UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 ____________________________ FORM 10-Q (Mark One) [x] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 1999 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 0-23441 ____________________ POWER INTEGRATIONS, INC. (Exact name of registrant as specified in its charter) <TABLE> <S> <C> DELAWARE 94-3065014 (State or other jurisdiction of (I.R.S. Employer Incorporation or organization) Identification No.) </TABLE> 477 N. Mathilda Avenue, Sunnyvale, California 94086 (Address of principal executive offices) (Zip code) (408) 523-9200 (Registrant's telephone number, including area code) _____________________________ 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 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 [x] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. <TABLE> <CAPTION> <S> <C> Class Outstanding at October 29, 1999 - --------------------------------------------- ------------------------------------ Common Stock, $.001 par value 13,219,342 shares </TABLE>
POWER INTEGRATIONS, INC. TABLE OF CONTENTS <TABLE> <CAPTION> PART I. FINANCIAL INFORMATION Page <S> <C> <C> Item 1. Financial Statements Condensed Consolidated Balance Sheets 3 Condensed Consolidated Statements of Operations 4 Condensed Consolidated Statements of Cash Flows 5 Notes To Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk 24 PART II. OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities and Use of Proceeds 25 Item 3. Defaults upon Senior Securities 25 Item 4. Submission of Matters to Vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits and Reports on Form 8-K 25 SIGNATURES 26 </TABLE> TOPSwitch, TinySwitch and EcoSmart are trademarks of Power Integrations, Inc. 2
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS POWER INTEGRATIONS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) <TABLE> <CAPTION> September 30, December 31, 1999 1998 ------------- ------------ <S> <C> <C> (unaudited) ASSETS CURRENT ASSETS: Cash and cash equivalents........................................................ $25,971 $24,176 Short-term investments........................................................... 34,846 20,242 Accounts receivable.............................................................. 9,474 4,640 Inventories...................................................................... 7,021 8,845 Prepaid expenses and other current assets........................................ 4,828 812 ------- ------- Total current assets..................................................... 82,140 58,715 ------- ------- PROPERTY AND EQUIPMENT, net......................................................... 8,801 6,339 ------- ------- $90,941 $65,054 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Current portion of capitalized lease obligations................................. $ 1,456 $ 1,950 Accounts payable................................................................. 6,970 5,866 Accrued payroll and related expenses............................................. 2,860 2,394 Taxes payable and other accrued liabilities...................................... 4,536 2,951 Deferred income on sales to distributors......................................... 2,866 2,566 ------- ------- Total current liabilities................................................ 18,688 15,727 ------- ------- CAPITALIZED LEASE OBLIGATIONS, net of current portion............................... 1,668 1,963 ------- ------- STOCKHOLDERS' EQUITY: Common stock..................................................................... 13 12 Additional paid-in capital....................................................... 63,495 57,289 Common stock warrants............................................................ -- 12 Stockholder notes receivable..................................................... (264) (274) Deferred compensation............................................................ (216) (321) Cumulative translation adjustment................................................ (108) (57) Retained earnings ( deficit)..................................................... 7,665 (9,297) ------- ------- Total stockholders' equity............................................... 70,585 47,364 ------- ------- $90,941 $65,054 ======= ======= </TABLE> The accompanying notes are an integral part of these condensed consolidated balance sheets. 3
POWER INTEGRATIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (In thousands, except per share amounts) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ---------------------- 1999 1998 1999 1998 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> NET REVENUES: Product sales........................................... $29,829 $19,907 $72,930 $48,456 License fees and royalties.............................. 311 410 1,010 1,400 ------- ------- ------- ------- Total net revenues................................... 30,140 20,317 73,940 49,856 ------- ------- ------- ------- COST OF REVENUES.......................................... 12,667 10,635 32,616 26,865 ------- ------- ------- ------- GROSS PROFIT.............................................. 17,473 9,682 41,324 22,991 ------- ------- ------- ------- OPERATING EXPENSES: Research and development................................ 2,813 1,947 7,684 5,226 Sales and marketing..................................... 2,893 2,376 8,097 5,989 General and administrative.............................. 4,324 1,067 7,120 2,345 ------- ------- ------- ------- Total operating expenses............................. 10,030 5,390 22,901 13,560 ------- ------- ------- ------- INCOME FROM OPERATIONS.................................... 7,443 4,292 18,423 9,431 ------- ------- ------- ------- OTHER INCOME, net......................................... 510 399 1,527 775 ------- ------- ------- ------- INCOME BEFORE PROVISION FOR INCOME TAXES............................................. 7,953 4,691 19,950 10,206 PROVISION FOR INCOME TAXES................................ 1,185 351 2,988 1,735 ------- ------- ------- ------- NET INCOME................................................ $ 6,768 $ 4,340 $16,962 $ 8,471 ======= ======= ======= ======= EARNINGS PER SHARE: Basic................................................... $0.52 $0.35 $1.32 $0.70 ======= ======= ======= ======= Diluted................................................. $0.47 $0.33 $1.22 $0.65 ======= ======= ======= ======= SHARES USED IN PER SHARE CALCULATION: Basic................................................... 13,138 12,229 12,898 12,133 ======= ======= ======= ======= Diluted................................................. 14,295 13,128 13,954 13,110 ======= ======= ======= ======= </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 4
POWER INTEGRATIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (In thousands) <TABLE> <CAPTION> Nine Months Ended September 30, --------------------------------- 1999 1998 --------------- --------------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income...................................................................... $ 16,962 $ 8,471 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization................................................. 2,368 2,278 Deferred compensation expense................................................. 105 105 Deferred income taxes......................................................... (3,600) -- Tax benefit associated with employee stock plans.............................. 3,825 -- Change in operating assets and liabilities: Accounts receivable........................................................ (4,834) 665 Inventories................................................................ 1,824 (1,689) Prepaid expenses and other current assets.................................. (416) (91) Accounts payable........................................................... 1,104 (1,292) Accrued liabilities........................................................ 2,000 2,050 Deferred income on sales to distributors................................... 300 1,366 -------- -------- Net cash provided by operating activities............................... 19,638 11,863 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment........................................... (4,058) (1,785) Purchases of short-term investments........................................... (47,072) (38,071) Proceeds from sales and maturities of short-term investments.................. 32,468 14,033 -------- -------- Net cash used in operating activities................................... (18,662) (25,823) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from issuance of common stock.................................... 2,370 658 Proceeds from stockholder note repayment...................................... 10 -- Principal payments under capitalized lease obligations........................ (1,561) (1,543) -------- -------- Net cash provided by (used in) financing activities..................... 819 (885) -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............................ 1,795 (14,845) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD................................ 24,176 25,553 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD...................................... $ 25,971 $ 10,708 ======== ======== SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Capitalized lease obligations incurred for property and equipment............. $ 772 $ 1,439 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest........................................................ $ 246 $ 388 ======== ======== Cash paid for income taxes.................................................... $ 3,212 $ 475 ======== ======== </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 5
POWER INTEGRATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION: The condensed consolidated financial statements include the accounts of Power Integrations, Inc. (the Company), a Delaware corporation, and its wholly owned subsidiaries. Significant inter-company accounts and transactions have been eliminated. While the financial information furnished is unaudited, the condensed consolidated financial statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for the fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Power Integrations, Inc. consolidated financial statements for the year ended December 31, 1998 included in its Form 10-K. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Cash and Cash Equivalents and Short-Term Investments The Company considers cash invested in highly liquid financial instruments with an original maturity of three months or less to be cash equivalents. Cash investments in highly liquid financial instruments with original maturities greater than three months but not longer than fifteen months are classified as short-term investments. As of September 30, 1999, the Company's short-term investments consisted of U.S. government backed securities, corporate commercial paper and other high quality commercial and municipal securities, which were classified as held to maturity and were valued using the amortized cost method which approximates market. Revenue Recognition Product revenues consist of sales to original equipment manufacturers, or OEMs, merchant power supply manufacturers and distributors. Revenues from product sales to OEMs and merchant power supply manufacturers are recognized upon shipment. Sales to distributors are made under terms allowing certain rights of return and protection against subsequent price declines on the Company's products held by the distributors. As a result of the Company's distributor agreements, the Company defers recognition of revenue and the proportionate costs of revenues derived from sales to distributors until the distributors resell the Company's products to their customers. The margin deferred as a result of this policy is reflected as "deferred income on sales to distributors" in the accompanying condensed consolidated balance sheets. Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Segment Reporting During 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures About Segments of an Enterprise and Related Information." SFAS 131 requires a new basis of determining reportable business segments, i.e., the management approach. This approach requires that business segment information used by management to assess performance and manage company resources be the source for information disclosure. On this basis, the Company is organized and operates as one business segment, the design, development, manufacture and marketing of proprietary, high-voltage, analog integrated circuits for use primarily in the AC to DC power conversion markets. 6
POWER INTEGRATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued) New Accounting Standards In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS No. 133 requires companies to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company does not expect the adoption of SFAS No. 133 to have a material impact on its financial statements. 3. INVENTORIES: Inventories are stated at the lower of cost (first-in, first-out) or market. Inventories consist of the following (in thousands): <TABLE> <CAPTION> September 30, December 31, 1999 1998 ------------------------------ <S> <C> <C> Raw materials.............................................................. $1,675 $3,132 Work-in-process............................................................ 2,961 2,901 Finished goods............................................................. 2,385 2,812 ------ ------ $7,021 $8,845 ====== ====== </TABLE> 4. SIGNIFICANT CUSTOMERS AND EXPORT SALES: Customer Concentration The Company's end user base is highly concentrated and a relatively small number of OEMs and distributors accounted for a significant portion of the Company's net revenues. For the nine months ended September 30, 1999 and 1998, ten customers accounted for approximately 68% and 67% of total net revenues, respectively. The following customers accounted for more than 10% of total net revenues: <TABLE> <CAPTION> Nine Months Ended September 30, ------------------- Customer 1999 1998 -------- ---- ---- <S> <C> <C> A.......................................................................... 16% 22% B.......................................................................... 11% 13% </TABLE> Export Sales The Company markets its products in North America and in foreign countries through its sales personnel and a worldwide network of independent sales representatives and distributors. As a percentage of total net revenues, export sales, which consist of domestic sales to customers in foreign countries, are comprised of the following: <TABLE> <CAPTION> Nine Months Ended September 30, ------------------- 1999 1998 ---- ---- <S> <C> <C> Japan...................................................................... 2% 3% Taiwan..................................................................... 19% 28% Hong Kong/China............................................................ 19% 23% Korea...................................................................... 14% 6% Western Europe............................................................. 16% 16% Other...................................................................... 8% 6% ---- ---- Total foreign..................................................... 78% 82% ==== ==== </TABLE> 7
POWER INTEGRATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 5. EARNINGS PER SHARE: Earnings per share are calculated in accordance with SFAS No. 128 "Earnings Per Share". SFAS No. 128 requires companies to compute earnings per share under two different methods (basic and diluted). Basic earnings per share are calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted earnings per share are calculated by dividing net income by the weighted average shares of outstanding common stock and common stock equivalents during the period. Common stock equivalents included in the diluted calculation consist of dilutive shares issuable upon the exercise of outstanding common stock options and warrants computed using the treasury stock method. The following table sets forth the calculation of basic and diluted earnings per share (in thousands, except per share amounts): <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------ ------------------ 1999 1998 1999 1998 -------- -------- -------- -------- <S> <C> <C> <C> <C> Basic earnings per share: Net income................................................... $ 6,768 $ 4,340 $16,962 $ 8,471 ------- ------- ------- ------- Weighted average common shares............................... 13,138 12,229 12,898 12,133 ------- ------- ------- ------- Basic earnings per share.................................. $ 0.52 $ 0.35 $ 1.32 $ 0.70 ------- ------- ------- ------- Diluted earnings per share: Net income................................................... $ 6,768 $ 4,340 $16,962 $ 8,471 ------- ------- ------- ------- Weighted average common shares............................... 13,138 12,229 12,898 12,133 Weighted average common share equivalents: Options................................................... 1,134 647 1,024 672 Employee stock purchase plan.............................. 23 -- 32 -- Warrants.................................................. -- 252 -- 305 ------- ------- ------- ------- Diluted weighted average common shares....................... 14,295 13,128 13,954 13,110 ------- ------- ------- ------- Diluted earnings per share............................. $ 0.47 $ 0.33 $ 1.22 $ 0.65 ======= ======= ======= ======= </TABLE> 6. PROVISION FOR INCOME TAXES: Income tax expense for the nine-month periods ended September 30, 1999 and 1998 includes a provision for Federal, state and foreign taxes based on the annual estimated effective tax rate applicable to the Company and its subsidiaries for the year. The difference between the statutory rate and the Company's effective tax rate for the nine months ended September 30, 1999 is primarily due to the beneficial impact of deferred taxes resulting from a reduction in the valuation allowance of $3.6 million. 7. LEGAL PROCEEDINGS: In July 1998, the Company filed a complaint for patent infringement in the U.S. District Court, Northern District of California, against its largest end user, Motorola. In August 1998, the Company voluntarily dismissed the complaint, and filed a new complaint in the U.S. District Court, District of Delaware, alleging that Motorola has infringed and continues to infringe two of the Company's circuit patents. In October 1998, Motorola asserted various counterclaims against the Company, alleging that the Company is infringing certain of Motorola's patents. Trial of this action was held in October 1999. On October 15, 1999, a unanimous jury returned a verdict in favor of the Company. The jury determined that Motorola had willfully infringed one of the Company's patents and awarded the Company $32.3 million in compensatory damages. The jury also found that the Company had not infringed any of the asserted Motorola patents and that two of the Motorola patents were invalid. 8
POWER INTEGRATIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Proceedings in this matter are continuing. The Company anticipates that Motorola will seek to have the jury verdict overturned. If the verdict were overturned, the Company might not ultimately prevail in this litigation and this litigation could have a material adverse effect on the Company's business, financial condition and operating results. 8. SUBSEQUENT EVENT On October 20, 1999, the Company's Board of Directors approved a two-for- one split of the Company's common stock in the form of a 100 percent stock dividend. This stock split will be effective for shareholders of record at the close of business on November 8, 1999 and distribution is expected to be made on November 22, 1999. Share and per-share data have not been adjusted to give effect to the split. 9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This Management's Discussion and Analysis of Financial Condition and Operating results includes a number of forward-looking statements which reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including those discussed in the "Risk Factors" and elsewhere in this report, that could cause actual results to differ materially from historical results or those anticipated. In this report, the words "anticipates," "believes," "expects," "future," "intends," and similar expressions identify forward-looking statements. We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. The following management's discussion and analysis of financial condition and results of operations should be read in conjunction with management's discussion and analysis of financial condition and results of operations included in our Form 10-K for the year ended December 31, 1998. Overview We design, develop, manufacture and market proprietary, high-voltage, analog integrated circuits, or ICs, for use primarily in AC to DC power conversion markets. We have targeted high-volume power supply markets, including the cellular telephone, personal computer, cable and direct broadcast satellite and various consumer and industrial electronics markets. Our initial focus is on those markets that are sensitive to size, portability, energy efficiency, time- to-market and benefits of integrated power supplies. We believe our patented TOPSwitch ICs, introduced in 1994, are the first highly integrated power conversion ICs to achieve widespread market acceptance. We introduced an enhanced family of ICs, TOPSwitch-II, in April 1997. In September 1998, we announced the TinySwitch family of integrated circuits that incorporates our new EcoSmart technology. This new family of ICs is designed to enable a new class of light, compact, energy-efficient power supplies. Results of Operations The following table sets forth certain operating data as a percentage of total net revenues for the periods indicated. <TABLE> <CAPTION> Percentage of Percentage of Total Net Revenues for Total Net Revenues for Three Months Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- 1999 1998 1999 1998 --------- ---------- --------- ---------- <S> <C> <C> <C> <C> Net revenues: Product sales........................................ 99.0% 98.0% 98.6% 97.2% License fees and royalties........................... 1.0 2.0 1.4 2.8 ----- ----- ----- ----- Total net revenues................................ 100.0 100.0 100.0 100.0 ----- ----- ----- ----- Cost of revenues....................................... 42.0 52.3 44.1 53.8 ----- ----- ----- ----- Gross profit........................................... 58.0 47.7 55.9 46.2 ----- ----- ----- ----- Operating expenses: Research and development............................. 9.4 9.6 10.4 10.5 Sales and marketing.................................. 9.6 11.7 11.0 12.0 General and administrative........................... 14.3 5.3 9.6 4.7 ----- ----- ----- ----- Total operating expenses.......................... 33.3 26.6 31.0 27.2 ----- ----- ----- ----- Income from operations................................. 24.7 21.1 24.9 19.0 Other income, net...................................... 1.7 1.9 2.0 1.5 ----- ----- ----- ----- Income before provision for income taxes............... 26.4 23.0 26.9 20.5 ----- ----- ----- ----- Provision for income taxes............................. 3.9 1.7 4.0 3.5 ----- ----- ----- ----- Net income ............................................ 22.5% 21.3% 22.9% 17.0% ===== ===== ===== ===== </TABLE> 10
Comparison of the Three and Nine Months Ended September 30, 1999 and 1998 Net revenues. Net revenues consist of revenues from product sales, which are calculated net of returns and allowances, plus license fees and royalties paid by a licensee of our technology. Net revenues for the third quarter ended September 30, 1999 were $30.1 million compared to $20.3 million for the third quarter of 1998, an increase of $9.8 million, or 48.3%. Net revenues for the nine months ended September 30, 1999 were $73.9 million compared to $49.9 million for the comparable period of 1998, an increase of $24.1 million, or 48.3%. Net revenues from product sales represented $29.8 million and $19.9 million in the third quarter of 1999 and 1998, respectively. Net revenues from product sales represented $72.9 million and $48.5 million in the nine months ended September 30, 1999 and 1998, respectively. The increase in net revenues from product sales for the three months and nine months ended September 30, 1999 was due primarily to strong demand for our products across all of our major markets and geographies. In particular, sales to the cellular phone market increased approximately 50% for the quarter and 120% for the nine months ended September 30, 1999 compared to the same periods of the prior year. In total, sales of our TOPSwitch and TinySwitch products accounted for 97.8% and 97.2% of net revenues from product sales for the three months ended September 30, 1999 and 1998, respectively, and 96.7% and 94.4% for the nine months ended September 30, 1999 and 1998, respectively. Net revenues from royalties were $311,000 for the third quarter of 1999, compared to $410,000 for the third quarter of 1998, and $1.0 million for the nine months ended September 30, 1999, compared to $1.4 million for the same period in 1998. We expect net revenues from royalties to continue to decline and account for a small percentage of our net revenues. International sales were $23.2 million in the third quarter of 1999 compared to $16.7 million for the same period in 1998, an increase of $6.5 million, or 39.1%, which represented 77.0% of net revenues compared to 82.1% in the comparable period of 1998. International sales were $56.8 million for the nine months ended September 30, 1999 compared to $40.7 million for the same period in 1998, an increase of $16.1 million, or 39.6%, which represented 76.9% of net revenues compared to 81.7% in the comparable period of 1998. Although the power supplies using our products are designed and distributed worldwide, most of these power supplies are manufactured in Asia. As a result, sales to this region were 61.9% and 65.6% of our product sales for the three months ended September 30, 1999 and 1998, respectively, and 61.7% and 64.7% of our product sales for the nine months ended September 30, 1999 and 1998, respectively. We expect international sales to continue to account for a large portion of our net revenues. Direct sales for the third quarter of 1999 were divided 39.0% to distributors and 61.0% to original equipment manufacturers, or OEMs, and power supply merchants, compared to 50% to distributors and 50% to OEMs and power supply merchants for the same quarter in 1998. For the nine months ended September 30, 1999, direct sales were divided 41.5% to distributors and 58.5% to OEMs and power supply merchants, compared to 52.9% to distributors and 47.1% to OEMs and power supply merchants for the same period in 1998. For the quarter ended September 30, 1999, sales to two customers accounted for 14.1% and 11.3% of net revenues, and for the quarter ended September 30, 1998, those same two customers accounted for 23.8% and 13.3% of net revenues. For the nine months ended September 30, 1999, sales to two customers accounted for 15.9% and 11.1% of net revenues, and for the nine months ended September 30, 1998, those same two customers accounted for 22.1% and 13.0% of net revenues. The exact dollar amounts and percentages of sales to end customers are difficult to ascertain because most of those sales occur through distributors or indirectly through sales to merchant power supply manufacturers, which in turn sell power supplies to OEMs. However, we estimate that direct and indirect sales to Motorola, who is our largest end user, accounted for approximately 23% and 15% of net revenues for the quarters ended September 30, 1999 and 1998, respectively, and approximately 22% and 12% of net revenues for the nine months ended September 30, 1999 and 1998, respectively. Direct sales to Motorola were 6.7% and 5.9% of net revenues for the quarters ended September 30, 1999 and 1998, respectively, and 9.7% and 4.7% of net revenues for the nine months ended September 30, 1999 and 1998, respectively. Cost of revenues; Gross profit. Gross profit is equal to net revenues less cost of revenues. Our cost of revenues consists primarily of costs associated with the purchase of wafers, the assembly and packaging of our 11
products, and internal labor and overhead associated with the testing of both wafers and packaged components. Gross profit for the third quarter of 1999 was $17.5 million, or 58.0%, of net revenues, compared to $9.7 million, or 47.7%, of net revenues for the same period in 1998. Gross profit for the nine months ended September 30, 1999 was $41.3 million, or 55.9%, of net revenues, compared to $23.0 million, or 46.2%, of net revenues for the same period in 1998. The increase in gross profit for the three months and nine months ended September 30, 1999 was primarily due to efficiencies achieved from increased sales volume, lower prices for wafers and better manufacturing yields due to improved test equipment. Gross profit also benefited from a one-time credit from one of our suppliers in the amount of $1.2 million recorded in the third quarter of 1999. The credit resulted in gross profit improvement of 4.0% for the quarter and 1.6% for the nine months ended September 30, 1999. We cannot assure you that these or other factors will have a favorable impact on our gross profit in future periods. Research and development expenses. Research and development expenses consist primarily of employee-related expenses, expensed material and facility costs associated with the development of new processes and new products. We also expense prototype wafers and mask sets related to new products as research and development costs until new products are released to production. Research and development expenses for the third quarter of 1999 were $2.8 million compared to $1.9 million for the same period in 1998, an increase of $866,000, or 44.5%, which represented 9.3% and 9.6% of our net revenues in each period, respectively. Research and development expenses for the first nine months of 1999 were $7.7 million compared to $5.2 million for the same period in 1998, an increase of $2.5 million, or 47.0%, which represented 10.4% and 10.5% of net revenues in each period, respectively. The increase for the three months and nine months ended September 30, 1999 was primarily due to increased salaries and other costs related to the hiring of additional engineering personnel, outside consulting fees and expensed prototype materials caused by the transition of foundry manufacturing processes, and bringing newly developed products into manufacturing. We expect research and development expenses to continue to increase in absolute dollars but to fluctuate as a percentage of our net revenues. Sales and marketing expenses. Sales and marketing expenses consist primarily of employee-related expenses, commissions to sales representatives and facilities expenses, including expenses associated with our regional sales and support offices. Sales and marketing expenses for the third quarter of 1999 were $2.9 million compared to $2.4 million for the same period in 1998, an increase of $517,000, or 21.8%, which represented 9.6% and 11.7% of our net revenues in each period, respectively. Sales and marketing expenses for the first nine months of 1999 were $8.1 million compared to $6.0 million for the same period in 1998, an increase of $2.1 million, or 35.2%, which represented 11.0% and 12.0% of our net revenues in each period, respectively. The increase for the three months and nine months ended September 30, 1999 was primarily a result of the addition of personnel to support increased sales, and to increase the availability of field application engineers. We expect sales and marketing expenses to continue to increase in absolute dollars but to fluctuate as a percentage of our net revenues. General and administrative expenses. General and administrative expenses consist primarily of employee-related expenses for administration, finance, human resources and general management, as well as consulting, outside services, legal and auditing expenses. For the quarters ended September 30, 1999 and 1998, general and administrative expenses were $4.3 million and $1.1 million, respectively, which represented 14.3% and 5.3% of our net revenues in each period. For the nine months ended September 30, 1999 and 1998, general and administrative expenses were $7.1 million and $2.3 million, respectively, which represented 9.6% and 4.7% of our net revenues in each period. This increase in spending was primarily attributable to increased professional and legal expenses related to our patent infringement lawsuit filed against Motorola. Other income, net. Other income, net, for the third quarter of 1999 increased by $111,000 over the same period in 1998, and for the nine months ended September 30, 1999, it increased by $752,000 over the same period in 1998. The increase for the three month and nine month periods ended September 30, 1999 was due primarily to additional interest income from an increase in short-term investments in 1999. Provision for income taxes. Provision for income taxes represents Federal, state and foreign taxes. The provision for income taxes was $1.2 million for the third quarter of 1999 compared to $351,000 for the same period in 1998. The provision for income taxes was $3.0 million for the first nine months of 1999 compared to $1.7 million for the same period in 1998. Our estimated effective tax rate for 1999 is 15% compared to 17% used in the same period for 1998. The difference between the statutory rate and our effective tax rate for 1999 is primarily due to the beneficial impact of deferred taxes resulting from a reduction in the valuation allowance. 12
Liquidity and Capital Resources At September 30, 1999, we had approximately $60.8 million in cash, cash equivalents and short-term investments. In addition, under a revolving line of credit agreement with Union Bank of California, we can borrow up to $10.0 million. A portion of the credit line is used to cover advances for commercial letters of credit and standby letters of credit, which we provide to Matsushita and OKI prior to the shipment of wafers by those foundries to us. The balance of this credit line is unused and available. The line of credit agreement contains financial covenants and requires that we maintain profitability on a quarterly basis and not pay or declare dividends without the bank's prior consent. We have financed a significant portion of our machinery and equipment through capital equipment leases. We financed additional equipment during the nine months ended September 30, 1999 in the amount of $772,000. We do not expect to obtain any additional financing for equipment purchases during the balance of 1999. As of September 30, 1999, we had working capital, defined as current assets less current liabilities, of approximately $63.2 million, which was an increase of approximately $20.4 million over December 31, 1998. Our operating activities generated cash of $19.6 million and $11.9 million in the nine months ended September 30, 1999 and 1998, respectively. Cash generated in the first nine months of 1999 was principally the result of net income in the amount of $17.0 million, depreciation and amortization, tax benefits from employee stock plans and increases in accounts payable and accrued liabilities with a reduction in inventory. This was partially offset by increases in accounts receivable and deferred income taxes. Cash generated in the first nine months of 1998 was principally the result of net income of $8.5 million, depreciation and amortization, increases in deferred revenue and accrued liabilities, offset by an increase in inventories and a decrease in accounts payable. Our investing activities were a net transfer from cash and cash equivalents to short-term investments of $14.6 million and $24.0 million in the nine months ended September 30, 1999 and 1998, respectively. We believe that cash generated from operations, together with existing sources of liquidity, will satisfy our projected working capital and other cash requirements for at least the next 12 months. Year 2000 Issues Some computers, software, and other equipment include computer code in which calendar year data is abbreviated to only two digits. As a result of this design decision, some of these systems could fail to operate or fail to produce correct results if "00" is interpreted to mean 1900, rather than 2000. These problems are widely expected to increase in frequency and severity as the year 2000 approaches, and are commonly referred to as the year 2000 problem. Assessment. The year 2000 problem affects the computers, software and other equipment that we use, operate or maintain for our operations. Early during 1999 we organized a program team to monitor the assessment and remediation status of our year 2000 projects and to report such status to our board of directors. In addition, the project team assessed the potential effect and costs of remediating the year 2000 problem for our internal systems. During the second quarter of 1999, our year 2000 project plan was reviewed by an independent consulting firm as to completeness and progress. There were no major omissions identified. The primary recommendations of the independent consulting firm focused on the importance of our testing and contingency planning activities. The review recommendations were incorporated into the plan. Products. We have evaluated the functionality of our past and present products with respect to any year 2000 problems and have determined that none of our past or present products utilize date-related functions and, therefore, have no year 2000 problems. Internal Infrastructure. During the second quarter of 1999 we completed an inventory of our computers, software applications and production equipment used in connection with our internal operations and we categorized those systems as critical or non-critical. During subsequent quarters we completed the remediation and testing of all critical computers and software applications as well as most of the production equipment used in the manufacture of our products. Production testers that handle over 98% of our product volume have now been successfully upgraded 13
for year 2000 compliance and tested. We have developed acceptable work-arounds for the remainder of our test equipment and we do not anticipate any material disruption to our production as a result of employing these work-arounds. Testing of non-critical computers, software applications and production equipment will be continued throughout the remainder of the calendar year. Systems Other than Information Technology Systems. In addition to computers and related systems, the operation of office and facilities equipment, including fax machines, telephone switches, security systems, and other common devices, may be affected by the year 2000 problem. As of June 30, 1999, we had completed remediation of critical office and facilities equipment with the exception of our telephone equipment. We are now targeting replacement of our telephone equipment and software with a new, fully compliant system during the month of November 1999. We estimate the total cost to us of completing any required modifications, upgrades or replacements of our internal systems, beyond expenditures planned to meet the needs for managing our growth, to be approximately $350,000, almost all of which we believe will be incurred during 1999. This estimate is being monitored and we will revise it as additional information becomes available. Based on the activities described above, we do not believe that the year 2000 problem will have a material adverse effect on our business or operating results. In addition, we have not deferred any material information technology projects as a result of our year 2000 problem activities. Suppliers. During the second and third quarters of 1999 we contacted all third-party suppliers of components used in the manufacture of our products, with special emphasis on those suppliers categorized as critical. During this process we identified one or more suppliers who are our single source of products and reviewed information they provided to us regarding their year 2000 programs. As of the third quarter of 1999, these suppliers have represented to us in writing that they have achieved year 2000 compliance. However, we have limited or no control over the actions of these third-party suppliers. Thus, while we expect that we will be able to resolve any significant year 2000 problems with these third parties, we cannot assure you that these suppliers will resolve any or all year 2000 problems before the occurrence of a material disruption to the operation of our business. Any failure of these third parties to resolve year 2000 problems with their systems, on a timely basis, could have a material adverse effect on our business, operating results and financial condition. Customers. During the second and third quarters of 1999 we contacted our significant customers to understand their situations regarding year 2000 readiness and to ensure that any inability on their part to take delivery of planned product shipments will not substantially impact our revenue flow. However, we have limited or no control over the actions of these customers. Thus, while we expect that we will be able to resolve any significant year 2000 problems with them, we cannot ensure you that these customers will not materially reduce their purchases from us in order to resolve their year 2000 problems. Any failure of these customers to resolve year 2000 problems with their systems on a timely basis, could have a material adverse effect on our business, operating results and financial condition. Most Likely Consequences of Year 2000 Problems. We believe we have identified and resolved all year 2000 problems that could materially adversely affect our business operations prior to the times when these problems could cause disruptions to our business. However, we believe that it is not possible to determine with complete certainty that we have identified or corrected all year 2000 problems affecting us. The number of devices that could be affected and the interactions among these devices are simply too numerous. In addition, no one can accurately predict how many year 2000 problem-related failures will occur or the severity, duration or financial consequences of these perhaps inevitable failures. As a result, we believe that the following consequences are possible: . a significant number of operational inconveniences and inefficiencies for us, our contract manufacturers and our customers that will divert management's time and attention and financial and human resources from ordinary business activities; 14
. several business disputes and claims for pricing adjustments or penalties due to year 2000 problems by our customers, which we believe will be resolved in the ordinary course of business; and . a few serious business disputes alleging that we failed to comply with the terms of contracts or industry standards of performance, some of which could result in litigation or contract termination. Worst case year 2000 scenario. While it is impossible to evaluate every aspect of year 2000 compliance, we believe the worst case scenario related to year 2000 compliance issues would be the failure of a sole or limited source supplier to be year 2000 compliant. The failure of one of these suppliers to be year 2000 compliant could seriously interrupt the flow of materials into the manufacturing process and therefore delay the manufacture and sale of our products. However, due to the general uncertainty inherent in the year 2000 computer problem resulting from the uncertainty of the year 2000 readiness of third-party suppliers, we are unable to determine at this time whether the consequences of year 2000 failures will have a material impact on our business. Contingency Plans. During the third and fourth quarters of 1999 we are developing contingency plans to be implemented if our efforts to identify and correct year 2000 problems affecting our internal systems are not effective. Depending on the systems affected, these plans could include: . accelerated replacement of affected equipment or software; . use of more costly express carriers to supplement freight forwarding services; . reliance on power generation devices to sustain critical voice and data functions; . short-to medium-term use of backup equipment and software; . increased work hours for our personnel; and . use of contract personnel on an accelerated schedule to correct any year 2000 problems that arise or to provide manual workarounds for information systems. Our implementation of any of these contingency plans could have a material adverse effect on our business, operating results and financial condition. Disclaimer. The discussion of our efforts and expectations relating to year 2000 compliance are forward-looking statements. Our ability to achieve year 2000 compliance and the level of incremental costs associated therewith could be adversely affected by, among other things, the availability and cost of programming and testing resources, third party suppliers' ability to modify proprietary software, and unanticipated problems identified in the ongoing compliance review. New Accounting Standards In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS No. 133 requires companies to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. We do not expect that the adoption of SFAS No. 133 will have a material impact on our financial statements. Factors That May Affect Future Results of Operations Our future results of operations are dependent upon a number of factors, including those described below. For a complete description of these factors, see our Form 10-K for the year ended December 31, 1998. 15
Our Operating Results Fluctuate and Are Unpredictable. Our net revenues and operating results have varied significantly in the past, are difficult to forecast, are subject to numerous factors both within and outside of our control, and may fluctuate significantly in the future. As a result, our operating results in a future quarter or quarters could fall below the expectations of public market analysts or investors. If that occurs, the price of our stock may decline. Some of the reasons our operating results may fluctuate in the future include the following: . Our Operating Results Depend on the Volume and Timing of Orders Received. Our net revenues and operating results are substantially dependent upon the volume and timing of orders received from our customers. We have historically experienced lengthy sales cycles, which limit our visibility regarding future financial performance. We are also subject to the risks to which the markets for our customers' or end users' products are subject, and to technological or other changes in those markets which may affect customer-buying patterns. In addition, the ordering patterns of some of our existing large customers have been unpredictable in the past, and we expect that customer-ordering patterns will continue to be unpredictable in the future. Not only does the volume of units ordered by particular customers vary substantially from period to period, but also purchase orders received from particular customers often vary substantially from early oral estimates provided by those customers for planning purposes. Our business is characterized by short-term customer orders and shipment schedules, and customer orders typically can be canceled or rescheduled without significant penalty to the customer. We have in the past experienced customer cancellations of substantial orders for reasons beyond our control, and significant cancellations could occur again at any time in the future. . Our Operating Results Are Subject to Competitive Pressures on Selling Prices. Our net revenues and operating results are also subject to competitive pressures on selling prices. Historically, average selling prices of products in the semiconductor and the high-voltage AC to DC power supply industries have decreased over the lives of the products. If we are unable to successfully introduce new products with higher average selling prices or are unable to reduce manufacturing costs to offset expected decreases in the prices of our existing products, our operating margins will be adversely affected. . Our Operating Results Are Dependent Upon the Volume and Timing of Our Orders With Our Foundries. Our operating results are also substantially dependent upon the volume and timing of orders that we place with our foundries. Due to the absence of substantial noncancellable backlog, we must plan our production and inventory levels based on internal forecasts of customer demand, which is unpredictable and may fluctuate substantially. If we underestimate the number of units required to meet customer demand and fail to maintain adequate inventory levels, we may lose significant revenue opportunities and market share to our competitors. On the other hand, if we overestimate the number of units required to meet customer demand, our operating results may be materially adversely affected as a result of costs associated with carrying excess inventory and with obsolescence. Excess inventory and obsolescence costs could be further increased by any unestimated returns from our distributors or customers. . Our net revenues and operating results may also fluctuate because of the following factors: . unavailability of raw materials; . fluctuations in manufacturing yields, whether resulting from the transition to new foundries or from other factors; . changes in product mix, including the impact of new product introduction on existing products; . our ability to develop and bring to market new products and technologies on a timely basis; . the introduction of products and technologies by our competitors; 16
. market acceptance of our and our customers' products; . the timing of investments in research and development and sales and marketing; and . fluctuations in exchange rates, particularly exchange rates between the U.S. dollar and the Japanese yen. We Depend on the Cellular Phone Battery Charger and Desktop PC Stand-By Markets for a Majority of Our Net Revenues. A limited number of applications of our products, primarily in the cellular phone battery chargers and desktop PC stand-by markets, currently account for the majority of our net revenues. We expect that our net revenues and operating results will continue to be substantially dependent upon these markets for the foreseeable future. The cellular phone and desktop PC markets can be highly cyclical and have been subject to significant economic downturns at various times. Any significant downturn in these markets could cause a decline in our net revenues and a reduction in the price of our stock. Our net revenues and operating results are subject to many of the risks to which the cellular phone battery charger and desktop PC stand-by markets for these applications are subject, and may also be impacted by technological or other developments in these markets. In particular, recent advances in battery technology which offer competitive advantages to the OEMs of cellular telephones permit these OEMs, including our largest end user, Motorola, to lower, or consider lowering, the wattage level of the power supplies used to recharge batteries. As the output power has dropped below 5 watts for some slow or trickle chargers, some OEMs have substituted older alternative technologies for switchers. Although this has not had any significant impact on our business to date, it could in the future if these older technological alternatives are more cost effective than our current and future product offerings. Similarly, if a competitor successfully and cost-effectively combines desktop PC stand-by power supplies with the main PC desktop power supplies before we do, demand for our products could be materially adversely affected. We believe that our future success will depend in part upon our ability to penetrate additional markets for our products, and we cannot assure you that we will be able to overcome the marketing or technological challenges necessary to do so. To the extent that a competitor penetrates additional markets before we do, or takes market share from us in our existing markets, our net revenues and financial condition could be materially adversely affected. We Are Highly Dependent on a Limited Number of Customers. Our end user base is highly concentrated, and a relatively small number of OEMs, directly or indirectly through merchant power supply manufacturers, account for a significant portion of our net revenues. Accordingly, if one of these OEMs significantly reduces its purchases from us, our net revenues may decline. We have experienced these effects in the past and we cannot assure you that our customers will not reduce, cancel or delay orders in the future. We expect to continue to be dependent upon a relatively limited number of customers for a significant portion of our net revenues in future periods. Also, no customer is presently obligated either to purchase a specified amount of products or to provide us with binding forecasts of product purchases for any period. Our products are typically one of many components used in a larger product produced by our customers. Demand for our products is therefore subject to many risks beyond our control, including, among others: . competition faced by our customers in their particular end markets; . market acceptance of the products of our customers; . technical challenges which may or may not be related to the components supplied by us; and . the technical, sales and marketing and management capabilities of our customers and the financial and other resources of our customers. 17
Motorola's Energy Systems Group, or ESG, has informed us of its intent to move a high volume charger program to another solution. We expect that this transition will occur in the first quarter of 2000. As a result of this decision, our direct sales to ESG may be significantly reduced, which may significantly reduce our net revenues. We Are Dependent on Our Wafer Suppliers. We outsource all of our semiconductor manufacturing and product assembly, except for testing and finishing. We have supply arrangements for the production of wafers with Matsushita and OKI. Although certain aspects of our relationships with Matsushita and OKI are contractual, many important aspects of these relationships depend on the continued cooperation of these strategic partners and, in many instances, the parties' course of conduct deviates from the literal provisions of the contracts. We cannot assure you that our strategic partners and we will continue to work together successfully in the future or that either Matsushita or OKI will not seek an early termination of its wafer supply agreement with us. If we were unable to obtain wafers from Matsushita and OKI and could not timely qualify another supplier, we would not be able to supply our customers with the products they require, which would cause our net revenues to decline. Our wafer supply contracts with Matsushita and OKI terminate in June 2000 and September 2003, respectively. We cannot assure you that we will be able to reach an agreement with Matsushita to extend the term of its wafer supply agreement. Failure to reach, in a timely fashion, an extension of our agreement with Matsushita or to enter into an arrangement with another manufacturer could result in material disruptions in supply. In addition, the terms of our agreement with Matsushita limit the conditions under which we can enter into similar arrangements with other Japanese manufacturers or their subsidiaries during the term of this agreement. Any disruption in our supply of wafers would adversely impact our ability to sell our product and would cause a decline in our net revenues. In addition, our products do not require leading edge device process geometries. As device process geometries become increasingly smaller and as demand for such smaller geometries increases, Matsushita and OKI may decide at some point to convert all of their manufacturing processes to smaller geometries in response to these industry trends. We estimate that it would take between 9 to 12 months from the time we identified an alternate manufacturing source before that source could produce wafers with acceptable manufacturing yields in sufficient quantities to meet our needs. We typically receive shipments from Matsushita or OKI approximately 8 to 10 weeks after placing orders, and lead times for new products can be substantially longer. To provide sufficient time for assembly, testing and finishing, we typically need to receive wafers from Matsushita or OKI 4 to 6 weeks before the desired ship date to our customers. As a result of these factors and the fact that customers' orders can be made with little advance notice, we have only a limited ability to react to fluctuations in demand for our products. This could cause us to have an excess or a shortage of inventory of a particular product. From time to time we have been unable to fully satisfy customer requests as a result of these factors. Any significant disruptions in deliveries would materially adversely affect our business and operating results. Although we provide OKI and Matsushita with rolling forecasts of our production requirements, the ability of Matsushita or OKI to provide wafers to us is limited by the available capacity of the foundry in which it manufactures wafers for us. An increased need for capacity to meet internal demands or demands of other customers could cause Matsushita and OKI to reduce capacity available to us. Matsushita and OKI may also require us to pay amounts in excess of contracted or anticipated amounts for wafer deliveries or require us to make other concessions in order to acquire the wafer supply necessary to meet our customers' requirements. Any of these concessions could materially adversely affect our business. We Rely on Our Contracted Foundries and Independent Subcontractors to Produce Wafers and Assemble Finished Products at Acceptable Yields. We depend on Matsushita and OKI to produce wafers, and independent subcontractors to assemble finished products, at acceptable yields and to deliver them to us in a timely manner. The failure of Matsushita or OKI to supply us wafers at acceptable yields could prevent us from selling our products to our customers and would likely cause a decline in our net revenues. The manufacture of our TOPSwitch products utilizes a CMOS process with a proprietary, highly sensitive implant process step. To the extent this process prevents our wafer foundries from achieving acceptable manufacturing yields or causes them to delay product shipments, our financial condition and operating results would be materially adversely affected. Our IC assembly process also requires our manufacturers to use a high-voltage molding compound available from only one vendor, 18
which is difficult to process. This compound and its required processes, together with the other non-standard materials and processes needed to assemble our products, require a more exacting level of process control than normally required for standard packages. Unavailability of the sole source compound or problems with the assembly process can materially adversely affect yields and cost to manufacture. Good production yields are particularly important to our business and financial results, including our ability to meet our customers' demand for products and to maintain profitability. As we continue to increase our product output, our foundries and assemblers may experience a decrease in yields. We cannot assure you that acceptable yields will be maintainable in the future. Matsushita Has Licenses to Our Technology Which It May Use to Our Detriment. Our ability to take advantage of the potentially large Japanese market for our products is largely dependent on Matsushita and its ability to promote and deliver our products. Pursuant to our agreement with Matsushita, Matsushita has the right to manufacture and sell products using our technology to Japanese companies worldwide and to subsidiaries of Japanese companies located in Asia. Some of these products are redistributed by the Japanese customers to their manufacturing operations in other regions. In addition, we have agreed not to sell our products in Japan to new customers. Although we receive royalties on Matsushita's sales, these royalties are substantially lower than the gross profit we would receive on direct sales. In addition, the royalties Matsushita pays us are denominated in Japanese yen and are subject to risks inherent in exchange rate fluctuations. Should we fail to negotiate acceptable royalty- bearing extensions to our contract with Matsushita, we would need to expend substantial effort and expense to establish ourselves in this market directly or through a different partner. We cannot assure you that we would not lose customers for Matsushita's products during any transition. We cannot assure you that Matsushita will not use the technology rights we have granted it to develop or market competing products following any termination of its relationship with us or after termination of Matsushita's royalty obligation to us. Our International Sales Subject Us to Substantial Risks. Sales to customers outside of the United States account for a large portion of our net revenues. These sales involve a number of risks to us, including: . imposition of government controls; . potential insolvency of international distributors and representatives; . reduced protection for intellectual property rights in some countries; . the impact of recessionary environments in economies outside the United States; . longer receivables collection periods; . tariffs and other trade barriers and restrictions; and . the burdens of complying with a variety of foreign laws. Furthermore, because substantially all of our foreign sales are denominated in U.S. dollars, increases in the value of the dollar would increase the price in local currencies of our products in foreign markets and make our products relatively more expensive and less price competitive than competitors' products that are priced in local currencies. Our failure to adequately address these risks could reduce our international sales, which would materially adversely affect our operating results. We Are Dependent on Foreign Manufacturers and Assemblers for the Manufacture of Our Wafers. Because we depend on Matsushita and OKI, both located in Japan, for the manufacture of all of our finished silicon wafers and on foreign assembly subcontractors of our products, we are directly affected by the political and economic conditions of the countries in which our wafers are or are expected to be manufactured. To the extent that these countries experience prolonged work stoppages or other inability to manufacture and assemble our products, our business, financial condition or operating results could be materially adversely affected. Our contracts with Matsushita and OKI are denominated in Japanese yen, which exposes us to the risk of increased costs for finished wafers. We do not believe we could readily pass this increase through to our customers. 19
New Products and Technological Change May Render Our and Our Customers' Products Out of Date. Our future success depends in significant part upon our ability to develop new ICs for high-voltage power conversion for existing and new markets, to introduce these products in a timely manner and to have these products selected for design into products of leading manufacturers. If we fail to develop and sell new products in a timely manner, our net revenues could decline. The development of new devices is highly complex, and from time to time we have experienced delays in completing the development of new products. Successful product development and introduction depends on a number of factors, including: . accurate new product definition; . timely completion and introduction of new product designs; . availability of foundry capacity; . achievement of acceptable manufacturing yields; and . market acceptance of our and our customers' products. We cannot be sure that we will be able to adjust to changing market demands as quickly and cost-effectively as necessary to compete successfully. Furthermore, we cannot assure you that we will be able to introduce new products in a timely and cost-effective manner or in sufficient quantities to meet customer demand or that such products will achieve market acceptance. Our or our customers' failure to develop and introduce new products successfully and in a timely manner would materially adversely affect our business, financial condition and operating results. In addition, customers may defer or return orders for existing products in response to the introduction of new products. Although we maintain reserves against returns, we cannot assure you that these reserves will be adequate. We Have Historically Experienced a Lengthy Sales Cycle. Our products are generally incorporated into a customer's products at the design stage. However, customer decisions to use our products, commonly referred to as design wins, which can often require us to expend significant resources without any assurance of success, often precede volume sales, if any, by a year or more. If a customer decides at the design stage not to incorporate our products into its product, we may not have another opportunity for a design win with respect to that product for many months or years. Because of this lengthy sales cycle, we may experience a delay between increasing expenses for research and development and our sales and marketing efforts and the generation of volume production revenues, if any, from these expenditures. Moreover, the value of any design win will largely depend upon the commercial success of the customer's product. We cannot assure you that we will continue to achieve design wins or that any design win will result in future revenues. Our failure to timely develop and introduce products that are incorporated into our customers' products could significantly reduce our net revenues and adversely affect our operating results. Our Products Must Meet Exacting Specifications, and Undetected Defects and Failures May Occur. The fabrication and assembly of ICs are highly complex and precise processes. We expect that our customers will continue to establish demanding specifications for quality, performance and reliability that our products must meet. ICs as complex as those we sell often encounter development delays and may contain undetected defects or failures when first introduced or after commencement of commercial shipments. We have from time to time in the past experienced product quality, performance or reliability problems. We cannot guarantee that defects or failures will not occur in the future relating to our product quality, performance and reliability that may have a material adverse effect on our operating results. If these defects and failures occur, we could experience lost revenue, increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments and product returns or discounts, any of which would harm our operating results. 20
The High-Voltage Power Supply Industry is Extremely Competitive and Highly Price-Sensitive. The high-voltage power supply industry is intensely competitive and characterized by extreme price sensitivity. Accordingly, the most significant competitive factor in the target markets for our products is cost effectiveness. Our products face competition from alternative technologies, including traditional linear transformers and discrete switcher power supplies. We believe that at current pricing, our high-voltage power conversion IC families of products offer favorable cost-performance benefits compared to the competition. However, there has recently been over capacity of discrete components, which has resulted in significant price erosion for these products. Continued significant erosion in the price of competing products, including high-voltage Bipolar and MOSFET transistors and PWM controller ICs, could adversely affect the cost effectiveness of our products. Also, older alternative technologies to switchers are more cost-effective than discrete switchers and integrated switchers that use our products in certain power ranges for some applications. If power requirements for applications in which our products are currently utilized, including battery chargers for cellular telephones, drop below certain power levels, these older alternative technologies can be used more cost effectively than our TOPSwitch-based switchers. Recently, our TOPSwitch product families have begun to meet additional competition from hybrid and single high-voltage ICs similar to TOPSwitch. Fairchild Semiconductor, OnSemiconductor, STMicroelectronics and Sanken are developing or producing these competing products. We expect competition to increase as companies like these see the success we have had in converting older technologies to the integrated solutions used in our product offerings. To the extent these competitors' products are more cost effective than our products, our operating results could be materially adversely affected. Many of our emerging competitors, including Fairchild Semiconductor, OnSemiconductor, STMicroelectronics and Sanken, have significantly greater financial, technical, manufacturing and marketing resources than we do. In a market where a high- voltage IC is designed into a customer's product and the provider of the IC is therefore the sole source of the IC for that product, greater manufacturing resources may be a significant factor in the customer's choice of the IC because of the customer's perception of greater certainty in its source of supply. Our ability to compete in our target markets also depends on these factors: . the timing and success of new product introductions by us and our competitors; . the pace at which our customers incorporate our products into their end user products; . the availability of wafer fabrication and finished good manufacturing capability; . availability of adequate sources of raw materials; and . the protection of our products by effective utilization of intellectual property laws. We cannot assure you that our products will continue to compete favorably or that we will be successful in the face of increasing competition from new products and enhancements introduced by existing competitors or new companies entering this market. We believe our failure to compete successfully in the high-voltage power supply business would materially reduce our operating results. We Must Protect Our Intellectual Property. Our future success depends upon our ability to protect our intellectual property, including patents, trade secrets, and know-how, and to continue our technological innovation. We cannot assure you that the steps we have taken to protect our intellectual property will be adequate to prevent misappropriation or that others will not develop competitive technologies or products. Moreover, the laws of some foreign countries in which our technology is or may in the future be licensed may not protect our intellectual property rights to the same extent as the laws of the United States, thus increasing the possibility of infringement of our intellectual property. We Depend on a Few Key Personnel. Our success depends to a significant extent upon the continued service of our executive officers and other key management and technical personnel, and on our ability to continue to attract, retain and motivate qualified personnel, such as experienced systems applications engineers. The 21
competition for these employees is intense, particularly in Silicon Valley. The loss of the services of one or more of our engineers, executive officers or other key personnel or our inability to recruit replacements for these individuals or to otherwise attract, retain and motivate qualified personnel could have a material adverse effect on our business, financial condition or operating results. We do not have long-term employment contracts with, and we do not have in place "key person" life insurance policies on, any of our employees. Our Future Success Depends On Our Successful Management of Growth. We have experienced a period of rapid growth and expansion, which has placed, and continues to place, a significant strain on our resources. To accommodate this growth, we have implemented and will continue to implement new and upgraded operational and financial systems, procedures and controls, including the improvement of our internal management systems, which may require substantial management efforts. These efforts if not accomplished successfully, could adversely affect our business and cause our net revenues to decline. In addition, any future periods of rapid growth or expansion could be expected to place a significant strain on our limited managerial, financial, engineering and other resources. Relationships with new customers generally require significant engineering support. As a result, any increase in the number of customers using our technology will increase the strain on our resources, particularly our engineers. These strains may result in delays or difficulties in our research and development process, which could make it difficult for us to develop future generations of our products and to remain competitive. In addition, the rapid rate of hiring new employees could be disruptive and adversely affect the efficiency of our research and development process. Arrival of the Year 2000 May Create Unforeseen Difficulties. Many computer systems were not designed to handle any dates beyond the year 1999, and therefore, computer hardware and software for virtually all businesses will need to be modified prior to the year 2000 in order to remain functional. We are concerned that many enterprises will be devoting a substantial portion of their information systems spending to resolving this upcoming year 2000 problem. This expense may result in spending being diverted from ICs for use in AC to DC power conversion in the near future. We have assessed the impact of the year 2000 issue on our internal information systems and have completed the remediation and testing of all critical computers and software applications, as well as most of the production equipment used in the manufacture of our products. Production testers that handle over 98% of our product volume have now been successfully upgraded for year 2000 compliance and tested. We have developed acceptable work-arounds for the remainder of our test equipment and we do not anticipate any material disruption to our production as a result of employing these work- arounds. Testing of non-critical computers, software applications and production equipment will be continued throughout the remainder of the calendar year. We have evaluated the functionality of our current products with respect to any year 2000 problems and have determined that our current products have no year 2000 problems. We do not anticipate that addressing the year 2000 problem for our internal information systems and future products will have a material impact on our operations or financial results. However, we cannot assure you that these costs will not be greater than anticipated, or that we will complete the corrective actions we have undertaken before any year 2000 problems could occur. The year 2000 issue could lower demand for our products while increasing our costs. These factors, while not quantified, could have a material adverse impact on our operations and financial results. We have relationships with key suppliers, who are our single source or one of a limited number of providers of certain materials used in our products. During the second and third quarters of 1999 we completed the process of contacting all third-party suppliers of components used in the manufacture of our products, with special emphasis on those suppliers categorized as critical. During this process we identified one or more sole source suppliers and reviewed information they provided to us regarding their year 2000 programs. As of the third quarter of 1999, these suppliers have represented to us in writing that they have achieved year 2000 compliance. However, we have limited or no control over the actions of these third-party suppliers. Thus, while we expect that we will be able to resolve any significant year 2000 problems with these third parties, we cannot assure you that these suppliers will resolve any or all year 2000 problems before the occurrence of a material disruption to the operation of our business. Any failure of these third parties to resolve year 2000 problems with their systems, on a timely basis, could have a material adverse effect on our business, operating results and financial condition. 22
We Have Adopted Anti-Takeover Measures Which May Make it More Difficult for a Third Party to Acquire Us. Our board of directors has the authority to issue up to 3,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock. In February 1999, our board of directors adopted a preferred stock purchase rights plan intended to guard against hostile takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock. These provisions provide, among other things, that: . stockholders may not take action by written consent; . the ability of stockholders to call special meetings and to raise matters at stockholders' meetings is restricted; and . certain amendments of our certificate of incorporation, and all amendments of our bylaws, require the approval of holders of at least two-thirds of the voting power of all outstanding shares. We are also subject to the anti-takeover provisions of section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. The application of section 203 could have the effect of delaying or preventing a change of control. Our Stock Price Has Been Volatile. Our common stock has been, and is likely to be, volatile. We cannot assure you that the trading price of our common stock will remain at or near the price at which you may have purchased it. Factors including future announcements concerning us or our competitors, quarterly variations in operating results, announcements of technological innovations, the introduction of new products or changes in our product pricing policies or those of our competitors, proprietary rights or other litigation, changes in earnings estimates by analysts and other factors could cause the market price of our common stock to fluctuate substantially. In addition, stock prices for many technology companies fluctuate widely for reasons which may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as recessions or military conflicts may materially adversely affect the market price of our common stock. Moreover, the trading prices of many high technology stocks are at or near their historical highs and reflect price/earning ratios substantially above historical norms. 23
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS. There has not been a material change in our exposure to interest rate and foreign currency risks since the date of the 1998 Form 10-K. Interest Rate Risk. Our exposure to market risk for changes in interest rates relate primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We invest in high-credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer. As stated in our policy, we ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in safe and high-credit quality securities and by constantly positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer, guarantor or depository. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. The table below presents principal amounts and related weighted average interest rates for our investment portfolio at September 30, 1999. All investments mature, by policy, in 15 months or less. (in thousands, except average interest rates) <TABLE> <CAPTION> Average Carrying Interest Amount Rate ---------- ---------- Cash Equivalents: <S> <C> <C> Tax-exempt securities............................................................. $15,000 3.75% ------- ---- Total cash equivalents....................................................... 15,000 3.75% ------- ---- Short-term Investments: U.S. corporate securities......................................................... 24,100 5.23% Foreign securities................................................................ 3,079 4.97% Tax-exempt securities............................................................. 7,000 3.75% ------- ---- Total short-term investments................................................. 34,179 4.90% ------- ---- Total investment securities.................................................. $49,179 4.55% ======= ==== </TABLE> Foreign Currency Exchange Risk. We transact business in various foreign countries. Our primary foreign currency cash flows are in Japan and Western Europe. Currently, we do not employ a foreign currency hedge program utilizing foreign currency forward exchange contracts as the foreign currency transactions and risks to date have not been significant. 24
PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In July 1998, we filed a complaint for patent infringement in the U.S. District Court, Northern District of California, against our largest end user, Motorola. In August 1998, we voluntarily dismissed the complaint, and filed a new complaint in the U.S. District Court, District of Delaware, alleging that Motorola has infringed and continues to infringe two of our circuit patents. In October 1998, Motorola asserted various counterclaims against us, alleging that we are infringing certain of Motorola's patents. Trial of this action was held in October 1999. On October 15, 1999, a unanimous jury returned a verdict in our favor. The jury determined that Motorola had willfully infringed one of our patents and awarded us $32.3 million in compensatory damages. The jury also found that we had not infringed any of the asserted Motorola patents and that two of the Motorola patents were invalid. Proceedings in this matter are continuing. We anticipate that Motorola will seek to have the jury verdict overturned. If the verdict were overturned, we might not ultimately prevail in this litigation and this litigation could have a material adverse effect on our business, financial condition and operating results. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. Exhibits. The following exhibits are attached hereto and filed herewith: 10.25 Sublease between the Company and Atweb, Inc., dated as of July 1, 1999. 27.1 Financial Data Schedule. b. Reports on Form 8-K. None 25
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. POWER INTEGRATIONS, INC. Dated: November 9, 1999 By: /s/ Robert G. Staples ----------------------------- Robert G. Staples Chief Financial Officer 26