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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 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)

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 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.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

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 September 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. As such, 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 manufacturer. The wafer supply agreement, which expires in June 2005, is renewable upon mutual agreement by the parties. In connection with the technology license agreement, the Company is entitled to receive a royalty on the manufacturer’s sales of products that incorporate the Company’s technology.

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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 Statement of Financial Accounting Standards (“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), allowance for doubtful accounts, 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. Such adjustments were not material for the nine months ended September 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.

3. INVENTORIES:

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)

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 typically account for a significant portion of the Company’s net revenues. The top ten customers accounted for approximately 69.9% and 77.0% of total net revenues for the three months ended September 30, 2004 and 2003, respectively, and 70.4% and 77.0% of total net revenues for the nine months ended September 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 September 30, 2004 and December 31, 2003, approximately 74.4% and 71.3% of accounts receivable, respectively, were concentrated with the top 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 97.8% and 97.9% of net revenues from product sales for the three months ended September 30, 2004 and 2003, respectively, and 97.3 % and 98.9% of net revenues from product sales for the nine months ended September 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)

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 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 2,021,238 and 256,099 shares of Company common stock outstanding for the three month periods ended September 30, 2004 and 2003, respectively, and options to purchase 1,537,701 and 392,919 shares of Company common stock outstanding for the nine month periods ended September 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.

6. PROVISION FOR INCOME TAXES:

Income tax expense for the nine-month periods ended September 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 nine-month period ended September 30, 2004 is primarily due to the beneficial impact of lower income tax rates on international sales, research and development credits and a benefit of $1.1 million resulting from a reduction in the Company’s estimated income-tax liabilities due to the favorable conclusion of certain tax contingencies. The difference between the Federal statutory rate of 35% and the Company’s effective tax rate used for the nine-month period ended September 30, 2003 is primarily due to the beneficial impact of research and development credits, extraterritorial income exclusion and Federal tax-exempt investments. The tax provision for the three and nine month periods ended September 30, 2004 was calculated using an annual effective income tax rate of 26%, which was adjusted for the favorable conclusion of certain tax contingencies in the third quarter of 2004, which resulted in an effective tax rate of approximately 8% and 20% for the three and nine month periods, respectively. The tax provision for the three and nine month periods ended September 30,

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2003 was calculated using an annual effective income tax rate of 28%. The estimated effective income tax rate for the quarter ending December 31, 2004 is 26%. The estimated annual effective income tax rate for 2004 is 26% reduced by the impact of the $1.1 million reduction recorded in the third quarter of 2004. The estimated income tax rates for the quarter and year ended December 31, 2004 may be subject to change.

7. INDEMNIFICATIONS:

The Company sells products to its distributors under contracts, collectively referred to as Distributor Sales Agreements (“DSA”). Each DSA contains the relevant terms of the contractual arrangement with the distributor, and generally includes certain provisions for indemnifying the distributor against losses, expenses, and liabilities from damages that may be awarded against the distributor 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 DSA 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 indemnification to individual customers.

The Company believes its internal development processes and other policies and practices limit its exposure related to such indemnifications. 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 distributors or customers for any losses related to these indemnifications and no material claims were outstanding as of September 30, 2004. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnifications.

8. RECENT ACCOUNTING PRONOUNCEMENTS:

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 46 (revised December 2003 by FIN No. 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 No. 46R replaces FIN No. 46, “Consolidation of Variable Interest Entities,” issued in January 2003. The Company is required to apply FIN No. 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, FIN No. 46R will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN No. 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 No. 46R first applies may be used to measure the assets, liabilities and non-controlling interest of the VIE. As of September 30, 2004, the Company did not have any VIEs and therefore, management believes the adoption of FIN No. 46R will not have a material impact on the Company’s financial position, results of operations or cash flows.

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), “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, which was 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 SAB 104. 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.

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POWER INTEGRATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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. Adoption of the recognition and measurement guidance of EITF 03-1 has been temporarily deferred by the FASB. However, the disclosure requirements continue to be effective for annual periods ending after June 15, 2004. Management believes the adoption of EITF 03-1 will not have a material impact on the Company’s financial position, results of operations or cash flows.

In June 2004, the FASB issued EITF Issue No. 02-14 (“EITF 02-14”), “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock.” EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means. EITF 02-14 states that an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The accounting provisions of EITF 02-14 are effective for reporting periods beginning after September 15, 2004. Management believes the adoption of EITF 02-14 will not have a material impact to the Company’s financial position, results of operations or cash flows.

9. LEGAL PROCEEDINGS:

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 that 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.

On October 20, 2004, the Company filed a complaint for patent infringement in the U.S. District Court for the District of Delaware, against Fairchild Semiconductor International, Inc., a Delaware corporation, and Fairchild Semiconductor Corporation, a Delaware corporation (collectively, “Fairchild”). The Company’s complaint alleges that Fairchild produces certain circuits which infringed and continue to infringe certain of the Company’s patents. The Company seeks, among other things, an order enjoining Fairchild from infringing the Company’s patents and an award for damages resulting from the alleged infringement.

There can be no assurance that the Company will prevail in its litigation with either System General or Fairchild. This litigation, whether or not determined in the Company’s favor or settled by the Company, will be costly and will 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 electronic 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 these strategies by developing products, which are more energy efficient and have increased functionality, and by focusing 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 linear power supplies and power supplies built with discrete electronic components. Our products offer the following key benefits to manufacturers of 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, product royalty arrangements and other consideration. 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

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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 have completed the qualification of ZMD as our third foundry partner and expect to begin taking delivery of production wafers from ZMD during the fourth quarter of 2004.

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 and assumptions, particularly 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 delivered at frontier, commonly known as DAF. As such, 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 manufacturer. 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 manufacturer’s sales of its own products that incorporate our technology.

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 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. We analyze these factors when we initially establish the reserve, and then each quarter when we review the adequacy of the reserve. 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. 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 pay us, 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 September 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 results 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 Nine Months Ended September 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 September 30, 2004 were $32.9 million compared to $34.5 million for the three months ended September 30, 2003, a decrease of $1.6 million, or 4.6%. Net revenues for the nine months ended September 30, 2004 were $103.1 million compared to $93.4 million for the comparable period of 2003, an increase of $9.6 million or 10.3%.

Net revenues from product sales were $32.3 million and $34.0 million in the third quarter of 2004 and 2003, respectively. Net revenues from product sales were $101.3 million and $92.1 million in the nine months ended September 30, 2004 and 2003, respectively. The decrease in net revenues from product sales for the three months ended September 30, 2004 was driven primarily by decreased sales of our products in the communications end market due to weak demand with a smaller decrease in the computer end market. These decreases were somewhat offset by increased sales of our products in the consumer and industrial end markets. The increase in net revenues from product sales for the nine months ended September 30, 2004 was primarily from increased demand in the consumer, computer and industrial end markets in the first half of the year, offset by a decrease in the communication end market. Net revenues from non-cell phone applications, including the consumer market, the industrial market and the computer market, were up in the aggregate 22% year-to-date compared to the first nine months of 2003. Specifically, for this period, net revenues from the consumer market were up 35%, net revenues from the industrial market were up 26%, and net revenues from the computer market were up 5%.

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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 is as follows:

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

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 $30.1 million in the third quarter of 2004 compared to $32.1 million for the same period in 2003, a decrease of $2.1 million, or 6.5%. International sales represented 91.2% of net revenues compared to 93.1% in the three months ended September 30, 2004 and 2003, respectively. International sales were $94.6 million for the nine months ended September 30, 2004 compared to $87.3 million for the same period in 2003, an increase of $7.3 million, or 8.4%. International sales represented 91.8% of net revenues compared to 93.4% in the nine months ended September 30, 2004 and 2003, respectively. As with our worldwide product revenue, the decrease in our international sales for the three months ended September 30, 2004 reflected a slowdown in sales of our products in the communications end market due to weak demand after seeing increased sales of our products across all of our end markets during the first half of the year. 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 73.4% and 80.2% of our product sales for the three months ended September 30, 2004 and 2003, respectively, and 76.6% and 81.0% of our product sales for the nine months ended September 30, 2004 and 2003, respectively. Combined product sales to our customers in Europe and North America increased as a percentage of total product sales while sales to our customers in Asia declined as a percentage of total product sales. Combined sales to Europe and North America, as a percent of total product sales, were approximately 7.2% higher for the three months ended September 30, 2004 and approximately 4.6% higher for the nine months ended September 30, 2004, compared to the same periods in 2003. We expect international sales to continue to account for a large portion of our net revenues.

Net product sales for the third quarter of 2004 were divided 54.4% to distributors and 45.6% to OEMs and power supply merchants, compared to 60.3% to distributors and 39.7% to OEMs and power supply merchants for the third quarter of 2003. For the nine months ended September 30, 2004, net product sales were divided 55.1% to distributors and

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44.9% to OEMs and power supply merchants, compared to 60.8% to distributors and 39.2% to OEMs and power supply merchants for the same period in 2003. In the three months ended September 30, 2004, two separate customers, both of who are distributors, accounted for approximately 15.5% and 17.4% of our net revenues, respectively. In the three months ended September 30, 2003, the same two distributors accounted for approximately 22.1% and 21.8% of our net revenues, respectively. No other customers accounted for 10% or more of our net revenues in that period. For the nine months ended September 30, 2004, sales to the same two distributors accounted for approximately 18.9% and 17.0% of our net revenues, respectively, compared to approximately 19.4% and 25.0% of our net revenues, respectively, for the nine months ended September 30, 2003. A third customer who is an OEM accounted for approximately 10.7% of our net revenues for the nine months ended September 30, 2004 and less than 10% for the nine months ended September 30, 2003.

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 costs associated with the testing of both wafers and packaged components and testing of packaged components by sub-contractors. Gross profit was $15.8 million, or 47.8% of net revenues, for the three months ended September 30, 2004, compared to $16.3 million, or 47.2% of net revenues, for the three months ended September 30, 2003. Gross profit for the nine months ended September 30, 2004 was $49.0 million, or 47.5% of net revenues, compared to $46.5 million, or 49.8% of net revenues for the same period in 2003. The increase in gross profit percentage for the three months ended September 30, 2004 reflects improved labor and overhead costs absorbed on products sold during the third quarter of 2004. The decrease in gross profit percentage for the nine months ended September 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 third quarter of 2004 were $4.1 million compared to $4.3 million for the same period in 2003, which represented 12.4% of our net revenues in both periods. Research and development expenses for the nine months ended September 30, 2004 were $12.3 million compared to $12.6 million for the same period in 2003, which represented 12.0% and 13.4% of our net revenues in each period, respectively. As a percentage of net revenues, research and development expenses for the nine months ended September 30, 2004 were lower than during the comparable period in 2003, primarily as a result of increased revenues in 2004. 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 $3.4 million, or 10.4% of net revenues, for the third quarter of 2004, compared to $3.8 million, or 11.1% of net revenues for the same period in 2003. Sales and marketing expenses for the nine months ended September 30, 2004 were $11.5 million compared to $11.8 million for the same period in 2003, which represented 11.1% and 12.6% of our net revenues in each period, respectively. In absolute dollars, sales and marketing expenses for the three and nine months ended September 30, 2004 were slightly down from the same periods in 2003, primarily as a result of lower sales commissions in 2004. However, while sales and marketing expenses may fluctuate as a percentage of our net revenues, 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 and fees for audit and tax services. For the quarters ended September 30, 2004 and 2003, general and administrative expenses were $2.4 million and $1.7 million, respectively, which represented 7.2% and 4.9% of our net revenues, respectively. For the nine months ended September 30, 2004 and 2003, general and administrative expenses were $6.0 million and $5.1 million, respectively, which represented 5.8% and 5.5% of our net revenues, respectively. General and administrative expenses increased for the three and nine month periods in 2004, primarily due to increased legal and professional services incurred. This includes a substantial increase in legal expenses and other costs related to compliance activities resulting from the Sarbanes-Oxley Act of 2002, and in particular, Section 404 of that Act, which requires documentation and testing of our internal controls over financial reporting. We expect general and administrative expenses to increase in absolute dollars, particularly in light of recently filing separate patent infringement claims against

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System General Corporation and Fairchild Semiconductor (as described in Part II Other Information, Item 1 Legal Proceedings), and ongoing efforts to comply with the requirements of the Sarbanes-Oxley Act, but these expenses may fluctuate as a percentage of our net revenues.

Other income, net. Other income, net, for the third quarter of 2004 increased by $0.2 million compared to the same period in 2003. For the nine months ended September 30, 2004, other income, net, was $0.7 million, which was slightly lower compared the same period in 2003. The increase for the three-month period ended September 30, 2004 was due primarily to increases in cash and investments and slightly increased interest rates.

Provision for income taxes. Provision for income taxes represents Federal, state and foreign taxes. The provision for income taxes was $0.5 million for the quarter ended September 30, 2004 compared to $1.8 million for the quarter ended September 30, 2003. The provision for income taxes was $4.1 million for the nine months ended September 30, 2004 compared to $5.0 million for the same period in 2003. The difference between the Federal statutory rate of 35% and our effective tax rate used for the nine-month period ended September 30, 2004 is primarily due to the beneficial impact of lower income tax rates on international sales, research and development credits and a benefit of $1.1 million resulting from a reduction in our estimated income-tax liabilities due to the favorable conclusion of certain tax contingencies. The difference between the Federal statutory rate of 35% and our effective tax rate used for the nine-month period ended September 30, 2003 is primarily due to the beneficial impact of research and development credits, extraterritorial income exclusion and Federal tax-exempt investments. The tax provision for the three and nine month periods ended September 30, 2004 was calculated using an annual effective income tax rate of 26%, which was adjusted for the favorable conclusion of certain tax contingencies in the third quarter of 2004, which resulted in an effective tax rate of approximately 8% and 20% for the three and nine month periods, respectively. The tax provision for the three and nine month periods ended September 30, 2003 was calculated using an annual effective income tax rate of 28%. The estimated effective income tax rate for the quarter ended December 31, 2004 is 26%. The estimated annual effective income tax rate for 2004 is 26% reduced by the impact of the $1.1 million reduction recorded in the third quarter of 2004. The estimated income tax rates for the quarter and year ended December 31, 2004 may be subject to change.

Liquidity and Capital Resources

As of September 30, 2004, we had approximately $144.0 million in cash, cash equivalents and short-term and long-term investments, an increase of approximately $28.7 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 September 30, 2004, there were outstanding letters of credit totaling approximately $5.2 million. The balance of this credit line was unused and available as of September 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 September 30, 2004, we were in compliance with these financial covenants.

As of September 30, 2004, we had working capital, defined as current assets less current liabilities, of approximately $156.5 million, an increase of approximately $20.9 million from December 31, 2003. Our operating activities generated cash of $25.3 million and $13.2 million in the nine months ended September 30, 2004 and 2003, respectively. Cash generated in the first nine months of 2004 was principally the result of net income in the amount of $15.9 million plus additions from non-cash activities of $7.7 million and a decrease in inventory of $0.9 million and an increase in deferred income of $1.0 million, partially offset by an increase in prepaid expenses of $1.1 million. Cash generated in the first nine months of 2003 was principally the result of net income in the amount of $12.8 million, plus additions for non-cash activities of $11.9 million partially offset by increases in inventory of $4.8 million, accounts receivable of $4.0 million and prepaid expenses of $2.8 million.

Our investing activities were net purchases of $8.8 million in the nine months ended September 30, 2004 of short-term and long-term investments, and net proceeds from the maturities of short-term investments of $19.7 million in the nine months ended September 30, 2003. Purchases of property and equipment were $4.7 million and $8.6 million in the nine months ended September 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 $7.9 million and $16.3 million in the nine months ended September 30, 2004 and 2003, respectively.

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On October 20, 2004, we announced that our board of directors had authorized the repurchase of up to $40.0 million of our common stock. The repurchases will take place from time to time on the open market. In addition, the board of directors authorized that the repurchases be made pursuant to Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. The repurchase program may be suspended or discontinued at any time.

During the first nine months of 2004, a significant portion of our cash flow was generated by our operations. If our operating results were to deteriorate as a result of decrease in customer demand for our products, 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 Financial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No. 46 (revised December 2003 by FIN No. 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 No. 46R replaces FIN No. 46, “Consolidation of Variable Interest Entities,” issued in January 2003. We are required to apply FIN No.46R to variable interests in VIEs created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, FIN No. 46R will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN No. 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 No. 46R first applies may be used to measure the assets, liabilities and non controlling interest of the VIE. As of September 30, 2004, we did not have any VIEs and therefore, we believe the adoption of FIN No. 46R will not have a material impact on our financial position, results of operations or cash flows.

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), “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, which was 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 SAB 104. 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. Adoption of the recognition and measurement guidance of EITF 03-1 has been temporarily deferred by the FASB. However, the disclosure requirements continue to be 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.

In June 2004, the FASB issued EITF Issue No. 02-14 (“EITF 02-14”), “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock.” EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means. EITF 02-14 states that an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The accounting provisions of EITF 02-14 are effective for reporting periods beginning after September 15, 2004. We believe the adoption of EITF 02-14 will not have a material impact to our financial position, results of operations or cash flows.

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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: