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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 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)

(408) 414-9200

(Registrant’s telephone number, including area code)

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

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

Common Stock, $0.001 par value

(Title of Class)

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.408 of this Chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  x    NO  ¨

The aggregate market value of registrant’s voting and non-voting common equity held by nonaffiliates of registrant on June 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $885,512,102, based upon the closing sale price of the common stock as reported on the NASDAQ National Market. Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

Outstanding shares of registrant’s common stock, $0.001 par value, as of February 28, 2005: 29,775,308.

DOCUMENTS INCORPORATED BY REFERENCE

Parts of the definitive Proxy Statement for registrant’s 2005 Annual Meeting of Stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form are incorporated by reference into Part III of this Form 10-K Report.

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PART I

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

Item 1. Business

Overview

We design, develop, manufacture and market proprietary, high-voltage, analog integrated circuits, commonly referred to as ICs, primarily for use in electronic power supplies, also known as switched-mode power supplies or switchers. Power supplies convert electricity from a source, such as a wall socket, to the power needed by an electronic device. This conversion entails, among other functions, reducing the voltage and, when necessary, converting alternating current to direct current (AC-DC). Switched-mode power supplies perform these functions using an array of electronic components, often including ICs such as ours. The vast majority of our ICs are used in AC-DC switchers, though we are now also targeting certain DC-DC applications. Our focus is on applications that are sensitive to size, portability, energy efficiency and time-to-market, which are the primary benefits that our ICs provide. We have targeted applications in the following markets for our ICs:

We believe our patented TOPSwitch ICs, introduced in 1994, were the first highly integrated power conversion ICs to achieve widespread market acceptance. Since the introduction of TOPSwitch, we have introduced a number of other families of ICs that further improve upon the functionality and cost-effectiveness of TOPSwitch, and enable us to address a wider range of applications. In June 2002, we further expanded our addressable market with the introduction of DPA-Switch, a highly integrated high-voltage DC-DC power conversion IC designed specifically for use in distributed power architectures. With our current portfolio of products we can address applications requiring up to 290 watts of power, in AC-DC applications, and up to 100 watts of power in DC-DC applications. Since introducing TOPSwitch in 1994, we have shipped approximately 1.5 billion ICs.

We were incorporated in California on March 25, 1988 and reincorporated in Delaware in December 1997. We maintain a World Wide Website at www.powerint.com.

Industry Background

Virtually every electronic device that plugs into a wall socket requires a power supply to convert high-voltage alternating current, provided by electric utilities, into low-voltage direct current required by most electronic devices. A power supply may be located inside a device, such as a DVD player or computer, or it may be outside the device as in the case of a cell phone charger or a cordless phone adapter.

Until approximately 1970, virtually all AC-DC power supplies used linear transformers to reduce voltage and provide safety isolation. These devices, consisting primarily of copper wire wound around an iron core, tend to be bulky, heavy, and inefficient, meaning that they waste a substantial amount of electricity. In the 1970s, the invention of high-voltage discrete semiconductors enabled the development of a new generation of power supplies known as switchers, which operate at much higher frequencies, allowing the use of smaller, more efficient transformers.

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Although discrete switchers offer advantages over linear transformers, particularly for high-power applications, over the years they have not kept pace with the technological advances made in the electronic devices they power. Discrete switchers require numerous components, limiting the power supply designer’s ability to reduce the size and increase the functionality of power supplies while also meeting increasingly stringent cost and energy-efficiency requirements. In addition, discrete switchers involve a high level of design complexity, which increases time-to-market and development risks for new products.

Early attempts to replace discrete switchers with integrated switchers, that use high-voltage analog ICs did not achieve widespread acceptance in the marketplace because the integrated switchers were not cost-effective. We addressed this opportunity in 1994 with the industry’s first cost-effective power conversion IC, our TOPSwitch IC.

Our Highly Integrated Solution

Our patented ICs integrate onto a single chip many of the functions otherwise performed by numerous discrete electronic components. In particular, our ICs combine a high-voltage power transistor, or MOSFET, with low-voltage control circuitry. Because of this integration, our TOPSwitch, TinySwitch, DPA-Switch and LinkSwitch products enable many power supplies to have a total cost equal to or lower than discrete switchers and linear transformers. Our products offer the following key benefits to power supplies:

Our highly integrated ICs enable the design and production of cost-effective switchers that use up to 70% fewer components and have enhanced functionality compared to discrete-based solutions. For example, our ICs provide thermal and short circuit protection without increasing system cost, while discrete switchers must include additional components (and therefore incur additional cost) to provide these functions. Switchers that incorporate our integrated ICs are smaller, lighter, and more portable than comparable power supplies built with linear transformers, which are still commonly used in many low-power applications.

Our patented EcoSmart technology, included in all of our ICs introduced since 1998, improves the energy efficiency of electronic devices during both normal operation and stand-by mode. Compared to discrete switchers and linear transformers, our technology enables manufacturers to cost-effectively meet the growing demand for energy-efficient products, and to comply with increasingly stringent energy-efficiency requirements.

Our integrated circuits make power supply designs simpler and more suitable for high volume manufacturing. We also provide automated design tools and reference designs that reduce time-to-market and product development risk.

Products in our current IC families can address a power range up to 290 watts, in AC-DC applications, and up to 100 watts in DC-DC applications. Within each of our product families, the switcher designer can scale up or down in power to address a wide range of designs with minimal design effort.

Energy Efficiency

Linear transformers and most discrete switchers draw significantly more electricity than the amount consumed by the devices they power. As a result, billions of dollars of electricity is wasted each year, and

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millions of tons of air pollution are unnecessarily produced. This economic and environmental waste occurs during both normal operation of a device, and in so-called “standby” mode, when the device is performing little or no useful function. For example, computers and printers waste energy while in standby or “sleep” mode. TVs and DVD players that are turned off by remote control consume energy while awaiting a remote control signal to turn them back on. A cell-phone charger left plugged in to a wall socket continues to draw electricity even when not connected to the phone. Many typical household appliances, such as microwave ovens, dishwashers and washing machines, consume power even when not in use. The Berkeley National Laboratory conducted a study in 2000, which estimated that standby power alone amounted to as much as ten percent of residential energy consumption.

As the number of electronic products in service grows, governments are taking action to promote cost-effective ways to conserve energy. For example, the Energy Star program and the European Union Code of Conduct encourage manufacturers of electronic devices such as home appliances, DVD players, computers and TVs to comply with the Environmental Protection Agency’s (EPA) energy-efficiency standards. In early 2005, each of these programs instituted new standards on the efficiency of external power supplies (EPS). In addition state and Federal governments are also addressing the need to conserve energy. For example, in late 2004, the State of California introduced mandatory external power supply efficiency standards that will take effect in July 2006. In 2001, President Bush issued an executive order requiring the Federal government to purchase electronics, including computers, that consume less than one watt when not in use. Numerous other countries around the world have also instituted energy-efficiency standards affecting a wide range of electronic devices.

Our EcoSmart technology, included in all of our ICs introduced since 1998, dramatically improves the efficiency of electronic devices, reducing waste in both operating and standby modes. This proprietary technology allows manufacturers to meet all current and currently proposed worldwide energy-efficiency regulations. Since its introduction in 1998, we estimate that EcoSmart technology has saved consumers and businesses more than $800 million in electricity costs, and we believe that these savings will grow at an accelerating rate as more EcoSmart-enabled devices are sold.

Products

Below is a brief description of our products:

TOPSwitch, our first cost-effective commercial product, was introduced in 1994. The TOPSwitch family consists of 13 products. The key benefits that the TOPSwitch family brings to power supplies, compared to discrete switchers, are fewer components, reduced size, enhanced functionality and lower cost in many applications. Our TOPSwitch products integrate a PWM controller, a high-voltage MOSFET and a number of other electronic components into a single 3 terminal IC.

The TOPSwitch-II family was introduced in April 1997 and consists of 11 products. The TOPSwitch-II products further lower the cost of switching power supplies by improving upon the performance of TOPSwitch and addressing low power applications with lower cost packaging. The TOPSwitch-II family uses the same proprietary architecture as the original TOPSwitch family, enabling designers of switchers experienced with TOPSwitch to take advantage of the TOPSwitch-II benefits without implementing a new architecture.

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The TinySwitch family was introduced in September 1998 and consists of five products. The TinySwitch topology was specifically designed to address applications below 10 watts. TinySwitch was the first family of chips to incorporate our EcoSmart technology to address the growing need to reduce energy waste in electronic products. EcoSmart technology dramatically improves the operating efficiency of electronic devices and reduces the amount of energy consumed in standby and no-load modes of operation, enabling our customers to meet governmental energy efficiency guidelines and regulations. EcoSmart technology has been included in all product families that we have introduced since 1998.

The TOPSwitch-FX family was introduced in March 2000 and consists of six products. New features integrated into the TOPSwitch-FX further reduce the system cost of switching power supplies and improve their performance. This product line also incorporates our energy saving EcoSmart technology. The TOPSwitch-FX family delivers up to 75 watts of power for use in applications such as cell phone chargers, personal computers, set-top boxes and DVD players.

The TOPSwitch-GX family was introduced in November 2000 and consists of 23 products. We believe that TOPSwitch-GX is the first monolithic high-voltage IC capable of supplying output power levels up to 290 watts, TOPSwitch-GX incorporates our patented, new high-voltage technology, further improving silicon efficiency and resulting in devices that are significantly more cost-effective than competing high voltage products. This product family incorporates the features offered in earlier TOPSwitch products as well as new features through additional user configurable pins. These configurable pins allow a higher level of end user design flexibility. Applications for TOPSwitch-GX devices include set-top boxes, DVD players, desktop computers, LCD monitors, and printers.

The TinySwitch-II family was introduced in March 2001, and now consists of six products addressing power levels up to 23 watts. This product line maintains the simplicity of the previous TinySwitch line while providing additional features that enable lower system cost. The TinySwitch-II utilizes the same high-voltage silicon technology found in TOPSwitch-GX. Applications for TinySwitch-II include adapters for portable equipment such as cell phones, PDAs, digital cameras, computer peripherals, and power tools, as well as power supplies found in PCs, audio/video equipment and home appliances.

The LinkSwitch family was introduced in September 2002 and consists of nine products, including the LinkSwitch-TN and LinkSwitch-HF family extensions introduced in 2004. Deriving its name from the phrase “linear killer switch”, the LinkSwitch is the industry’s first highly integrated high-voltage power conversion IC designed specifically to displace low power (0 to 3 watts) linear transformers by delivering switcher benefits – smaller size, lighter weight, superior performance and energy efficiency – at comparable linear transformer cost. Applications for LinkSwitch devices include low power adapters and chargers for personal electronics such as cell phones, cordless phones, digital cameras, and MP3 players. LinkSwitch can also be used in consumer applications and many industrial applications.

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The DPA-Switch family was introduced in June 2002 and consists of seven products. The DPA-Switch is the first monolithic high voltage switching power IC designed specifically for use in DC-DC converters and distributed power architectures. It is capable of supplying output power levels of up to 100 watts. DPA-Switch allows designers to eliminate up to 50 external components from the design of a typical discrete DC-DC converter, resulting in a shorter design cycle, smaller board size and higher reliability. Applications include network line cards, servers, power over ethernet (PoE) devices, voice over IP (VoIP) phones, Digital PBX phones, DC-DC converter modules and industrial controls.

Markets and Customers

Our strategy is to target markets that can benefit the most from our highly integrated power conversion ICs. The following chart shows the primary applications of our products in power supplies in several major market categories.

Revenue by our end market categories for 2004 was approximately 33 percent consumer, 31 percent communications, 22 percent computer, 8 percent industrial electronics and 6 percent other markets.

Sales, Distribution and Marketing

We sell our products to original equipment manufacturers (OEMs) and merchant power supply manufacturers through a direct sales staff and through a worldwide network of independent sales representatives and distributors. Our international sales representatives also act as distributors in Europe and Asia. In the United States, we use two national distributors and a number of regional sales representatives. We have sales offices in California, Georgia and Illinois, as well as in England, Germany, Italy, India, China, Japan, Korea and Taiwan. Direct sales to OEMs and merchant power supply manufacturers represented approximately 44%, 39% and 47% of our net product revenues for 2004, 2003 and 2002, respectively, while sales through distributors accounted for approximately 56%, 61% and 53% for 2004, 2003 and 2002, respectively. All distributors are entitled to certain return privileges based on sales revenue and are protected from price reductions affecting their inventories. Our distributors are not subject to minimum purchase requirements and the sales representatives and distributors can discontinue marketing any of our products at any time.

We estimate that our top ten customers, including distributors which resell to OEMs and merchant power supply manufacturers, accounted for 71%, 76% and 81% of our net revenues for 2004, 2003 and 2002,

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respectively. For 2004, Memec Electronic Components and Synnex Technologies each accounted for 19% of our net revenues. In 2003, Memec and Synnex accounted for 25% and 20% of our net revenues, respectively. In 2002 Memec and Synnex accounted for 22% and 15% of our net revenues, respectively. Also in 2002, Samsung Electronics, an OEM, accounted for 14% of our net revenues. No other customers accounted for more than 10% of net revenues during 2004, 2003 and 2002. In 2004, 2003 and 2002, international sales comprised 92%, 93% and 96%, respectively, of our net revenues. See note 2 in our notes to consolidated financial statements regarding material sales in individual countries.

Sales of our products are generally made pursuant to standard purchase orders, which are frequently revised, prior to shipment, to reflect changes in the customer’s requirements. Product deliveries are scheduled upon our receipt of purchase orders. Generally, these orders allow customers to reschedule delivery dates and cancel purchase orders without significant penalties. For these reasons, we believe that purchase orders received, while useful for scheduling production, are not necessarily reliable indicators of future revenues.

Technology

We have developed a patented high-voltage, power IC technology, which uses our proprietary high voltage MOS transistor structure and fabrication process. This technology enables us to integrate high-voltage n-channel transistors and industry-standard CMOS and bipolar control circuitry on the same monolithic IC. Both the IC device structure and the wafer fabrication process contribute to the cost effectiveness of our high-voltage technology. In 2003, we introduced an improved, high-voltage technology that further reduces the silicon area of our devices by using dual-conduction layers. In 2004, we made additional improvements to our integrated high-voltage technology to further shrink the silicon area of our ICs. Our high voltage ICs are implemented on low cost silicon wafers using standard 5V CMOS silicon processing techniques with a relatively large feature size of 1 to 3-microns.

Our proprietary IC designs combine complex control circuits and high-voltage transistors on the same monolithic IC. Our IC design technology takes advantage of our high-voltage process to minimize the die size of both the high-voltage device and control circuits and improve the performance of our ICs versus alternative integrated technologies. We also have developed expertise in the design of switching power supplies, resulting in innovative topologies that reduce system cost increase system performance and improve the energy efficiency of power supplies compared to alternative approaches. Our innovations in IC circuit designs and system level architectures have enabled us to develop revolutionary products such as the highly integrated TOPSwitch, TOPSwitch-FX, TOPSwitch-GX, TinySwitch, LinkSwitch and DPA-Switch families of ICs.

Research and Development

Our research and development efforts are focused on improving our high-voltage device structures, wafer fabrication processes, analog circuit designs and system level architecture. By these efforts, we seek to introduce new products to expand our addressable markets, further reduce the costs of our products, and improve the cost effectiveness and enhance the functionality of our customers’ power supplies. We have assembled a multidisciplined team of highly skilled engineers to meet our research and development goals. These engineers have expertise in high-voltage device structure and process technology, analog design, and power supply systems architecture.

In 2004, 2003 and 2002, we spent $16.2 million, $16.4 million and $14.7 million, respectively, on research and development efforts. We expect to continue to invest funds in research and development activities. The development of high-voltage analog ICs is highly complex. We cannot guarantee that we will develop and introduce new products in a timely and cost-effective manner or that our development efforts will successfully permit our products to meet changing market demands.

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Intellectual Property and Other Proprietary Rights

We use a combination of patents, trademarks, copyrights, trade secrets and confidentiality procedures to protect our intellectual property rights. As of December 31, 2004 we held 117 U.S. patents and had generally filed for or received foreign patent protection on these patents resulting in 81 foreign patents. The U.S. patents have expiration dates ranging from 2006 to 2024. We also hold trademarks in the U.S. and various other countries including Taiwan, Korea, Hong Kong, China, Europe, and Japan.

We regard as proprietary certain equipment, processes, information and knowledge that we have developed and used in the design and manufacture of our products. Our trade secrets include a proprietary high volume production process that produces our patented high-voltage ICs. We attempt to protect our trade secrets and other proprietary information through non-disclosure agreements, proprietary information agreements with employees and consultants and other security measures.

We have granted a perpetual non-transferable license to Matsushita Electric Industrial Co, Ltd. (Matsushita) to use our semiconductor patents and other intellectual property for our current high-voltage technology, including our TOPSwitch technology and improvements on the existing technology. This perpetual non-transferable license allows Matsushita to manufacture and design products for internal use and for sale or distribution to other Japanese companies and their subsidiaries in Asia. To the extent the products they manufacture and design are not based on the TOPSwitch technology, Matsushita may make sales or other distribution to Asian companies in Asia. Matsushita has granted us perpetual cross licenses to the technology developed by them under their license rights. We have agreed not to license the technology licensed to Matsushita to other Japanese companies or their subsidiaries prior to July 2005. In exchange for its license rights, Matsushita has paid and will continue to pay royalties on products using the licensed technology during fixed periods.

Manufacturing

We contract with Matsushita, OKI Electric Industry (OKI), and ZMD Analog Mixed Signal Services GmbH & CoKG (ZMD) to manufacture our wafers in foundries located in Japan and Germany. Our products are assembled and packaged by independent subcontractors in China, Malaysia and the Philippines. We perform testing at our facility in San Jose, California, and through our packaging subcontractors in Asia. Our fabless manufacturing model enables us to focus on our engineering and design strengths, minimize fixed costs on capital expenditures and still have access to high-volume manufacturing capacity. Our products do not require leading edge process geometries for them to be cost-effective, and thus we can use our foundries’ older, low-cost facilities for wafer manufacturing. However, because of our proprietary, highly sensitive implant process, we must interact closely with our foundries to achieve satisfactory yields. Although we generally utilize standard IC packages for assembly, some materials and aspects of assembly are specific to our products. We require our manufacturers to use a high-voltage molding compound that is difficult to process and is available from only one supplier. 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. As a result, we must be involved with our contractors on an active engineering basis to maintain and improve the process.

Our wafer supply agreements with Matsushita, OKI, and ZMD expire in June 2005, April 2008, and December 2009, respectively. Under the terms of our agreement with Matsushita, we establish, by mutual agreement, minimum production capacity to be made available by Matsushita for the production of our wafers, and we supply Matsushita with monthly orders and rolling 6-month forecasts on a monthly basis. We also establish pricing by good faith agreement, subject to our right to most favored pricing. Under the terms of the OKI agreement, OKI has agreed to reserve a specified amount of production capacity and to sell wafers to us at fixed prices, which are subject to periodic review jointly by OKI and us. Our agreements with both Matsushita and OKI provide for the purchase of wafers in Japanese yen. Both agreements allow for mutual sharing of the impact of the exchange rate fluctuation between Japanese yen and the U.S. dollar. Under the terms of the ZMD

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agreement, ZMD has agreed to reserve a specified amount of production capacity and to sell wafers to us at fixed prices, which are subject to periodic review jointly by ZMD and us. The agreement with ZMD also requires us to supply ZMD with rolling 6-month forecasts on a monthly basis. Our purchases of wafers from ZMD are denominated in U.S. dollars.

Although certain aspects of our relationships with Matsushita OKI, and ZMD 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, OKI, or ZMD in the future, that they will continue to provide us with sufficient capacity at their foundries to meet our needs, or that any of them will not seek an early termination of their wafer supply agreement with us. Contractual provisions limit the conditions under which we can enter into such arrangements with other Japanese manufacturers or their subsidiaries during the term of the agreement with Matsushita. Our operating results would suffer in the event of a supply disruption with OKI, Matsushita, or ZMD and if we were unable to quickly qualify alternative manufacturing sources for existing or new products or if these sources were unable to produce wafers with acceptable manufacturing yields.

We typically receive shipments from our foundries approximately five to seven weeks after placing orders, and lead times for new products can be substantially longer. To provide sufficient time for assembly, testing and finishing, we typically need to receive wafers from Matsushita, OKI and ZMD four to six weeks before the desired ship date to our customers. As a result of these factors and the fact that customers’ orders can be made with little advance notice, we have only a limited ability to react to fluctuations in demand for our products. We carry a substantial amount of wafer and finished goods inventory to help offset these factors to better serve our markets and meet customer demand.

Competition

The high-voltage power supply industry is intensely competitive and characterized by extreme price sensitivity. In recent years there has been an oversupply of discrete components such as high-voltage bipolar and MOSFET transistors, PWM controller ICs, and passive components, which has resulted in significant price erosion for these products. Historically, providers of these components have been our primary competitors. In addition, companies such as Fairchild Semiconductor, STMicroelectronics, ON Semiconductor, Infineon, Philips and Sanken Electric Company have developed and marketed hybrid and monolithic power conversion ICs in competition with us. We have also observed aggressive pricing by competitors on these products in recent years. We expect competition from monolithic and hybrid products to increase as companies see the success we had in converting older technologies to the integrated solutions enabled by our product offerings. However, we believe that we are the leading innovator in the power conversion market, and that our ICs are superior to competing integrated products in terms of functionality and cost effectiveness.

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. Our failure to compete successfully in the high-voltage power supply business would materially adversely affect our business, financial condition and operating results.

Warranty

We generally warrant that our products will substantially conform to the published specifications for 12 months from the date of shipment. Under the terms of our purchase orders, our liability is limited to either a credit equal to the purchase price or replacement of the defective part.

Employees

As of December 31, 2004, we employed 310 full time personnel, consisting of 115 in manufacturing, 74 in research and development, 94 in sales, marketing and applications support, and 27 in finance and administration.

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Investor Information

We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the Exchange Act). Therefore, we file periodic reports, proxy statements and other information with the Securities and Exchange Commission (the SEC). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington D.C. 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.

You can access financial and other information at our Investor Relations website. The address is www.powerint.com. We make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.

Our Corporate Governance Guidelines, the charters of our Audit Committee, our Compensation and Equity Award Committee, and our Nominating and Corporate Governance Committee and our Code of Business Conduct and Ethics (including code of ethics provisions that apply to our principal executive officer, principal financial officer, controller and senior financial officers) are available on our website at www.powerint.com under “Corporate Governance Policies.” These items are also available in print to any stockholder who requests them by calling (408) 414-9200.

Directors and Executive Officers of Power Integrations

As of February 28, 2005, members of the board of directors and our executive officers, who are elected by and serve at the discretion of the board of directors, were as follows:

Balu Balakrishnan has served as president and chief executive officer and as a director of Power Integrations since January 2002. He served as president and chief operating officer from April 2001 to January 2002. From January 2000 to April 2001, he was vice president of engineering and strategic marketing. From September 1997 to January 2000, he was vice president of engineering and new business development. From September 1994 to September 1997, Mr. Balakrishnan served as vice president of engineering and marketing.

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Derek Bell has served as vice president of engineering and technology since April 2001. Previously Mr. Bell was the Chief Operations Officer at Palmchip during 2000 and 2001. Mr. Bell was vice president of engineering for the professional services group at Synopsys, an electric design automation company, during 1999 and 2000, vice president of strategic alliances at Cirrus Logic, a semiconductor company, from 1996 to 1999, vice president and general manager of the application specific product group at National Semiconductor, a semiconductor company, from 1995 to 1996 and served as president and chief executive officer of NovaSensor, a manufacturer of silicon sensors from 1990 to 1994. He also held various senior management positions at Signetics, a semiconductor company, from 1972 to 1990, most recently as group vice president.

John M. Cobb has served as our vice president, finance and administration and chief financial officer since April 2001. From April 1990 to October 2000, Mr. Cobb held various senior level financial positions at Quantum Corporation, a computer storage company, most recently as vice president, finance and chief financial officer of the company’s hard disk drive group.

Bruce Renouard has served as our vice president, worldwide sales since February 2002. Mr. Renouard joined our company in January 2002 as a member of the sales organization. From August 1999 to August 2001, he served as vice president, worldwide sales of Zoran Corporation, a provider of digital solutions in the multimedia and consumer electronics markets. Mr. Renouard held the position of director, worldwide market development from June 1997 to August 1999 for IDT/Centaur, an X 86 processor company. From January 1995 to June 1997, he served as national distribution sales manager for Cyrix Corp, a company specializing in Intel compatible processors.

John Tomlin has served as our vice president, operations since October 2001. From 1981 to 2001, Mr. Tomlin served in a variety of senior management positions in operations, service, logistics and marketing, most recently as vice president of worldwide operations at Quantum Corporation, a computer storage company.

Clifford J. Walker has served as our vice president, corporate development since June 1995. From September 1994 to June 1995, Mr. Walker served as vice president of Reach Software, a software company. From December 1993 to September 1994, Mr. Walker served as president of Morgan Walker, a consulting company.

Howard F. Earhart served as our president, chief executive officer and as a director from January 1995 until January 2002, and continues as a director and chairman of the board of directors. Mr. Earhart brings more than 30 years of executive management experience to Power Integrations. His management experience includes photographic film products at Eastman Kodak, a consumer and industrial imaging company, and consumer products at Memorex Corporation, a digital media company, where he was president of the consumer products group. Mr. Earhart also served as the chief executive officer of Lin Data Corporation and Information Magnetics Corporation; both companies manufacture semiconductor-based components for the disk drive industry. Mr. Earhart currently serves on the board of directors of two private companies.

Alan D. Bickell has served as a member of the board of directors since April 1999. Mr. Bickell retired in 1996 after more than 30 years with Hewlett Packard, a computer hardware company, serving as a corporate senior vice president and managing director of geographic operations since 1992. Mr. Bickell is a member of the Board of Trustees of Menlo College, and serves on the board of directors of the Peking University Educational Foundation (USA).

Nicholas E. Brathwaite has served as a member of the board of directors since January 2000. Mr. Brathwaite has been with Flextronics, an electronics company, since the acquisition of nChip in 1995, where he held the position of Vice President and General Manager of Operations. As a founding member of nChip, Mr. Brathwaite was responsible for all manufacturing and operational activities including wafer fabrication, wafer test, and module assembly. Before joining nChip, Mr.Brathwaite spent six years with Intel Corporation, a microprocessor company, in various engineering Management positions in technology development and manufacturing. He is also a member of the board of directors of Photon Dynamics, Inc., a yield management solutions company for the flat panel display market, and Hughes Software Systems, a software company in the communications industry.

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R. Scott Brown has served as member of the board of directors since July 1999. Mr. Brown has been retired since May 1, 1999. From 1985 to May 1999, Mr. Brown served as senior vice president of worldwide sales and support for Xilinx, Inc., a designer and developer of complete programmable logic solutions for use by electronic equipment manufacturers.

Balakrishnan S. Iyer became a member of the board of directors in February 2004. From October 1998 to June 2003, Mr. Iyer served as senior vice president and chief financial officer for Conexant Systems, Inc., a worldwide leader in semiconductor systems solutions for communications applications. From 1997 to 1998, Mr. Iyer served as senior vice president and chief financial officer for VLSI Technology, Inc., a semiconductor company; Mr. Iyer also serves on the boards of Conexant Systems Inc., Invitrogen Corporation, Qlogic Corporation and Skyworks Solutions, Inc.

E. Floyd Kvamme has served as a member of the board of directors since September 1989. Mr. Kvamme has been a general partner of Kleiner Perkins Caufield & Byers, a venture capital company, since 1984, and now is a partner emeritus. Mr. Kvamme also serves on the board of directors of Harmonic Inc., a broadband optical networking and digital video systems company, National Semiconductor, a semiconductor company, Photon Dynamics, a yield management solutions company for the flat panel display market, and two private companies.

Steven J. Sharp is one of the founders of Power Integrations and has served as a member of the board of directors since our inception in 1988. Mr. Sharp is chairman of the board of directors of TriQuint Semiconductor, a manufacturer of electronic components for the communications industry. He served as president, chief executive officer and chairman of the board of TriQuint Semiconductor from 1991 until July 2002. Prior to TriQuint Semiconductor, Mr. Sharp was associated with various venture capital and startup semiconductor firms. He helped start Crystal Semiconductor (now Cirrus Logic), Gazzelle Microelectronics (now TriQuint) and MegTest (now Teledyne). He also founded Silicon Architects (now Synopsys). Mr. Sharp also serves on the board of directors of several private companies and charitable organizations.

Item 2. Properties.

In October 2003, we purchased our main executive, administrative, manufacturing and technical offices for approximately $30.0 million. These offices are located in San Jose, California in an 118,000 square foot facility.

Item 3. Legal Proceedings.

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 and its U.S. subsidiary. The complaint alleges that certain integrated 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.

On October 20, 2004, we 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 complaint alleges that Fairchild produces certain integrated circuits, which infringed and continue to infringe certain of our patents. We seek, among other things, an order enjoining Fairchild from infringing our patents and an award for damages resulting from the alleged infringement.

There can be no assurance that we will prevail in our litigation with either System General or Fairchild. This litigation, whether or not determined in our favor or settled by us, will be costly and will 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 its technology, any of which could have a material adverse effect on our business, financial condition and operating results.

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Item 4. Submission of Matters to a Vote of Security Holders.

None.

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PART II

Item 5. Market for Power Integrations Common Equity, Related Stockholder Matters, and Power Integrations Purchases of Equity Securities.

Our common stock trades on the Nasdaq National Market under the symbol “POWI.” As of February 28, 2005, there were approximately 92 stockholders of record. Because brokers and other institutions on behalf of stockholders hold many of such shares, we are unable to estimate the total number of stockholders represented by these record holders. The following table sets forth, for the quarter indicated, the range of daily closing prices per share of our common stock as reported on the Nasdaq National Market:

We have not paid any cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future.

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. In addition, the board of directors authorized that the repurchases be made pursuant to Rule 10b5-1 of the Exchange Act. As of December 31, 2004 we have purchased 590,000 shares for an aggregate amount of $11.8 million. The Company purchased an additional 850,000 shares subsequent to December 31, 2004 through February 28, 2005 for an aggregate amount of $15.5 million. The repurchase program may be suspended or discontinued at any time.

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Item 6. Selected Financial Data.

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Operating Results.

This report includes a number of forward-looking statements. The use of such words and phrases as “will”, “expect”, “believe”, “should”, “anticipate”, “outlook”, “if”, “future” and similar words and phrases identify forward looking statements. Such statements reflect our current views with respect to future events and our potential financial performance and are subject to risks and uncertainties that could cause our actual results and financial position to differ materially from what we say in this report. These factors include, but are not limited to, our ability to maintain and establish strategic relationships; the risks inherent in the development and delivery of complex technologies; our ability to attract, retain and motivate qualified personnel; the emergence of new markets for our products and services, and our ability to compete in those markets based on timeliness, cost and market demand; and our limited financial resources. We make these forward looking statements based upon information available on the date hereof, and we have no obligation (and expressly disclaim any such obligation) to update or alter any forward looking statements, whether as a result of new information or otherwise. We more fully discuss these and other risk factors in “Item 7—Management’s Discussion and Analysis of Financial Condition and Operating Results— Factors That May Affect Future Results of Operations” and elsewhere in this report.

Overview

We design, develop, manufacture and market proprietary, high-voltage, analog ICs for use primarily in electronic power supplies, also known as switched-mode power supplies or switchers. 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, that are more energy-efficient and have increased functionality, and by continuing to focus on cost reduction strategies to remain price competitive. Our net revenues were $136.6 million, $125.7 million and $108.2 million in 2004, 2003 and 2002, respectively. Our business is characterized by short-term orders and short customer lead times. Customers typically 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.

Total operating expenses in 2004, 2003 and 2002 were $39.5 million, $38.8 million and $35.4 million, respectively. For 2005, we expect our operating expenses to increase significantly due to the implementation of SFAS No. 123R (as described below in Recently Issues Accounting Pronouncements) beginning in the third quarter of 2005, the legal costs associated with our patent infringement lawsuits against System General and Fairchild (as described in Part I, Item 3, Legal Proceedings), and the addition of resources to research and development, and sales and marketing.

Our quarterly and annual 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 Matsushita in return for the foundry relationship, license fees and product royalty arrangements. License fees and royalties consist of royalties on products shipped by Matsushita incorporating licensed technology, and have accounted for a small percentage of our net revenues. We expect this trend to continue in 2005.

A portion of our cost of revenues consists of the cost of wafers. 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. Our agreement to purchase wafers from ZMD is denominated in U.S. dollars. We began purchasing wafers from ZMD at the end of 2004.

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Critical Accounting Policies and Estimates

Our critical accounting policies are as follows:

Our critical accounting policies are both important to the portrayal of our financial condition and results of operations, 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. For more information regarding our accounting policies, see note 2 in the notes to the consolidated financial statements.

The preparation of financial statements and related disclosures 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 distributor pricing credits, bad debts and inventories. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.

Revenue recognition

Product revenues consist of sales to OEMs, merchant power supply manufacturers and distributors. Shipping terms to international 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. Prior to 2004, title to our products passed to the customer upon shipment from our facilities (FOB-point of origin) and as such revenue was recognized upon shipment for all OEMs and merchant power supply manufacturers. Sales to North American OEMs and merchant power supply manufacturers are still recognized upon shipment, as this is when the title is passed to the customer.

Historically, approximately 50% to 60 % of our total sales have been made to distributors pursuant to agreements that allow certain rights of return and protection against subsequent price declines on our products held by these distributors. As a result, we defer the recognition of revenue and the costs of revenues derived from sales to distributors until such distributors resell our products to their customers. We determine the amounts to defer based on the level of actual inventory on hand at our distributors as well as inventory that is in transit to them. The gross profit that is deferred as a result of this policy is reflected as “deferred income on sales to distributors” in the accompanying consolidated balance sheet.

Estimating sales returns and allowances

Net revenue consists of product revenue reduced by estimated sales returns and allowances. To estimate sales returns and allowances, we analyze, both when we initially establish the reserve, and then each quarter when we review the adequacy of the reserve, the following factors: historical returns, current economic trends, levels of inventories of our products held by our customers, and changes in customer demand and acceptance of our products. This reserve represents a reserve of the gross margin on estimated future returns and is reflected as a reduction to accounts receivable in the accompanying consolidated balance sheet. Increases to the reserve are recorded as a reduction to net revenue equal to the expected customer credit memo and a corresponding credit is made to cost of sales equal to the estimated cost of the returned product. The net difference, or gross margin, is recorded as an addition to the reserve. Because the reserve for sales returns and allowances is based on our

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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 future net revenues could be adversely affected.

Estimating distributor pricing credits

Historically, approximately 50% to 60% of our total sales have been made to distributors. Frequently, distributors need a cost lower than the standard distribution price to win business. In these circumstances, the distributor submits a request to us for a lower “sell-in” price on a specific end-customer transaction or a series of transactions. After the distributor ships product to its customer under an approved transaction, the distributor submits a “ship & debit” claim to us to adjust its cost from the standard price to the approved lower price. After verification by us, a credit memo is issued to the distributor to adjust the sell-in price from the standard distribution price to the approved lower price. We maintain a reserve for these credits that appears as a reduction to accounts receivable in our accompanying consolidated balance sheet. Any increase in the reserve results in a corresponding reduction in our net revenues. To establish the adequacy of our reserves, we analyze historical ship and debit amounts and levels of inventory in the distributor channels. If our reserves are not adequate, our net revenues could be adversely affected.

From time to time we will reduce the distribution list price, as a result, we give our distributors protection against price declines, in the form of credits, on products they hold. The credits are referred to as “Price Protection.” Since we do not recognize revenue until the distributor sells the product to its customers, we generally do not need to provide reserves for price protection. However, in rare instances we must consider price protection in the analysis of reserve requirements, as there may be a timing gap between a price decline and the issuance of price protection credits. If a price protection reserve is required, we will maintain a reserve for these credits that appears as a reduction to accounts receivable in our accompanying consolidated balance sheet. Any increase in the reserve results in a corresponding reduction in our net revenues. We analyze distribution price declines and levels of inventory in the distributor channels. If our reserves are not adequate, our net revenues could be adversely affected.

Estimating allowance for doubtful accounts

We maintain an allowance for losses we may incur as a result of our customers’ inability to make required payments. Any increase in the allowance results in a corresponding increase in our general and administrative expenses. In establishing this allowance, and then evaluating the adequacy of the allowance for doubtful accounts each quarter, we analyze historical bad debts, 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 deteriorates, 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 sheet, 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 December 31, 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

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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, a valuation allowance would be recorded 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.

Results of Operations

The following table sets forth certain operating data in dollars, as a percentage of total net revenues and increase (decrease) over prior periods for the periods indicated.

Comparison of Years Ended December 31, 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 Matsushita. Net revenues increased 8.7% to $136.6 million in 2004 compared to $125.7 million in 2003. Net revenues from product sales represented $134.3 million and $123.9 million of net revenues in 2004 and 2003, respectively. Our consumer-related revenue grew approximately 25% over 2003 and accounted for approximately 33% of our net revenue in 2004. The growth was driven primarily by an increase in sales of our products incorporated into DVD players, set-top boxes, and home appliances of approximately 50%, 30%, and 25% respectively. In 2004, revenues from our industrial market grew approximately 20%, and accounted for approximately 8% of our net. This revenue increase was a result of strong growth across a variety of applications, including metering and control applications. Revenues derived from the computer market grew approximately 6% from 2003. The total revenue increase was partially offset by lower revenues from the communications market, which is dominated by cell phones. Communications revenues declined approximately 6% compared to 2003, driven by a number of factors including weakness in the cell phone market in China, the loss of a portion of Samsung’s charger business in late 2003 to a competing part that we believe infringes on our patents, and price declines due to competition, and the increasing use of lower-power chargers, which require lower priced ICs.

Our product revenue mix for 2004 in the end markets that we serve was approximately 33% in the consumer category, 31% in the communications category, 22% in the computer category, 8% in the industrial electronics category and 6% in the other category. Revenue mix by product family in 2004 was approximately 54% from TinySwitch I and II, 28% from TOPSwitch FX and GX, 15% from TOPSwitch I and II, and 3% from Link Switch and DPA-Switch combined.

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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 we receive 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 $125.8 million in 2004 compared to $117.0 million in 2003, representing approximately 92% and 93% of net revenues in those respective periods. Although the power supplies using our products are designed and distributed worldwide, most of these power supplies are manufactured in Asia. As a result, sales to this region were 78% and 81% of our net revenues for 2004 and 2003, respectively. We expect international sales to continue to account for a large portion of our net revenues.

Direct sales for 2004 were divided 56% to distributors and 44% to OEMs, and merchant power supply manufacturers, compared to 61% to distributors and 39% to OEMs and merchant power supply manufacturers for 2003. In 2004, two customers, both of whom are distributors, each accounted for approximately 19% of net revenues. In 2003, the same two customers accounted for approximately 25% and 20% of net revenues.

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 various foundries 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 $65.2 million, or 47.7% of net revenues, in 2004, compared to $62.9 million, or 50.0% of net revenues, in 2003. The decline in gross margin was due primarily to higher wafer costs caused by the strengthening of the Japanese yen compared to the dollar. We expect our gross profit margin to remain relatively flat in the first half of 2005 compared with the full-year 2004, but if pricing pressures from our customers increase as a result of an economic slowdown or for other reasons, or if the Japanese yen continues to strengthen, our gross profit could be lower. In the second half of 2005, we expect our gross margin to decline as a result of the implementation of SFAS No. 123R in the third quarter.

Research and development expenses. Research and development expenses consist primarily of employee-related expenses, and expensed material and facility costs associated with the development of new processes and new products. We also expense prototype wafers and mask sets related to new products as research and development costs until new products are released to production. Research and development expenses were $16.2 million, or 11.8% of net revenues, in 2004, compared to $16.4 million, or 13.1% of net revenues, in 2003. In absolute dollars, research and development expense remained relatively flat from period to period. We expect research and development expenses to increase in 2005, primarily as a result of the implementation of SFAS No. 123R in the third quarter, but depending on our ability to sell our products in the current economic environment, such 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 and support offices. Sales and marketing expenses were $15.3 million, or 11.2% of net revenues, in 2004, compared to $15.5 million, or 12.3% of net revenues, in 2003. In absolute dollars, sales and marketing expenses for 2004 were relatively flat from 2003. We expect sales and marketing expenses to increase in 2005 due primarily to the implementation of SFAS No. 123R in the third quarter and an increase in sales headcount and related expenses, but depending on the general economic environment and subsequent demand for our products, sales and marketing expenses 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, professional services, legal and auditing expenses. General and administrative expenses were $8.1 million, or 5.9% of net revenues, in 2004, compared to $6.8 million, or 5.4% of net revenues, in 2003. The increase in absolute dollars in general and administrative expenses for 2004 was attributable primarily to increases in professional and legal services incurred. This increase includes a substantial increase in consulting and auditing expenses and other costs related to compliance activities resulting from the Sarbanes-Oxley Act of 2002, and in

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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 2005 due to the implementation of SFAS No. 123R in the third quarter, the legal expenses associated with our recently filed patent infringement claims against System General and Fairchild, and our ongoing efforts to comply with the requirements of the Sarbanes-Oxley Act. However, these expenses may fluctuate as a percentage of our net revenues depending on the sales levels we are able to achieve given current economic conditions.

Interest and other income, net. Interest and other income, net, was $1.1 million in 2004 and $1.0 million in 2003. The increase was due primarily to increases in cash and investments and slightly higher interest rates.

Provision for income taxes. Provision for income taxes for 2004 and 2003 represents Federal, state and foreign taxes. The provision for income taxes was $6.4 million for 2004 compared to $7.0 million for 2003. Our estimated effective tax rate used for 2004 was 28%, excluding a $1.1 million tax benefit we recognized in the third quarter. The estimated effective tax rate used for 2003 was also 28%. The difference between the Federal statutory rate of 35% and our effective tax rate used for 2004 of 24% is primarily due to the beneficial impact of lower income tax rates on international sales, research and development credits, 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, and Federal tax-exempt investments. We expect our effective tax rate to be approximately 26% in 2005. We believe the rate will decline over time if we are able to grow our international business.

Comparison of Years Ended December 31, 2003 and 2002

Net revenues. Net revenues increased 16.2% to $125.7 million in 2003 compared to $108.2 million in 2002. Net revenues from product sales represented $123.9 million and $106.8 million of net revenues in 2003 and 2002, respectively. Our non-cell phone-related revenues grew approximately 30% over 2002. Revenues from our consumer market grew approximately 40% and comprised approximately 28% of our net revenue. This growth was primarily driven by an increase of approximately 43% in revenues from sales of our products incorporated into DVD players, the nearly doubling of our revenue from sales of our products incorporated into set-top boxes, and an increase of approximately 37% in revenue from sales of our products incorporated into home appliances. Revenues from our computer market grew approximately 23% over 2002, and accounted for approximately 22% of our net revenues in 2003. Revenues derived from the industrial electronics market grew approximately 59% from 2002 to 2003. Revenues derived from the communications market, which was dominated by cell phones, were relatively flat from 2002 to 2003. Our revenue mix for 2003 in the end markets, which we served, was approximately 36% in the communications category, 28% in the consumer category, 22% in the computer category, 8% in the industrial electronics category and 6% in the other category. Revenue mix by product family in 2003 was approximately 51% from TinySwitch I and II, 27% from TOPSwitch FX and GX, 20% from TOPSwitch I and II, and 2% from Link Switch and DPA-Switch combined. Net revenues from royalties were $1.8 million in 2003 compared to $1.3 million in 2002.

International sales were $117.0 million in 2003 compared to $104.5 million in 2002, representing approximately 93% and 96% of net revenues in those respective periods. Sales to Asia were 81.1% and 83.1% of our net revenue for 2003 and 2002, respectively.

Direct sales for 2003 were divided 61% to distributors and 39% to OEMs, and merchant power supply manufacturers, compared to 53% to distributors and 47% to OEMs and merchant power supply manufacturers for 2002. In 2003, two customers, both of whom are distributors, accounted for approximately 25% and 20% of net revenues. In 2002, the same two customers accounted for approximately 22% and 15% of net revenues. Also in 2002, one other customer, an OEM, accounted for approximately 14% of net revenues.

Cost of revenues; Gross profit. Gross profit was $62.9 million, or 50.0% of net revenues, in 2003, compared to $47.5 million, or 43.9% of net revenues, in 2002. The improved gross margin was a result of our continued focus on reducing manufacturing costs. Cost improvements were primarily the result of improved yields and lower test costs.

Research and development expenses. Research and development expenses were $16.4 million, or 13.1% of net revenues, in 2003, compared to $14.7 million, or 13.6% of net revenues, in 2002. The increase in absolute dollars for 2003 was due primarily to increased salaries and other costs related to the hiring of additional engineering personnel.

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Sales and marketing expenses. Sales and marketing expenses, which includes applications engineering were $15.5 million, or 12.3% of net revenues, in 2003, compared to $14.5 million, or 13.4% of net revenues, in 2002. In absolute dollars, sales and marketing expenses for 2003 were slightly up from 2002, primarily as a result of expanding our worldwide sales and applications engineering staffs.

General and administrative expenses. General and administrative expenses were $6.8 million, or 5.4% of net revenues, in 2003, compared to $6.2 million, or 5.7% of net revenues, in 2002. The increase in absolute dollars in general and administration expenses for 2003 was attributable primarily to increases in professional and legal expenses.

Interest and other income, net. Interest and other income, net, was $1.0 million in 2003 and $1.7 million in 2002. Due primarily to lower interest rates in 2003, our interest income decreased even though our cash equivalents and short-term investments increased in 2003.

Provision for income taxes. Provision for income taxes for 2003 and 2002 represented Federal, state and foreign taxes. The provision for income taxes was $7.0 million for 2003 compared to $4.1 million for 2002. Our estimated effective tax rate used for 2003 was 28% and for 2002 was 30%. The difference between the statutory rate of 35% and our effective tax rate was due primarily to the favorable effects of research and development tax credits, international sales not subject to Federal taxation under the current laws and regulations, and apportionment of state taxes, net of the Federal benefit.

Selected Quarterly Results of Operations

The following tables set forth certain consolidated statements of income data for each of the quarters in the years ended December 31, 2004 and 2003 as well as the percentage of our net revenues represented by each item. This information has been derived from our unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements contained herein and include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of such information when read in conjunction with our annual audited consolidated financial statements and notes thereto appearing elsewhere in this report. The operating results for any quarter are not necessarily indicative of the results for any subsequent period or for the entire fiscal year.

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Net revenues increased in the first three quarters of 2003, and then remained relatively flat, or decreased, over the next five quarters. The decrease in net revenues in the last half of 2004 was due primarily to decreases in demand for our products, primarily in the communications end market. The decrease was partially offset by increased sales of our products in the consumer and industrial markets.

Our gross profit, as a percentage of net revenues, declined slightly over the first three quarters of 2003, and improved in the fourth quarter of 2003, due to a one-time benefit in the amount of approximately $360,000 resulting from the reversal of deferred rent due to the purchase of our San Jose facilities. In 2004, our gross profit fluctuated as a percentage of net revenues, declining during the first two quarters of 2004, and recovering slightly in the last two quarters. These fluctuations were due primarily to the benefit from our continued focus on manufacturing costs reductions, by improving our process technology, and through price reductions from our foundries, offset by increased pricing pressure from customers and the unfavorable currency fluctuation between the dollar and the Japanese yen.

Research and development expenses remained relatively flat in absolute dollars during the eight quarters presented. The decrease in the fourth quarter of 2003 was primarily from a one-time benefit in the amount of approximately $235,000 from the reversal of deferred rent due to the purchase of our San Jose facilities. The slight decrease in the fourth quarter of 2004 was due primarily to a reduction in engineering materials expense.

Sales and marketing expenses remained somewhat stable in absolute dollars during the eight quarters presented as we focused on controlling discretionary spending. In the fourth quarter of 2003, sales and marketing expenses received a one-time benefit in the amount of approximately $146,000 from the reversal of deferred rent due to the purchase of our San Jose facilities. In the third quarter of 2004 sales and marketing expenses declined slightly as a result of a decrease in accrued executive bonus and commission expenses.

General and administrative expenses generally increased over the eight quarters due primarily to increased use of outside professional services. The increase in absolute dollars in general and administration expenses for 2004 was attributable primarily to increases in professional and legal services incurred. This includes a substantial increase in consulting and auditing 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.

Interest and other income, declined in the second two quarters of 2003, due primarily to decreased interest rates. Interest income increased in the last two quarters of 2004 as our cash increased slightly and interest rates began to recover.

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Liquidity and Capital Resources

Since our initial public offering of common stock in December 1997, our principal source of funding has been cash from our operations.

As of December 31, 2004, we had approximately $122.3 million in cash, cash equivalents and short-term investments. In addition, under a revolving line of credit agreement with Union Bank of California, we can borrow up to $10.0 million. A portion of the credit line is used to cover advances for commercial letters of credit and standby letters of credit, which we provide to Matsushita and OKI prior to the shipment of wafers by those foundries to us. As of December 31, 2004, there were outstanding letters of credit totaling approximately $5.3 million. The balance of this credit line is unused and available. The line of credit agreement contains financial covenants with which we have remained in compliance, and requires that we maintain profitability on a quarterly basis and not pay or declare dividends without the bank’s prior consent. As of December 31, 2004, we had no outstanding capital equipment leases.

As of December 31, 2004, we had working capital, defined as current assets less current liabilities, of approximately $143.5 million, which was an increase of approximately $7.8 million over December 31, 2003. Our operating activities generated cash of $30.1 million and $20.4 million in the years ended December 31, 2004 and 2003, respectively. Cash generated in the year ended December 31, 2004 was principally the result of net income in the amount of $20.4 million, depreciation and amortization and tax benefits associated with employee stock option exercises, partially offset by an increase in inventories and accounts receivable. Cash generated in the year ended December 31, 2003 was principally the result of net income in the amount of $18.1 million, depreciation and amortization and tax benefits associated with employee stock option exercises, partially offset by an increase in inventories, accounts receivables and prepaid expenses.

Our investing activities were a net transfer from cash and cash equivalents to investments of $9.9 million for the year ended December 31, 2004, and were a net transfer from short-term investments to cash and cash equivalents of $26.8 million for the year ended December 31, 2003. We also purchased capital assets in the amount of $8.1 million and $37.8 million for the years ended December 31, 2004 and 2003, respectively. Capital asset purchases in 2003 included the purchase of our San Jose headquarters facilities in the amount of approximately $30.0 million. Our financing activities in 2004 consisted primarily of $11.8 million for the repurchase of 590,000 shares of our common stock, and receipts of $9.1 million from the issuance of common stock through the exercise of stock options and purchases through our employee stock purchase plan. In 2003 we had receipts from the issuance of common stock through the exercise of stock options and purchases through our employee stock purchase plan of $23.6 million.

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 board of directors authorized that the repurchases be made pursuant to Rule 10b5-1 of the Exchange Act. As of December 31, 2004, we had purchased approximately 590,000 shares for an aggregate amount of $11.8 million. The repurchase program may be suspended or discontinued at any time.

As of December 31, 2004, we had commitments through September 2008 for our operating lease totaling approximately $797,000. See note 4 in the notes to consolidated financial statements.

During 2004, a significant portion of our cash flow was generated by our operations. If our operating results deteriorate in 2005, as a result of decrease in customer demand or severe pricing pressures from our customers or our competitors, our ability to generate positive cash flow from operations may be jeopardized. In that case, we may be forced to use our cash, cash equivalents and short-term investments to fund our operations. We believe that cash generated from operations, together with existing sources of liquidity, will satisfy our projected working capital and other cash requirements for at least the next 12 months.

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Table of Contents

Index to Financial Statements

Contractual Obligations

As of December 31, 2004, we had the following contractual obligations and commitments:

(in thousands)