting Topic 842 as an adjustment to the opening balance sheet of the period of adoption (i.e., January 1, 2019). The Company also elected the other available practical expedients, and will not separate lease components from non-lease components, and will not reassess whether contracts are or contain leases, lease classification, or initial direct costs for existing leases as of January 1, 2019. Only the minimum lease payments in accordance with Topic 840 were included in the calculation of the ROU and liability for existing leases as of January 1, 2019. The condensed consolidated balance sheets and results from operations for reporting periods beginning after January 1, 2019 are presented under Topic 842, while prior period amounts are not adjusted and continue to be reported in accordance with the historic accounting under Topic 840.

The Company's leases include office buildings for its facilities worldwide and car leases in Israel, which are all classified as operating leases. Certain lease agreements include rental payments that are adjusted periodically for the consumer price index ("CPI"). The ROU and lease liability were calculated using the initial CPI and will not be subsequently adjusted. Certain leases include renewal options that are under the Company's sole discretion. The renewal options were included in the ROU and liability calculation if it was reasonably assured that the Company will exercise the option.

The cumulative effect of the changes made to the condensed consolidated balance sheet as of January 1, 2019 for the adoption of Topic 842 were as follows:



	December 31, 2018		Adjustments		January 1, 2019
	(in thousands)
Other long-term assets	$	118,182	$	69,102	$	187,284
Accrued and other liabilities	$	121,878	$	16,618	$	138,496
Other long-term liabilities	$	54,113	$	52,484	$	106,597

MELLANOX TECHNOLOGIES, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)

The components of lease expense and supplemental cash flow information related to leases for the three and six months ended June 30, 2019 were as follows:



	Three Months Ended		Six Months Ended
	June 30, 2019		June 30, 2019
	(in thousands)
Components of lease expense
Operating lease cost	$	5,997	$	11,859
Supplemental cash flow information:
Cash paid for amounts included in the measurement of lease liabilities	$	5,199	$	10,016
Supplemental non-cash information related to lease liabilities arising from obtaining right-of-use assets	$	1,545	$	2,862

For the six months ended June 30, 2019, the weighted average remaining lease term is 6.6 years, and the weighted average discount rate is 3.22 percent. The discount rate was determined based on the estimated collateralized borrowing rate of the Company, adjusted to the specific lease term and location of each lease.

Maturities of lease liabilities as of June 30, 2019 were as follows:



	(in thousands)
2019 (remainder of the year)	$	17,766
2020	16,081
2021	9,591
2022	7,012
2023	6,919
Thereafter	19,169
Total (1)	76,538
Less: Imputed interest	(7,342		)
Lease liability	$	69,196

(1) Future lease payments have not been reduced by minimum sublease rental income of $2.3 million owed to the Company in the future under noncancelable subleases.

The lease liabilities as of June 30, 2019 do not include the obligations under a lease agreement related to an office being built in Tel Aviv, Israel. The Company is not involved in the construction and will not be exposed to any risks during the construction period. The lease term expires 10 years after the expected lease inception. In addition, the lease contains a renewal option, which the Company determined is not reasonably assured to be exercised. As of June 30, 2019, the estimated total future lease obligation is approximately $31.1 million.

NOTE 15—RESTRUCTURING CHARGES:

In connection with the discontinuation of its 1550nm silicon photonics development activities, the Company initiated a restructuring plan in the first quarter of 2018 to wind down the business operations related to these activities, which primarily included terminating employees, exiting contracts with vendors, selling assets, and exiting facilities. The Company recorded $3.5 million, $3.4 million, and $2.4 million of employee separation and severance costs, contract exit costs with vendors, and impairment charges or losses on disposal of assets during the six months ended June 30, 2018, respectively. The Company does not expect any significant restructuring charges in the future.

ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition as of June 30, 2019 and results of operations for the three and six months ending June 30, 2019 and 2018 should be read together with our financial statements and related notes included elsewhere in this report. This discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that involve risks, uncertainties and assumptions. Words such as "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect," "predict," "potential" and similar expressions, as they relate to us, our business and our management, are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. The identification of certain statements as "forward-looking" is not intended to mean that other statements not specifically identified are not forward-looking. All statements other than statements about historical facts are statements that could be deemed forward-looking statements, including, but not limited to, statements that relate to the pending merger with NVIDIA Corporation, our future revenues, product development and introductions, customer demand, our dependence on key customers for a substantial portion of our revenue, performance of our subcontractors, growth rates, market adoption of our products, competitive factors, gross margins, levels of research, development and other related costs, expenditures, protection of our proprietary rights and patents, tax expenses and benefits, cash flows, management’s plans and objectives for current and future operations, and worldwide economic conditions.

Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those set forth under the section entitled "Risk Factors" in Part II, Item 1A of this report and in the section entitled "Risk Factors" in Part 1, Item 1A of our Annual Report on Form 10-K for fiscal year ended December 31, 2018. We urge you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. All forward-looking statements included in this report are based on information available to us on the date of this report, and we assume no obligation to update any forward-looking statements contained in this report. Quarterly financial results may not be indicative of the financial results of future periods.

Unless the context requires otherwise, references in this report to the "Company," "we," "us" and "our" refer to Mellanox Technologies, Ltd. and its wholly owned subsidiaries.

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 intelligent and 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, enterprise data center, storage, Big Data, machine learning, telecommunications, financial services, and media/entertainment markets. 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 are one of the early suppliers of 25/50/100/200Gb/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, 100, 200 and 400Gb/s.

Pending Merger with NVIDIA Corporation

On March 10, 2019, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with NVIDIA Corporation, a Delaware corporation ("NVIDIA"), NVIDIA International Holdings Inc., a Delaware corporation and wholly owned subsidiary of NVIDIA ("Parent") and Teal Barvaz Ltd., a wholly owned subsidiary of Parent organized under the laws of the State of Israel and wholly owned subsidiary of Parent ("Merger Sub"). NVIDIA has agreed to guarantee the payment and performance obligations of Parent under the Merger Agreement. The Merger Agreement and the Merger (as defined below) have been approved by our board of directors and the boards of directors of NVIDIA, Parent and Merger Sub.

The Merger Agreement provides that, upon the terms and subject to the satisfaction or waiver of the conditions set forth therein, Merger Sub will be merged with and into Mellanox (the "Merger") in accordance with Sections 314-327 of the Companies Law 5759-1999 of the State of Israel, with Mellanox continuing as the surviving corporation and a wholly owned subsidiary of Parent.

At the effective time of the Merger (the "Effective Time"), each ordinary share, par value NIS 0.0175 per share, of Mellanox (a "Company Share") issued and outstanding immediately prior to the Effective Time, other than any shares owned by Mellanox, Parent and their respective subsidiaries or any shares held in Mellanox’s treasury, will be deemed to have been transferred to the Parent in exchange for the right to receive $125.00 in cash, without interest and subject to applicable withholding taxes.

The Merger Agreement contains customary representations, warranties and covenants. The consummation of the Merger is conditioned on the receipt of the approval of our shareholders, as well as the satisfaction of other customary closing conditions, including domestic and foreign regulatory approvals and performance in all material respects by each party of its obligations under the Merger Agreement. At our extraordinary general meeting held on June 20, 2019, our shareholders approved the consummation of the Merger. Closing of the Merger is expected by the end of calendar year 2019.

The Merger Agreement contains certain customary termination rights by either us or Parent, including if the Merger is not consummated by December 10, 2019, subject to two three-month extensions in order to obtain required regulatory approvals. If the Merger Agreement is terminated under certain circumstances, including termination by us to enter into a superior proposal, a termination by Parent following a change of our board of directors’ recommendation or a termination by Parent as a result of a willful material breach of the Merger Agreement’s no-solicitation obligations by us, we will be obligated to pay to Parent a termination fee equal to $225 million in cash. If the Merger Agreement is terminated under certain circumstances involving the failure to obtain certain regulatory approvals, Parent will be obligated to pay us a termination fee equal to $350 million in cash.

The foregoing description of the Merger Agreement and the Merger does not purport to be complete and is subject to, and qualified in its entirety by, the full text of the Merger Agreement. For additional details on the transaction, please refer to the copy of the Merger Agreement attached as Exhibit 2.1 to our Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on March 11, 2019.

We recorded transaction-related costs of $7.8 million, principally for investment banking and legal fees associated with the pending acquisition, during the six months ended June 30, 2019. These costs are recorded in general and administrative expenses included in the condensed consolidated statement of operations for the six months ended June 30, 2019. Additional transaction-related costs are expected to be incurred through the closing of the Merger.

The pending transaction with NVIDIA may have significant effects on us, including, among others, deferrals, delays or cancellations of purchase orders by our customers and the significant diversion of management and employee attention from ordinary course matters. For a more extensive discussion of those and other possible effects, please refer to "Risk Factors" in Part II, Item 1A of this report.

Our Business

Revenues. We derive revenues from sales of our ICs, boards, switch systems, cables, modules, software, accessories and other product groups. Revenues for the three months ended June 30, 2019 were $310.3 million compared to $268.5 million for the three months ended June 30, 2018, representing an increase of $41.8 million, or approximately 15.6%. Revenues for the six months ended June 30, 2019 were $615.5 million compared to $519.5 million for the six months ended June 30, 2018, representing an increase of $96.0 million, or approximately 18.5%. Our revenues for the six months ended June 30, 2019 are not necessarily indicative of our future results. 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.

Our products have broad adoption with multiple end customers across HPC, cloud, Web 2.0, enterprise data center, storage, Big Data, machine learning, telecommunications, financial services, and media/entertainment markets. 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 51.8% and 55.9% of our total revenues for the six months ended June 30, 2019 and 2018, 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 board and system 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 sales 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 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.

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, advertising, trade shows and promotions, travel, amortization of intangibles, and allocable facilities related 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 and administrative expenses.

Taxes on Income

Our operations in Israel have been granted "Approved Enterprise" status by the Investment Center of the Israeli Ministry of Economy and Industry and "Beneficiary Enterprise" status by the Israeli Income Tax Authority, which makes us eligible for tax benefits under the Encouragement Law. Under the terms of the Beneficiary Enterprise program, 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 10.0% and the current corporate tax rate, depending on the percentage of foreign investment in the Company) commencing fiscal year 2013 through 2021.

in Israel will comply with the terms of the Preferred Technological Enterprise regime. Therefore, we may utilize the tax benefits under this regime after the end of the benefit period of its Approved and Beneficiary Enterprise statuses (i.e., 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 its operations in Tel-Aviv, Israel, will be subject to a corporate rate of 12.0%.

To prepare our unaudited condensed 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 condensed consolidated balance sheet.

Critical Accounting Policies and Estimates

Our unaudited condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these unaudited condensed 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, allowances for doubtful accounts, investment valuation, warranty reserves, inventory reserves, long-term asset valuations, useful lives of property, equipment, and intangibles, accounting for business combinations, goodwill and purchased intangible asset valuation, investments in privately-held companies, accounting and fair value of financial instruments and derivatives, deferred income tax asset valuation, uncertain tax positions, and litigation and other loss contingencies have the greatest potential impact on our unaudited condensed consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates.

See our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 21, 2019, for a discussion of critical accounting policies and estimates. There have been no changes in our critical accounting policies as compared to what was disclosed in the Form 10-K for the year ended December 31, 2018.

Results of Operations

The following table sets forth our condensed consolidated statements of operations as a percentage of revenues for the periods indicated:



	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2019		2018			2019		2018
Total revenues	100.0	%	100.0		%	100.0	%	100.0		%
Cost of revenues	35.5		38.6			35.4		37.1
Gross profit	64.5		61.4			64.6		62.9
Operating expenses:
Research and development	32.0		32.5			31.2		33.4
Sales and marketing	12.7		13.3			12.9		14.5
General and administrative	6.2		8.8			6.2		7.7
Restructuring and impairment charges	—		0.6			0.2		1.8
Total operating expenses	50.9		55.2			50.5		57.4
Income from operations	13.6		6.2			14.1		5.5
Interest and other, net	0.8		(0.1	)		1.7		(0.2	)
Income before taxes on income	14.4		6.1			15.8		5.3
Provision for (benefit from) taxes on income	2.0		(0.1	)		1.7		(5.1	)
Net income	12.4	%	6.2		%	14.1	%	10.4		%

Comparison of the Three Months Ended June 30, 2019 to the Three Months Ended June 30, 2018

The following tables represent our total revenues for the three months ended June 30, 2019 and 2018 by product type and interconnect protocol:



	Three Months Ended June 30,
	2019		% of Revenues		2018		% of Revenues
	(dollars in thousands)
ICs	$	53,046	17.1	%	$	28,934	10.8	%
Boards	120,643		38.9	%	136,708		50.9	%
Switch systems	73,808		23.8	%	57,074		21.3	%
Cables, accessories and other	62,827		20.2	%	45,746		17.0	%
Total Revenues	$	310,324	100.0	%	$	268,462	100.0	%



	Three Months Ended June 30,
	2019		% of Revenues		2018		% of Revenues
	(dollars in thousands)
InfiniBand:
HDR	$	28,620	9.2	%	$	—	—	%
EDR	66,643		21.5	%	59,319		22.1	%
FDR	28,972		9.3	%	35,649		13.3	%
QDR/DDR/SDR	8,646		2.8	%	7,143		2.6	%
Total	132,881		42.8	%	102,111		38.0	%
Ethernet	169,131		54.5	%	157,470		58.7	%
Other	8,312		2.7	%	8,881		3.3	%
Total revenues	$	310,324	100.0	%	$	268,462	100.0	%

Revenues. Revenues were $310.3 million for the three months ended June 30, 2019, compared to $268.5 million for the three months ended June 30, 2018, representing an increase of $41.8 million, or approximately 15.6%. Infiniband product sales increased by $30.8 million, which was mainly due to the introduction of our 200 gigabit HDR InfiniBand solutions and the transition from FDR products to the EDR product generation. Ethernet product sales increased by $11.7 million primarily due to the increased adoption of our 25 gigabit per second and above solutions. The revenues for the three months ended June 30, 2019 are not necessarily indicative of future results.

Gross Profit and Margin. Gross profit was $200.3 million for the three months ended June 30, 2019, compared to $164.8 million for the three months ended June 30, 2018, representing an increase of $35.5 million, or approximately 21.5%. Gross margin was 64.5% in the three months ended June 30, 2019, compared to the gross margin of 61.4% in the three months ended June 30, 2018. The lower gross margin in the three months ended June 30, 2018 was primarily due to a $9.3 million settlement of a contingent royalty obligation recorded during the second quarter of 2018. Gross margin for the three months ended June 30, 2019 is not necessarily indicative of future results.

Research and Development.

The following table presents details of our research and development expenses for the periods indicated:



	Three Months Ended June 30,
	2019		% of Revenues		2018		% of Revenues
	(dollars in thousands)
Salaries and benefits	$	56,005	18.0	%	$	51,649	19.2	%
Share-based compensation	14,486		4.7	%	8,340		3.1	%
Development and tape-out costs	7,582		2.4	%	7,303		2.8	%
Other	21,256		6.9	%	19,860		7.4	%
Total Research and development	$	99,329	32.0	%	$	87,152	32.5	%

Research and development expenses were $99.3 million for the three months ended June 30, 2019, compared to $87.2 million for the three months ended June 30, 2018, representing an increase of $12.1 million, or approximately 14.0%. The increase in salaries and benefits was primarily attributable to merit-based salary increases and higher bonus expenses. The increase in other expense was primarily attributable to higher outsourcing of research and development activities during the three months ended June 30, 2019.

Please refer to "Share-based Compensation Expense" below for a discussion of its impact on research and development expenses.

Sales and Marketing.

The following table presents details of our sales and marketing expenses for the periods indicated:



	Three Months Ended June 30,
	2019		% of Revenues		2018		% of Revenues
	(dollars in thousands)
Salaries and benefits	$	23,933	7.7	%	$	22,448	8.4	%
Share-based compensation	6,504		2.1	%	3,646		1.4	%
Trade shows and promotions	3,848		1.2	%	3,894		1.5	%
Other	5,017		1.7	%	5,685		2.0	%
Total Sales and marketing	$	39,302	12.7	%	$	35,673	13.3	%

Sales and marketing expenses were $39.3 million for the three months ended June 30, 2019, compared to $35.7 million for the three months ended June 30, 2018, representing an increase of $3.6 million, or approximately 10.2%. The increase in salaries and benefits was primarily attributable to merit-based salary increases.

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:



	Three Months Ended June 30,
	2019		% of Revenues		2018		% of Revenues
	(dollars in thousands)
Salaries and benefits	$	6,362	2.1	%	$	5,763	2.1	%
Share-based compensation	5,130		1.7	%	2,515		0.9	%
Professional services	5,844		1.9	%	13,613		5.1	%
Other	1,863		0.5	%	1,744		0.7	%
Total General and administrative	$	19,199	6.2	%	$	23,635	8.8	%

General and administrative expenses were $19.2 million

Mellanox Technologies, Ltd. 10-Q