10-Q 1 powi-2014930x10qq3.htm 10-Q POWI-2014.9.30-10Q Q3
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 ____________________________________________________________________________
FORM 10-Q
 ____________________________________________________________________________
(Mark One)
x
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended September 30, 2014
or
o
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from ______  to  ______
Commission File Number 0-23441
 ____________________________________________________________________________
POWER INTEGRATIONS, INC.
(Exact name of registrant as specified in its charter)
 ____________________________________________________________________________
DELAWARE
 
94-3065014
(State or other jurisdiction of
Incorporation or organization)
 
(I.R.S. Employer
Identification No.)
5245 Hellyer Avenue, San Jose, California, 95138
(Address of principal executive offices) (Zip code)
(408) 414-9200
(Registrant’s telephone number, including area code)
 ____________________________________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange 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 o
Indicate by check mark whether the registrant submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  x   NO  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer  x
 
Accelerated filer  o
Non-accelerated filer    o 
(Do not check if  a smaller reporting company)
 
Smaller reporting company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  o    NO  x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Shares Outstanding at October 17, 2014
Common Stock, $.001 par value
29,525,131
 
 
 
 
 



POWER INTEGRATIONS, INC.
TABLE OF CONTENTS
 
 
 
Page
 
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 5.
 
 
 
Item 6.
 
 
 
 

2



Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q includes a number of forward-looking statements that involve many risks and uncertainties. Forward-looking statements are identified by the use of the words “would”, “could”, “will”, “may”, “expect”, “believe”, “should”, “anticipate”, “if”, “future”, “intend”, “plan”, “estimate”, “potential”, “targets”, “seek” or “continue” and similar words and phrases, including the negatives of these terms, or other variations of these terms, that denote future events. These 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 and adversely from what is projected or implied in any forward-looking statements included in this Form 10-Q. These factors include, but are not limited to, the risks described under Item 1A of Part II — “Risk Factors,” Item 2 of Part I — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q, including, but not limited to: our quarterly operating results are volatile and difficult to predict, and if we fail to meet the expectations of public market analysts or investors, the market price of our common stock may decrease significantly; if demand for our products declines in our major end markets, our net revenues will decrease; intense competition in the high-voltage power supply industry may lead to a decrease in our average selling price and reduced sales volume of our products; if we are unable to adequately protect or enforce our intellectual property rights, we could lose market share, incur costly litigation expenses, suffer incremental price erosion or lose valuable assets, any of which could harm our operations and negatively impact our profitability; if we do not prevail in our litigation, we will have expended significant financial resources, potentially without any benefit, and may also suffer the loss of rights to use some technologies; and our international sales activities account for a substantial portion of our net revenues, which subjects us to substantial risks. We make these forward-looking statements based upon information available on the date of this Form 10-Q, and we have no obligation (and expressly disclaim any obligation) to update or alter any forward-looking statements, whether as a result of new information or otherwise except as otherwise required by securities regulations.



3


PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
POWER INTEGRATIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands)
 
September 30,
 
December 31,
 
2014
 
2013
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
60,720

 
$
92,928

Short-term marketable securities
153,144

 
109,179

Accounts receivable, net of allowances of $195 and $120 in 2014 and 2013, respectively (Note 2)
10,381

 
12,389

Inventories
56,958

 
42,235

Deferred tax assets
2,103

 
2,059

Prepaid expenses and other current assets
8,773

 
18,632

Total current assets
292,079

 
277,422

PROPERTY AND EQUIPMENT, net
96,506

 
90,141

INTANGIBLE ASSETS, net
36,873

 
40,334

GOODWILL
80,599

 
80,599

DEFERRED TAX ASSETS (Note 9)
9,472

 
9,449

OTHER ASSETS
3,887

 
3,476

Total assets
$
519,416

 
$
501,421

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
24,777

 
$
20,772

Accrued payroll and related expenses
8,834

 
8,900

Taxes payable
2,753

 
2,266

Deferred tax liabilities
1,103

 
943

Deferred income on sales to distributors
18,744

 
15,727

Other accrued liabilities
2,224

 
1,810

Total current liabilities
58,435

 
50,418

LONG-TERM INCOME TAXES PAYABLE (Note 9)
2,722

 
6,885

DEFERRED TAX LIABILITIES
4,397

 
5,273

OTHER LIABILITIES
2,229

 
2,159

Total liabilities
67,783

 
64,735

COMMITMENTS AND CONTINGENCIES (Notes 9, 10, 11 and 12)

 

STOCKHOLDERS’ EQUITY:
 
 
 
Common stock
29

 
30

Additional paid-in capital
203,076

 
223,660

Accumulated other comprehensive loss
(474
)
 
(470
)
Retained earnings
249,002

 
213,466

Total stockholders’ equity
451,633

 
436,686

Total liabilities and stockholders’ equity
$
519,416

 
$
501,421

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

4


POWER INTEGRATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per share amounts)
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014

2013
 
2014
 
2013
NET REVENUES
$
90,144

 
$
91,715

 
$
262,202

 
$
256,677

COST OF REVENUES
41,092

 
42,941

 
118,437

 
121,832

GROSS PROFIT
49,052

 
48,774

 
143,765

 
134,845

 
 
 
 
 
 
 
 
OPERATING EXPENSES:

 
 
 
 
 
 
Research and development
13,458

 
12,984

 
41,314

 
38,745

Sales and marketing
11,564

 
11,212

 
35,906

 
33,357

General and administrative
7,155

 
7,984

 
22,614

 
23,784

Total operating expenses
32,177

 
32,180

 
99,834

 
95,886

INCOME FROM OPERATIONS
16,875

 
16,594

 
43,931

 
38,959

OTHER INCOME
 
 
 
 
 
 
 
Other income, net
381

 
82

 
836

 
864

Total other income
381

 
82

 
836

 
864

INCOME BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES
17,256

 
16,676

 
44,767

 
39,823

PROVISION FOR (BENEFIT FROM) INCOME TAXES
1,145

 
22

 
(423
)
 
(1,406
)
NET INCOME
$
16,111

 
$
16,654

 
$
45,190

 
$
41,229

 
 
 
 
 
 
 
 
EARNINGS PER SHARE:
 
 
 
 
 
 
 
Basic
$
0.54

 
$
0.56

 
$
1.50

 
$
1.41

Diluted
$
0.52

 
$
0.54

 
$
1.46

 
$
1.36

 
 
 
 
 
 
 
 
SHARES USED IN PER SHARE CALCULATION:
 
 
 
 
 
 
 
Basic
30,013

 
29,762

 
30,186

 
29,235

Diluted
30,757

 
30,652

 
31,053

 
30,237

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


5


POWER INTEGRATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(In thousands)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014

2013
 
2014
 
2013
Net income
$
16,111

 
$
16,654

 
$
45,190

 
$
41,229

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments, net of $0 tax in the three and nine months ended September 30, 2014 and 2013 (Note 2)
(53
)
 
118

 
(42
)
 
(46
)
Unrealized gain (loss) on marketable securities, net of $0 tax in the three and nine months ended September 30, 2014 and 2013 (Note 2)
(246
)
 
196

 
(7
)
 
(62
)
Amortization of defined benefit pension items, net of tax of $4 and $4 in the quarters ended September 30, 2014 and 2013, respectively, and $12 and $12 in the nine months ended September 30, 2014 and 2013, respectively (Note 2)
15

 
15

 
45

 
43

Total other comprehensive income (loss)
(284
)
 
329

 
(4
)
 
(65
)
Total comprehensive income
$
15,827

 
$
16,983

 
$
45,186

 
$
41,164

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


6


POWER INTEGRATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
Nine Months Ended
 
September 30,
 
2014
 
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
45,190

 
$
41,229

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
11,849

 
12,062

Amortization of intangibles
4,723

 
5,526

Loss on sale of property and equipment
170

 
17

Gain on sale of assets held for sale

 
(497
)
Stock-based compensation expense
10,670

 
12,155

Amortization of premium on marketable securities
1,296

 
472

Deferred income taxes
(782
)
 
(4,806
)
Provision for (reduction in) accounts receivable allowances
75

 
(127
)
Excess tax benefit from employee stock plans
(437
)
 

Tax benefit associated with employee stock plans
815

 

Change in operating assets and liabilities:
 
 
 
Accounts receivable
1,933

 
(7,648
)
Inventories
(14,639
)
 
4,359

Prepaid expenses and other assets
9,955

 
1,595

Accounts payable
2,509

 
2,952

Taxes payable and accrued liabilities
(3,257
)
 
2,608

Deferred income on sales to distributors
3,017

 
5,311

Net cash provided by operating activities
73,087

 
75,208

 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Purchases of property and equipment
(17,394
)
 
(11,250
)
Proceeds from sale of property and equipment

 
36

Proceeds from sale of assets held for sale

 
959

Other assets
(1,261
)
 

Purchases of marketable securities
(45,269
)
 
(96,271
)
Proceeds from maturities of marketable securities

 
25,450

Net cash used in investing activities
(63,924
)
 
(81,076
)
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Issuance of common stock under employee stock plans
13,104

 
27,638

Repurchase of common stock
(45,258
)
 

Payments of dividends to stockholders
(9,654
)
 
(7,046
)
Excess tax benefit from employee stock plans
437

 

Net cash (used in) provided by financing activities
(41,371
)
 
20,592

 
 
 
 
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
(32,208
)
 
14,724

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
92,928

 
63,394

CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
60,720

 
$
78,118

 
 
 
 
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Unpaid property and equipment
$
4,359

 
$
1,871

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
 
 
 
Cash refund for income taxes, net of payments
$
(3,707
)
 
$
(569
)

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


7


POWER INTEGRATIONS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1. BASIS OF PRESENTATION:

The condensed consolidated financial statements include the accounts of Power Integrations, Inc., a Delaware corporation (the “Company”), and its wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation.
    
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) that 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 in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). The results for interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated financial statements should be read in conjunction with the Power Integrations, Inc. consolidated financial statements and the notes thereto for the year ended December 31, 2013, included in its Form 10-K filed on February 13, 2014, with the Securities and Exchange Commission.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

No material changes have been made to the Company's significant accounting policies disclosed in Note 2, Summary of Significant Accounting Policies, in its Annual Report on Form 10-K, filed on February 13, 2014, for the year ended December 31, 2013. The accounting policy information below is to aid in the understanding of the financial information disclosed.

Cash and Cash Equivalents

The Company considers cash invested in highly liquid financial instruments with maturities of three months or less at the date of purchase to be cash equivalents.

Marketable Securities

The Company generally holds securities until maturity; however, they may be sold under certain circumstances including, but not limited to, when necessary for the funding of acquisitions and other strategic investments. As a result the Company classifies its investment portfolio as available-for-sale. The Company classifies all investments with an original maturity date greater than three months as short-term investments in its Condensed Consolidated Balance Sheets. As of September 30, 2014, and December 31, 2013, the Company's marketable securities consisted primarily of highly liquid corporate securities, commercial paper and other high-quality commercial securities.

Amortized cost and estimated fair market value of investments classified as available-for-sale at September 30, 2014, were as follows (in thousands):
 
Amortized
 
Gross Unrealized
 
Estimated Fair
 
 Cost
 
Gains
Losses
 
 Market Value
Investments due in less than 3 months:
 
 
 
 
 
 
       Corporate securities
$
6,000

 
$
3

$

 
$
6,003

       Total
$
6,000

 
$
3

$

 
$
6,003

 
 
 
 
 
 
 
Investments due in 4-12 months:
 
 
 
 
 
 
       Corporate securities
$
37,175

 
$
62

$

 
$
37,237

       Total
$
37,175

 
$
62

$

 
$
37,237

Investments due between 12 months and 5-years:
 
 
 
 
 
 
       Corporate securities
$
109,766

 
$
204

$
(66
)
 
$
109,904

       Total
$
109,766

 
$
204

$
(66
)
 
$
109,904

Total investment securities
$
152,941

 
$
269

$
(66
)
 
$
153,144



8

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

Amortized cost and estimated fair market value of investments classified as available-for-sale at December 31, 2013, were as follows (in thousands):    
 
Amortized
 
Gross Unrealized
 
Estimated Fair
 
 Cost
 
Gains
Losses
 
 Market Value
Investments due in less than 3 months:
 
 
 
 
 
 
       Commercial paper
$
3,098

 
$
1

$

 
$
3,099

       Total
$
3,098

 
$
1

$

 
$
3,099

 

 


 
 
Investments due in 4-12 months:

 


 
 
       Corporate securities
$
6,007

 
$
33

$

 
$
6,040

       Total
$
6,007

 
$
33

$

 
$
6,040

 

 


 
 
Investments due between 12 months and 5-years:

 


 
 
       Corporate securities
$
102,963

 
$
202

$
(26
)
 
$
103,139

       Total
$
102,963

 
$
202

$
(26
)
 
$
103,139

Total investment securities
$
112,068

 
$
236

$
(26
)
 
$
112,278

As of September 30, 2014, and December 31, 2013, the Company evaluated the nature of the investments with a loss position, which were primarily high-quality corporate securities, and determined the unrealized losses were not other-than-temporary.

Revenue Recognition

Product revenues consist of sales to original equipment manufacturers (“OEMs”), merchant power supply manufacturers and distributors. Approximately 76% of the Company's net product sales were made to distributors in the nine months ended September 30, 2014, and 75% in the twelve months ended December 31, 2013. The Company applies the provisions of Accounting Standard Codification (“ASC”) 605-10 (“ASC 605-10”) and all related appropriate guidance. Revenue is recognized when all of the following criteria have been met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectability is reasonably assured. Customer purchase orders are generally used to determine the existence of an arrangement. Delivery is considered to have occurred when title and risk of loss have transferred to the Company's customer. The Company evaluates whether the price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. With respect to collectability, the Company performs credit checks for new customers and performs ongoing evaluations of its existing customers' financial condition and requires letters of credit whenever deemed necessary.

Sales to international OEM customers and merchant power supply manufacturers that are shipped from the Company's facility in California are pursuant to “delivered at frontier” (“DAF”) shipping terms. 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 the product in that country. Sales to international OEMs and merchant power supply manufacturers for shipments from the Company's facility outside of the United States are pursuant to “EX Works” ("EXW") shipping terms, meaning that title to the product transfers to the customer upon shipment from the Company's foreign warehouse. Shipments to OEMs and merchant power supply manufacturers in the Americas are pursuant to “free on board” (“FOB”) point of origin shipping terms, meaning that title is passed to the customer upon shipment. Revenue is recognized upon title transfer for sales to OEMs and merchant power supply manufacturers, assuming all other criteria for revenue recognition are met.
    
Sales to most of the Company's distributors are made under terms allowing certain price adjustments and rights of return on the Company's products held by its distributors. As a result of these rights, the Company defers the recognition of revenue and the costs of revenues derived from sales to distributors until the Company's distributors report that they have sold the Company's products to their customers. The Company's recognition of such distributor revenue is based on point of sale reports received from the distributors, at which time the price is no longer subject to adjustment and is fixed, and the products are no longer subject to return to the Company except pursuant to warranty terms. 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 total deferred revenue as of September 30, 2014, and December 31, 2013, was approximately $30.7 million and

9

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

$25.5 million, respectively. The total deferred cost as of September 30, 2014, and December 31, 2013, was approximately $12.0 million and $9.8 million, respectively.

Frequently, distributors need to sell at a price lower than the standard distribution price in order to win business. At or soon after the distributor invoices its customer, the distributor submits a “ship and debit” price adjustment claim to the Company to adjust the distributor's cost from the standard price to the pre-approved lower price. After verification by the Company, a credit memo is issued to the distributor for the ship and debit claim. The Company maintains a reserve for unprocessed claims and future ship and debit price adjustments. The reserve appears as a reduction to accounts receivable in the Company's accompanying consolidated balance sheets. To the extent future ship and debit claims significantly exceed amounts estimated, there could be a material impact on the deferred revenue and deferred margin ultimately recognized. To evaluate the adequacy of its reserves, the Company analyzes historical ship and debit payments and levels of inventory in the distributor channels.

Sales to certain of the Company's distributors are made under terms that do not include rights of return or price concessions after the product is shipped to the distributor. Accordingly, product revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met.

Common Stock Repurchases and Cash Dividend

In October 2012, the Company's board of directors authorized the use of $50.0 million for the repurchase of the Company's common stock, with repurchases to be executed according to pre-defined price/volume guidelines. In May 2014, the board authorized the use of an additional $50.0 million for this purpose. In the three months ended September 30, 2014, the Company purchased 0.4 million shares for $19.5 million, and in the nine months ended September 30, 2014, the Company purchased 0.9 million shares for $45.3 million. As of September 30, 2014, the Company had $34.3 million remaining on its repurchase authorization; in October 2014, the board increased the Company's repurchase authorization by an additional $25.0 million. The Company did not purchase shares in the year ended December 31, 2013, as the price of the Company’s stock exceeded the maximum price set forth in the guidelines mentioned above. Authorization of future repurchase programs is at the discretion of the board of directors and will depend on the Company's financial condition, results of operations, capital requirements, business conditions and other factors.

In January 2013, the Company's board of directors declared quarterly cash dividend payments in the amount of $0.08 per share to be paid to stockholders of record at the end of each quarter in 2013. Dividend payouts totaling approximately $2.3 million each were paid on March 29, 2013 and June 28, 2013, and approximately $2.4 million was paid on each of September 30, 2013 and December 31, 2013.

In October 2013, the Company's board of directors declared four quarterly cash dividends in the amount of $0.10 per share to be paid to stockholders of record at the end of each quarter in 2014. Dividend payouts totaling approximately $3.0 million each were paid on March 31, 2014 and June 30, 2014. In April 2014, the Company's board of directors increased the quarterly dividends for the third and fourth quarters of 2014 to $0.12 per share. A dividend payout totaling approximately $3.6 million was paid on September 30, 2014. The declaration of any future cash dividend is at the discretion of the board of directors and will depend on the Company's financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination that cash dividends are in the best interests of the Company's stockholders.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP 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 ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, income tax, stock-based compensation and inventories. These estimates are based on historical facts and various other assumptions that the Company believes to be reasonable at the time the estimates are made. 

10

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

Components of the Company's Condensed Consolidated Balance Sheet    
Accounts Receivable (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Accounts receivable trade
$
43,618

 
$
42,410

Accrued ship and debit and rebate claims
(33,042
)
 
(29,901
)
Allowance for doubtful accounts
(195
)
 
(120
)
Total
$
10,381

 
$
12,389

Prepaid Expenses and Other Current Assets (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Prepaid legal fees
$
2,635

 
$
6,267

Prepaid income tax
837

 
7,521

Prepaid maintenance agreements
890

 
947

Interest receivable
764

 
519

Supplier prepayment
622

 
757

Other
3,025

 
2,621

Total
$
8,773

 
$
18,632

    
Changes in accumulated other comprehensive income (loss) for the three months ended September 30, 2014 and 2013 (in thousands):
 
Unrealized Gains and Losses on Available-for-Sale Securities
 
Defined Benefit Pension Items
 
Foreign Currency Items
 
Total
 
Three Months Ended
 
Three Months Ended
 
Three Months Ended
 
Three Months Ended
 
September 30,
 
September 30,
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
 
2014
 
2013
 
2014
 
2013
Beginning balance at July 1,
$
449

 
$
(120
)
 
$
(750
)
 
$
(532
)
 
$
111

 
$
(35
)
 
$
(190
)
 
$
(687
)
Other comprehensive income (loss) before reclassifications
(246
)
 
196

 

 

 
(53
)
 
118

 
(299
)
 
314

Amounts reclassified from accumulated other comprehensive income (loss)

 

 
15

(1
)
15

(1
)

 

 
15

 
15

Net-current period other comprehensive income (loss)
(246
)
 
196

 
15

 
15

 
(53
)
 
118

 
(284
)
 
329

Ending balance at September 30,
$
203

 
$
76

 
$
(735
)
 
$
(517
)
 
$
58

 
$
83

 
$
(474
)
 
$
(358
)
____________________________
(1) This component of accumulated other comprehensive income is included in the computation of net periodic pension cost for the three months ended September 30, 2014 and 2013.

    

11

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

Changes in accumulated other comprehensive income (loss) for the nine months ended September 30, 2014 and 2013 (in thousands):
 
Unrealized Gains and Losses on Available-for-Sale Securities
 
Defined Benefit Pension Items
 
Foreign Currency Items
 
Total
 
Nine Months Ended
 
Nine Months Ended
 
Nine Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
 
2014
 
2013
 
2014
 
2013
Beginning balance at December 31,
$
210

 
$
138

 
$
(780
)
 
$
(560
)
 
$
100

 
$
129

 
$
(470
)
 
$
(293
)
Other comprehensive income (loss) before reclassifications
(7
)
 
(62
)
 

 

 
(42
)
 
(46
)
 
(49
)
 
(108
)
Amounts reclassified from accumulated other comprehensive income (loss)

 

 
45

(1)
43

(1)

 

 
45

 
43

Net-current period other comprehensive income (loss)
(7
)
 
(62
)
 
45

 
43

 
(42
)
 
(46
)
 
(4
)
 
(65
)
Ending balance at September 30,
$
203

 
$
76

 
$
(735
)
 
$
(517
)
 
$
58

 
$
83

 
$
(474
)
 
$
(358
)
____________________________
(1) This component of accumulated other comprehensive income is included in the computation of net periodic pension cost for the nine months ended September 30, 2014 and 2013.

3. STOCK PLANS AND SHARE-BASED COMPENSATION:

Stock Plans

As of September 30, 2014, the Company had two stock-based compensation plans (the “Plans”) which are described below.

2007 Equity Incentive Plan

The 2007 Equity Incentive Plan (the "2007 Plan") was adopted by the board of directors on September 10, 2007, and approved by the stockholders on November 7, 2007, as an amendment and restatement of the 1997 Stock Option Plan (the "1997 Plan"). The 2007 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards ("RSUs"), stock appreciation rights, performance-based awards ("PSUs"), long-term performance based awards ("PRSUs") and other stock awards to employees, directors and consultants. As of September 30, 2014, the maximum remaining number of shares that may be issued under the 2007 Plan was 6,635,367 shares, which includes options granted but not exercised and awards granted but unvested and shares remaining available for issuance under the 1997 Plan, including shares subject to outstanding options and stock awards under the 1997 Plan. Pursuant to the 2007 Plan, the exercise price for incentive stock options and non-statutory stock options is generally at least 100% of the fair market value of the underlying shares on the date of grant. Options generally vest over 48 months measured from the date of grant. Options generally expire no later than ten years after the date of grant, subject to earlier termination upon an optionee's cessation of employment or service.  

Beginning January 27, 2009, grants pursuant to the Directors Equity Compensation Program (which was adopted by the board of directors on January 27, 2009) to non-employee directors have been made primarily under the 2007 Plan. The Directors Equity Compensation Program provides for grants to outside directors as follows: effective annually, upon the first trading day of July, each outside director receives a grant of an equity award with an aggregate value of $100,000, which will become exercisable or vest immediately prior to the Company's next annual meeting of stockholders, subject to the director's continued service. At each outside director's election, such award may consist entirely of RSUs or entirely of stock options. The quantity of options would be calculated by dividing $100,000 by the Black-Scholes value on the date of grant. The quantity of RSUs issued would be calculated by dividing $100,000 by the grant-date fair value. Further, on the date of election of a new outside director, such new director would receive such grant as continuing outside directors receive on the first trading day of July; provided, however, that such grant is prorated for the portion of the year that such new outside director will serve until the

12

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

next first trading day of July. The Directors Equity Compensation Program will remain in effect at the discretion of the board of directors or the compensation committee of the board.

On July 28, 2009, the 2007 Plan was amended generally to prohibit outstanding options or stock appreciation rights from being canceled in exchange for cash without stockholder approval.

1997 Employee Stock Purchase Plan

Under the 1997 Employee Stock Purchase Plan (the “Purchase Plan”), eligible employees may apply accumulated payroll deductions, which may not exceed 15% of an employee's compensation, to the purchase of shares of the Company's common stock at periodic intervals. The purchase price of stock under the Purchase Plan is equal to 85% of the lower of (i) the fair market value of the Company's common stock on the first day of each offering period, or (ii) the fair market value of the Company's common stock on the purchase date (as defined in the Purchase Plan). Each offering period consists of one purchase period of approximately six months' duration. An aggregate of 3,000,000 shares of common stock were reserved for issuance to employees under the Purchase Plan. As of September 30, 2014, 2,691,754 shares had been purchased and 308,246 shares were reserved for future issuance under the Purchase Plan.

Stock-Based Compensation

The Company applies the provisions of ASC 718-10. Under the provisions of ASC 718-10, the Company recognizes the fair value of stock-based compensation in financial statements over the requisite service period of the individual grants, which generally equals a four-year vesting period. The Company uses estimates of volatility, expected term, risk-free interest rate, dividend yield and forfeitures in determining the fair value of these awards and the amount of compensation expense to recognize. The Company uses the straight-line method to amortize all stock awards granted over the requisite service period of the award, and uses historical data to estimate pre-vesting forfeitures, recognizing expense only for those awards that are expected to vest.
 
Determining Fair Value of Stock Options

The Company uses the Black-Scholes valuation model for valuing stock option grants using the following assumptions and estimates:

Expected Volatility. The Company calculates expected volatility based on the historical price volatility of the Company's stock.

Expected Term. The Company utilizes a model which uses historical exercise, cancellation and outstanding option data to calculate the expected term of stock option grants.

Risk-Free Interest Rate. The Company bases the risk-free interest rate used in the Black-Scholes valuation model on the implied yield available on a U.S. Treasury note with a term approximately equal to the expected term of the underlying grants.

Dividend Yield. The dividend yield was calculated by dividing the annual dividend by the average closing price of the Company's common stock on a quarterly basis.
 

13

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

    
The following table summarizes the stock-based compensation expense recognized in accordance with ASC 718-10 for the three and nine months ended September 30, 2014, and September 30, 2013 (in thousands).
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014

2013
 
2014
 
2013
Cost of revenues
$
131

 
$
296

 
$
648

 
$
824

Research and development
971

 
1,485

 
3,522

 
4,231

Sales and marketing
779

 
964

 
2,578

 
2,588

General and administrative
699

 
1,446

 
3,922

 
4,512

Total stock-based compensation expense
$
2,580

 
$
4,191

 
$
10,670

 
$
12,155


Stock-based compensation expense in the three months ended September 30, 2014, was $2.6 million (comprising approximately $0.2 million related to stock options, a reduction to expense of $0.8 million related to performance shares that are not expected to vest in 2014 (see the performance-based awards section below for details), $2.8 million related to RSUs and $0.4 million related to the Purchase Plan). In the nine months ended September 30, 2014, stock compensation expense was $10.7 million (comprising approximately $1.0 million related to stock options, $0.4 million related to performance-based awards, $8.4 million related to RSUs and $0.9 million related to the Purchase Plan).

Stock-based compensation expense in the three months ended September 30, 2013, was $4.2 million (comprising approximately $0.6 million related to stock options, $0.8 million related to performance-based awards, $2.5 million related to RSUs and $0.3 million related to the Purchase Plan). In the nine months ended September 30, 2013, stock-based compensation was $12.2 million (comprising approximately $2.3 million related to stock options, $2.2 million related to performance-based awards, $6.8 million related to RSUs and $0.9 million related to the Purchase Plan).

The following table summarizes total compensation expense related to unvested awards not yet recognized, net of expected forfeitures, and the weighted-average period over which it is expected to be recognized as of September 30, 2014.
 
September 30, 2014
 
Unrecognized
Compensation
Expense for Unvested
Awards
 
Weighted Average
Remaining
Recognition
Period
 
(In thousands)
 
(In years)
Options
 
$
999

 
 
1.30
Performance-based awards
 
164

 
 
0.25
Long-term performance-based awards
 
1,076

 
 
2.25
Restricted stock units
 
22,349

 
 
2.51
Purchase plan
 
570

 
 
0.50
Total unrecognized compensation expense
 
$
25,158

 
 
 

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

Three Months Ended
Nine Months Ended
 
September 30,
September 30,
 
2014

2013
2014

2013
Risk-free interest rates
0.05%

0.08%
0.05% - 0.07%

0.08% - 0.11%
Expected volatility rates
48%

37%
30% - 48%

33% - 37%
Expected dividend yield
0.85%

0.62%
0.66% - 0.85%

0.62% - 0.80%
Expected term of purchase right (in years)
0.5

0.5
0.5

0.5
Weighted-average estimated fair value of purchase rights
$15.25

$13.87
$14.40

$11.01

The Company did not grant stock options in the three and nine months ended September 30, 2014 or September 30, 2013, and therefore no fair-value assumptions were reported.    

14

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


A summary of stock option activity under the Plans, excluding performance-based awards and restricted stock units, as of September 30, 2014, and changes during the nine months then ended, is presented below:
 
Shares
(in thousands)
 
Weighted-
Average
Exercise
Price
 
Weighted-Average
Remaining
Contractual
Term
(in years)
 
Aggregate
Intrinsic Value
(in thousands)
Outstanding at January 1, 2014
1,691

 
$27.34
 
 
 
 
Granted

 

 
 
 
 
Exercised
(308
)
 
$28.63
 
 
 
 
Forfeited or expired

 

 
 
 
 
Outstanding at September 30, 2014
1,383

 
$27.05
 
3.74
 
$
37,150

Exercisable at September 30, 2014
1,318

 
$26.36
 
3.56
 
$
36,309

Vested and expected to vest at September 30, 2014
1,381

 
$27.03
 
3.73
 
$
37,120


The Company did not grant stock options in the three and nine months ended September 30, 2014, and September 30, 2013. Beginning in 2010 the Company's equity grants to new hires and its annual incentive grants to non-executive employees have been primarily in the form of RSUs. The total intrinsic value of options exercised during the three months ended September 30, 2014 and 2013, was approximately $1.8 million and $14.0 million, respectively. The intrinsic value of options exercised during the nine months ended September 30, 2014 and 2013, was approximately $8.7 million and $24.2 million, respectively.

Performance-based Awards ("PSUs")

Under the performance-based awards program, the Company grants awards in the first half of the performance year in an amount equal to twice the target number of shares to be issued if the target performance metrics are met. The number of shares that are released at the end of the performance year can range from zero to 200% of the targeted number depending on the Company's performance. In 2014, the performance metrics of this program are annual targets consisting of net revenue and non-GAAP operating income. Each performance-based award granted from the 2007 Plan will reduce the number of shares available for issuance under the 2007 Plan by 2.0 shares.

During the nine months ended September 30, 2014, the Company granted approximately 83,000 annual performance-based awards. As the net revenue and non-GAAP operating earnings are considered performance conditions, expenses associated with these awards, net of estimated forfeitures, are recorded throughout the year depending on the number of shares expected to vest based on progress toward the performance targets. The cost of performance-based awards is determined using the fair value of the Company's common stock on the grant date, reduced by the discounted present value of dividends expected to be declared before the awards vest. If the performance conditions are not achieved, no compensation cost is recognized and any previously recognized compensation is reversed. During the quarter ended September 30, 2014, the Company lowered its estimate of the PSUs expected to vest based on projections for the remainder of the performance year, resulting in the reversal of $0.8 million of previously recognized expense.

In January 2014, it was determined that approximately 83,000 shares of the approximately 100,000 performance-based awards granted in 2013, less forfeitures, vested in aggregate. The 2013 performance metrics consisted of revenue, non-GAAP operating income and strategic goals for such awards. Accordingly, 83,000 performance-based awards were released to the Company's employees and executives in the first quarter of 2014.


15

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

A summary of performance-based awards outstanding as of September 30, 2014, and activity during the nine months then ended, is presented below:
 
Shares
(in thousands)
 
Weighted- Average Grant Date Fair Value Per Share
 
Weighted-Average Remaining Contractual Term
(in years)
 
Aggregate Intrinsic Value
(in thousands)
Outstanding at January 1, 2014
100

 
$38.48
 
 
 
 
Granted
83

 
$53.93
 
 
 
 
Vested
(83
)
 
$38.48
 
 
 
 
Change in units due to performance achievement for PSUs vested in the year
(17
)
 
$38.48
 
 
 
 
Forfeited or expired

 

 
 
 
 
Outstanding at September 30, 2014
83

 
$53.93
 
0.25
 
$
4,501

Outstanding and expected to vest at September 30, 2014
5

 
 
 
0.25
 
$
270

    
The weighted-average grant-date fair value per share of performance-based awards granted in the nine months ended September 30, 2014 and 2013, was approximately $53.93 and $38.62, respectively (there were no PSUs granted in the three months ended September 30, 2014 and 2013). The grant-date fair value of awards released, which were fully vested, in the nine months ended September 30, 2014 and 2013, was approximately $3.2 million and $2.0 million, respectively. No awards were released in the three months ended September 30, 2014 and 2013.

Long-Term Performance-based Awards ("PRSUs")

            In the first quarter of 2014 the Company began granting long-term performance-based awards. The Company's PRSU program provides for the issuance of PRSUs which will vest based on Company performance measured against the 2014 PRSU Plan's established 2016 revenue target. The PRSUs were granted in an amount equal to twice the target number of shares to be issued if the target performance metric is met. The actual number of shares the recipient receives is determined at the end of a three-year performance period based on results achieved versus the Company's performance goal, and may range from zero to 200% of the targeted number. The performance goal for PRSUs granted in fiscal 2014 was based on the Company's adjusted annual revenue growth. Each long-term performance-based award granted from the 2007 Plan will reduce the number of shares available for issuance under the 2007 Plan by two shares.

            Recipients of a PRSU award generally must remain employed by the Company on a continuous basis through the end of the applicable three-year performance period in order to receive shares subject to that award. Expenses associated with these awards, net of estimated forfeitures, are recorded throughout the year depending on the number of shares expected to vest based on progress toward the performance target. The cost of long-term performance-based awards is determined using the fair value of the Company's common stock on the grant date, reduced by the discounted present value of dividends expected to be declared before the awards vest. If the performance conditions are not achieved, no compensation cost is recognized and any previously recognized compensation is reversed.

A summary of long-term performance-based awards outstanding as of September 30, 2014, and activity during the nine months then ended, is presented below:
 
Shares
(in thousands)
 
Weighted- Average Grant Date Fair Value Per Share
 
Weighted-Average Remaining Contractual Term
(in years)
 
Aggregate Intrinsic Value
(in thousands)
Outstanding at January 1, 2014

 

 
 
 
 
Granted
56

 
$56.15
 
 
 
 
Vested

 

 
 
 
 
Forfeited or expired

 

 
 
 
 
Outstanding at September 30, 2014
56

 
$56.15
 
2.25
 
$
3,014

Outstanding and expected to vest at September 30, 2014
49

 
 
 
2.25
 
$
2,653


16

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


The weighted-average grant-date fair value per share of long-term performance-based awards granted in the nine months ended September 30, 2014, was approximately $56.15 (there were no PRSUs granted in the three months ended September 30, 2014, or in the year ended December 31, 2013).

Restricted Stock Units (RSUs)

The Company grants restricted stock units to employees under the 2007 Plan. RSUs granted to employees typically vest ratably over a four-year period, and are converted into shares of the Company's common stock upon vesting on a one-for-one basis subject to the employee's continued service with the Company over that period. The fair value of RSUs is determined using the fair value of the Company's common stock on the date of the grant, reduced by the discounted present value of dividends expected to be declared before the awards vest. Compensation expense is recognized on a straight-line basis over the requisite service period of each grant adjusted for estimated forfeitures. Each RSU award granted from the 2007 plan will reduce the number of shares available for issuance under the 2007 Plan by 2.0 shares.
A summary of RSUs outstanding as of September 30, 2014, and changes during the nine months then ended, are as follows: 
 
Shares
(in thousands)
 
Weighted- Average Grant Date Fair Value Per Share
 
Weighted-Average Remaining Contractual Term
(in years)
 
Aggregate Intrinsic Value
(in thousands)
Outstanding at January 1, 2014
714

 
$38.97
 
 
 
 
Granted
262

 
$51.30
 
 
 
 
Vested
(259
)
 
$38.54
 
 
 
 
Forfeited or expired
(19
)
 
$42.02
 
 
 
 
Outstanding at September 30, 2014
698

 
$43.67
 
1.51
 
$
37,633

Outstanding and expected to vest at September 30, 2014
642

 
 
 
1.45
 
$
34,598


The weighted-average grant-date fair value per share of RSUs awarded in the three and nine months ended September 30, 2014, was approximately $58.03 and $51.30, respectively, and the grant-date fair value per share of RSUs awarded in the three and nine months ended September 30, 2013, was approximately $43.18 and $38.52, respectively. The grant-date fair value of RSUs vested in the three and nine months ended September 30, 2014, was approximately $0.5 million and $10.0 million, respectively, and the grant-date fair value of RSUs vested in the three and nine months ended September 30, 2013, was approximately $0.3 million and $7.1 million, respectively.

4. FAIR VALUE MEASUREMENTS:
ASC 820-10, Fair Value Measurements, clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, ASC 820-10 establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices for identical assets in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.
The Company's cash and investment instruments are classified within Level 1 or Level 2 of the fair-value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The type of instrument valued based on quoted market prices in active markets primarily includes money market securities. This type of instrument is generally classified within Level 1 of the fair-value hierarchy. The types of instruments valued based on other observable inputs (Level 2 of the fair-value hierarchy) include investment-grade corporate bonds and government, state, municipal and provincial obligations. Such types of investments are valued by using a multi-

17

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

dimensional relational model, the inputs are primarily benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including market research publications. The Company principally holds securities until maturity; however, they may be sold under certain circumstances, including, but not limited to, the funding of acquisitions and other strategic investments. As a result the Company classified its investment portfolio as available-for-sale. The Company's investments classified as Level 1 and Level 2 are available-for-sale investments, and were recorded at fair market value.
The fair-value hierarchy of the Company's marketable securities at September 30, 2014, and December 31, 2013, was as follows (in thousands):
 
Fair Value Measurement at
 
 
September 30, 2014
 
Description
September 30, 2014
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Money market funds
$
18,199

 
$
18,199

 
$

 
Corporate securities
153,144

 

 
153,144

 
     Total
$
171,343

 
$
18,199

 
$
153,144

 

 
Fair Value Measurement at
 
 
December 31, 2013
 
Description
December 31, 2013
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Commercial paper
$
3,099

 
$

 
$
3,099

 
Money market funds
17,492

 
17,492

 

 
Corporate securities
109,179

 

 
109,179

 
     Total
$
129,770

 
$
17,492

 
$
112,278

 

The Company did not transfer any investments between Level 1 and Level 2 of the fair-value hierarchy in the nine months ended September 30, 2014, and the twelve months ended December 31, 2013.

5. INVENTORIES:

Inventories (which consist of costs associated with the purchases of wafers from domestic and offshore foundries and of packaged components from offshore assembly manufacturers, as well as internal labor and overhead associated with the testing of both wafers and packaged components) are stated at the lower of cost (first-in, first-out) or market. Provisions, when required, are made to reduce excess and obsolete inventories to their estimated net realizable values. Inventories consist of the following (in thousands):
 
September 30,
2014
 
December 31,
2013
Raw materials
$
16,657

 
$
8,221

Work-in-process
11,777

 
13,216

Finished goods
28,524

 
20,798

Total
$
56,958

 
$
42,235


6. GOODWILL AND INTANGIBLE ASSETS:

There were no changes in the carrying amount of goodwill during the nine months ended September 30, 2014.


18

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

Intangible assets consist primarily of developed technology, acquired licenses, customer relationships, trade name, in-process research and development and patent rights, and are reported net of accumulated amortization. The Company amortizes the cost of all intangible assets over the shorter of the estimated useful life or the term of the developed technology, acquired licenses, customer relationships, trade name and patent rights, which range from two to 12 years, with the exception of $4.7 million of in-process research and development and $1.3 million for the purchase of an internet domain name. In-process research and development is assessed for impairment until the development is completed and products are available for sale, at which time the Company will begin to amortize the in-process research and development. The Company does not expect the amortization of in-process research and development to begin in 2014. The Company acquired the rights to the internet domain name www.power.com, which will become the Company's primary domain name; the cost to acquire the domain name has been recorded as an intangible asset and will not be amortized as it has an indefinite useful life. Amortization for acquired intangible assets was approximately $1.3 million and $1.8 million in the three months ended September 30, 2014 and 2013, respectively, and $4.7 million and $5.5 million in the nine months ended September 30, 2014 and 2013, respectively. The Company does not believe there is any significant residual value associated with the following intangible assets:
 
September 30, 2014
 
December 31, 2013
 
Gross
 
Accumulated
Amortization
 
Net
 
Gross
 
Accumulated
Amortization
 
Net
 
(in thousands)
Domain name
$
1,261

 
$

 
$
1,261

 
$

 
$

 
$

In-process research and development
4,690

 

 
4,690

 
4,690

 

 
4,690

Technology licenses
3,000

 
(2,550
)
 
450

 
3,000

 
(2,325
)
 
675

Patent rights
1,949

 
(1,949
)
 

 
1,949

 
(1,949
)
 

Developed technology
26,670

 
(7,182
)
 
19,488

 
26,670

 
(5,247
)
 
21,423

Customer relationships
17,610

 
(6,626
)
 
10,984

 
17,610

 
(4,664
)
 
12,946

Trade name
3,600

 
(3,600
)
 

 
3,600

 
(3,000
)
 
600

Total intangible assets
$
58,780

 
$
(21,907
)
 
$
36,873

 
$
57,519

 
$
(17,185
)
 
$
40,334


The estimated future amortization expense related to definite-lived intangible assets at September 30, 2014, is as follows:
Fiscal Year
Estimated
Amortization
(in  thousands)
2014
(remaining 3 months)
$
1,350

2015
 
5,009

2016
 
4,394

2017
 
3,994

2018
 
3,746

Thereafter
12,429

Total (1)
$
30,922

_______________
(1)
The total above excludes $4.7 million of in-process research and development that will be amortized upon completion of development over the estimated useful life of the technology.

7. SIGNIFICANT CUSTOMERS AND INTERNATIONAL SALES:

Segment Reporting

The Company is organized and operates as one reportable segment, the design, development, manufacture and marketing of integrated circuits and related components for use primarily in the high-voltage power-conversion market. The Company's chief operating decision maker, the Chief Executive Officer, reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance.

19

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

Customer Concentration

Ten customers accounted for approximately 59% of net revenues for both the three and nine months ended September 30, 2014, and 60% and 58% in the same periods of 2013, respectively. A significant portion of these revenues are attributable to sales of the Company’s products to distributors of electronic components. These distributors sell the Company’s products to a broad, diverse range of end users, including OEMs and merchant power supply manufacturers.

One customer, a distributor of the Company's products, accounted for more than 10% of the Company's net revenues in the three and nine months ended September 30, 2014 and 2013. The following table discloses that customer's percentage of revenues for the respective periods:
        
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
Customer
2014
 
2013
 
2014
 
2013
Avnet
19
%
 
19
%
 
20
%
 
19
%

No other customers accounted for 10% or more of the Company's net revenues in the periods mentioned.

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 evaluations of its customers' financial conditions 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 write-offs 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, 2014, and December 31, 2013, 67% and 71%, respectively, of accounts receivable were concentrated with the Company's top 10 customers.
The following customers represented 10% or more of accounts receivable:
        
Customer
September 30,
2014
 
December 31,
2013
Avnet
18
%
 
21
%
ATM Electronic Corporation
17
%
 
17
%

The above-mentioned customers are distributors of the Company’s products. No other customers accounted for 10% or more of the Company’s accounts receivable on these dates.
 
International Sales

The Company markets its products globally through its sales personnel and a worldwide network of independent sales representatives and distributors. As a percentage of total net revenues, international sales, which consist of sales to distributors and direct customers outside of the United States of America, comprise the following:     

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

    

Three Months  Ended

Nine Months Ended
 
September 30,

September 30,
 
2014

2013

2014

2013
Hong Kong/China
47
%

47
%

46
%
 
46
%
Taiwan
16
%

16
%

16
%
 
15
%
Korea
11
%

11
%

11
%
 
12
%
Western Europe (excluding Germany)
11
%

11
%

11
%
 
11
%
Japan
5
%

4
%

5
%
 
5
%
Singapore
1
%

2
%

1
%
 
2
%
Germany
2
%

2
%

2
%
 
2
%
Other
3
%

2
%

3
%
 
2
%
Total foreign revenue
96
%

95
%

95
%
 
95
%
    
The remainder of the Company’s sales is to customers within the United States of America.

Product Sales
    
Net revenues consist primarily of sales of the Company's high-voltage integrated-circuit products, IGBT drivers and high-voltage silicon diodes. When evaluating the Company's net revenues, the Company categorizes its sales into the following four end-market groupings: communications, computer, consumer and industrial. The table below provides the percentage of net sales activity by end market for the three and nine months ended September 30, 2014 and 2013:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
End Market
2014
 
2013
 
2014
 
2013
Communications
18
%
 
21
%
 
17
%
 
21
%
Computer
11
%
 
10
%
 
11
%
 
10
%
Consumer
36
%
 
34
%
 
37
%
 
35
%
Industrial
35
%
 
35
%
 
35
%
 
34
%

8. EARNINGS PER SHARE:

 Basic earnings per share are calculated by dividing net income by the weighted-average shares of common stock outstanding during the period. Diluted earnings per share are calculated by dividing net income by the weighted-average shares of common stock and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares included in this calculation consist of dilutive shares issuable upon the assumed exercise of outstanding common stock options, the assumed vesting of outstanding restricted stock units and both short- and long-term performance-based awards, and the assumed issuance of awards under the stock purchase plan, as computed using the treasury stock method.

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


A summary of the earnings per share calculation is as follows (in thousands, except per share amounts):        
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
16,111

 
$
16,654

 
$
45,190

 
$
41,229

Weighted-average common shares
30,013

 
29,762

 
30,186

 
29,235

Basic earnings per share
$
0.54

 
$
0.56

 
$
1.50

 
$
1.41

Diluted earnings per share (1):
 
 
 
 
 
 
 
Net income
$
16,111

 
$
16,654

 
$
45,190

 
$
41,229

Weighted-average common shares
30,013

 
29,762

 
30,186

 
29,235

Effect of dilutive securities:

 

 

 

Employee stock plans
744

 
890

 
867

 
1,002

Diluted weighted-average common shares
30,757

 
30,652

 
31,053

 
30,237

Diluted earnings per share
$
0.52

 
$
0.54

 
$
1.46

 
$
1.36

_______________ 
(1)
The Company includes the shares underlying performance-based awards in the calculation of diluted earnings per share if the performance conditions have been satisfied as of the end of the reporting period and excludes such shares when the necessary conditions have not been met. The Company has excluded the shares underlying the 2014 and 2013 awards in the 2014 and 2013 calculations, respectively, as those shares were not contingently issuable as of the end of the period. 

In the three and nine months ended September 30, 2014, all shares were included in the computation of diluted earnings per share as none were determined to be anti-dilutive, and in the three and nine months ended September 30, 2013, 35,000 shares and 149,000 shares, respectively, were not included in the computation of diluted earnings per share for the periods then ended because they were determined to be anti-dilutive.

9. PROVISION FOR INCOME TAXES:

Income-tax expense includes a provision for federal, state and foreign taxes based on the annual estimated effective tax rate applicable to the Company and its subsidiaries, adjusted for certain discrete items which are fully recognized in the period they occur.
In the quarter ended June 30, 2014, the Company reached a settlement with the IRS to close out the examination of the Company's federal income-tax returns for the years 2007 through 2009. As a result, the Company adjusted its tax balances based on the settlement's facts, circumstances, and information available at the reporting date.

The provision for income tax for the nine months ended September 30, 2014, includes, in the second quarter of 2014, a one-time benefit of $3.3 million comprising $2.8 million in federal income taxes and interest, and state income taxes of approximately $0.5 million. The one-time benefit includes the reversal of $4.1 million of related unrecognized tax benefits that had been recorded as non-current liabilities in the Company's consolidated balance sheets. The Company has now concluded all U.S. federal income-tax matters for the years through 2009.

The Company's effective tax rates for the three and nine month periods ended September 30, 2014, were 6.6% and (0.9)% respectively, compared with 0.1% and (3.5)% for the corresponding periods in 2013. The difference between the expected statutory rate of 35% and the Company's effective tax rate for the three months ended September 30, 2014, was due primarily to the beneficial impact of the geographic distribution of the Company's world-wide earnings. The difference between the expected statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2014, was due primarily to the beneficial impact of the geographic distribution of the Company's world-wide earnings and the above-mentioned settlement with the IRS. The difference between the expected statutory rate of 35% and the Company's

22

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

effective tax rate for the three months ended September 30, 2013, was primarily due to the beneficial impact of the geographic distribution of the Company's world-wide earnings. The difference between the expected statutory rate of 35% and the Company's effective tax rate for the nine months ended September 30, 2013, was primarily due to the beneficial impact of the geographic distribution of the Company's world-wide earnings and passage of the American Tax Relief Act of 2012 signed into law on January 2, 2013. The prior year impact of the 2012 Federal research and development tax credit benefit was recorded in the quarter ended March 31, 2013.

The Company accounts for income taxes under the provisions of ASC 740. Under the provisions of ASC 740, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, utilizing the tax rates that are expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities and projected future taxable income. In the event that the Company determines, based on available evidence and management judgment, that all or part of the net deferred tax assets will not be realized in the future, the Company would record a valuation allowance in the period the 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 the Company's expectations could have a material impact on its results of operations and financial position.

As of September 30, 2014, the Company recorded a full valuation allowance on its California and New Jersey deferred tax assets as the Company does not believe that it is more likely than not that the deferred tax assets will be fully realized. The Company also maintains a valuation allowance on capital losses for federal purposes and a valuation allowance with respect to certain of its deferred tax assets relating to tax credits in Canada.
 
The royalty arrangement between the Company and its foreign subsidiary concluded on October 31, 2012, resulting in a substantially lower effective tax rate for the Company in subsequent years. As a result of the royalty arrangement ending and to ensure an additional source of U.S. cash, the Company plans to repatriate a portion of its current year offshore earnings to the U.S. for domestic operations and accordingly has provided for estimated federal and state income taxes on such portion of its current year offshore earnings. If circumstances change and it becomes apparent that some or all of the undistributed earnings of the Company's offshore subsidiary will be remitted in the foreseeable future but income taxes have not been recognized, the Company will accrue income taxes attributable to such undistributed earnings.

Determining the consolidated provision for (benefit from) income tax expense, income tax liabilities and deferred tax assets and liabilities involves judgment. The Company calculates and provides for income taxes in each of the tax jurisdictions in which it operates, which involves estimating current tax exposures as well as making judgments regarding the recoverability of deferred tax assets in each jurisdiction. The estimates used could differ from actual results, which may have a significant impact on operating results in future periods.

In July 2013, the FASB issued a new accounting standard that requires the presentation of certain unrecognized tax benefits as reductions to deferred tax assets rather than as liabilities in the Company's condensed consolidated balance sheets when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The Company adopted this new standard on a prospective basis in the first quarter of 2014. The impact of the adoption was a reduction to long-term deferred tax assets and non-current income tax payable of approximately $4.3 million.


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

Unrecognized Tax Benefits

The Company applies the provisions of ASC 740-10, relating to accounting for uncertain tax income taxes. Changes in the Company's unrecognized tax benefits during the nine months ended September 30, 2014, were as follows (in thousands):
Unrecognized tax benefits balance at January 1, 2014
$
12,694

Gross increases for tax positions of current year
686

Gross increases for tax positions of prior years
285

Settlements
(4,361
)
Lapse of statute of limitations

Unrecognized tax benefits balance at September 30, 2014
$
9,304


The Company's total unrecognized tax benefits as of September 30, 2014 and December 31, 2013 were $9.3 million and $12.7 million, respectively. An income tax benefit of $4.0 million, net of valuation allowance adjustments, would be recorded if these unrecognized tax benefits are recognized. The Company cannot reasonably estimate the outcome at this time.

The Company's continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company has accrued interest and penalties at September 30, 2014, and December 31, 2013, of $0.1 million and $0.7 million, respectively, which have been recorded in long-term income taxes payable in the accompanying consolidated balance sheets.

10. 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 products are 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 right 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, 2014. 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.

11. COMMITMENTS:

Supplier Agreements

Three of the Company's major suppliers have wafer supply agreements based in U.S. dollars; however, the agreements with two of these foundries, Seiko Epson Corporation, or Epson, and ROHM Lapis Semiconductor Co., Ltd., or Lapis, also allow for mutual sharing of the impact of the exchange rate fluctuation between Japanese yen and the U.S. dollar on future purchases. Each year, the Company's management and these two suppliers review and negotiate future pricing; the negotiated pricing is denominated in U.S. dollars but is subject to contractual exchange rate provisions. The fluctuation in the exchange rate is shared equally between the Company and each of these suppliers on future purchases.



24

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

12. LEGAL PROCEEDINGS AND CONTINGENCIES:

From time to time in the ordinary course of business, the Company becomes involved in lawsuits, or customers and distributors may make claims against the Company. In accordance with ASC 450-10, the Company makes a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated.

On October 20, 2004, the Company filed a complaint against Fairchild Semiconductor International, Inc. and Fairchild Semiconductor Corporation (referred to collectively as "Fairchild") in the United States District Court for the District of Delaware. In its complaint, the Company alleged that Fairchild has and is infringing four of Power Integrations' patents pertaining to PWM integrated circuit devices. Fairchild denied infringement and asked for a declaration from the court that it does not infringe any Power Integrations patent and that the patents are invalid. The Court issued a claim construction order on March 31, 2006 which was favorable to the Company. The Court set a first trial on the issues of infringement, willfulness and damages for October 2, 2006. At the close of the first trial, on October 10, 2006, the jury returned a verdict in favor of the Company finding all asserted claims of all four patents-in-suit to be willfully infringed by Fairchild and awarding $34.0 million in damages. Fairchild raised defenses contending that the asserted patents are invalid or unenforceable, and the Court held a second trial on these issues beginning on September 17, 2007. On September 21, 2007, the jury returned a verdict in the Company's favor, affirming the validity of the asserted claims of all four patents-in-suit. Fairchild submitted further materials on the issue of enforceability along with various other post-trial motions, and the Company filed post-trial motions seeking a permanent injunction and increased damages and attorneys' fees, among other things. On September 24, 2008, the Court denied Fairchild's motion regarding enforceability and ruled that all four patents are enforceable. On December 12, 2008, the Court ruled on the remaining post-trial motions, including granting a permanent injunction, reducing the damages award to $6.1 million, granting Fairchild a new trial on the issue of willful infringement in view of an intervening change in the law, and denying the Company's motion for increased damages and attorneys' fees with leave to renew the motion after the resolution of the issue of willful infringement. On December 22, 2008, at Fairchild's request, the Court temporarily stayed the permanent injunction for 90 days. On January 12, 2009, Fairchild filed a notice of appeal challenging the Court's refusal to enter a more permanent stay of the injunction, and Fairchild filed additional motions requesting that both the Federal Circuit and the District Court extend the stay of injunction. The District Court temporarily extended the stay pending the Federal Circuit ruling on Fairchild's pending motion, but the Federal Circuit dismissed Fairchild's appeal and denied its motion on May 5, 2009, and the District Court issued an order on May 13, 2009 confirming the reinstatement of the permanent injunction as originally entered in December 2008. On June 22, 2009, the Court held a brief bench re-trial on the issue of willful infringement. On July 22, 2010, the Court found that Fairchild willfully infringed all four of the asserted patents, and the Court also invited briefing on enhanced damages and attorneys' fees. Fairchild also filed a motion requesting that the Court amend its findings regarding willfulness. On January 18, 2011, the Court denied Fairchild's request to amend the findings regarding Fairchild's willful infringement and doubled the damages award against Fairchild but declined to award attorneys' fees. On February 3, 2011, the Court entered final judgment in favor of the Company for a total damages award of $12.9 million. Fairchild filed a notice of appeal challenging the final judgment and a number of the underlying rulings, and the Company filed a cross-appeal seeking to increase the damages award. The appeal was argued on January 11, 2012, and the Federal Circuit issued a mixed ruling on March 26, 2013, affirming Fairchild's infringement of certain claims that support the basis for the permanent injunction while reversing, vacating, and remanding the findings with respect to other claims, including the Company's claim for damages. The Company filed a petition seeking Supreme Court review of the Federal Circuit’s ruling on damages issues, and the Supreme Court called for a response from Fairchild but ultimately declined to review the case. On remand, the Company intends to pursue its claim for financial compensation based on Fairchild's infringement.

On May 9, 2005, the Company filed a Complaint with the U.S. International Trade Commission (“ITC”) under section 337 of the Tariff Act of 1930, as amended, 19 U.S.C. section 1337 against System General (“SG”). The Company filed a supplement to the complaint on May 24, 2005. The Company alleged infringement of its patents pertaining to pulse width modulation (“PWM”) integrated circuit devices produced by SG, which are used in power conversion applications such as power supplies for computer monitors. The Commission instituted an investigation on June 8, 2005 in response to the Company's complaint. SG filed a response to the ITC complaint asserting that the patents-in-suit were invalid and not infringed. The Company subsequently and voluntarily narrowed the number of patents and claims in suit, which proceeded to a hearing. The hearing on the investigation was held before the Administrative Law Judge (“ALJ”) from January 18 to January 24, 2006. Post-hearing briefs were submitted and briefing concluded February 24, 2006. The ALJ's initial determination was issued on May 15, 2006. The ALJ found all remaining asserted claims valid and infringed, and recommended the exclusion of the infringing products as well as certain downstream products that contain the infringing

25

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

products. After further briefing, on June 30, 2006, the Commission decided not to review the initial determination on liability, but did invite briefs on remedy, bonding and the public interest. On August 11, 2006, the Commission issued an order excluding from entry into the United States the infringing SG PWM chips, and any LCD computer monitors, AC printer adapters and sample/demonstration circuit boards containing an infringing SG chip. The U.S. Customs Service is authorized to enforce the exclusion order. On October 11, 2006, the presidential review period expired without any action from the President, and the ITC exclusion order is now in full effect. SG appealed the ITC decision, and on November 19, 2007, the Federal Circuit affirmed the ITC's findings in all respects. On October 27, 2008, SG filed a petition to modify the exclusion order in view of a recent Federal Circuit opinion in an unrelated case, and the Company responded to oppose any modification, but the Commission modified the exclusion order on February 27, 2009. Nevertheless, the exclusion order still prohibits SG and related entities from importing the infringing SG chips and any LCD computer monitors, AC printer adapters, and sample/demonstration circuit boards containing an infringing SG chip.

On May 23, 2008, the Company filed a complaint against Fairchild Semiconductor International, Inc., Fairchild Semiconductor Corporation, and Fairchild's wholly owned subsidiary System General Corporation in the United States District Court for the District of Delaware. In its complaint, the Company alleged that Fairchild has infringed and is infringing three patents pertaining to power supply controller integrated circuit devices. Fairchild answered the Company's complaint on November 7, 2008, denying infringement and asking for a declaration from the Court that it does not infringe any Power Integrations patent and that the patents are invalid and unenforceable. Fairchild's answer also included counterclaims accusing the Company of infringing three patents pertaining to primary side power conversion integrated circuit devices. Fairchild had earlier brought these same claims in a separate suit against the Company, also in Delaware, which Fairchild dismissed in favor of adding its claims to the Company's already pending suit against Fairchild. The Company has answered Fairchild's counterclaims, denying infringement and asking for a declaration from the Court that it does not infringe any Fairchild patent and that the Fairchild patents are invalid. Fairchild also filed a motion to stay the case, but the Court denied that motion on December 19, 2008. On March 5, 2009, Fairchild filed a motion for summary judgment to preclude any recovery for post-verdict sales of parts found to infringe in the parties' other ongoing litigation, described above, and the Company filed its opposition and a cross-motion to preclude Fairchild from re-litigating the issues of infringement and damages for those same products. On June 26, 2009, the Court held a hearing on the parties' motions, and on July 9, 2009 the Court issued an order denying the parties' motions but staying proceedings with respect to the products that were found to infringe and which are subject to the injunction in the other Delaware case between the parties pending the entry of final judgment in that case; those products are expected to be addressed in the context of the parties’ remand proceedings following the appeal in their earlier litigation in Delaware, and the remainder of the case is proceeding. On December 18, 2009, the Court issued an order construing certain terms in the asserted claims of the Company's and Fairchild's patents in suit. Following the Court's ruling on claim construction, Fairchild withdrew its claim related to one of its patents and significantly reduced the number of claims asserted for the remaining two patents. The parties thereafter filed and argued a number of motions for summary judgment, and the Court denied the majority of the parties' motions but granted the Company's motion to preclude Fairchild from re-arguing validity positions that were rejected in the prior case between the parties. Because the assigned Judge retired at the end of July 2010, the case was re-assigned to a different Judge, and the Court vacated the trial schedule and had the parties provide their input on the appropriate course of action. The Court thereafter set a trial schedule with the jury trial on infringement and validity to begin in July 2011. On April 18, 2011, the Court rescheduled the trial to begin in January 2012, and on June 2, 2011, the Court moved the trial date to April 2012 to permit the parties to address another patent the Company accused Fairchild of infringing. Following a trial in April 2012, the jury returned a verdict finding that Fairchild infringes two of the Company's patents, that Fairchild has induced others to infringe the Company's patents, and also upheld the validity of the infringed patents. Of the two remaining counterclaim patents Fairchild asserted in the case, one was found not to be infringed, but the jury found the second patent to be infringed by a limited number of the Company's products, although the jury further found the Company did not induce infringement by any customers, including customers outside the United States. On March 29, 2013, the District Court denied most of the parties' post-trial motions on liability but granted the Company's motion for judgment as a matter of law finding that Fairchild infringed another of the Company's patents. On April 25, 2013, the Court denied both parties' motions regarding the unenforceability of each other's patents. The Company intends to challenge adverse findings on appeal; nevertheless, the Company estimates that even if the verdict on Fairchild's patent were ultimately upheld, the sales potentially impacted would amount to only about 0.3% of the Company's revenues. The Company requested an injunction preventing further infringement of its own patents by Fairchild, and Fairchild requested an injunction as well; following a hearing on the issue in June 2014, the Court denied Fairchild's request for an injunction against the Company and granted the Company's request for an injunction against Fairchild. The Company is also

26

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

seeking financial damages, as well as enhanced damages for willful infringement, issues to be decided in separate proceedings at a later date.
On June 28, 2004, the Company filed a complaint for patent infringement in the U.S. District Court, Northern District of California, against SG Corporation, a Taiwanese company, and its U.S. subsidiary. The Company's complaint alleged that certain integrated circuits produced by SG infringed and continue to infringe certain of its patents. On June 10, 2005, in response to the initiation of the International Trade Commission (ITC) investigation discussed above, the District Court stayed all proceedings. Subsequent to the completion of the ITC proceedings, the District Court temporarily lifted the stay and scheduled a case management conference. On December 6, 2006, SG filed a notice of appeal of the ITC decision as discussed above. In response, and by agreement of the parties, the District Court vacated the scheduled case management conference and renewed the stay of proceedings pending the outcome of the Federal Circuit appeal of the ITC determination. On November 19, 2007, the Federal Circuit affirmed the ITC's findings in all respects, and SG did not file a petition for review. The parties subsequently filed a motion to dismiss the District Court case without prejudice. On November 4, 2009, the Company re-filed its complaint for patent infringement against SG and its parent corporations, Fairchild Semiconductor International, Inc. and Fairchild Semiconductor Corporation, to address their continued infringement of patents at issue in the original suit that recently emerged from SG requested reexamination proceedings before the U.S. Patent and Trademark Office (USPTO). The Company seeks, among other things, an order enjoining Fairchild and SG from infringing the Company's patents and an award of damages resulting from the alleged infringement. Fairchild has denied infringement and asked for a declaration from the Court that it does not infringe any Power Integrations patent, that the patents are invalid, and that one of the two of the Company's patents now at issue in the case is unenforceable. On May 5, 2010, Fairchild and SG filed an amended answer including counterclaims accusing the Company of infringing two patents, and since that time Fairchild has withdrawn its claim for infringement of one of the patents it originally asserted against the Company but added another patent to the case over the Company's objections; the Company contests these claims vigorously. Both parties filed summary judgment motions and challenges to each other’s experts’ testimony, and the Court granted the Company’s motion for summary judgment of non-infringement with respect to one of Fairchild’s two patents. Following a trial on the remaining claims in February 2014, the jury returned a verdict in the Company’s favor, affirming the validity of the asserted claims of the Company’s patents-in-suit, finding that Fairchild and SG infringed the Company’s asserted patents and induced infringement by others, and awarding $105.0 million in damages. Although the jury awarded damages, at this stage of the proceedings the Company cannot state the amount, if any, it might ultimately recover from Fairchild, and no benefits have been recorded in the Company’s condensed consolidated financial statements as a result of the damages verdict. The Jury also rejected Fairchild’s remaining counterclaims for infringement against the Company. Fairchild challenged these rulings in post-trial motions, but the judge confirmed the jury’s determinations on infringement and damages, although the Court declined to find Fairchild’s infringement willful. Fairchild has since pressed its unenforceability claim with respect to one of the two patents it was found to infringe in post-trial briefing and requested reconsideration of the damages determinations, and the Company has filed motions requesting prejudgment interest and an injunction to prevent further infringement by Fairchild; rulings are expected in the coming months.

In February 2010, Fairchild and System General (“SG”) filed suits for patent infringement against the Company, Power Integrations Netherlands B.V., and representative offices of Power Integrations Netherlands in Shanghai and Shenzhen with the Suzhou Intermediate Court in the People's Republic of China. The suits assert four Chinese patents and seek an injunction and damages of approximately $19.0 million. Power Integrations Netherlands filed invalidation proceedings for all four asserted SG patents in the People's Republic of China Patent Reexamination Board (PRB) of the State Intellectual Property Office (SIPO), and all four challenges were accepted by the PRB, with hearings conducted in September 2010. In early January 2012, the Company received rulings from the PRB invalidating the majority of the claims Fairchild asserted in litigation, and the PRB determinations are currently on appeal. The Suzhou Court conducted evidentiary hearings in 2012 and issued rulings in late December 2012, finding that the Company did not infringe any of the asserted patents. Fairchild has filed appeals challenging the Suzhou Court's non-infringement rulings, and the appeals court in Nanjing has scheduled further hearings in the infringement proceedings for November of this year, with rulings on Fairchild’s appeals expected in the coming months. The Company continues to believe the Fairchild and SG claims are without merit and will continue to contest them vigorously.

On July 11, 2011, the Company filed a complaint in the U.S. District Court, District of Columbia, against David Kappos in his capacity as Director of the United States Patent and Trademark Office (“PTO”) as part of the ongoing reexamination proceedings related to one of the patents asserted against Fairchild and SG in the Delaware litigation described above. The Company filed a motion for summary judgment on a preliminary jurisdictional issue, and the PTO filed a cross-

27

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

motion to dismiss on this same issue; briefing on those motions was completed in October, 2011. On November 18, 2013, the Court granted the PTO’s motion and transferred the case to the Federal Circuit, where additional briefing is expected to take place over the next several months.

On May 1, 2012, Fairchild Semiconductor Corporation and Fairchild's wholly-owned subsidiary, System General Corporation (referred to collectively as “Fairchild”), filed a complaint against the Company in the United States District Court for the District of Delaware. In its complaint, Fairchild alleges that the Company has infringed and is infringing four patents pertaining to power conversion integrated circuit devices. The Company answered Fairchild's complaint, denying infringement and asking for a declaration from the Court that it does not infringe any Fairchild patent and that the Fairchild patents are invalid, and the Company has also asserted counterclaims against Fairchild for infringement of five of the Company's patents. Fairchild has withdrawn its claim for infringement of one of the patents it asserted against the Company after the Company's preliminary challenge; expert discovery is under way on the remaining patents, with an anticipated trial date in 2015.

On February 5, 2013, Trinity Capital Investment, LLC (“Trinity”) filed suit against the Company in California Superior Court.  The complaint alleged that SemiSouth Laboratories Inc. had entered into a lease agreement with Trinity, and that the Company guaranteed SemiSouth's obligations under the lease agreement.  The complaint further alleged that SemiSouth defaulted on the lease agreement in October 2012, and therefore the Company owed Trinity $2.4 million under the lease guaranty. On April 19, 2013, the Company answered the complaint, denying the allegations therein. On April 18, 2014, Trinity filed a request to dismiss the action without prejudice.

The Company is unable to predict the outcome of legal proceedings with certainty, and there can be no assurance that Power Integrations will prevail in the above-mentioned unsettled litigations. These litigations, whether or not determined in Power Integrations' favor or settled, will be costly and will divert the efforts and attention of the Company's management and technical personnel from normal business operations, potentially causing a material adverse effect on the business, financial condition and operating results. Currently, the Company is not able to estimate a loss or a range of loss for the ongoing litigation disclosed above, however adverse determinations in litigation could result in monetary losses, the loss of proprietary rights, subject the Company to significant liabilities, require Power Integrations to seek licenses from third parties or prevent the Company from licensing the technology, any of which could have a material adverse effect on the Company's business, financial condition and operating results.

In the quarter ended June 30, 2014, the IRS issued the Company a notice of proposed adjustments to the Company's taxable income for the years 2007 through 2009. The Company and IRS signed a formal closing agreement on May 20, 2014, to settle all positions and close out the examination of the Company's income-tax returns for the years 2007 through 2009. As a result, the Company adjusted its tax balances based on the facts, circumstances, and information available at the reporting date. The resolution of the 2007-2009 IRS audit resulted in a federal tax benefit to the Company of $2.8 million. Additionally, the Company recorded a state tax benefit of $0.5 million. Also, the agreement will allow the Company to repatriate up to $5.0 million from its foreign subsidiary without incurring additional U.S. income taxes.

    
13. RECENT ACCOUNTING PRONOUNCEMENTS:

In May 2014, the Financial Accounting Standards Board ("FASB") amended the existing accounting standards for revenue recognition, ASU 2014-09, Revenue from Contracts with Customers. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The Company is required to adopt the amendments in the first quarter of 2017. Early adoption is not permitted. The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. The Company is currently evaluating the impact of these amendments and the transition alternatives on its consolidated financial statements.

14. BANK LINE OF CREDIT:

On July 5, 2012, the Company entered into a Credit Agreement (the "Credit Agreement") with two banks. The Credit Agreement provides the Company with a $100.0 million revolving line of credit to use for general corporate purposes with a

28

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

$20.0 million sublimit for the issuance of standby and trade letters of credit. The Credit Agreement was amended on April 1, 2014, to extend the Credit Agreement termination date from July 5, 2015, to April 1, 2017, with all other terms of the Credit Agreement remaining the same. The Company's ability to borrow under the revolving line of credit is conditioned upon the Company's compliance with specified covenants, including reporting and financial covenants, primarily a minimum cash requirement and a debt to earnings ratio, with which the Company is currently in compliance. All advances under the revolving line of credit will become due on April 1, 2017, or earlier in the event of a default. As of September 30, 2014, the Company had no letters of credit outstanding and no amount outstanding under the credit agreement.


29



ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes to those statements included elsewhere in this Quarterly Report on Form 10-Q, and with the consolidated financial statements and management's discussion and analysis of our financial condition and results of operations in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on February 13, 2014. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in Part II, Item 1A-“Risk Factors” and elsewhere in this report. See also “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.

Overview

We design, develop and market analog and mixed-signal integrated circuits (ICs) and other electronic components and circuitry used in high-voltage power conversion. Our products are used in power converters that convert electricity from a high-voltage source (typically 48 volts or higher) to the type of power required for a specified downstream use. In most cases, this conversion entails, among other functions, converting alternating current (AC) to direct current (DC) or vice versa, reducing or increasing the voltage, and regulating the output voltage and/or current according to the customer's specifications.
A large percentage of our products are ICs used in AC-DC power supplies, which convert the high-voltage AC from a wall outlet to the low-voltage DC required by most electronic devices. Power supplies incorporating our products are used with all manner of electronic products including mobile phones, computers, entertainment and networking equipment, appliances, electronic utility meters, industrial controls and LED lights.
    Since our May 2012 acquisition of CT-Concept Technologie AG (Concept), we also offer IGBT drivers - circuit boards containing multiple ICs, electrical isolation components and other circuitry - used to operate arrays of high-voltage, high-power transistors known as IGBT modules. These driver/module combinations are used for power conversion in high-power applications (i.e., power levels ranging from tens of kilowatts up to one gigawatt) such as industrial motors, solar- and wind-power systems, electric vehicles and high-voltage DC transmission systems.

Our products bring a number of important benefits to the power-conversion market compared with less advanced alternatives, including reduced component count and design complexity, smaller size, higher reliability and reduced time-to-market. Our products also improve the energy efficiency of power converters, helping our customers meet the increasingly stringent efficiency standards that have been adopted around the world for many electronic products, and improving the efficacy of renewable-energy systems, electric vehicles and other high-power applications.

While the size of the power-supply market fluctuates with changes in macroeconomic conditions, the market has generally exhibited a modest growth rate over time as growth in the unit volumes of power supplies has largely been offset by reductions in the average selling price of components in this market. Therefore, the growth of our business depends primarily on our penetration of the power supply market, and our success in expanding the addressable market by introducing new products that address a wider range of applications. Our growth strategy includes the following elements:

Increase the penetration of our ICs in the “low-power” AC-DC power supply market. The largest proportion of our revenues comes from power-supply applications requiring 50 watts of output or less. We continue to introduce more advanced products that make our IC-based solutions more attractive in this market. We have also increased the size of our sales and field-engineering staff considerably in recent years, and we continue to expand our offerings of technical documentation and design-support tools and services to help customers use our ICs. These tools and services include our PI Expert™ design software, which we offer free of charge, and our transformer-sample service.

Increase the penetration of our products in higher-power applications. We believe we have developed and acquired technologies and products that enable us to bring the benefits of integration to applications requiring more than 50 watts of output. These include such applications as main power supplies for flat-panel TVs,

30


desktop PCs, game consoles and, by virtue of our acquisition of Concept, IGBT-driver applications such as industrial motors, renewable energy systems and electric vehicles.

Capitalize on the growing demand for more energy-efficient electronic products and lighting technologies, and for cleaner energy and transportation technologies. We believe that energy-efficiency is becoming an increasingly important design criterion for power supplies due largely to the emergence of standards and specifications that encourage, and in some cases mandate, the design of more energy-efficient electronic products. Power supplies incorporating our ICs are generally able to comply with all known efficiency specifications currently in effect.    

Additionally, technological advances combined with regulatory and legislative actions are resulting in the adoption of alternative lighting technologies such as light-emitting diodes, or LEDs. We believe this presents a significant opportunity for us because our ICs are used in driver (i.e. power-supply) circuitry for high-voltage LED lighting applications. Finally, the growing desire for less carbon-intensive sources of energy and modes of transportation represents an opportunity for us since our IGBT drivers are used in renewable-energy systems as well as electric trains and automobiles.

Our quarterly operating results are difficult to predict and subject to significant fluctuations. We plan our production and inventory levels based on internal forecasts of projected customer demand, which are highly unpredictable and can fluctuate substantially. Customers typically may cancel or reschedule orders on short notice without significant penalty and, conversely, often place orders with very short lead times to delivery. Also, external factors such as global economic conditions and supply-chain dynamics can cause our operating results to be volatile. Furthermore, because our industry is intensely price-sensitive, our gross margin (gross profit divided by net revenues) is subject to change based on the relative pricing of solutions that compete with ours. Variations in product and customer mix can also cause our gross margin to fluctuate. Because we purchase a large percentage of our silicon wafers from foundries located in Japan, our gross margin is influenced by fluctuations in the exchange rate between the U.S. dollar and the Japanese yen. Changes in the prices of raw materials used in our products, such as copper and gold, can also affect our gross margin. Although our wafer-fabrication and assembly operations are outsourced, as are most of our test operations, a portion of our production costs are fixed in nature. As a result, our unit costs and gross margin are impacted by the volume of units we produce.     

Recent Results

Our net revenues were $90.1 million and $91.7 million in the three months ended September 30, 2014 and 2013, respectively, and $262.2 million and $256.7 million in the nine months ended September 30, 2014 and 2013, respectively. For the three-month period, the decrease in revenues was due primarily to lower unit sales into the communications end market, particularly for cellphone chargers and residential-networking applications, partially offset by higher unit sales into the consumer and computing end markets. For the nine-month period, we experienced year-over-year growth in revenues from three of our primary end-market categories (industrial, consumer and computer), driven by higher unit sales for a wide range of applications including consumer appliances, LED lighting and desktop computers. The increase was partially offset by lower sales into the communications end market due primarily to lower unit sales for residential-networking applications and cellphone chargers. Our top ten customers, including distributors that resell to OEMs and merchant power supply manufacturers, accounted for 59% and 60% of our net revenues in the three months ended September 30, 2014 and 2013, respectively, and 59% and 58% of our net revenues in the nine months ended September 30, 2014 and 2013, respectively. Our top customer, a distributor of our products, accounted for approximately 19% of our net revenues in both the three months ended September 30, 2014 and 2013, and 20% and 19% of our net revenues in the nine months ended September 30, 2014 and 2013, respectively. International sales accounted for 96% and 95% of our net revenues in the three months ended September 30, 2014 and 2013, respectively, and 95% in both the nine months ended September 30, 2014 and 2013.

Our gross margin was 54.4% and 53.2% in the three months ended September 30, 2014 and 2013, respectively, and 54.8% and 52.5% in the nine months ended September 30, 2014 and 2013, respectively. The increase in gross margin for the both the three- and nine- month periods in 2014 compared to 2013 was due primarily to: favorable end-market mix, with a greater percentage of revenue coming from higher-margin end markets, and the decline in the value of the Japanese yen versus the U.S. dollar, which decreased the cost of silicon wafers purchased from our Japanese wafer-fabrication foundries.

Total operating expenses were $32.2 million in both the three-month periods ended September 30, 2014 and 2013; in the nine-month periods ended September 30, 2014 and 2013, operating expenses were $99.8 million and $95.9 million,

31


respectively. The year-over-year increase in the nine-month period was due primarily to higher research and development expenses, including increased headcount as well as greater engineering-materials and equipment-depreciation expenses, all in support of our product-development efforts. Sales and marketing expenses also increased, due primarily to the expansion of our sales and application-support staffs, which resulted in higher salary and related expenses.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) 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 ongoing basis, we evaluate our estimates, including those listed below. 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.

Our critical accounting policies are as follows:
revenue recognition;
stock-based compensation;
estimating write-downs for excess and obsolete inventory;
income taxes;
business combinations; and
goodwill and intangible assets.

Our critical accounting policies are 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, Summary of Significant Accounting Policies, in our Notes to Condensed Consolidated Financial Statements.

Revenue recognition

Product revenues consist of sales to original equipment manufacturers, or OEMs, merchant power supply manufacturers and distributors. Approximately 76% of our net product sales were made to distributors in the nine months ended September 30, 2014, and 75% in the twelve months ended December 31, 2013. We apply the provisions of Accounting Standard Codification (“ASC”) 605-10 (“ASC 605-10”) and all related appropriate guidance. Revenue is recognized when all of the following criteria have been met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectability is reasonably assured. Customer purchase orders are generally used to determine the existence of an arrangement. Delivery is considered to have occurred when title and risk of loss have transferred to our customer. We evaluate whether the price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. With respect to collectability, we perform credit checks for new customers and perform ongoing evaluations of our existing customers' financial condition and require letters of credit whenever deemed necessary.

Sales to international OEMs and merchant power supply manufacturers for shipments from our facility outside of the United States are pursuant to EX Works, or EXW, shipping terms, meaning that title to the product transfers to the customer upon shipment from our foreign warehouse. Sales to international OEM customers and merchant power supply manufacturers that are shipped from our facility in California are pursuant to delivered at frontier, or DAF, shipping terms. 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 the product in that country. Shipments to OEMs and merchant power supply manufacturers in the Americas are pursuant to free on board, or FOB, point of origin shipping terms meaning that title is passed to the customer upon shipment. Revenue is recognized upon title transfer for sales to OEMs and merchant power supply manufacturers, assuming all other criteria for revenue recognition are met.

Sales to most distributors are made under terms allowing certain price adjustments and rights of return on our products held by the distributors. As a result of these rights, we defer the recognition of revenue and the costs of revenues derived from sales to distributors until our distributors report that they have sold our products to their customers. Our recognition of such distributor sell-through is based on point of sales reports received from the distributor, at which time the price is no longer subject to adjustment and is fixed, and the products are no longer subject to return to us except pursuant to warranty terms. The

32


gross profit that is deferred upon shipment to the distributor is reflected as “deferred income on sales to distributors” in the accompanying consolidated balance sheets. The total deferred revenue as of September 30, 2014, and December 31, 2013, was approximately $30.7 million and $25.5 million, respectively. The total deferred cost as of September 30, 2014, and December 31, 2013, was approximately $12.0 million and $9.8 million, respectively.

Frequently, distributors need to sell at a price lower than the standard distribution price to win business. At the time the distributor invoices its customer, or soon thereafter, the distributor submits a “ship and debit” price adjustment claim to us to adjust the distributor's cost from the standard price to the pre-approved lower price. After we verify that the claim was pre-approved, a credit memo is issued to the distributor for the ship and debit claim. We maintain a reserve for these unprocessed claims and for estimated future ship and debit price adjustments. The reserve appears as a reduction to accounts receivable in our accompanying consolidated balance sheets. To the extent future ship and debit claims significantly exceed amounts estimated, there could be a material impact on the deferred revenue and deferred margin ultimately recognized. To evaluate the adequacy of our reserves, we analyze historical ship and debit payments and levels of inventory in the distributor channels.

Sales to certain of our distributors are made under terms that do not include rights of return or price concessions after the product is shipped to the distributor. Accordingly, product revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met.

Stock-based compensation

We apply the provisions of ASC 718-10, Share-Based Payment. Under the provisions of ASC 718-10, we recognize the fair value of stock-based compensation in our financial statements over the requisite service period of the individual grants, which generally equals a four-year vesting period. We use estimates of volatility, expected term, risk-free interest rate, dividend yield and forfeitures in determining the fair value of these awards and the amount of compensation cost to recognize. Changes in these estimates could result in changes to our compensation charges.

Estimating write-downs for excess and obsolete inventory

When evaluating the adequacy of our valuation adjustments for excess and obsolete inventory, we identify excess and obsolete products and also analyze historical usage, forecasted production based on demand forecasts, current economic trends and historical write-offs. This write-down is reflected as a reduction to inventory in the 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 write-downs, which could adversely impact our cost of revenues and operating results.

Income taxes

Income-tax expense is an estimate of current income taxes payable or refundable in the current fiscal year based on reported income before income taxes. Deferred income taxes reflect the effect of temporary differences and carryforwards that are recognized for financial reporting and income-tax purposes.

We account for income taxes under the provisions of ASC 740. Under the provisions of ASC 740, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, utilizing the tax rates that are expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize valuation allowances to reduce any deferred tax assets to the amount that we estimate will more likely than not be realized based on available evidence and management's judgment. We limit the deferred tax assets recognized related to certain officers' compensation to amounts that we estimate will be deductible in future periods based upon Internal Revenue Code Section 162(m). In the event that we determine, based on available evidence and management judgment, that all or part of the net deferred tax assets will not be realized in the future, we would record a valuation allowance in the period the 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.

As of September 30, 2014, we maintain a full valuation allowance on our California and New Jersey deferred tax assets as we do not believe that it is more likely than not that the deferred tax assets will be fully realized. We also maintain a valuation allowance on capital losses for federal purposes and a valuation allowance with respect to certain of our deferred tax assets relating to tax credits in Canada.


33


In the quarter ended June 30, 2014, the IRS issued to us a notice of proposed adjustments to our taxable income for the years 2007 through 2009. On May 20, 2014 we signed an agreement to settle all positions and close out the examination of our income tax returns for the years 2007 through 2009. As a result, we adjusted our tax balances based on the facts, circumstances, and information available at the reporting date. The resolution of the audit resulted in a federal tax benefit to us of $2.8 million; we also recorded a state tax benefit of $0.5 million. The agreement with IRS also allows us to repatriate up to $5.0 million from our foreign subsidiary without incurring additional U.S. income taxes.

Business combinations

The purchase price of an acquisition is allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition. To the extent the purchase price exceeds the fair value of the net identifiable tangible and intangible assets acquired and liabilities assumed, such excess is allocated to goodwill. We determine the estimated fair values after review and consideration of relevant information, including discounted cash flows, quoted market prices and estimates made by management. We adjust the preliminary purchase price allocation, as necessary, during the measurement period of up to one year after the acquisition closing date as we obtain more information as to facts and circumstances existing at the acquisition date impacting asset valuations and liabilities assumed. Acquisition-related costs are recognized separately from the acquisition and are expensed as incurred.

Goodwill and intangible assets
In accordance with ASC 350-10, Goodwill and Other Intangible Assets, we evaluate goodwill for impairment on an annual basis, or as other indicators of impairment emerge. The provisions of ASC 350-10 require that we perform a two-step impairment test. In the first step, we compare the implied fair value of our single reporting unit to its carrying value, including goodwill. If the fair value of our reporting unit exceeds the carrying amount no impairment adjustment is required. If the carrying amount of our reporting unit exceeds the fair value, step two will be completed to measure the amount of goodwill impairment loss, if any exists. If the carrying value of our single reporting unit's goodwill exceeds its implied fair value, then we record an impairment loss equal to the difference, but not in excess of the carrying amount of the goodwill. Under the amendments of ASC 350-10, ASU No. 2011-08, Testing Goodwill for Impairment, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we elect this option, and after assessing the totality of events or circumstances we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. We have not elected this option to date. We evaluated goodwill for impairment in the fourth quarter 2013, and concluded that no impairment existed as of December 31, 2013. Additionally, no impairment indicators have been identified during the nine months ended September 30, 2014.

ASC 350-10 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives, and reviewed for impairment in accordance with ASC 360-10, Accounting for the Impairment or Disposal of Long-Lived Assets. We review long-lived assets, such as acquired intangibles, in-process research and development and property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We measure recoverability of assets to be held and used by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, we recognize an impairment charge by the amount by which the carrying amount of the asset exceeds the fair value of the asset.


34



Results of Operations

The following table sets forth certain operating data as a percentage of net revenues for the periods indicated.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
Net revenues
100.0
%
 
100.0
%
 
100.0
 %
 
100.0
 %
Cost of revenues
45.6

 
46.8

 
45.2

 
47.5

Gross profit
54.4

 
53.2

 
54.8

 
52.5

Operating expenses:
 
 
 
 
 
 
 
Research and development
14.9

 
14.2

 
15.8

 
15.1

Sales and marketing
12.8

 
12.2

 
13.7

 
13.0

General and administrative
7.9

 
8.7

 
8.6

 
9.2

Total operating expenses
35.6

 
35.1

 
38.1

 
37.3

Income from operations
18.8

 
18.1

 
16.7

 
15.2

Other income, net
0.4

 
0.1

 
0.3

 
0.4

Income before provision for (benefit from) income taxes
19.2

 
18.2

 
17.0

 
15.6

Provision for (benefit from) income taxes
1.3

 

 
(0.2
)
 
(0.5
)
Net income
17.9
%
 
18.2
%
 
17.2
 %
 
16.1
 %

Comparison of the Three and Nine Months Ended September 30, 2014 and 2013

Net revenues. Net revenues consist of revenues from product sales, which are calculated net of returns and allowances. Net revenues for the three and nine months ended September 30, 2014, were $90.1 million and $262.2 million, respectively, and in the same periods of 2013 revenues were $91.7 million and $256.7 million, respectively. For the three-month period, the decrease in revenues was due primarily to lower unit sales into the communications end market, particularly for cellphone chargers and residential-networking applications, partially offset by higher unit sales into the consumer and computing end markets. For the nine-month period, we experienced year-over-year growth in revenues from three of our primary end-market categories (industrial, consumer and computer), driven by higher unit sales for a wide range of applications including consumer appliances, LED lighting and desktop computers. The increase was partially offset by lower sales into the communications end market due primarily to lower unit sales for residential-networking applications and cellphone chargers.

Our net revenue mix by end market for the three and nine months ended September 30, 2014, compared to the three and nine months ended September 30, 2013, were as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
End Market
2014
 
2013
 
2014
 
2013
Communications
18
%
 
21
%
 
17
%
 
21
%
Computer
11
%
 
10
%
 
11
%
 
10
%
Consumer
36
%
 
34
%
 
37
%
 
35
%
Industrial
35
%
 
35
%
 
35
%
 
34
%

International sales, consisting of sales outside of the United States of America based on “ship to” customer locations, were $86.2 million and $250.1 million in the three and nine months ended September 30, 2014, respectively; in the same periods of 2013, international sales were $86.7 million and $242.6 million, respectively. Although power converters using our products are distributed to end markets worldwide, most are manufactured in Asia. As a result, sales to this region represented 80% of our net revenues in both the three and nine months ended September 30, 2014, and 80% in both the three and nine months ended September 30, 2013. We expect international sales, and sales to the Asia region in particular, to continue to account for a large portion of our net revenues in the future.


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Sales to distributors accounted for 74% and 76% of net revenues in the three and nine months ended September 30, 2014, respectively; sales to distributors accounted for 75% in both the three and nine months ended September 30, 2013. Direct sales to OEMs and power-supply manufacturers accounted for the remainder.
One customer, a distributor of our products, accounted for more than 10% of our net revenues in the three and nine months ended September 30, 2014 and 2013, as shown in the following table:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
Customer
2014
 
2013
 
2014
 
2013
Avnet
19%
 
19%
 
20%
 
19%
    
No other customers accounted for 10% or more of our net revenues in these periods.

Gross profit. Gross profit is net revenues less cost of revenues. Our cost of revenues consists primarily of costs associated with the purchase of wafers from our contracted foundries, the assembly, packaging and testing of our products by sub-contractors, product testing performed in our own facilities, amortization of acquired intangible assets, and overhead associated with the management of our supply chain. Gross margin is gross profit divided by net revenues. The table below compares gross profit and gross margin for the three and nine months ended September 30, 2014 and 2013 (dollars in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
                  Net revenues
$
90.1

 
$
91.7

 
$
262.2

 
$
256.7

                  Gross profit
$
49.1

 
$
48.8

 
$
143.8

 
$