News Column

POWER INTEGRATIONS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

July 31, 2014

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, 29



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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 CONCEPT IGBT-driver products 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 $89.0 million and $87.9 million in the three months ended June 30, 2014 and 2013, respectively, and $172.1 million and $165.0 million in the six months ended June 30, 2014 and 2013, respectively. For the three- and six-month periods, 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. Our top ten customers, including distributors that resell to OEMs and merchant power supply manufacturers, accounted for 61% and 60% of our net revenues in the three months ended June 30, 2014 and 2013, respectively, and 60% and 59% of our net revenues in the six months ended June 30, 2014 and 2013, respectively. Our top customer, a distributor of our products, accounted for approximately 20% and 19% of our net revenues in both the three and six months ended June 30, 2014 and 2013, respectively. International sales accounted for 95% and 94% of our net revenues in the three and six months ended June 30, 2014 and 2013, respectively. Our gross margin was 54.8% and 52.6% of net revenues in the three months ended June 30, 2014 and 2013, respectively, and 55.0% and 52.2% of net revenues in the six months ended June 30, 2014 and 2013, respectively. The increase in gross margin for the both the three- and six- month periods was due primarily to: favorable end-market mix, with a greater percentage of revenue coming from higher-margin end markets; cost benefits from higher production volume; 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 in the three months ended June 30, 2014 and 2013, were $34.4 million and $32.9 million, respectively, and operating expenses in the six months ended June 30, 2014 and 2013, were $67.7 million and $63.7 million, respectively. Expenses were higher in 2014 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- 30



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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 77% of our net product sales were made to distributors in the six months ended June 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 gross profit that is deferred upon shipment to the distributor is reflected as "deferred income on sales to distributors" in the 31



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accompanying consolidated balance sheets. The total deferred revenue as of June 30, 2014, and December 31, 2013, was approximately $31.6 million and $25.5 million, respectively. The total deferred cost as of June 30, 2014, and December 31, 2013, was approximately $12.5 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 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 carry-forwards 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 June 30, 2014, we recorded 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. 32



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For 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 six months ended June 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. 33



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Results of Operations

The following table sets forth certain operating data as a percentage of net revenues for the periods indicated.

Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues 100.0 % 100.0 % 100.0 % 100.0 % Cost of revenues 45.2 47.4 45.0 47.8 Gross profit 54.8 52.6 55.0 52.2 Operating expenses: Research and development 16.1 15.3 16.2 15.6 Sales and marketing 13.7 12.9 14.1 13.4 General and administrative 8.9 9.2 9.0 9.6 Total operating expenses 38.7 37.4 39.3 38.6 Income from operations 16.1 15.2 15.7 13.6 Other income, net 0.2 0.6 0.3 0.5 Income before provision for (benefit from) income taxes 16.3 15.8 16.0 14.1 Provision for (benefit from) income taxes (2.5 ) 0.2 (0.9 ) (1.0 ) Net income 18.8 % 15.6 % 16.9 % 15.1 %



Comparison of the Three and Six Months Ended June 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 six months ended June 30, 2014, were $89.0 million and $172.1 million, respectively, and in the same periods of 2013 revenues were $87.9 million and $165.0 million, respectively. For the three- and six-month periods, 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 major 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. Our net revenue mix by end market for the three and six months ended June 30, 2014, compared to the three and six months ended June 30, 2013, were as follows: Three Months Ended Six Months Ended June 30, June 30, End Market 2014 2013 2014 2013 Communications 15 % 21 % 17 % 21 % Computer 12 % 10 % 11 % 10 % Consumer 38 % 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 $84.8 million and $163.8 million in the three and six months ended June 30, 2014, respectively; in the same periods of 2013 international sales were $82.8 million and $155.9 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 six months ended June 30, 2014, and 81% and 80% for the three and six months ended June 30, 2013, respectively. 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. Sales to distributors accounted for 78% and 77% of net revenues in the three and six months ended June 30, 2014, respectively; in the same periods of 2013 sales to distributors accounted for 76% and 75%, respectively. Direct sales to OEMs and power-supply manufacturers accounted for the remainder. 34



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One customer, a distributor of our products, accounted for more than 10% of our net revenues in the three and six months ended June 30, 2014 and 2013, as shown in the following table:



Three Months Ended Six Months Ended

June 30, June 30, Customer 2014 2013 2014 2013 Avnet 20% 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 six months ended June 30, 2014 and 2013 (dollars in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues $ 89.0$ 87.9$ 172.1$ 165.0 Gross profit $ 48.7$ 46.2$ 94.7$ 86.1 Gross margin 54.8 % 52.6 % 55.0 % 52.2 % The increase in gross margin for the three and six months ended June 30, 2014, compared with the same periods in the prior year was due primarily to: favorable end-market mix, with a greater percentage of revenue coming from sales into higher-margin end markets; cost benefits from higher production volume; 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. Research and development expenses. Research and development, or R&D, expenses consist primarily of employee-related expenses (including stock-based compensation) and expensed material and facility costs associated with the development of new technologies and new products. We also record R&D expenses for prototype wafers related to new products until such products are released to production. The table below compares R&D expenses for the three and six months ended June 30, 2014 and 2013 (dollars in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues $ 89.0$ 87.9$ 172.1$ 165.0 R&D expenses $ 14.4$ 13.5$ 27.9$ 25.8 R&D expenses as a % of net revenue 16.1 % 15.3 % 16.2 % 15.6 % R&D expenses increased in the three and six months ended June 30, 2014, compared to the same periods in 2013, reflecting increased payroll and related expenses (stemming from increased headcount and annual salary increases) and greater expenses associated with engineering materials and equipment depreciation, all in support of product-development efforts to generate continued growth. Sales and marketing expenses. Sales and marketing expenses consist primarily of employee-related expenses, including stock-based compensation, commissions to sales representatives, amortization of intangible assets and facilities expenses, including expenses associated with our regional sales and support offices. 35



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The table below compares sales and marketing expenses for the three and six months ended June 30, 2014 and 2013 (dollars in millions):

Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues $ 89.0$ 87.9$ 172.1$ 165.0



Sales and marketing expenses $ 12.2$ 11.4 $

24.3 $ 22.1

Sales and marketing expenses as a % of net revenue 13.7 % 12.9 % 14.1 % 13.4 % Sales and marketing expenses increased in the three and six months ended June 30, 2014, compared to the same periods in 2013, due primarily to increased salary and related expenses reflecting the expansion of our sales and application-support staffs and annual salary increases; these factors were partially offset by lower amortization of acquisition-related intangible assets, as our Concept trade name was fully amortized one month into the current quarter. General and administrative expenses. General and administrative, or G&A, expenses consist primarily of employee-related expenses, including stock-based compensation expenses, for administration, finance, human resources and general management, as well as consulting, professional services, legal and audit expenses. The table below compares G&A expenses for the three and six months ended June 30, 2014 and 2013 (dollars in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues $ 89.0$ 87.9$ 172.1$ 165.0 G&A expenses $ 7.8$ 8.1$ 15.5$ 15.8 G&A expenses as a % of net revenue 8.8 % 9.2 % 9.0 % 9.6 %



G&A expenses decreased in the three and six months ended June 30, 2014, compared to the same periods in 2013 due primarily to lower legal fees.

Other income, net. Other income, net consists primarily of interest income earned on cash and cash equivalents, marketable securities and other investments, and foreign exchange gains or losses. The table below compares other income, net for the three and six months ended June 30, 2014 and 2013 (dollars in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net revenues $ 89.0$ 87.9$ 172.1$ 165.0 Other income $ 0.2$ 0.6$ 0.5$ 0.8 Other income as a % of net revenue 0.2 % 0.6 % 0.3 % 0.5 % Other income, net decreased in the three and six months ended June 30, 2014, compared to the same periods in 2013. The decrease was due primarily to a gain recognized in the second quarter of 2013 on the sale of investment related assets. Provision for (benefit from) income taxes. Provision for (benefit from) income taxes represents federal, state and foreign taxes. The table below compares income tax expenses (benefits) for the three and six months ended June 30, 2014 and 2013 (dollars in millions): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Income before provision for income taxes $ 14.5$ 13.9$ 27.5$ 23.1 Provision for (benefit from) income taxes $ (2.2 )$ 0.2$ (1.6 )$ (1.4 ) Effective tax rate (15.1 )% 1.3 % (5.7 )% (6.2 )% 36



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In the quarter ended June 30, 2014, we reached an agreement with the IRS to settle all positions and close out the examination of our income tax returns for the years 2007 through 2009. As a result, our provision for income tax in the second quarter of 2014 included 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 our consolidated balance sheets. Reflecting the net impact of the benefit, our effective tax rates for the three and six months ended June 30, 2014, were (15.1)% and (5.7)% respectively, compared with 1.3% and (6.2)% for the corresponding periods in 2013. In the three and six months ended June 30, 2014, the effective tax rate was lower than the expected statutory federal income tax rate of 35% primarily due to the audit agreement described in Note 9, Provision for Income Taxes, in our Notes to Condensed Consolidated Financial Statements. The difference between the expected statutory rate of 35% and the Company's effective tax rate for the three and six months ended June 30, 2013, was primarily due to the beneficial impact of the geographic distribution of our 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.



Liquidity and Capital Resources

As of June 30, 2014, we had $212.4 million in cash, cash equivalents and short-term marketable securities, an increase of approximately $10.3 million from $202.1 million as of December 31, 2013. As of June 30, 2014, we had working capital, defined as current assets less current liabilities, of $240.1 million, an increase of approximately $13.1 million from $227.0 million as of December 31, 2013. On July 5, 2012, we entered into a credit agreement (the "Credit Agreement") with two banks. The Credit Agreement provides us with a $100.0 million revolving line of credit to use for general corporate purposes with a $20.0 million sub-limit 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. Our ability to borrow under the revolving line of credit is conditioned upon our compliance with specified covenants, primarily a minimum cash requirement and a debt-to-earnings ratio, with which we are currently in compliance. The Credit Agreement terminates on April 1, 2017, and all advances under the revolving line of credit will become due on such date, or earlier in the event of a default. As of June 30, 2014, we had no amounts outstanding under our agreement. Operating activities generated cash of $42.5 million in the six months ended June 30, 2014. Net income for this period was $29.1 million; we also incurred non-cash depreciation, amortization and stock-based compensation expenses of $7.8 million, $3.4 million and $8.1 million, respectively. Significant changes in assets and liabilities included (1) a $5.3 million decrease in prepaid expenses and other assets due primarily to a decrease in prepaid legal and prepaid income taxes; and (2) a $3.4 million increase in deferred income on sales to distributors, due to increased inventory levels at our distributors reflecting lower-than-expected sales in the first quarter of 2014 and an expectation of higher sales in the second half of 2014. These items were partially offset by: (1) a $8.9 million increase in inventory, reflecting anticipated growth in future quarters; (2) a $4.7 million decrease in taxes payable and accrued liabilities related primarily to the release of reserves attributable to the above-mentioned IRS settlement and the adoption of ASU 2013-11 (see Note 13, Recent Accounting Pronouncements, for details); and (3) a $4.0 million increase in accounts receivable due to the timing of cash receipts in June 2014 compared to December 2013. Operating activities generated cash of $46.2 million in the six months ended June 30, 2013. Net income for this period was $24.6 million; we also incurred non-cash depreciation, amortization and stock-based compensation expenses of $8.0 million, $3.7 million and $8.0 million, respectively, partially offset by a $2.4 million increase in deferred taxes due primarily to the retroactive application of the American Tax Relief Act of 2012, which was signed into law on January 2, 2013, (refer to Note 9, Provision for Income Taxes, in our Notes to Condensed Consolidated Financial Statements, for details). Significant changes in operating assets and liabilities included (1) a $5.2 million decrease in prepaid expenses resulting primarily from a decrease in prepaid taxes related to a tax refund, (2) a $3.5 million increase in accounts payable due to the timing of payments for inventory, partially offset by a $0.9 million payment to one of our foundries in the first quarter of 2013 for product development, and (3) a $3.5 million increase in deferred income on sales to distributors due to increased inventory levels at our distributors as of June 30, 2013, compared to December 31, 2012. These additional sources of cash and non-cash items were partially offset by an $8.3 million increase in accounts receivable due to higher customer shipments in June 2013 versus December 2012. 37



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Our investing activities in the six months ended June 30, 2014, resulted in a $34.6 million net use of cash, consisting primarily of: $24.8 million for the purchases of marketable securities and $9.9 million for purchases of property and equipment, primarily machinery and equipment for production and research and development. Our investing activities in the six months ended June 30, 2013, resulted in a $34.3 million net use of cash, consisting of: (1) $28.4 million, net, for purchases of marketable securities and (2) $6.9 million for purchases of property and equipment, primarily machinery and equipment for our New Jersey facility, building improvements in our San Jose headquarter facility, and an ERP software upgrade. Our financing activities in the six months ended June 30, 2014, resulted in a $21.7 million net use of cash. Financing activities consisted primarily of $25.7 million for the repurchase of our common stock and $6.1 million for the payment of dividends to stockholders. This cash usage was offset by proceeds of $9.9 million from the issuance of common stock, including the exercise of employee stock options and the issuance of shares through our employee stock purchase plan. Our financing activities in the six months ended June 30, 2013, resulted in net cash proceeds of $10.1 million. Financing activities consisted primarily of proceeds of $14.7 million from the issuance of common stock, including the exercise of employee stock options and the issuance of shares through our employee stock purchase plan, partially offset by $4.7 million for the payment of dividends to stockholders. In January 2013, our board of directors declared four quarterly cash dividends in the amount of $0.08 per share to be paid to stockholders of record at the end of each quarter in 2013. Quarterly dividend payouts of 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, our 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; payouts of approximately $3.0 million each occurred on March 31, 2014 and June 30, 2014. In April 2014, our board of directors increased the dividend payments for the third and fourth quarters of 2014 to $0.12 per share. The first of these payouts is scheduled to take place on September 30, 2014. The declaration of any future cash dividend is at the discretion of the board of directors and will depend on our 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 our stockholders. In October 2012, our board of directors authorized the use of $50.0 million for the repurchase of our common stock, with repurchases to be executed according to pre-defined price/volume guidelines set by the board. In May 2014 our board of directors authorized the use of an additional $50.0 million for this purpose. In the three months ended June 30, 2014 we purchased 0.5 million shares for a total cost of $25.7 million. As of June 30, 2014, we had $53.8 million available for future stock repurchases. We did not purchase shares in the three-month period ended March 31, 2014, and in the year ended December 31, 2013, as the price of our common stock exceeded the maximum price set forth in the guidelines mentioned above. Authorization of future stock repurchase programs is at the discretion of the board of directors and will depend on our financial condition, results of operations, capital requirements, business conditions and other factors. As of June 30, 2014, we had a contractual obligation related to income tax, which consisted primarily of unrecognized tax benefits of approximately $9.0 million. A portion of the tax obligation was classified as long-term income taxes payable and a portion is recorded in deferred tax assets in our condensed consolidated balance sheet. The settlement period for our income tax liabilities cannot be determined; however, they are not expected to be due within the next year. In the quarter ended June 30, 2014, we reached an agreement with the IRS to close out the examination of our income tax returns for the years 2007 through 2009 (See Note 9, Provision for Income Taxes, in our Notes to Condensed Consolidated Financial Statements). The agreement will allow us to repatriate up to $5.0 million from our foreign-based subsidiary in future periods without incurring additional U.S. income taxes. There were no other material changes, other than stated in the liquidity section above, outside of the ordinary course of business in our contractual commitments reported in our Annual Report on Form 10-K for the year ended December 31, 2013. Our cash, cash equivalents and investment balances may change in future periods due to changes in our planned cash outlays, including changes in incremental costs such as direct and integration costs related to future acquisitions. We expect continued sales growth in our foreign business and plan to use the earnings generated by our foreign subsidiaries to continue to fund both the working capital and growth needs of our foreign entities, along with providing funding for any future foreign acquisitions. We do not provide for U.S. taxes on our undistributed earnings of foreign subsidiaries that we intend to invest 38



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indefinitely outside the U.S., unless such taxes are otherwise required under U.S. tax law. In 2013, we determined that a portion of our current year earnings of foreign subsidiaries may be remitted in the future to the U.S. for domestic cash flow purposes and, accordingly, provided for the related U.S. taxes in our consolidated financial statements. Currently the majority of our cash and marketable securities are held in the U.S. If we change our intent to invest our undistributed earnings outside the U.S. indefinitely or if a greater amount of undistributed earnings are needed for U.S. operations than previously anticipated and for which U.S. taxes have not been recorded, we would be required to accrue or pay U.S. taxes (subject to an adjustment for foreign tax credits, where applicable) and withholding taxes payable to various foreign countries on some or all of these undistributed earnings. As of December 31, 2013, we had undistributed earnings of foreign subsidiaries that are indefinitely invested outside of the U.S. of approximately $105.0 million. If our operating results deteriorate during the remainder of 2014, either as a result of a decrease in customer demand, or severe pricing pressures from our customers or our competitors, or for other reasons, our ability to generate positive cash flow from operations may be jeopardized. In that case, we may be forced to use our cash, cash equivalents and short-term investments, use our credit agreement or seek additional financing from third parties to fund our operations. We believe that cash generated from operations, together with existing sources of liquidity, will satisfy our projected working capital and other cash requirements for at least the next 12 months.



Off-Balance Sheet Arrangements

As of June 30, 2014, we did not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.



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. We are 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. We are currently evaluating the impact of these amendments and the transition alternatives on our consolidated financial statements.



Recently Adopted Standard

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 our Condensed Consolidated Balance Sheets when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. We adopted this standard 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. 39



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