Joe Shiffler - Director, Investor Relations Balu Balakrishnan - President and Chief Executive Officer Sandeep Nayyar - Vice President, Finance and Chief Financial Officer.

Evan Wang - Stifel Nicolaus Vincent Celentano - Raymond James Tore Svanberg - Stifel Gus Richard - Northland Sidney Ho - Deutsche Bank.

Good afternoon. My name is John and I will be your conference operator today. At this time, I would like to welcome everyone to the Power Integrations Third Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the presenters' remarks, there will be a question-and-answer session.

(Operator instructions) Thank you. Mr. Joe Shiffler, Director of Investor Relations, you may begin your conference..

Thank you. Good afternoon and thanks for joining us to discuss Power Integrations' financial results for the third quarter of 2014. With me on the call are Balu Balakrishnan, President and CEO of Power Integrations; and Sandeep Nayyar, our Chief Financial Officer.

During today's call, we will refer to financial measures not calculated according to Generally Accepted Accounting Principles. Please refer to today's press release available on our website at investors.powerint.com for an explanation of our reasons for using such non-GAAP measures as well as tables reconciling these measures to our GAAP results.

Our discussion today, including Q&A session, will include forward-looking statements reflecting our forecast of certain aspects of the company's future business and financial results.

Such statements are denoted by such words like will, would, believe, should, expect, outlook, estimate, plan, goal, anticipate, project, potential, forecast and similar expressions that look towards future events or performance. Forward-looking statements are based on current information that is dynamic and subject to abrupt changes.

Our forward-looking statements are subject to risks and uncertainties, which may cause actual results to differ materially from those projected or implied in our statements. Such risks and uncertainties are discussed in today's press release and in Part 2 of our most recent Form 10-Q filed with the SEC on July 31, 2014.

This conference call is the property of Power Integrations and any recording or rebroadcast is expressly prohibited without the written consent of Power Integrations. And now I'll turn the call over to Balu..

Thanks, Joe, and good afternoon. Our revenues and earnings increased sequentially, but we observed a slowdown in orders as the quarter progressed, resulting in less than seasonal topline growth.

Revenues from the communications end market grew more than 20% sequentially, driven by strength in mobile phone chargers and the new demand from a large Asian customer in the residential networking space.

However, demand was softer than expected in the industrial, consumer and computing markets, all of which we serve predominantly through distribution channels. Overall, distribution sales decreased by nearly 5% compared to the prior quarter.

From a booking standpoint, after a strong July, orders declined in August and again in September, resulting in a sequential decline in total bookings for the quarter and a lower starting backlog for the fourth quarter compared to Q3. Orders in October have remained lackluster.

These trends are not what we typically see at this time of the year and not what we anticipated three months ago when we gave our Q3 outlook. Of course, we have noted the negative tone of some recent economic data and commentary from certain of our industry peers suggesting that macro or cyclical factors may be weighing on the demand.

Taking these factors into account, we are forecasting fourth quarter revenues of $86 million plus or minus $3 million. The midpoint of that range would be a mid single-digit decline consistent with the forecast given by many of our peers.

While our near-term outlook reflects the uncertainty of the current demand environment, our profitability and cash flow remains healthy and our balance sheet remains a solid driver.

We reported a non-GAAP operating margin of 23% for the third quarter due in part to a gross margin that remains at the high end of our target range and thanks also to a significant reduction in operating expenses.

We expect OpEx to raise in Q4 mainly to patent litigation expenses, but otherwise plan to manage spending carefully in light of the current demand environment.

We generated more than $30 million in cash flow from operations in the third quarter and added cash to our balance sheet despite using more than $20 million for share repurchases and dividends.

Our dividend increased to $0.12 per share in the third quarter, and this month our Board approved a $25 million increase in our buyback authorization, reflecting our continued confidence in the long-term prospects of our company.

We have expanding addressable markets, its strong pipeline of innovative products with which we serve these markets and a tailwind created by the growing demand for energy efficiency and renewable energy.

Over the past five years, we have broadened our focus from low-powered applications like adapters and standby power supplies to a wider range of power conversion applications ranging from milliwatts to megawatts of output and spanning the clean power ecosystem from the generation and transmission of energy to the efficient consumption of power in everything from electronics to lighting to heavy industry.

As a reflection of this ongoing evolution, we have developed a new corporate brand identity, which we plan to unveil in the coming weeks. Our new look will feature an updated logo emblematic of our unparalleled expertise in power conversion.

We will also launch a new website and a new web address, power.com, shining a brighter light on the breadth of our product offerings and technical knowhow and signaling our ambitious long-term strategic and financial goals. We are excited about this important symbolic step for our company and we look forward to rolling it out in the weeks ahead.

And now I'll turn it over to Sandeep for a review of the financials..

Thank you and good afternoon. I'll quickly go over the third quarter results and the outlook. And then we will open it up for questions. I'll focus my remarks primarily on the non-GAAP numbers which are reconciled to the corresponding GAAP numbers in the tables accompanying our press release.

Third quarter revenues were $90.1 million, an increase of 1% from the prior quarter. Sales into the communication end market rose more than 20% sequentially, reflecting strength in mobile phone chargers and residential networking.

However, as Balu noted, sales into the other end market categories reflected the broad slowdown in orders that occurred from August onwards. Revenues from the consumer market, our largest category, were down mid single-digits, while sales into the computer market declined low single-digits. And sales into the industrial market were flat.

Revenue mix for the third quarter was 36% consumer, 35% industrial, 18% communication and 11% computer. 74% of revenues in the quarter were on distribution sales, while 26% of sales were direct.

That's a change from a 78% to 22% ratio last quarter, reflecting the relative softness of the distribution business and the strength in communication where we tend to sell directly to high-volume customers. Non-GAAP gross margin for the quarter was 55.3%, in the middle of our forecasted range.

Non-GAAP operating expenses for the quarter were $29.1 million, down more than $600,000 from the prior quarter, largely reflecting expense controls we have implemented in light of the weaker demand environment. Non-GAAP operating margin for the quarter was a solid 23%. Non-GAAP earnings were $0.65 per diluted share, up $0.04 from the prior quarter.

Our weighted average diluted share count was 30.76 million shares, down more than 1% from the prior quarter, reflecting buyback activity. We bought back 359,000 shares during the quarter utilizing $19.5 million and leaving roughly $34 million remaining on our buyback authorization at quarter-end.

Buyback activity accelerated after the early October pullback in our share price. And as Balu noted, our Board of Directors has allocated an additional $25 million for repurchase activity.

Despite the buyback activity that took place in Q3, cash and investments on the balance sheet increased slightly during the quarter, thanks to strong operating cash flows of $30.6 million. Capital expenditures in the quarter totaled $7.5 million. We also paid our $3.6 million in dividends as our quarterly dividend increased to $0.12 per share.

Inventories increased by $5.7 million during the quarter, reflecting the lower-than-expected demand. That's 126 days of inventory, up from the last quarter, but still roughly in line with our targeted range of 110 million plus or minus 15 days.

Turning to the outlook, we expect fourth quarter revenues to be in the range of $86 million plus or minus $3 million, a decrease of between 1% to 8%.

We expect non-GAAP gross margins to be approximately 54%, down from the third quarter, reflecting a less favorable end market mix and a slightly larger contribution from newer products which carry lower than average gross margins at this stage of their lifecycles.

Non-GAAP operating expenses should be between $29.5 million and $30 million, with the increase from Q3 driven largely by higher litigation expenses, reflecting the timing of activity in one of our ongoing patent suits. Lastly, I expect the non-GAAP effective tax rate to remain in the range of 6% to 7% for the fourth quarter.

With that, I'll turn it back over to Joe..

Okay. We'll open it up now for questions and answers. John, would you please give the instructions for the Q&A session..

(Operator instructions) Your first question comes from the line of Tore Svanberg from Stifel..

This is Evan Wang calling in for Tore. My first question is about your communications business, and it was up very nicely. I was wondering if you have any 10% customer during the quarter as a result of the ramp..

No, we don't..

I know you won't guide for the March quarter, but do you have any visibility into how that might look like?.

How the communications market would look like?.

No, the overall business. If you could actually give us more of a sense of what the fourth quarter might be driven by as well as how you see the March quarter shaping up..

It's hard for us to have visibility into which markets will do well in the Q4 quarter, because most of our revenues go through distribution. However, we do have more visibility into the communications market, because a lot of the customers there we sell directly to.

And our expectation is the communication market will do better overall as a percentage compared to the total revenue, and that's because of our growth in rapid charging..

Without the March quarter, I think, is it likely to be a seasonal quarter? Do you see the potential for doing better than seasonal?.

It's really too early to tell. The decrease in bookings, I would say, in the last three months starting in August has been a very big surprise to us. And so we are not quite sure exactly what to expect for the rest of the year and definitely not for the 2015. We'll just have to wait and see how things go..

Your next question comes from the line of Steve Smigie from Raymond James..

This is Vincent Celentano filling in for Steve. Going into 2015, I want to see what drivers you see in appliances and what overall level of growth you think you can achieve..

Well, appliances has been a very strong market for us. We've been growing consistently except for the recent downturn, which seems to be very broad-based from everything we can tell, both not only in appliances, but also in industrial.

Having said that, our content in appliances has been growing, especially because of the new energy efficiency requirements. We see growth in CAPZero, SENZero and LinkZero products, because many of the appliance customers are asking for no consumption during standby. So we see that as a growth market as long as the macro is supportive of that..

And then I'm going into LED, same question as far as going to 2015, any color as far as what's the growth potential and what drivers through 2015?.

First of all, in Q3, the LED market declined particularly more than other markets in the industrial sector, and I think that's something that is consistent with what is reported by a number of companies. We think it is a short-term issue. We expect the LED market to be a long-term growth factor for us.

From everything we can tell, it's still the best lighting technology. And with the incandescent being phased out in most countries, we believe LED will be the ultimate winner in the lighting market. Exactly how it will grow is yet to be seen.

We are a little surprised and disappointed that this year will be a relatively small growth, but it's very possible that will come back to a stronger growth next year..

Your next question comes from the line of Tore Svanberg from Stifel..

I have a follow-up question. I was wondering if you can give us a little bit more color on what you're seeing with your distributors. Are the orders weaker because of inventory in the channel or is it because your lead times are really short? I was just wondering if you can give us a little more color on the dynamics there..

Well, I think the inventory at distributors is higher than normal mainly because of the sudden slowdown in demand. And our expectation is they will burn that through the next few months. But other than that, we don't have any other visibility. Obviously we get visibility into where they ship only after we get the POS at the end of the quarter.

So we don't have that much information other than the general broad slowdown that you'll see in the last three months..

Your next question comes from the line of Gus Richard from Northland..

Just real quick, your litigation expenses are going to be up in the quarter.

Can you just give a little bit more color as to how much that is?.

This last quarter, we did about roughly $1.5 million. I think it will be about $300,000 to $400,000 more roughly in Q4..

And what was it in Q3? I'm sorry..

It's roughly about $1.5 million..

Is that lit coming to an end or is this just a new round of the beginning?.

Well, this is just one of the cases. And that's why we have said for going forward if you look at it on an annual basis for modeling purposes to still keep it in the $6 million to $6.5 million for the full year..

I was just hoping you could give a little bit more color on the weakness in the PC market.

Is it just your customers have an inventory correction and a similar question with consumer? Can you sort of talk a little bit about where you see the weakness there?.

So as we mentioned in our script, the communications market did very well. It went up 20%. But all other markets were flat or down. Industrial was flat and the consumer was down mid-single digits and the computer was down slightly in the low-single digits, I should say. I don't think there is any particular trend we see.

It's just a very broad-based demand deduction. Most of these customers are through distribution and so we see that the distribution revenue has decreased 5 percentage points relative to Q2. And everything we can tell, that is very broad-based..

Over the last couple of years in the first quarter, you guys have suffered through an inventory correction in PCs.

Does this slight weakness in the PCs, is that foreshadowing further weakness or do you have any further color on what you think is going on in that market?.

It's hard for us to tell. The next few months will be more revealing. We always see things in the rearview mirror. So it is difficult to tell whether this is a short-term inventory correction or it is a macro issue or a cyclical issue. We just have to wait and see. But it's definitely not something that would be expected at this time of the year.

Usually September and October are very strong months for us both in terms of bookings and shipments. And this time, it has not been the case..

And the gross margins are holding up quite well in the fourth quarter, given the mix should be weaker. And I would imagine you're sort of trolling back on the manufacturing.

Can you just talk about what's holding it up here?.

Basically part of the reason that we have been holding up is that the ramp on some of the new products has been a little slower. Added to that, basically we've had a good mix till the previous quarter, but this quarter the mix shifted. So in the beginning first half, the mix was more favorable.

But as the mix is shifting, you're seeing the gradual decline continuing to happen and you will continue to see that into the next year a little bit from where we are exiting in Q4..

You're not backing off on what you put into the fab and building?.

That is something we are evaluating. And as we go through, that could be a headwind in the next quarter depending on how this quarter keeps shaping up. So that's the thing we are closely watching and evaluating and obviously we will be making adjustments if the order pattern continues into the next couple of months..

And just remind me what your inventory target range is..

This last quarter, we ended at 126 days. Our model is 110 plus or minus 15. So we're somewhere around there. And based on how the slowdown has happened, it could taper up a little bit from there. But obviously if the orders continue to be the way we are, we will adjust our production..

Your next comes from the line Sidney Ho from Deutsche Bank..

I am calling in for Ross Seymore. With regards to the guidance of down 1% to 8%, I know you've mentioned earlier that the visibility by end market is not that great and you also commented that communications will do better.

I was just hoping that you can talk about, is communications actually going to be up, and relative to all the other end markets, which one will be impacted more than the others?.

Well, as I said, I believe relatively communications will be up in Q4. Exactly which ones will be impacted among the other three markets, it's very hard to tell at this time. I can't think of any specific pattern. Some of them have seasonality and others don't. For example, our high power revenue doesn't have a discernible seasonality.

So we just have to wait and see. The reason we know the communications will do well is because of the new designs that will be ramping through Q4, specifically in rapid charging..

And then as a follow-up, if I look at your industrial end market and put a average decline of call it 5% for next quarter, you're looking at the full year kind of year over year it's kind of flattish versus I think the rest of the market is probably up, call it 5% to 10%.

Is there some trend that we should be looking at and how should we think about next year for industrial?.

I think the industrial should be good next year for multiple reasons. One is in the high power area, we are seeing a number of new designs, especially in the solar market in China, and that would be a growth factor for us.

And also, we opened a design center for high power in Germany and the activity in the design center indicates that there is a huge demand for our high power products and that a lot of customers are asking for customized designs for their end products. So we are optimistic about that growing.

The other area in industrial is the LED, which is the second largest segment. And there after the softness in the second half of this year, our expectation is that it will come back.

And this year, our growth could be relatively small, which is not what we expected, but it looks like it's going to be a relatively small growth this year mainly because of the softness in the second half of this year. And if our expectation is right, we should grow very nicely in the LED market.

So both of them would drive the industrial market, because they're number one and number two segments..