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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004.

or

For the transition period from              to             

Commission File Number 0-23441

POWER INTEGRATIONS, INC.

(Exact name of registrant as specified in its charter)

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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    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 of Contents

POWER INTEGRATIONS, INC.

TABLE OF CONTENTS

TOPSwitch, TinySwitch, LinkSwitch, DPA-Switch, EcoSmart and P I Expert are trademarks of Power Integrations, Inc.

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PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

POWER INTEGRATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(In thousands)

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

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POWER INTEGRATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(In thousands, except per share amounts)

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

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POWER INTEGRATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(In thousands)

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

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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 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 Company’s consolidated financial statements and the notes thereto for the year ended December 31, 2003 included in its Form 10-K filed on March 10, 2004 with the Securities and Exchange Commission.

Cash and Cash Equivalents and Short-Term and Long-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 maturities greater than three months but not longer than twelve months from the balance sheet date are classified as short-term investments. Investments in highly liquid financial instruments with maturities greater than twelve months from the balance sheet date are classified as long-term investments. As of June 30, 2004, the Company’s short-term and long-term investments consisted of U.S. government backed securities, municipal bonds, 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 fair market value.

Revenue Recognition

Product revenues consist of sales to original equipment manufacturers, or OEMs, merchant power supply manufacturers and distributors. Shipping terms to OEMs and merchant power supply manufacturers are delivered at frontier, which is commonly referred to as DAF. Title to the product passes to the customer when the shipment reaches the destination country and revenue is recognized upon the arrival of our product in that country. 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 the 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 Company evaluates the amounts to defer based on the level of actual inventory on hand at its distributors as well as inventory that is in transit to its distributors. The gross profit that is deferred as a result of this policy is reflected as “deferred income on sales to distributors” in the accompanying condensed consolidated balance sheets.

The Company has a wafer supply agreement and a technology license agreement with an unaffiliated wafer foundry. The wafer supply agreement, which expires in June 2005, is renewable. In connection with the technology license agreement, the Company is entitled to receive a royalty on the wafer foundry’s sales of its own products that incorporate the Company’s technology. The Company recognizes royalty revenue upon receipt of payment from the wafer foundry.

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Expense related to employee ownership programs through stock options

The Company has elected to follow Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for employee stock options rather than the alternative fair value accounting allowed by SFAS No. 123, “Accounting for Stock Based Compensation.” APB No. 25 provides that expense relative to the Company’s employee ownership programs through stock options is measured based on the intrinsic value of stock options granted on the date of the grant and the Company recognizes expense in its statement of income using the straight-line method over the vesting period for fixed awards. Under SFAS No. 123, the fair value of stock options at the date of grant is recognized in earnings over the vesting period of the options. Had expense related to employee ownership programs through the Company’s stock option plans been determined under a fair value method consistent with SFAS No. 123, “Accounting for Stock Based Compensation,” and related interpretations, the Company’s net income would have been reduced to the following pro forma amounts (in thousands, except per share information):

The fair value of stock options granted is established on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The fair value of employees’ stock purchase rights under the Company’s employee stock purchase plan was estimated using the Black-Scholes model with the following weighted average assumptions:

Use of 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 sales returns, distributor price protection allowances (ship and debit reserve), doubtful accounts receivables, excess and obsolete inventories and income taxes. 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

Comprehensive income for the Company consists of net income, plus the effect of foreign currency translation adjustments, which was not material for the six months ended June 30, 2004 and 2003. Accordingly, comprehensive income closely approximates actual net income.

Segment Reporting

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.

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Customer Concentration

The Company’s end user base is highly concentrated and a relatively small number of OEMs, power supply merchants and distributors typically account for a significant portion of the Company’s net revenues. Ten customers accounted for approximately 70.7% and 77.1% of total net revenues for the three months ended June 30, 2004 and 2003, respectively, and 71.2% and 77.7% of total net revenues for the six months ended June 30, 2004 and 2003, respectively.

The following customers accounted for more than 10% of total net revenues:

Customers A and B are distributors of the Company’s products and customer C is an OEM.

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 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. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance sheet credit exposure related to its customers. As of June 30, 2004 and December 31, 2003, approximately 73.0% and 71.3% of accounts receivable, respectively, were concentrated with ten customers.

The following customers accounted for more than 10% of accounts receivable:

Customers A and B are distributors of the Company’s products.

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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:

Product Sales

Sales of the Company’s TOPSwitch and TinySwitch products accounted for 96.6% and 99.4% of net revenues from product sales for the three months ended June 30, 2004 and 2003, respectively, and 97.0 % and 99.5% of net revenues from product sales for the six months ended June 30, 2004 and 2003, respectively. TOPSwitch products include TOPSwitch, TOPSwitch II, TOPSwitch FX and TOPSwitch GX. TinySwitch products include TinySwitch and TinySwitch II.

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 number of shares of common stock outstanding during the period. Diluted earnings per share are calculated by dividing net income by the weighted average number of shares of outstanding common stock during the period, increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. Dilutive potential shares of common stock 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):

Options to purchase 1,626,117 and 473,259 shares of Company common stock outstanding for the three month periods ended June 30, 2004 and 2003, respectively, and options to purchase 456,234 and 665,706 shares of Company common stock outstanding for the six month periods ended June 30, 2004 and 2003, respectively, were not included in the computation of diluted earnings per share for the periods then ended because the exercise prices of the options to purchase shares of Company common stock were greater than the average market price of the Company’s common stock during those periods, and therefore, their effect would have been antidilutive.

Income tax expense for the six-month periods ended June 30, 2004 and 2003 includes a provision for Federal, state and foreign taxes based on the annual estimated effective tax rate applicable to the Company and its subsidiaries. The difference between the Federal statutory rate of 35% and the Company’s effective tax rate used for the six-month period ended June 30, 2004 is primarily due to the beneficial impact of international sales subject to lower tax rates and research and development credits. The difference between the Federal statutory rate of 35% and the Company’s effective tax rate used for the six-month period ended June 30, 2003 is primarily due to the beneficial impact of research and development credits, extraterritorial income exclusion and Federal tax-exempt investments. The Company adjusted its effective tax rate from 28% to 26% for the six months ended June 30, 2004 to reflect the estimated annual effective income tax rate for 2004. The tax provision for the six months ended June 30, 2003 was calculated using an annual effective income tax rate of 28%. The estimated annual effective income tax rate for 2004 may be subject to change in the future.

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company sells products to its distributors under contracts, which the Company refers to as Standard Distributor Sales Agreements (each an “SDSA”). Each SDSA contains the relevant terms of the contractual arrangement with the customer, and generally includes certain provisions for indemnifying the customer against losses, expenses, and liabilities from damages that may be awarded against the customer in the event the Company’s hardware is found to infringe upon a patent, copyright, trademark, or other proprietary right of a third party (Customer Indemnification). The SDSA generally limits the scope of and remedies for the Customer Indemnification obligations in a variety of industry-standard respects, including, but not limited to, limitations based on time and geography, and a right to replace an infringing product. The Company also, from time to time, has granted a specific Customer Indemnification to individual customers upon the customer’s request.

The Company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the SDSA. In addition, the Company requires its employees to sign a proprietary information and inventions agreement, which assigns the rights to its employees’ development work to the Company. To date, the Company has not had to reimburse any of its customers for any losses related to these indemnification provisions and no material claims were outstanding as of June 30, 2004. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the SDSA, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

In January 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003 by FIN 46R), “Consolidation of Variable Interest Entities,” which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was issued in January 2003. The Company will be required to apply FIN 46R to variable interests in variable interest entities, or VIEs, created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and non controlling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and non controlling interest of the VIE. Management believes the adoption of FIN 46R will not have a material impact to the Company’s financial position, results of operations or cash flows as the Company does not have any VIEs.

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB104”), “Revenue Recognition.” SAB 104 supercedes SAB 101, “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (the “FAQ”) issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In March 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03–1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting guidance of EITF 03-1 is effective for years beginning after June 15, 2004, while the disclosure requirements are effective for annual periods ending after June 15, 2004. Management believes the adoption of EITF 03-1 will not have a material impact to the Company’s financial position, results of operations or cash flows.

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

On June 28, 2004, the Company filed a complaint for patent infringement in the U.S. District Court, Northern District of California, against System General Corporation, a Taiwanese company. The Company’s complaint alleges certain circuits produced by System General Corporation infringed and continue to infringe certain of the Company’s patents. The Company seeks, among other things, an order enjoining System General Corporation from infringing the Company’s patents and an award for damages resulting from the alleged infringement.

Litigation may be necessary to resolve the claims the Company has asserted against System General Corporation. There can be no assurance that the Company would prevail in any future litigation. Any litigation, whether or not determined in the Company’s favor or settled by the Company, would be costly and would divert the efforts and attention of the Company’s management and technical personnel from normal business operations, which could have a material adverse effect on the Company’s business, financial condition and operating results. Adverse determinations in litigation could result in the loss of the Company’s proprietary rights, subject the Company to significant liabilities, require the Company to seek licenses from third parties or prevent the Company from licensing its technology, any of which could have a material adverse effect on the Company’s business, financial condition and operating results.

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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”, “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, 2003.

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. These ICs are used in a wide variety of electronics products primarily for the communications, consumer, computer and industrial electronics markets. Our strategy is to continue to diversify into new markets and to expand our existing customer base. We believe we can achieve our goals by continuing to develop products, which are more energy efficient and have increased functionality, and by continuing to focus on cost reduction strategies to remain price competitive. Our business is characterized by short-term orders and short customer lead times. Customers can cancel or reschedule orders without significant penalty. We plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially.

We have developed several families of high-voltage power conversion ICs, which we believe are the first highly integrated power conversion ICs to achieve widespread market acceptance. These patented ICs achieve a high level of system integration by combining a number of electronic components into a single IC. Our TOPSwitch, TinySwitch, DPA-Switch and LinkSwitch products enable many power supplies to have a total cost equal to or lower than discrete switchers. Our products offer the following key benefits to power supplies:

Our quarterly operating results are volatile and difficult to predict. Our net revenues and operating results have varied significantly in the past, are difficult to forecast and are subject to numerous factors both within and outside of our control. As a result, our quarterly and annual operating results may fluctuate significantly in the future. For a discussion of the factors that may affect our quarterly and annual operating results, please see “Factors that May Affect Future Results of Operations.”

We license certain technologies and grant limited product manufacturing and marketing rights to strategic parties in return for wafer foundry relationships, license fees and product royalty arrangements. License fees and royalties consist primarily of royalties on products shipped by licensees incorporating licensed technology, and have accounted for a small percentage of our net revenues.

A portion of our cost of revenues consists of the cost of wafers. We currently purchase wafers from Matsushita Electric Industrial Co, Ltd. (“Matsushita”), and from OKI Electric Industry (“OKI”). The contract prices to purchase wafers from Matsushita and OKI are denominated in Japanese yen. The agreements with both vendors allow for mutual sharing of the impact of the exchange rate fluctuation between Japanese yen and the U.S. dollar. Nevertheless, changes in the exchange rate between the U.S. dollar and the Japanese yen subject our gross profit and operating results to the potential for material fluctuations. We have a wafer supply agreement with a third wafer foundry, ZMD Analog Mixed Signal Services GmbH & CoKG (“ZMD”). Our agreement to purchase wafers from ZMD is denominated in U.S. dollars. We expect to begin purchasing wafers from ZMD by the end of 2004.

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Critical Accounting Policies and Estimates

We believe our critical accounting policies and estimates are as follows:

We believe that these policies and estimates are important to the portrayal of our financial condition and results and require us to make judgments and estimates about matters that are inherently uncertain. A brief description of these critical accounting policies is set forth below.

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, doubtful accounts receivables 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.

Revenue recognition

Product revenues consist of sales to OEMs, merchant power supply manufacturers and distributors. Shipping terms to OEMs and merchant power supply manufacturers are DAF. Title to our product passes to the customer when the shipment reaches the destination country and revenue is recognized upon the arrival of our product in that country. At that time, we provide for estimated sales returns and other allowances related to those sales. Between 50% and 65% 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 the 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 to the distributors. The gross profit that we defer as a result of this policy is reflected as “deferred income on sales to distributors” in the accompanying condensed consolidated balance sheets.

We have a wafer supply agreement and a technology license agreement with an unaffiliated wafer foundry. The wafer supply agreement, which expires in June 2005, is renewable. In connection with the technology license agreement, we are entitled to receive a royalty on the wafer foundry’s sales of its own products that incorporate our technology. We recognize royalty revenue upon receipt of payment from the wafer foundry.

Estimating sales returns and allowances

Net revenues consist of product revenues 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, a number of factors, including: 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.

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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. When we evaluate the adequacy of the reserve each quarter, 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 among other things, 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.

Income taxes

We recognize Federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax authorities. We also recognize Federal, state and foreign deferred tax liabilities or assets for our estimate of future tax effects attributable to temporary differences and carry forwards and record a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and judgment, are not expected to be realized. As of June 30, 2004, no valuation allowance had been recorded to reduce our deferred tax assets. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, will be sufficient to fully recover our deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our result of operations and financial position. We account for income tax contingencies in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.”

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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.

Comparison of the Three Months and Six Months Ended June 30, 2004 and 2003

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 three months ended June 30, 2004 were $35.9 million compared to $29.8 million for the three months ended June 30, 2003, an increase of $6.1 million, or 20.6%. Net revenues for the six months ended June 30, 2004 were $70.1 million compared to $58.9 million for the comparable period of 2003, an increase of $11.2 million or 19.1%.

Net revenues from product sales were $35.4 million and $29.4 million in the second quarter of 2004 and 2003, respectively. Net revenues from product sales were $69.0 million and $58.1 million in the six months ended June 30, 2004 and 2003, respectively. The increase in net revenues from product sales for the three months and six months ended June 30, 2004 was driven primarily by increased sales of our products in the consumer end market with smaller increases in the computer and industrial end markets. Net revenues from the consumer end market increased approximately 43% and 45% for the three months and six months ended June 30, 2004, respectively, compared to the same periods in 2003, driven primarily by increased sales of our products for set-top boxes, DVD players and home appliances.

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Approximate revenue mix by product family expected for the full year 2004 compared to actual revenue mix by product family for 2003:

Approximate revenue mix by end markets served expected for the full year 2004 compared to actual revenue mix by end markets for 2003:

Customer demand for our products can change quickly and unexpectedly. Our customers perceive that our products are readily available and typically order only for their short-term needs. Our revenue levels are highly dependent on the amount of new orders that are received for which product can be delivered by us within the same period. Orders that are booked and shipped within the same period are called “turns business”. Because of the uncertainty of customer demand, and the short lead-time environment and high turns business, it is difficult to predict future levels of revenues and profitability.

International sales were $33.2 million in the second quarter of 2004 compared to $27.7 million for the same period in 2003, an increase of $5.5 million, or 19.9%. International sales represented 92.3% of net revenues compared to 93.1% in the three months ended June 30, 2004 and 2003, respectively. International sales were $64.5 million for the six months ended June 30, 2004 compared to $55.1 million for the same period in 2003, an increase of $10.4 million, or 17.1%. International sales represented 92.1% of net revenues compared to 93.6% in the six months ended June 30, 2004 and 2003, respectively. In absolute dollars, the increase in our international sales for the three months and six months ended June 30, 2004 was primarily from increased sales of our products in the consumer end market with smaller increases in the computer and industrial 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 77.8% and 81.6% of our product sales for the three months ended June 30, 2004 and 2003, respectively, and 78.2% and 81.5% of our product sales for the six months ended June 30, 2004 and 2003, respectively. While sales to all our major regions increased, combined sales to our customers in Europe and North America increased at a higher rate than sales to our customers in Asia. Combined sales to Europe and North America, as a percent of total product sales, were approximately 3.5% higher for the three and six months periods ended June 30, 2004, compared to the same period in 2003. We expect international sales to continue to account for a large portion of our net revenues.

Net product sales for the second quarter of 2004 were divided 55.0% to distributors and 45.0% to OEMs and power supply merchants, compared to 63.2% to distributors and 36.8% to OEMs and power supply merchants for the second quarter of 2003. For the six months ended June 30, 2004, net product sales were divided 55.5% to distributors and 44.5% to OEMs and power supply merchants, compared to 61.3% to distributors and 38.7% to OEMs and power supply merchants for the same period in 2003. In the three months ended June 30, 2004, two separate customers, both of who are distributors, accounted for approximately 18.6% and 18.0% of net revenues, and one OEM customer accounted for approximately 11.4% of net revenues. In the three months ended June 30, 2003, the same two distributors accounted for approximately 23.8% and 22.6% of net revenues. For the six months ended June 30, 2004, sales to the same two distributors accounted for approximately 20.5% and 16.8% of net revenues, respectively, compared to approximately 26.9% and 17.8% of net revenues, respectively, for the six months ended June 30, 2003. Sales to the same OEM customer accounted for approximately 12.4% of net revenues for the six months ended June 30, 2004 and less than 10% for the six months ended June 30, 2003.

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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 from Matsushita and OKI, the assembly and packaging of our products by sub-contractors, internal labor and overhead associated with the testing of both wafers and packaged components and testing of packaged components by sub-contractors. Gross profit was $16.6 million, or 46.1% of net revenues, for the three months ended June 30, 2004, compared to $15.1 million, or 50.8% of net revenues, for the three months ended June 30, 2003. Gross profit for the six months ended June 30, 2004 was $33.2 million, or 47.4% of net revenues, compared to $30.2 million, or 51.3% of net revenues for the same period in 2003. The decrease in gross profit percentage for the three months and six months ended June 30, 2004 was due primarily to lower overhead absorption earlier in the year as we reduced our inventory and, to a lesser extent, the strengthening of the Japanese yen over the past year.

Research and development expenses. Research and development expenses consist primarily of employee-related expenses, expensed engineering 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 second quarter of 2004 were $4.1 million compared to $4.2 million for the same period in 2003, which represented 11.4% and 14.0% of our net revenues in each period, respectively. Research and development expenses for the six months ended June 30, 2004 were $8.2 million compared to $8.3 million for the same period in 2003, which represented 11.8% and 14.0% of our net revenues in each period, respectively. In absolute dollars, research and development expenses for the three months and six months ended June 30, 2004 were primarily unchanged from the same periods in 2003, but were significantly lower as a percent of net revenues as a result of increased revenues in the three and six months periods ended June 30, 2004 compared to the same periods in 2003. We expect research and development expenses to increase in absolute dollars, but those expenses may 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 offices and support offices, and field application engineering costs. Sales and marketing expenses were $3.9 million, or 11.0% of net revenues, for the second quarter of 2004, compared to $3.9 million, or 13.2% of net revenues for the same period in 2003. Sales and marketing expenses for the six months ended June 30, 2004 were $8.1 million compared to $8.0 million for the same period in 2003, which represented 11.5% and 13.5% of our net revenues in each period, respectively. In absolute dollars, sales and marketing expenses for the six months ended June 30, 2004 were slightly up from the same period in 2003, primarily as a result of expanding our worldwide sales and applications engineering staffs. We expect sales and marketing expenses to continue to increase in absolute dollars as we continue to expand our sales and marketing presence worldwide, but may 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 fees, outside services, legal fees and audit and tax services. For the quarters ended June 30, 2004 and 2003, general and administrative expenses were $2.1 million and $1.8 million, respectively, which represented 5.7% and 6.1% of our net revenues, respectively. For the six months ended June 30, 2004 and 2003, general and administrative expenses were $3.6 million and $3.4 million, respectively, which represented 5.2% and 5.8% of our net revenues, respectively. In absolute dollars general and administrative expenses for the three and six month periods were up from the same periods in 2003, primarily due to increased legal and professional services incurred. We expect general and administrative expenses to increase in absolute dollars, particularly in light of our recently filed patent infringement claim against System General Corporation and expenses related to compliance with the requirements of the Sarbanes-Oxley Act of 2002, but these expenses may fluctuate as a percentage of our net revenues.

Other income, net. Other income, net, for the second quarter of 2004 decreased by $0.3 million compared to the same period in 2003. For the six months ended June 30, 2004, other income, net, decreased by $0.3 million compared to the same period in 2003. The decrease for the three and six-month period ended June 30, 2004 was due primarily to fluctuation in foreign exchange rates in 2004 compared to 2003.

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Provision for income taxes. Provision for income taxes represents Federal, state and foreign taxes. The provision for income taxes was $1.6 million for the quarter ended June 30, 2004 compared to $1.5 million for the quarter ended June 30, 2003. The provision for income taxes was $3.6 million for the six months ended June 30, 2004 compared to $3.1 million for the same period in 2003. We adjusted our effective tax rate from 28% to 26% for the six months ended June 30, 2004 to reflect the estimated annual effective tax rate for 2004. Our estimated annual effective tax rate used for the six months ended June 30, 2003 was 28%. The difference between the statutory rate of 35% and our effective tax rate for the six months ended June 30, 2004 is due primarily to the favorable effects of research and development tax credits and international sales subject to lower tax rates. The difference between the statutory rate of 35% and our effective tax rate for the six months ended June 30, 2003 is due primarily to the favorable effects of research and development credits, extraterritorial income inclusion, and federal tax-exempt investments. The estimated annual effective income tax rate for 2004 may be subject to change in the future.

Liquidity and Capital Resources

As of June 30, 2004, we had approximately $134.9 million in cash, cash equivalents and short-term and long-term investments, an increase of approximately $19.5 million from December 31, 2003. In addition, under a revolving line of credit 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, and also to our workers compensation insurance carrier as part of our insurance program. As of June 30, 2004, there were outstanding letters of credit totaling approximately $5.1 million. The balance of this credit line was unused and available as of June 30, 2004. The line of credit agreement, which expires on June 30, 2006, 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 June 30, 2004, we were in compliance with these financial covenants.

As of June 30, 2004, we had working capital, defined as current assets less current liabilities, of approximately $148.7 million, an increase of approximately $13.0 million from December 31, 2003. Our operating activities generated cash of $16.9 million and $4.7 million in the six months ended June 31, 2004 and 2003, respectively. Cash generated in the first six months of 2004 was principally the result of net income in the amount of $10.1 million, depreciation and amortization of $3.5 million, the tax benefit associated with employee stock plans of $1.8 million and a decrease in inventory of $3.3 million, partially offset by an increase in accounts receivable of $3.1. Cash generated in the first six months of 2003 was principally the result of net income in the amount of $8.1 million, depreciation and amortization of $3.4 million and the tax benefit associated with employee stock plans of $2.6 million, partially offset by increases in inventory of $5.0 million and accounts receivable of $3.0 million and a decrease in accounts payable of $1.9 million.

Our investing activities were net purchases of $10.8 million in the six months ended June 30, 2004 of short-term and long-term investments, and net proceeds from the maturities of short-term investments of $11.0 million in the six months ended June 30, 2003. Purchases of property and equipment were $2.9 million and $5.1 million in the six months ended June 30, 2004 and 2003, 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 $5.6 million and $8.0 million in the six months ended June 30, 2004 and 2003, respectively.

During the first six months of 2004, a significant portion of our cash flow was generated by our operations. If our operating results deteriorate during the remainder of 2004, 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, or seek financing from third parties 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 January 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003 by FIN 46R), “Consolidation of Variable Interest Entities,” which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” which was issued in January 2003.

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We will be required to apply FIN 46R to variable interests in VIEs created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and non controlling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and non controlling interest of the VIE. We believe the adoption of FIN 46R will not have a material impact to our financial position, results of operations or cash flows as we do not have any VIEs.

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB104”), “Revenue Recognition.” SAB 104 supercedes SAB 101, “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of Emerging Issues Task Force (EITF) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (“the FAQ”) issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on our financial position, results of operations or cash flows.

In March 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03–1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting guidance of EITF 03-1 is effective for years beginning after June 15, 2004, while the disclosure requirements are effective for annual periods ending after June 15, 2004. We believe the adoption of EITF 03-1 will not have a material impact to our financial position, results of operations or cash flows.

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:

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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. Our customer base is highly concentrated, and a relatively small number of distributors, OEMs and merchant power supply manufacturers account for a significant portion of our revenues. 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 solutions 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 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, power supplies for TV set top boxes and power supplies for home appliances 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. Announcements of economic slowdown by major companies in any of the end markets we serve, could indirectly through our customers, cause 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.

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 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 may 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

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approximately 92% and 94% of our net revenues in the six months ended June 30, 2004 and 2003, respectively. 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:

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, which expires in June 2005, and with OKI, which expires in April 2008. 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 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 wafer foundries to meet our needs, or that either of them will not seek an early termination of its wafer supply agreement with us. Any serious disruption in the supply of wafers from either OKI or Matsushita would harm our business. We estimate that it would take 9 to 18 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. In May 2003, we signed a wafer supply agreement with a third wafer foundry, ZMD Analog Mixed Signal Services GmbH & CoKG. ZMD is located in Germany and is expected to be able to produce wafers for us by the end of 2004. Our agreement with ZMD expires on December 31, 2009.

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 capacity of the wafer foundry in which they manufacture 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 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 and test 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, 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 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.

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Although we receive royalties on Matsushita’s sales, these royalties are substantially lower than the gross profit we receive on direct sales. We cannot assure 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 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 for potential customer returns, we cannot assure that these reserves will be adequate.

If our products do not penetrate additional markets, our business will not grow as we expect. We believe that our future success depends in part upon our ability to penetrate additional markets for our products. We cannot assure 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 situated near San Francisco, California, and most of our major suppliers (wafer foundries and assembly houses), are located in areas that have been subject to severe earthquakes. In the event of an earthquake, we and/or most of our major suppliers may be temporarily unable to continue operations and may suffer significant property damage. Any such interruption in our ability or that of our major suppliers 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 economic consequences of current and potential military actions or 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.

An outbreak of a contagious disease may adversely impact the operations of our major suppliers and our global operations. If there is an outbreak of a contagious disease such as Severe Acute Respiratory Syndrome (SARS), it could have an adverse impact on our major customers and suppliers. It could also have an impact on the end market demand for consumer products that incorporate our chips. These factors could harm our global sales and operations.

If we are unable to adequately protect or enforce our intellectual property rights, we could lose market share, incur costly litigation expenses, suffer incremental price erosion or lose valuable assets, any of which could harm our operations and negatively impact our profitability. 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 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.

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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.

On June 28, 2004, we filed a complaint for patent infringement in the U.S. District Court, Northern District of California, against System General Corporation, a Taiwanese company. Our complaint alleges certain circuits produced by System General Corporation infringed and continue to infringe certain of our patents. We seek, among other things, an order enjoining System General Corporation from infringing our patents and an award for damages resulting from the alleged infringement.

Litigation may be necessary to resolve the claims we have asserted against System General Corporation. There can be no assurance that we would prevail in any future litigation. Any litigation, whether or not determined in our favor or settled by us, would be costly and would divert the efforts and attention of our management and technical personnel from normal business operations, which could have a material adverse effect on our business, financial condition and operating results. Adverse determinations in litigation could result in the loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from third parties or prevent us from licensing our technology, any of which could have a material adverse effect on our business, financial condition and operating results.

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 could harm our business. In addition, if one or more of these individuals leaves our employ, and we are unable to quickly and efficiently replace those individuals with qualified personnel who can smoothly transition into their new roles, our business may suffer. 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.

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 addition, our board of directors adopted a Preferred Stock Purchase Rights Plan intended to guard against hostile takeover tactics. 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, our customers 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.

Recently enacted changes in securities laws and regulations are likely to increase our costs. The Sarbanes-Oxley Act of 2002 that became law in July 2002 requires changes in some of our corporate governance practices. The Act also requires the Securities and Exchange Commission to promulgate new rules on a variety of subjects. In addition to final rules made be the Securities and Exchange Commission, Nasdaq has revised its requirements for companies that are Nasdaq-listed. These new rules and regulations have and will increase our legal and financial compliance costs, and make some activities more difficult, time consuming and/or costly. These new rules and regulations also make it more expensive