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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, 2002.
 
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)
 
DELAWARE
    
94-3065014
(State or other jurisdiction of
Incorporation or organization)
    
(I.R.S. Employer
Identification No.)
 
5245 Hellyer Avenue, San Jose, California 95138
(Address of principal executive offices) (Zip code)
 
(408) 414-9200
(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.
 
                        Class                         

    
Outstanding at October 31, 2002

Common Stock, $.001 par value
    
28,492,218 shares
 
 


Table of Contents
 
POWER INTEGRATIONS, INC.
 
TABLE OF CONTENTS
 
PART I.    FINANCIAL INFORMATION
  
Page

Item 1.
  
Financial Statements
    
       
3
       
4
       
5
       
6
Item 2.
     
11
Item 3.
     
22
Item 4.
     
22
PART II.    OTHER INFORMATION
    
Item 1.
     
23
Item 2.
     
23
Item 3.
     
23
Item 4.
     
23
Item 5.
     
23
Item 6.
     
23
       
24
 
TOPSwitch, TinySwitch, LinkSwitch, DPA-Switch and EcoSmart are trademarks of Power Integrations, Inc.

2


Table of Contents
PART I.    FINANCIAL INFORMATION
 
ITEM 1.    FINANCIAL STATEMENTS
 
POWER INTEGRATIONS, INC.
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
    
September 30,
2002

    
December 31,
2001

 
    
(unaudited)
        
ASSETS
                 
CURRENT ASSETS:
                 
Cash and cash equivalents
  
$
74,756
 
  
$
62,141
 
Short-term investments
  
 
28,866
 
  
 
14,724
 
Accounts receivable
  
 
8,800
 
  
 
5,124
 
Inventories
  
 
13,196
 
  
 
23,622
 
Deferred tax assets
  
 
5,346
 
  
 
5,346
 
Prepaid expenses and other current assets
  
 
2,254
 
  
 
1,526
 
    


  


Total current assets
  
 
133,218
 
  
 
112,483
 
PROPERTY AND EQUIPMENT, net
  
 
20,320
 
  
 
23,182
 
    


  


    
$
153,538
 
  
$
135,665
 
    


  


LIABILITIES AND STOCKHOLDERS’ EQUITY
                 
CURRENT LIABILITIES:
                 
Current portion of capitalized lease obligations
  
$
240
 
  
$
440
 
Accounts payable
  
 
6,475
 
  
 
4,641
 
Accrued payroll and related expenses
  
 
3,662
 
  
 
3,164
 
Taxes payable and other accrued liabilities
  
 
5,083
 
  
 
1,604
 
Deferred income on sales to distributors
  
 
2,133
 
  
 
1,798
 
    


  


Total current liabilities
  
 
17,593
 
  
 
11,647
 
    


  


LONG TERM LIABILITIES:
                 
Capitalized lease obligations, net of current portion
  
 
94
 
  
 
275
 
Deferred rent
  
 
672
 
  
 
441
 
    


  


Total long term liabilities
  
 
766
 
  
 
716
 
    


  


STOCKHOLDERS’ EQUITY:
                 
Common stock
  
 
28
 
  
 
28
 
Additional paid-in capital
  
 
87,579
 
  
 
81,758
 
Stockholder notes receivable
  
 
 
  
 
(38
)
Cumulative translation adjustment
  
 
(116
)
  
 
(117
)
Retained earnings
  
 
47,688
 
  
 
41,671
 
    


  


Total stockholders’ equity
  
 
135,179
 
  
 
123,302
 
    


  


    
$
153,538
 
  
$
135,665
 
    


  


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

3


Table of Contents
 
POWER INTEGRATIONS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(In thousands, except per share amounts)
 
    
Three Months Ended September 30,

  
Nine Months Ended September 30,

    
2002

  
2001

  
2002

  
2001

NET REVENUES:
                           
Product sales
  
$
27,712
  
$
22,710
  
$
77,963
  
$
69,516
License fees and royalties
  
 
456
  
 
293
  
 
1,023
  
 
930
    

  

  

  

Total net revenues
  
 
28,168
  
 
23,003
  
 
78,986
  
 
70,446
COST OF REVENUES
  
 
16,328
  
 
13,092
  
 
45,454
  
 
37,766
    

  

  

  

GROSS PROFIT
  
 
11,840
  
 
9,911
  
 
33,532
  
 
32,680
    

  

  

  

OPERATING EXPENSES:
                           
Research and development
  
 
3,561
  
 
3,586
  
 
10,817
  
 
10,828
Sales and marketing
  
 
3,756
  
 
3,797
  
 
10,803
  
 
11,146
General and administrative
  
 
1,600
  
 
1,537
  
 
4,581
  
 
4,273
    

  

  

  

Total operating expenses
  
 
8,917
  
 
8,920
  
 
26,201
  
 
26,247
    

  

  

  

INCOME FROM OPERATIONS
  
 
2,923
  
 
991
  
 
7,331
  
 
6,433
OTHER INCOME, net
  
 
365
  
 
325
  
 
1,265
  
 
1,419
    

  

  

  

INCOME BEFORE PROVISION FOR INCOME TAXES
  
 
3,288
  
 
1,316
  
 
8,596
  
 
7,852
PROVISION FOR INCOME TAXES
  
 
986
  
 
395
  
 
2,579
  
 
2,389
    

  

  

  

NET INCOME
  
$
2,302
  
$
921
  
$
6,017
  
$
5,463
    

  

  

  

EARNINGS PER SHARE:
                           
Basic
  
$
0.08
  
$
0.03
  
$
0.21
  
$
0.20
    

  

  

  

Diluted
  
$
0.08
  
$
0.03
  
$
0.20
  
$
0.19
    

  

  

  

SHARES USED IN PER SHARE CALCULATION:
                           
Basic
  
 
28,451
  
 
27,758
  
 
28,298
  
 
27,622
    

  

  

  

Diluted
  
 
29,074
  
 
29,339
  
 
29,494
  
 
28,748
    

  

  

  

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

4


Table of Contents
 
POWER INTEGRATIONS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(In thousands)
 
    
Nine Months Ended September 30,

 
    
2002

    
2001

 
CASH FLOWS FROM OPERATING ACTIVITIES:
                 
Net income
  
$
6,017
 
  
$
5,463
 
Adjustments to reconcile net income to net cash provided by operating activities:
                 
Depreciation and amortization
  
 
5,013
 
  
 
4,873
 
Deferred rent
  
 
231
 
  
 
349
 
Provision for accounts receivable and other allowances
  
 
 
  
 
229
 
Tax benefit associated with employee stock plans and stock compensation to non-employees
  
 
1,486
 
  
 
1,305
 
Change in operating assets and liabilities:
                 
Accounts receivable
  
 
(3,676
)
  
 
(318
)
Inventories
  
 
10,426
 
  
 
(2,743
)
Prepaid expenses and other current assets
  
 
(728
)
  
 
2,654
 
Accounts payable
  
 
1,834
 
  
 
(1,235
)
Accrued liabilities
  
 
3,977
 
  
 
(2,615
)
Deferred income on sales to distributors
  
 
335
 
  
 
(768
)
    


  


Net cash provided by operating activities
  
 
24,915
 
  
 
7,194
 
    


  


CASH FLOWS FROM INVESTING ACTIVITIES:
                 
Purchases of property and equipment
  
 
(2,150
)
  
 
(6,931
)
Purchases of short-term investments
  
 
(36,575
)
  
 
(24,750
)
Proceeds from sales and maturities of short-term investments
  
 
22,433
 
  
 
27,303
 
    


  


Net cash used in investing activities
  
 
(16,292
)
  
 
(4,378
)
    


  


CASH FLOWS FROM FINANCING ACTIVITIES:
                 
Net proceeds from issuance of common stock
  
 
4,335
 
  
 
3,773
 
Proceeds from stockholder note repayment
  
 
38
 
  
 
38
 
Principal payments under capitalized lease obligations
  
 
(381
)
  
 
(505
)
    


  


Net cash provided by financing activities
  
 
3,992
 
  
 
3,306
 
    


  


NET INCREASE IN CASH AND CASH EQUIVALENTS
  
 
12,615
 
  
 
6,122
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
  
 
62,141
 
  
 
36,462
 
    


  


CASH AND CASH EQUIVALENTS AT END OF PERIOD
  
$
74,756
 
  
$
42,584
 
    


  


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
                 
Cash paid for interest
  
$
20
 
  
$
53
 
    


  


Cash paid for (refunds of) income taxes, net of refunds
  
$
(775
)
  
$
3,849
 
    


  


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

5


Table of Contents
 
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. Certain reclassifications were made to the prior year financial information to conform to the current period presentation. The condensed consolidated financial statements should be read in conjunction with the Power Integrations, Inc. consolidated financial statements for the year ended December 31, 2001 included in its Form 10-K filed on March 22, 2002 with the Securities and Exchange Commission.
 
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. 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, 2002, the Company’s short-term investments consisted of U.S. government backed securities, corporate commercial paper and other high quality commercial 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 such 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 accounting principles generally accepted in the United States of America 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. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition and allowances for receivables and inventories. These estimates are based on historical facts and various other assumptions that the Company believes to be reasonable at the time the estimates are made.
 
Comprehensive Income
 
SFAS No. 130, “Reporting Comprehensive Income,” establishes standards for reporting and the presentation of comprehensive income and its components. SFAS No. 130, requires companies to report a new measurement of income to include unrealized gains and losses, net of the tax effect that have historically been excluded from net income and reflected instead in stockholders’ equity. Comprehensive income for the Company consists of net income plus the effect of foreign currency translation adjustments, which was not material for the nine months ended September 30, 2002 and 2001. Accordingly, comprehensive income closely approximates actual net income.

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Table of Contents

POWER INTEGRATIONS, INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
Segment Reporting
 
SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” establishes standards for reporting and the presentation of 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 and DC to DC power conversion markets.
 
Recent Accounting Pronouncements
 
In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections Business Combinations.” The provisions of SFAS No. 145 related to the rescission of SFAS No. 4 are effective for financial statements issued for fiscal years beginning after May 15, 2002, and the provisions related to SFAS No. 13 are effective for transactions occurring after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The Company does not expect the adoption to have a significant impact on the Company.
 
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 revises the accounting for specified employee and contract terminations that are part of restructuring activities. Companies will be able to record a liability for a cost associated with an exit or disposal activity only when the liability is incurred and can be measured at fair value. Commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and therefore, does not meet the requirement for recognizing a liability and related expense. This statement only applies to termination benefits offered for a specific termination event or a specified period. It will not affect accounting for the costs to terminate a capital lease. The Company is required to adopt this statement for exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption to have a significant impact on the Company.
 
3.    INVENTORIES:
 
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):
 
    
September 30,
2002

  
December 31,
2001

Raw materials
  
$
999
  
$
1,571
Work-in-process
  
 
6,007
  
 
12,528
Finished goods
  
 
6,190
  
 
9,523
    

  

    
$
13,196
  
$
23,622
    

  

7


Table of Contents

POWER INTEGRATIONS, INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
4.    SIGNIFICANT CUSTOMERS AND EXPORT SALES:
 
Customer Concentration
 
The Company’s end user base is highly concentrated and a relatively small number of OEMs, power supply merchants and distributors accounted for a significant portion of the Company’s net revenues. Ten customers accounted for approximately 82.4% and 77.4% of total net revenues for the three months ended September 30, 2002 and 2001, respectively, and approximately 81.5% and 73.1% of total net revenues for the nine months ended September 30, 2002 and 2001, respectively.
 
The following customers accounted for more than 10% of total net revenues:
 
    
Three Months Ended
September 30,

      
Nine Months Ended
September 30,

 
Customer

  
2002

      
2001

      
2002

      
2001

 
A
  
24.0
%
    
19.0
%
    
22.7
%
    
22.8
%
B
  
10.3
%
    
16.3
%
    
13.4
%
    
12.2
%
C
  
16.3
%
    
*
 
    
14.8
%
    
*
 
D
  
*
 
    
14.5
%
    
*
 
    
*
 

*
 
less than 10% or no sales
 
Customers A and B are distributors of the Company’s products, customer C is an OEM and customer D is a power supply merchant.
 
Concentration of Credit Risk
 
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash investments and trade receivables. The Company has cash investment policies that limit cash investments to short-term, low risk investments. With respect to trade receivables, the Company performs ongoing credit evaluations of its customers’ financial condition and requires letters of credit whenever deemed necessary. Additionally, the Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends related to past losses and other relevant information. As of September 30, 2002 and December 31, 2001, approximately 80.8% and 75.2% of accounts receivable, respectively, were concentrated with ten customers.
 
The following customers accounted for more than 10% of accounts receivables:
 
      
September 30,
2002

      
December 31,
2001

 
Customer

         
A
    
30.7
%
    
18.5
%
B
    
*
 
    
15.3
%
C
    
11.3
%
    
10.2
%

*
 
less than 10% or no balance

8


Table of Contents

POWER INTEGRATIONS, INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
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:
 
    
Three Months Ended
September 30,

      
Nine Months Ended
September 30,

 
    
2002

      
2001

      
2002

      
2001

 
Hong Kong/China
  
33.0
%
    
24.0
%
    
28.0
%
    
27.9
%
Korea
  
23.8
%
    
14.3
%
    
24.4
%
    
12.8
%
Taiwan
  
20.2
%
    
35.4
%
    
25.2
%
    
28.9
%
Germany
  
6.0
%
    
6.6
%
    
6.2
%
    
7.0
%
Europe – excluding Germany
  
5.9
%
    
10.0
%
    
7.2
%
    
11.1
%
Japan
  
2.5
%
    
1.2
%
    
1.7
%
    
1.7
%
Singapore
  
2.0
%
    
0.4
%
    
1.2
%
    
0.6
%
Other
  
2.6
%
    
2.6
%
    
2.5
%
    
2.4
%
    

    

    

    

Total foreign
  
96.0
%
    
94.5
%
    
96.4
%
    
92.4
%
    

    

    

    

 
Product Sales
 
Sales of the Company’s TOPSwitch and TinySwitch products accounted for 98.8% and 99.5% of net revenues from product sales for the three months ended September 30, 2002 and 2001, respectively, and 99.0 % and 98.3% of net revenues from product sales for the nine months ended September 30, 2002 and 2001, respectively. TOPSwitch products include TOPSwitch, TOPSwitch II, TOPSwitch FX and TOPSwitch GX. TinySwitch products include TinySwitch and TinySwitch II.

9


Table of Contents

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 shares issuable under the employee stock purchase plan 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):
 
    
Three Months
Ended
September 30,

  
Nine Months
Ended
September 30,

    
2002

  
2001

  
2002

  
2001

Basic earnings per share:
                           
Net income
  
$
2,302
  
$
921
  
$
6,017
  
$
5,463
    

  

  

  

Weighted average common shares
  
 
28,451
  
 
27,758
  
 
28,298
  
 
27,622
    

  

  

  

Basic earnings per share
  
$
0.08
  
$
0.03
  
$
0.21
  
$
0.20
    

  

  

  

Diluted earnings per share:
                           
Net income
  
$
2,302
  
$
921
  
$
6,017
  
$
5,463
    

  

  

  

Weighted average common shares
  
 
28,451
  
 
27,758
  
 
28,298
  
 
27,622
Weighted average common share equivalents:
                           
Options
  
 
618
  
 
1,569
  
 
1,187
  
 
1,120
Employee stock purchase plan
  
 
5
  
 
12
  
 
9
  
 
6
    

  

  

  

Diluted weighted average common shares
  
 
29,074
  
 
29,339
  
 
29,494
  
 
28,748
    

  

  

  

Diluted earnings per share
  
$
0.08
  
$
0.03
  
$
0.20
  
$
0.19
    

  

  

  

 
6.    PROVISION FOR INCOME TAXES:
 
Income tax expense for the nine-month periods ended September 30, 2002 and 2001 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 Federal statutory rate of 35% and the Company’s effective tax rate of 30% for the nine months ended September 30, 2002 and 2001 is primarily due to the beneficial impact of international sales, research and development credits and Federal tax-exempt investments.

10


Table of Contents
 
ITEM 2:
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 
This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements, which reflect our current views with respect to future events and financial performance. In this report, the words “will”, “expects”, “believe”, “should”, “anticipate”, “outlook”, “if”, “future” and similar expressions identify forward-looking statements. Such statements are subject to certain risks and uncertainties, including our development efforts, the success of our product strategies, the maintenance of significant business relationships, as well as those discussed in the “Factors That May Affect Future Results of Operations” and elsewhere in this report. As a result of these risks, our actual results may differ materially from our historical or anticipated results. 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, 2001.
 
Overview
 
We design, develop, manufacture and market proprietary, high-voltage, analog integrated circuits, or ICs, for use primarily in AC to DC and DC to DC power conversion markets. We have targeted high-volume power supply markets, including the communications, consumer, computer and industrial electronics markets. Our initial focus is on those applications that are sensitive to size, portability, energy efficiency and time-to-market. We introduced the TOPSwitch family of ICs in 1994 followed by an enhanced family of ICs, TOPSwitch-II, in April 1997. In September 1998, we announced the TinySwitch family of integrated circuits for power supplies used in a broad range of electronic products. TinySwitch ICs, which are designed to reduce standby energy by incorporating our new EcoSmart technology, enable a new class of light, compact, energy-efficient power supplies. In March 2000, we introduced the TOPSwitch-FX family of products, which also incorporates our EcoSmart technology to help engineers meet the growing need for environmentally friendly power solutions. In November 2000, we introduced the TOPSwitch-GX family of products. The GX family is capable of supplying output levels from 6 watts to 290 watts. In March 2001, we introduced the TinySwitch-II family of products with power levels ranging from 3 watts to 20 watts. In June 2002, we introduced DPA-Switch, which is a family of products that is the first highly integrated high-voltage power conversion IC designed specifically for use in DC-DC converters and distributed power architectures (DPAs). The four-device family covers a wide input voltage range of 16V to 75V, targeting 24 V/48V applications. In September 2002, we introduced LinkSwitch, which is an AC-DC power conversion IC specifically designed to replace linear transformers in the 0-3 watt range. The LinkSwitch family will enable electronics manufacturers to build smaller and more energy efficient power supplies for use in a large assortment of electronic products in the 0-3 watt range. All of our products introduced since 1998, except DPA-Switch, incorporate our EcoSmart technology.
 
Critical Accounting Policies
 
We believe our critical accounting policies are as follows:
 
 
 
revenue recognition;
 
 
 
estimating sales returns and allowances;
 
 
 
estimating ship and debit reserve;
 
 
 
estimating allowance for doubtful accounts; and
 
 
 
estimating reserve for excess and obsolete inventory.
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, sales returns, allowance for ship and debit, bad debts and inventories. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.

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A brief description of these policies is set forth below.
 
Revenue recognition
 
Product revenues consist of sales to OEMs, merchant power supply manufacturers and distributors. Revenues from product sales to OEMs and merchant power supply manufacturers are recognized upon shipment. At that time, we provide for estimated sales returns and other allowances related to those sales. Between 45% and 55% of our sales are made to distributors under terms allowing certain rights of return and price protection for our products held in the distributors’ inventories. Therefore, we defer recognition of revenue and the proportionate cost of revenues derived from sales to distributors until the distributors sell our products to their customers. We evaluate the amounts to defer based on the level of actual distributors’ inventory on hand as well as inventory that is in transit. The gross profit deferred as a result of this policy is reflected as “deferred income on sales to distributors” in the accompanying condensed consolidated balance sheets.
 
Estimating sales returns and allowances
 
Net revenue consists of product revenue reduced by estimated sales returns and allowances. To estimate sales returns and allowances, we analyze, both when we initially establish the reserve, and then each quarter when we review the adequacy of the reserve, the following factors: historical returns, current economic trends, levels of inventories of our products held by our customers, and changes in customer demand and acceptance of our products. This reserve is reflected as a reduction to accounts receivable in the accompanying consolidated balance sheets. Increases to the reserve are recorded as a reduction to net revenue. Because the reserve for sales returns and allowances is based on our judgments and estimates, particularly as to future customer demand and acceptance of our products, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are not adequate, our net revenues could be adversely affected.
 
Estimating ship and debit reserve
 
A large portion of our sales is made to distributors. Under certain circumstances, some of those sales are subject to credits that distributors claim on certain transactions and as protection against subsequent price declines on products they hold. The credits are referred to as “ship and debits.” The credits are available to the distributors after they have sold our products through to their end customer. We maintain a reserve for these credits that appears as a reduction to accounts receivable in our accompanying consolidated balance sheets. Any increase in the reserve results in a corresponding reduction in our net revenues. To establish the adequacy of the reserve, we analyze historical ship and debit payments and levels of inventory in the distributor channels. If our reserves are not adequate, our net revenues could be adversely affected.
 
Estimating allowance for doubtful accounts
 
We maintain an allowance for losses we may incur as a result of our customers’ inability to make required payments. Any increase in the allowance results in a corresponding increase in our general and administrative expenses. In establishing this allowance, and then evaluating the adequacy of the allowance for doubtful accounts each quarter, we analyze historical bad debt, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. If the financial condition of one or more of our customers unexpectedly deteriorated, resulting in their inability to make payments, or if we otherwise underestimate the losses we incur as a result of our customers’ inability to pay us, we could be required to increase our allowance for doubtful accounts which could adversely affect our operating results.
 
Estimating reserve for excess and obsolete inventory
 
We identify excess and obsolete products and analyze historical usage, forecasted production based on demand forecasts, current economic trends, and historical write-offs when evaluating the adequacy of the reserve for excess and obsolete inventory. This reserve is reflected as a reduction to inventory in the accompanying consolidated balance sheets, and an increase in cost of revenues. If actual market conditions are less favorable than our assumptions, we may be required to take additional reserves, which could adversely impact our cost of revenues and operating results.

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Results of Operations
 
The following table sets forth certain operating data as a percentage of total net revenues for the periods indicated.
 
    
Percentage of Total Net Revenues for Three Months Ended September 30,

    
Percentage of Total Net Revenues for Nine Months Ended September 30,

 
    
2002

    
2001

    
2002

    
2001

 
Net revenues:
                           
Product sales
  
98.4
%
  
98.7
%
  
98.7
%
  
98.7
%
License fees and royalties
  
1.6
 
  
1.3
 
  
1.3
 
  
1.3
 
    

  

  

  

Total net revenues
  
100.0
 
  
100.0
 
  
100.0
 
  
100.0
 
Cost of revenues
  
58.0
 
  
56.9
 
  
57.5
 
  
53.6
 
    

  

  

  

Gross profit
  
42.0
 
  
43.1
 
  
42.5
 
  
46.4
 
    

  

  

  

Operating expenses:
                           
Research and development
  
12.6
 
  
15.6
 
  
13.7
 
  
15.4
 
Sales and marketing
  
13.3
 
  
16.5
 
  
13.7
 
  
15.8
 
General and administrative
  
5.7
 
  
6.7
 
  
5.8
 
  
6.1
 
    

  

  

  

Total operating expenses
  
31.6
 
  
38.8
 
  
33.2
 
  
37.3
 
    

  

  

  

Income from operations
  
10.4
 
  
4.3
 
  
9.3
 
  
9.1
 
Other income, net
  
1.3
 
  
1.4
 
  
1.6
 
  
2.0
 
    

  

  

  

Income before provision for income taxes
  
11.7
 
  
5.7
 
  
10.9
 
  
11.1
 
    

  

  

  

Provision for income taxes
  
3.5
 
  
1.7
 
  
3.3
 
  
3.4
 
    

  

  

  

Net income
  
8.2
%
  
4.0
%
  
7.6
%
  
7.7
%
    

  

  

  

 
Comparison of the Three and Nine Months Ended September 30, 2002 and 2001
 
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 licensees of our technology. Net revenues for the quarter ended September 30, 2002 were $28.2 million compared to $23.0 million for the third quarter of 2001, an increase of $5.2 million, or 22.5%. Net revenues for the nine months ended September 30, 2002 were $79.0 million compared to $70.5 million for the comparable period of 2001, an increase of $8.5 million or 12.1%.
 
Net revenues from product sales represented $27.7 million and $22.7 million in the third quarter of 2002 and 2001, respectively. Net revenues from product sales represented $78.0 million and $69.5 million in the nine months ended September 30, 2002 and 2001, respectively. The increase in net revenues from product sales for the three months ended September 30, 2002 was driven primarily by increased sales of our products in the communications end market, and the nine month increase was driven primarily by increases in the communications and computer end markets. Sales increases were primarily from cell phone chargers in the communications market and LCD monitors and PDAs in the computer market. We expect our full year revenue mix for 2002, as a percentage of net revenues in the end markets which we serve, to be approximately 42% in the communications category, 25% in the consumer category, 21% in the computer category, 6% in the industrial electronics category and 6% in the all other category. This compares to approximately 36% in the communications category, 31% in the consumer market category, 19% in the computer category, 7% in the industrial electronics category and 7% in the all other category for the full year of 2001. We also expect the revenue mix of our product families for the full year of 2002 to be approximately 33% for TOPSwitch and TOPSwitch II, 43% for TinySwitch and TinySwitch II, 23% for TOPSwitch FX and GX and 1% for other products. This compares to approximately 60% for TOPSwitch and TOPSwitch II, 23% for TinySwitch and TinySwitch II, 16% for TOPSwitch FX and GX and 1% for other products for the full year of 2001.

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International sales were $27.0 million in the third quarter of 2002 compared to $21.7 million for the same period in 2001, an increase of $5.3 million, or 24.4%, which represented 96.0% of net revenues compared to 94.5% in the comparable period of 2001. International sales were $76.1 million for the nine months ended September 30, 2002 compared to $65.1 million for the same period in 2001, an increase of $11.0 million, or 16.9%, which represented 96.4% of net revenues compared to 92.4% in the comparable period of 2001. The increase in our international sales for the three months and nine months ended September 30, 2002 was driven primarily by increased sales of our products in the communications and computer end markets. Although the power supplies using our products are designed and distributed to end markets worldwide, most of these power supplies are manufactured in Asia. As a result, sales to this region were 83.9% and 77.6% of our product sales for the three months ended September 30, 2002 and 2001, respectively, and 82.7% and 74.2% of our product sales for the nine months ended September 30, 2002 and 2001, respectively. We expect international sales to continue to account for a large portion of our net revenues.
 
Direct sales for the third quarter of 2002 were divided 50.9% to distributors and 49.1% to original equipment manufacturers, or OEMs, and power supply merchants, compared to 49.0% to distributors and 51.0% to OEMs and power supply merchants for the same quarter in 2001. For the nine months ended September 30, 2002, direct sales were divided 51.7% to distributors and 48.3% to OEMs and power supply merchants, compared to 50.6% to distributors and 49.4% to OEMs and power supply merchants for the same period in 2001. For the quarter ended September 30, 2002, sales to one customer accounted for 24.0% of net revenues, compared to 19.0% of net revenues for the quarter ended September 30, 2001. A second customer accounted for 10.3% of net revenues for the quarter ended September 30, 2002, compared to 16.3% for the quarter ended September 30, 2001. For the nine months ended September 30, 2002, sales to these two customers accounted for 22.7% and 13.4% of net revenues respectively, compared to 22.8% and 12.2% of net revenues, respectively, for the nine months ended September 30, 2001. Both of these customers are distributors. One other customer, who is an OEM, accounted for 16.3% of net revenues for the quarter ended September 30, 2002 and 14.8% of net revenues for the nine months ended September 30, 2002. Sales to this customer for both the quarter and nine months ended September 30, 2001 were less than 10%. Another customer, a power supply merchant, accounted for 14.5% of net revenues for the three months ended September 30, 2001. Sales to this customer for the quarter ended September 30, 2002 and the nine months ended September 30, 2002 and 2001 were less than 10%. There were no other customers accounting for sales of more than 10% during the periods reported.
 
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 products, and internal labor and overhead associated with the testing of both wafers and packaged components. Gross profit for the third quarter of 2002 was $11.8 million, or 42.0% of net revenues, compared to $9.9 million, or 43.1% of net revenues for the same period in 2001. Gross profit for the nine months ended September 30, 2002 was $33.5 million, or 42.5% of net revenues, compared to $32.7 million, or 46.4% of net revenues for the same period in 2001. The decrease in gross profit percentage for the three months and nine months ended September 30, 2002 was due primarily to manufacturing inefficiencies associated with the initial ramping of our newer products, TinySwitch II and TOPSwitch GX, and the adverse impact of continued customer pricing pressure. We expect our gross profit percentage to be in a range of 42% to 48% over the next few quarters, but we cannot assure you that we will be able to accomplish these results.
 
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 2002 were $3.6 million compared to $3.6 million for the same period in 2001, which represented 12.6% and 15.6% of our net revenues in each period, respectively. Research and development expenses for the first nine months of 2002 were $10.8 million compared to $10.8 million for the same period in 2001, which represented 13.7% and 15.4% of net revenues in each period, respectively. Expenditures for research and development costs were essentially unchanged from the quarter and nine months ended September 30, 2001. We expect research and development expenses to continue to increase in absolute dollars as we continue to invest in new product development.

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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 offices and applications engineering. Sales and marketing expenses for the third quarter of 2002 were $3.8 million compared to $3.8 million for the same period in 2001, which represented 13.3% and 16.5% of our net revenues in each period, respectively. Sales and marketing expenses for the first nine months of 2002 were $10.8 million compared to $11.1 million for the same period in 2001, a decrease of $300,000, or 3.1%, which represented 13.7% and 15.8% of our net revenues in each period, respectively. Included in the above marketing expenses are costs associated with applications engineering, which represented $800,000 and $1.0 million for the three months ended September 30, 2002 and 2001, respectively, and $2.6 million and $2.8 million for the nine months ended September 30, 2002 and 2001, respectively. We include applications engineering costs as part of sales and marketing expenses due to the fact that our products are generally incorporated into a customer’s power supply at the design stage. Our sales and marketing efforts are focused on facilitating the customer’s use of our products in the design of new power supplies for specific applications. An important competitive factor in determining whether a customer decides to use our products in its designs is our commitment to provide comprehensive application design support. We expect sales and marketing expenses to continue to increase in absolute dollars as we continue to expand our sales and marketing presence worldwide.
 
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 fees, outside services, legal fees, auditing and tax services. For the quarters ended September 30, 2002 and 2001, general and administrative expenses were $1.6 million and $1.5 million, respectively, which represented 5.7% and 6.7% of our net revenues, respectively. For the nine months ended September 30, 2002 and 2001, general and administrative expenses were $4.6 million and $4.3 million, respectively, which represented 5.8% and 6.1% of our net revenues, respectively. The increase in spending through September 30, 2002, was attributable primarily to increases in professional and legal expenses. Included in legal expenses are outside costs related to patents, which have been expensed as incurred, and we plan to continue with this policy in the future. For the nine months ended September 30, 2002 and 2001, those costs were approximately $608,000 and $446,000, respectively. We expect general and administrative expenses to continue to increase in absolute dollars, but to fluctuate as a percentage of our net revenues.
 
Other income, net.    Other income, net, for the third quarter of 2002 increased $41,000 compared to the same period in 2001 and for the nine months ended September 30, 2002, decreased by $154,000 compared to the same period in 2001. The decrease for the nine month period ended September 30, 2002 was due primarily to lower interest rates on our cash equivalents and short-term investments in 2002 compared to 2001.
 
Provision for income taxes.    Provision for income taxes represents Federal, state and foreign taxes. The provision for income taxes was $1.0 million for the third quarter of 2002 compared to $400,000 for the same period in 2001. The provision for income taxes was $2.6 million for the first nine months of 2002 compared to $2.4 million for the same period in 2001. Our estimated effective tax rate used for both 2002 and 2001 was 30%. The difference between the statutory rate of 35% and our effective tax rate of 30% for the periods presented is due primarily to the beneficial impact of international sales, research and development credits and Federal tax-exempt investments.
 
Liquidity and Capital Resources
 
At September 30, 2002, we had approximately $103.6 million in cash, cash equivalents and short-term investments, an increase of approximately $26.8 million from December 31, 2001. In addition, under a revolving line of credit with Union Bank of California, we can borrow up to $10.0 million. Approximately $4.6 million of the credit line is used to cover advances for standby letters of credit, which we provide to Matsushita and OKI prior to the shipment of wafers, by these foundries to us. The balance of this credit line was unused and available as of September 30, 2002. The line of credit agreement, which expires on July 1, 2004, contains financial covenants requiring that we maintain profitability on a quarterly basis and not pay or declare dividends without the bank’s prior consent. As of September 30, 2002, we were in compliance with these financial covenants. We have previously financed a significant portion of our machinery and equipment through capital equipment leases. The amounts due for these obligations for the next 12 months were $200,000 as of September 30, 2002. The remaining balance due for these obligations was $100,000. There was no additional equipment financing during the nine months ended September 30, 2002.

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As of September 30, 2002, we had working capital, defined as current assets less current liabilities, of approximately $115.6 million, an increase of approximately $14.8 million from December 31, 2001. Our operating activities generated cash of $24.9 million and $7.2 million in the nine months ended September 30, 2002 and 2001, respectively. Cash generated in the first nine months of 2002 was principally the result of net income in the amount of $6.0 million, depreciation and amortization, a decrease in inventory and an increase in accounts payable and accrued liabilities, partially offset by an increase in accounts receivable. Cash generated in the first nine months of 2001 was principally the result of net income in the amount of $5.5 million, depreciation and amortization, and a decrease in prepaid expenses, partially offset by an increase in inventory and a decrease in accounts payable and accrued liabilities.
 
Our investing activities were a net transfer to short-term investments from cash and cash equivalents of $14.1 million in the nine months ended September 30, 2002, and a net transfer to cash and cash equivalents from short-term investments of $2.6 million in the nine months ended September 30, 2001. Purchases of property and equipment were $2.2 million and $6.9 million in the nine months ended September 30, 2002 and 2001, respectively.
 
Our financing activities were primarily receipts from the issuance of common stock through the exercise of stock options and purchases through our employee stock purchase plan of $4.3 million and $3.8 million in the nine months ended September 30, 2002 and 2001, respectively, offset by payments for capitalized lease obligations of $400,000 and $500,000 in the nine months ended September 30, 2002 and 2001, respectively.
 
During the first nine months of 2002, a significant portion of our cash flow was generated by our operations. If our operating results deteriorate during 2002, as a result of decrease in customer demand, or severe pricing pressures from our customers or our competitors, or for other reasons, our ability to generate positive cash flow from operations may be jeopardized. In that case, we may be forced to use our cash, cash equivalents and short-term investments to fund our operations. 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.
 
Recent Accounting Pronouncements
 
In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections Business Combinations.” The provisions of SFAS No. 145 related to the rescission of SFAS No. 4 are effective for financial statements issued for fiscal years beginning after May 15, 2002, and the provisions related to SFAS No. 13 are effective for transactions occurring after May 15, 2002. SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 also rescinds SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The Company does not expect the adoption to have a significant impact on the Company.
 
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 revises the accounting for specified employee and contract terminations that are part of restructuring activities. Companies will be able to record a liability for a cost associated with an exit or disposal activity only when the liability is incurred and can be measured at fair value. Commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and therefore, does not meet the requirement for recognizing a liability and related expense. This statement only applies to termination benefits offered for a specific termination event or a specified period. It will not affect accounting for the costs to terminate a capital lease. The Company is required to adopt this statement for exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption to have a significant impact on the Company.

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Factors That May Affect Future Results of Operations
 
In addition to the other information in this report, the following factors should be considered carefully in evaluating our business before purchasing shares of our stock.
 
Our quarterly operating results are volatile and difficult to predict. If we fail to meet the expectations of public market analysts or investors, the market price of our common stock may decrease significantly.    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 quarterly operating results could fall below the expectations of public market analysts or investors. If that occurs, the price of our stock may decline.
 
Some of the factors that could affect our operating results include the following:
 
 
 
the volume and timing of orders received from customers;
 
 
 
the volume and timing of orders placed by us with our foundries;
 
 
 
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 timing of investments in research and development and sales and marketing;
 
 
 
cyclical semiconductor industry conditions; and
 
 
 
fluctuations in exchange rates, particularly the exchange rates between the U.S. dollar and the Japanese yen.
 
We do not have long-term contracts with any of our customers and if they fail to place, or if they cancel or reschedule orders for our products, our operating results and business may suffer.    Our business is characterized by short-term customer orders and shipment schedules. 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. In addition, customer orders can be canceled or rescheduled without significant penalty to the customer. In the past we have experienced customer cancellations of substantial orders for reasons beyond our control, and significant cancellations could occur again at any time.
 
Intense competition in the high-voltage power supply industry may lead to a decrease in the average selling price and reduced sales volume of our products, which may harm our business.    The high-voltage power supply industry is intensely competitive and characterized by significant price erosion. Our products face competition from alternative technologies, including traditional linear transformers and discrete switcher power supplies. If the price of competing products decreases significantly, the cost effectiveness of our products will be adversely affected. If power requirements for applications in which our products are currently utilized go outside the cost effective range of our products, these older alternative technologies can be used more cost effectively.
 
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, including our ability to introduce new products with higher average selling prices, would materially harm our operating results.
 
If demand for our products declines in the major end markets that we serve, our net revenues will decrease.    Applications of our products in the consumer, communications and computer end markets, such as cellular phone chargers, stand-by power supplies for PCs and main power supplies for TV set top boxes have and will continue to account for a large percentage of our net revenues. We expect that a significant level of our net revenues and operating results will continue to be dependent upon these applications in the near term. The demand for these products has been highly cyclical and has been subject to significant economic downturns at various times. The announcements of economic slowdown by major companies in some of the end markets we serve, indirectly through our customers, have caused a slowdown in demand for some of our ICs. When our customers are not successful in maintaining high levels of demand for their products, their demand for our ICs decreases, which adversely affects our operating results. Any significant downturn in demand in these markets would cause our net revenues to decline and could cause the price of our stock to fall.

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Because the sales cycle for our products can be lengthy, we may incur substantial expenses before we generate significant revenues, if any.    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 research and development and sales and marketing resources without any assurance of success, often precede volume sales, if any, by a year or more. 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. 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.
 
Our products must meet exacting specifications, and undetected defects and failures may occur which could cause customers to return or stop buying our products.    Our customers generally 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. If defects and failures occur in our products, 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.
 
Our international sales activities account for a substantial portion of our net revenues and subject us to substantial risks.    Sales to customers outside of the United States account for a large portion of our net revenues, including approximately 96% of our net revenues in the nine months ended September 30, 2002. If our international sales declined and we were unable to increase domestic sales, our revenues would decline and our operating results would be harmed. International sales involve a number of risks to us, including:
 
 
 
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;
 
 
 
tariffs and other trade barriers and restrictions; and
 
 
 
the burdens of complying with a variety of foreign laws.
 
Our failure to adequately address these risks could reduce our international sales, which would materially adversely affect our operating results. Furthermore, because substantially all of our foreign sales are denominated in U.S. dollars, increases in the value of the dollar 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.
 
We depend on third-party suppliers to provide us with wafers for our products and if they fail to provide us sufficient wafers, our business will suffer.    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 their continued cooperation. We cannot assure you that we will continue to work successfully with Matsushita or OKI in the future, that they will continue to provide us with sufficient capacity at their foundries to meet our needs, or that either of them will not seek an early termination of its wafer supply agreement with us. We estimate that it would take 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.

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Although we provide Matsushita and OKI with rolling forecasts of our production requirements, their ability to provide wafers to us is limited by the available capacities of the foundries in which these wafers are manufactured. 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 harm our business.
 
If our third-party suppliers and independent subcontractors do not produce our wafers and assemble our finished products at acceptable yields, our net revenues may decline.    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. In addition, our IC assembly process requires our manufacturers to use a high-voltage molding compound available from only one vendor, and 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. 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 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, it has the right to manufacture and sell products using our technology to Japanese companies worldwide and to subsidiaries of Japanese companies located in Asia. Although we receive royalties on Matsushita’s sales, these royalties are substantially lower than the gross profit we would receive on direct sales. 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.
 
If our efforts to enhance existing products and introduce new products are not successful, we may not be able to generate demand for our products.    Our 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. New product introduction schedules are subject to the risks and uncertainties that typically accompany development and delivery of complex technologies to the market place, including product development delays and defects. If we fail to develop and sell new products in a timely manner, our net revenues could decline.
 
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 these products will achieve market acceptance. Our failure, or our customers’ failure to develop and introduce new products successfully and in a timely manner would harm our business and may cause the price of our common stock to fall. 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 rely on a continuous supply of power to conduct operations, and any disruption in the availability of power supplied to us could interrupt our operations, increase our expenses and harm our business.    In 2000 and 2001, California experienced an energy crisis which caused the state to implement periodic rolling blackouts throughout California. Most of our operations are located in California, although part of our inventory is stored and shipped from an overseas facility. We currently have only limited backup generators for emergency alternate sources of power in the event of a blackout. If blackouts interrupt our supply of power, we would be temporarily unable to continue operations at our facilities. Any such interruption in our ability to continue operations at our facilities could delay shipments of our products to customers, and could result in lost revenue, which could harm our business and results of operations.

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If our products do not penetrate additional markets, our business will not grow as we predict.    We believe that our future success depends in part upon our ability to penetrate additional markets for our products. 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.
 
In the event of an earthquake, terrorist act or other disaster, our operations may be interrupted and our business would be harmed.    Our principal executive offices and operating facilities are located near San Francisco, California. This area has been subject to severe earthquakes. In the event of an earthquake, we may be temporarily unable to continue operations at our facilities and we may suffer significant property damage. Any such interruption in our ability to continue operations at our facilities could delay the development and shipment of our products.
 
Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the recent terrorist attacks on the United States, including the potential worsening or extension of the current global economic slowdown, the economic consequences of current and potential military actions or additional terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. Such uncertainties could also lead to delays or cancellations of customer orders, a general decrease in corporate spending or our inability to effectively market and sell our products. Any of these results could substantially harm our business and results of operations, causing a decrease in our revenues.
 
If we are unable to adequately protect or enforce our intellectual property rights, we could lose market share, incur costly litigation expenses or lose valuable assets.    Our 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. From time to time we have received, and we may receive in the future, communications alleging possible infringement of patents or other intellectual property rights of others. Litigation, which could result in substantial cost to us, may be necessary to enforce our patents or other intellectual property rights or to defend us against claimed infringement of the rights of others. The failure to obtain necessary licenses or other rights or litigation arising out of infringement claims could cause us to lose market share and harm our business.
 
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 must attract and retain qualified personnel to be successful and competition for qualified personnel is intense in our market.    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 analog design engineers and systems applications engineers. The 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 harm our business. We have neither long-term employment contracts with, nor key person life insurance policies on, any of our employees.
 
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.

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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.
 
The future trading price of our common stock could be subject to wide fluctuations in response to a variety of factors.    The price of our common stock has been, and is likely to be, volatile. 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, may harm the market price of our common stock.

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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 our 2001 Annual Report on Form 10-K.
 
Interest Rate Risk.    Our exposure to market risk for changes in interest rates relates 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 carrying value and related weighted average interest rates for our investment portfolio at September 30, 2002. All investments mature, by policy, in 15 months or less.
 
(in thousands, except average interest rates)
    
Carrying Value

  
Average Interest Rate

 
Cash Equivalents:
             
Taxable securities
  
$
63,612
  
2.18
%
    

  

Total cash equivalents
  
 
63,612
  
2.18
%
    

  

Short-term Investments:
             
U.S. corporate securities
  
 
12,083
  
2.45
%
U.S. government securities
  
 
16,783
  
2.47
%
    

  

Total short-term investments
  
 
28,866
  
2.46
%
    

  

Total investment securities
  
$
92,478
  
2.32
%
    

  

 
Foreign Currency Exchange Risk.    We transact business in various foreign countries. Our primary foreign currency cash flows are in Asia 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. We do maintain a Japanese yen account with an U. S. Bank for payments to suppliers and for cash receipts from Japanese suppliers and customers denominated in Japanese yen.
 
ITEM 4.     CONTROLS AND PROCEDURES.
 
(a)    Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this report. Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.
 
(b)    There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

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PART II.    OTHER INFORMATION
 
ITEM 1.     LEGAL PROCEEDINGS
 
None.
 
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.
 
Exhibit Number

  
Description

99.1
  
Certification of Chief Executive Officer
99.2
  
Certification of Chief Financial Officer
 
b.    Reports on Form 8-K.
 
None.

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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 12, 2002
  
By:    /s/    JOHN M. COBB
        
John M. Cobb
Chief Financial Officer

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CERTIFICATIONS
 
I, Balu Balakrishnan, Chief Executive Officer of the registrant, certify that:
 
 
1.
 
I have reviewed this quarterly report on Form 10-Q of Power Integrations, Inc.;
 
 
2.
 
Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
 
3.
 
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
 
4.
 
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
 
(a)
 
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
 
(b)
 
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
 
(c)
 
presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
 
5.
 
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):
 
 
(a)
 
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
 
(b)
 
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
 
 
6.
 
The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Dated:    November 12, 2002
  
By:    /s/    BALU BALAKRISHNAN
        
Balu Balakrishnan
Chief Executive Officer

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I, John M. Cobb, Chief Financial Officer of the registrant, certify that:
 
 
1.
 
I have reviewed this quarterly report on Form 10-Q of Power Integrations, Inc.;
 
 
2.
 
Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
 
3.
 
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
 
4.
 
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
 
(a)
 
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
 
(b)
 
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
 
(c)
 
presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
 
5.
 
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):
 
 
(a)
 
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
 
(b)
 
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
 
 
6.
 
The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Dated:    November 12, 2002
  
By:    /s/    JOHN M. COBB
        
John M. Cobb
Chief Financial Officer
 

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