Joe Shiffler - Power Integrations, Inc. Balu Balakrishnan - Power Integrations, Inc. Sandeep Nayyar - Power Integrations, Inc..

Tore Svanberg - Stifel, Nicolaus & Co., Inc. Ross C. Seymore - Deutsche Bank Securities, Inc. David Williams - Drexel Hamilton LLC.

Good afternoon. My name is Mariama, and I will be your conference operator today. At this time, I would like to welcome everyone to the Power Integrations' Third Quarter 2016 Earnings Call. Thank you. I would now like to turn the call over to Joe Shiffler, Director of Investor Relations. You may begin your conference..

Thank you. Good afternoon. Thanks for joining us to discuss Power Integrations' financial results for the third quarter of 2016. 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.power.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 the 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 words like will, would, believe, should, expect, outlook, estimate, plan, goal, anticipate, forecast and similar expressions that look toward 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 our most recent Form 10-K filed with the SEC on February 11, 2016.

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

Thanks, Joe, and good afternoon. Power Integrations reached a noteworthy milestone in the third quarter, surpassing $100 million in quarterly revenues for the first time in our history.

We are on track for double-digit revenue growth this year and we expect to carry strong momentum into 2017 on the strength of the InnoSwitch product cycle, new products for the high power and lighting markets and the robust product pipeline that will further expand our addressable market in the years ahead.

Our third quarter revenues were $103.8 million, up 17% year-over-year. The communications end market led the way with growth of better than 20% as our InnoSwitch products continued to capture share in the mobile device market, driven by the ongoing adoption of higher power rapid chargers for smartphones.

Revenues in the consumer end market also grew 20% year-over-year, driven by strong growth in appliances, where we continue to gain share, thanks to our exceptional energy efficiency performance and the reliability benefits of a highly integrated product.

Industrial revenues also contributed to the strong results, growing mid-teens year-over-year, driven by a broad range of applications, including utility meters, industrial control applications and fast-growing vertical markets, such as chargers for electric bikes and battery-powered tools.

Though the first three quarters of this year, revenues have increased 12% compared to 2015, we are forecasting strong year-over-year revenue growth again in the December quarter putting us on course for a solid double-digit revenue growth for the year, well ahead of the projected growth rate of analog semiconductor industry.

The leading driver of this growth has been the rapid adoption of InnoSwitch, one of the fastest product ramps in our history. Revenues from InnoSwitch are on track to double this year and will account for more than 10% of our sales, in just its third year in the market.

The bulk of the InnoSwitch sales today are from rapid charging applications for smartphones as reflected in the strong growth of our communications category, up nearly 30% through the first three quarters of the year.

This growth reflects our increased share of charger market, but also higher dollar content for charger, which in turn is driven by raising power levels and the higher level of integration offered by InnoSwitch.

InnoSwitch is in production with all of the top tier Chinese and Korean smartphone OEMs for rapid charging applications and recently began shipping in high volume for a major American supplier of Android phones, whose new flagship phone employs an 18-watt USB PD charger.

We expect rapid charging to be a significant growth driver beyond the current year as the penetration rate of fast chargers continue to go up, power levels continue to raise in support of increasingly feature-rich devices and new technologies such as USB PD, direct charging and Type-C connectors drive the need for sophisticated power conversion technologies such as InnoSwitch.

We also expect the rapid charging trend to expand beyond handsets to other mobile devices, such as tablets and notebooks. Our next-generation InnoSwitch, set to launch in the coming months, addresses higher power levels than the first-generation product that is extremely well suited for tablets and notebook chargers.

Based on the positive feedback we've already received from customers who have sampled the product, we expect to generate meaningful revenues from these applications in the second half of 2017. While rapid charging has been our biggest growth driver this year, it's far from the only one.

Consumer revenues have increased more than 10% through the first three quarters of the year, driven by strong growth in appliance applications, including major appliances, countertop appliances and air conditioners.

Given the high dollar value of these products and the costs associated with any quality issues, reliability is typically the most critical design criteria for appliance OEMs. Highly integrated power supplies are inherently more reliable than complex discrete designs, which often contain twice the number of components as a Power Integrations design.

Dollar content also continues to rise as applications incorporate more electronic features, even as efficiency specs continue to tighten. We expect even further content growth as appliances add IoT functionality and as our high value InnoSwitch products are adopted by appliance makers in the coming years.

Industrial revenues are also contributing to our growth this year, driven by several fast growing vertical markets, where technological shifts are creating demand for our products. We are seeing strong growth this year in smart utility meters, which require highly reliable power supplies to drive their electronic functionality.

Products that have not traditionally used battery chargers, such as lawn mowers, leaf blowers and high-end power tools are now going electric, and our products are used in the chargers for many of these devices.

Likewise in transportation, where battery-powered bicycles are replacing gas-powered scooters, bus fleets are being converted from gas to electric, and electric locomotives are now in widespread use. Meanwhile LEDs continue to replace traditional lighting technologies in general lighting applications.

We have seen a return to growth in LED lighting in 2016, and expect growth to continue in 2017 on the strength of several new products launched earlier this year, even more products to come.

While we have ample growth opportunities to sustain our momentum into 2017, we believe the outlook is even brighter beyond next year, as we begin to see revenue from recently announced products, and other new products to be introduced in the coming quarters.

One such product is our new SCALE-iDriver family of IGBT drivers, the first product synergy from our acquisition of CT-Concept. While design cycles for high power applications tend to be quite long, SCALE-iDriver has already scored its first design in at a major Asian industrial consortium with high volume shipments expected to begin in 2018.

We believe the SCALE-iDriver family and its derivatives will roughly double the size of our market opportunity for IGBT drivers, taking our total company TAM to more than $3 billion. We expect that number to exceed $4 billion in the near future, as we bring more new products to the market.

And with that I will turn it over to Sandeep for a review of the financials..

Thanks Balu, and good afternoon. I will quickly touch on a few financial highlights, focusing mainly on the non-GAAP numbers, which are reconciled to the corresponding GAAP figures in the tables accompanying our press release.

I will then conclude with a brief comment on the new FASB revenue recognition standard, which will require us to recognize sales into the distribution channel on a sell-in basis and which we are currently on track to adopt for fiscal year 2017. Looking at the Q3 results, revenues were $103.8 million, up 17% year-over-year and 7% sequentially.

The sequential increase was driven by double-digit growth in the consumer end market and high single-digit growth in communications. Revenues from the industrial market grew slightly on a sequential basis, while computer revenues fell slightly. Revenue mix for the quarter was 37% consumer, 30% industrial, 28% communication and 5% computer.

Gross margins ticked up slightly to 50.6% on a non-GAAP basis, an increase of 30 basis points sequentially, mainly reflecting above seasonal strength in the appliance market. Non-GAAP operating expenses were flat on a sequential basis at $30.7 million coming in slightly below our projections due mainly to the timing of head count additions.

Reflecting the strong revenue growth, slightly higher gross margin and flat operating expenses, non-GAAP operating margin increased by more than 2 percentage points coming in at 21% for the quarter. Our non-GAAP tax rate for the quarter was just over 4%, resulting in non-GAAP net income of $21.2 million or $0.72 per diluted share.

That's up from $0.55 in the year ago quarter, an increase of 31%. We generated $26.3 million in cash flow from operations in the quarter, while capital expenditures totaled $3.2 million. Cash and investments on the balance sheet totaled $226.6 million at quarter end, an increase of $24.3 million during the quarter.

Internal inventories increased modestly, picking up by one day to 87 days on hand, that level is below our target range of 110 plus or minus 15 days and we do anticipate building some inventory over the next several quarters.

Our outlook for the fourth quarter is for revenues of $101 million plus or minus $3 million, which would once again be a mid-teen year-over-year growth rate at the midpoint and would bring our growth rate for the full year into the low teens.

We expect a slightly less favorable end market mix in the fourth quarter, driven mainly by the continued growth in rapid charging revenues as well as a softer appliance market after the above-seasonal performance in Q3. We will also begin to feel the effect of the stronger yen, which increases the cost of wafers from our Japanese foundry partners.

Though partially offset by the favorable impact of higher production volumes, these factors should result in a lower gross margin in the fourth quarter around 50% on a non-GAAP basis. We expect non-GAAP operating expenses to be sequentially higher, as head count additions, we had expected in Q3, will now occur in Q4.

We also have decided to forgo a holiday shutdown this year and will therefore not see the typical seasonal reduction that we have seen in past years. Specifically, we expect non-GAAP expenses to be in the range of $31 million to $32 million. Lastly, our effective tax rate for the fourth quarter should be around 5%.

Before we go into Q&A, I would like to touch on the new FASB revenue recognition standards, which require sell-in revenue recognition on sales to distributors. As you know, we currently utilize sell-through revenue recognition for all our distribution sales, except for high power products.

While we have not yet made a final decision as to the timing, our current plan is to adopt the new standards, and covert to sell-in revenue recognition effective January 1, 2017. When we adopt the new standards, we will recast prior period financial data under the new standard in order to maintain comparability with historical results.

Our forthcoming Form 10-Q will include preliminary revenue and cost of sales data computed on a sell-in basis for the past seven quarters. We would then publish full recast financials for 2015 and 2016 in conjunction with our fourth quarter earnings release.

As for the impact on our results, the preliminary data for 2015 shows that, while the new rules will have some effect on the quarter-to-quarter seasonality of the revenues, the impact on annual revenues is very slight, with a difference of less than $1 million under the two accounting methods.

And again, you will be able to see that data in our forthcoming 10-Q filing. And with that, I will turn it back over to Joe..

Thanks, Sandeep. We'll go ahead and open it up for Q&A now. Mariama, would you please give the instructions for Q&A session..

Certainly. Your first question comes from Tore Svanberg with Stifel. Your line is open..

Yes. Thank you and congratulations on passing that $100 million milestone, pretty impressive..

Thanks, Tore..

First question is on the fourth quarter outlook. So, you talked about some of the moving parts with consumer probably being down seasonally and then communications still growing sequentially.

But what about some of the other businesses, especially industrial, how should we think about growth there in the fourth quarter?.

So, I think, industrial also will be, as a percentage of total revenue would be I think slightly lower. And I would say, the computer maybe slightly up, picking up slightly. But I think the main drivers of the mix change will be the communication going on with the continued strength that we are seeing with rapid charging.

And the consumer, the only reason, it's the timing of what has happened. Typically in Q3, we don't see consumer to be that strong, because air conditioning tends to be down.

What has happened is we have seen quite a bit of success in the air conditioning, and it could have happened because of a timing issue, where because of the holiday in the first week of October, but we are also seeing strength where we are winning share as well as the content is increasing.

So the patterns have been a little uneven over the last couple of years, but considering the strength we saw in Q3, that's what we have taken into account in giving our guidance for Q4..

Very good. And Balu, you said that the next-gen InnoSwitch is going to be sampling here pretty soon.

Could you talk a little bit more about the types of power levels we can expect from that generation?.

Sure. Our current InnoSwitch goes up to 25 watts. The next generation will extend that power range all the way up to about 55 watts for adaptor type applications and up to about 100 plus watts for open frame applications..

Very good. And just one more question on the InnoSwitch. So you talked about a design win here in the U.S. You don't have to mention the name, but I assume it's the Pixel, and that uses PD, USB PD.

Are you starting to finally see more and more design activity around the USB PD standard?.

Absolutely. The interest level in USB PD is very high. It is certainly gaining momentum against more proprietary type protocols, which was really causing a lot of confusion in the marketplace. We certainly get a feeling that most of the OEMs will eventually focus in on USB PD. Having said that, I think the USB PD adoption will really take off in 2018.

Obviously, we are seeing some early adopters like the one we just announced. That's our first USB PD design. There are a number of other designs going on, but there is a little bit of hesitation, because some of them have already chosen their own protocols, and say, I think they'll continue to ship that for a little while.

But, and also the USB PD is adding some special features into USB to account for direct charging.

The direct charging is a way of actually charging the cell phone directly from the charger, meaning that the charging function is moved to the adapter, so that you have less power dissipation in the phone, and that requires some additional changes to the USB standard which is being implemented.

So, once that's done, I think USB PD will really take off..

Very good. Just one last question, you talked about soon getting up to $4 billion from a SAM perspective.

Is that primarily coming from new InnoSwitch products or is there something else that you're working on that you haven't talked about?.

It actually comes, not only from the next generation InnoSwitch product, but from a number of other equally revolutionary products that we'll be introducing in the next few quarters. Some of them increase our ASP in existing markets. Some of them actually get us into new markets. So, I will stop there..

Very good. Great. Congratulations again guys. Thank you..

Thanks..

Thanks, Tore..

Your next question comes from Ross Seymore with Deutsche Bank. Your line is open..

Hi, guys. Thanks for letting me ask the question..

Hi..

On the InnoSwitch, the next-gen InnoSwitch side of things, can you just talk about not just the power levels, Tore asked that question, but some of the end markets that you think that will apply to first? I know it's the second half of next year, but where would you expect that to occur? And then the margin structure on that, the first generation InnoSwitch ramping up had some dilutive impact on gross margin originally.

Is this going to have the same effect or is the fact that it's going into different end markets change that dynamic?.

The answer is yes, it will change the dynamic. And the reason for that is that, it will go into applications, where the performance becomes even more important than the current InnoSwitch. For example, we will go into higher power, fast chargers for cell phones, we'll go into tablets, notebook adapters.

And the trend in all of those areas is higher efficiency to make the adapter smaller. So for example, the notebooks are now pretty much standardizing on about 45 watt charger. And that charger can also be used for tablets and cell phones, if it is USB compatible, it can address a wide range of power levels, with the same charger.

And so that means that they really would like the charger to be very, very compact and offer extremely high performance in terms of feature set.

So we think the Inno 3 will have a higher margin for multiple reasons, one is the performance requirement; number two, it uses a new technology which is a more cost effective technology, it's more denser technology. And so, the combination of those two will improve the gross margin..

I guess, similar to that, at the lack of a shutdown in the fourth quarter, I can't remember the time the last time, a semiconductor company was not shutting down at the end of the calendar year.

Can you just go into a little bit as to what's leading you to keep open?.

Sure. The good news is, we can't afford to shutdown. We can't afford to shut down for two reasons, both from a production point of view, we need to continue to work through the holidays. But also because of the new products, we have a number of very, very revolutionary new products. And we want to get them into market as quickly as possible.

So, we definitely want our employees to work through the holidays..

I guess this is my last question, follow-up to that one, one for Sandeep, the fact that the OpEx isn't going down, obviously is part of no shutdown and some of the incremental hiring. What is the seasonal pattern due to then in the first quarter, where usually from fourth quarter to first quarter, you would have the OpEx go up.

In this case, since it's not going down, how should we think about, OpEx, as we look forward into 2017?.

I think, Q1 typically will go up because, of the FICA resumption. And for 2017, I think, we should model it like to our standard model, where, if we grow the double-digit growth in revenue, the expenses will grow at 60% on that..

Great. Thanks and congrats on the great results..

Thank you..

Thank you..

Your next question comes from David Williams with Drexel Hamilton. Your line is open..

Hey. Good afternoon and thanks for taking my question.

First I guess, if you could just talk a little bit about, what you're hearing from maybe some of your customers in relation to what you're hearing out of Samsung? I understand there is – that you guys are not in that phone, are you hearing anything, I guess, maybe any concern or caution that maybe was something to do with the charging or perhaps that component that is at least contributing to the issues they're seeing there?.

Hi, David, this is Balu. We haven't met, but very nice to meet you on the conference call. What we know is that the rapid charging itself is unlikely to be an issue because so many phones these days use rapid charging, hundreds of millions of phones have been shipped with rapid charging, including other models that Samsung phones have rapid charging.

So, certainly that cannot be a fundamental issue. But beyond that we don't know exactly what is causing the problem. I believe Samsung has said, it is not the battery anymore, even though originally they thought it was the battery, but we don't know what is causing it, and I would hate to speculate on that..

Great. Thanks.

And then, maybe if you could just kind of touch on your backlog position, and how your bookings kind of fared through the quarter? And really kind of how they're shaping up through the end of the year?.

So, our bookings have done pretty well, and our book-to-bill has been over 1. And so, if you look at July and August, were very strong months, September tapering down a bit from there and October has continued to be at the level, somewhere similar to September..

And that's pretty typical for us, if you look at last year, it was the same way..

Great. And then, lastly I guess, can – you can kind of talk a little bit about the ASPs in consumer, and maybe your dollar content opportunity as you continue to ramp into that and we started seeing a little more growth there.

What do you think that total dollar opportunity could be for you guys?.

I mean, in terms of the addressable market?.

Yes..

The – I mean, are you talking, in terms of the content increase are you talking about or....

You are talking about the total addressable market?.

I'm sorry.

Yeah, just the dollar content opportunity that you see in that market, specifically?.

Got it. So historically, we have been in the auxiliary power supply that powers the electronics board, there is usually a control board that's connected to all the knobs on the appliance. But what's happening these days is that we are finding increase in content in multiple areas.

One is in reducing power consumption in standby, and we have two products that become very popular, one is CAPZero, which reduces losses related to input capacitor discharge circuitry. And then, we also have, what's called SENZero product that reduces the consumption from sense circuitry, so that's adding content.

In addition to that, IoT features like having a wireless node, typically increases the power requirement by 3 watts to 4 watts, which means that, they have to use a more expensive higher power power supply chip from us, so that increases the content. But more recently, what we are finding is that many of the products have more than one power supply.

For example, if you take a refrigerator, they are now using electronically commutated motors that requires a separate controller, and they tend to use a separate power supply for that, because of the physical separation of the motor from the rest of the circuitry. The other area is LED lighting.

As you noticed, many of the refrigerators have LED lighting now. And they typically use a separate power supply because it's constant current drive. So, and the similar thing they are finding in the air conditioning, two separate power supplies, one for the control board, one for the motor.

So that all of these things are increasing our content and therefore increasing our total SAM in this marketplace..

Great. Thanks so much guys. Good luck on the quarter..

Okay, thanks..

Thanks, David..

Your next question comes from Tore Svanberg with Stifel. Your line is open..

Yeah, thanks. I just had a few follow-ups. First of all on gross margins, obviously a lot of different moving parts there.

But Sandeep, how long would it take for you to get your inventories back up to your target level? And then the other part of that question is, how much more impact are you expecting from the Japanese yen for the next few quarters?.

So, I think it's going to take a couple of quarters with the demand continuing to be robust for us to build our inventory back, it will take a few quarters. For the Japanese yen, it's hard as you know to predict but, and you know it takes five to six months for the impact of the Japanese yen to flow into our P&L.

If you look at the beginning of this year, the yen was at about ¥120. And if you look where we are today, it's somewhere around ¥104 to ¥105. Now we don't know what the full impact of this would be next year because it's still some more time to go before we know that. We'll be in a better position to know that.

But if you look at just from the ¥120 to the ¥104 or ¥105, that's like 150 basis points because every 10% change in yen impacts us roughly 100 basis points. So, directionally that's a big headwind for us, added to which, the mix is obviously, with rapid charging continuing to increase.

But we have a lot of measures of cost reductions as well as going to lower, die shrink as well as package cost, test costs. So we have a lot of things which will be offsetting the headwinds that we have, but directionally obviously, the headwinds are quite strong at this point of time but it's a little early to tell..

Very good. And you talked about some of the dynamics in consumer on why that this is kind of seeing a resurgence.

But if you look at the impact or what's boosting your growth there between let's say IoT or electronification versus more stringent standards, what's having a bigger impact do you think on your growth in consumer?.

Okay. That's a good question. It's a hard question to answer.

But directionally, I would say that the content increase is probably our number one, whether it's because they're using multiple chips and/or multiple power supplies, that's probably the biggest impact, followed by IoT, because IoT increases our dollar content also and then followed by share gains.

They're actually gaining share against our competitors..

Okay. And one last question, you talked about the IGBT driver revenue potentially contributing in 2018 with the new products.

How should we think about that business from a profitability perspective, because I assume those products are probably carrying higher than corporate gross margin?.

That's correct. They are on the higher end of our range, 50% to 55% range, so that those products will help the gross margin..

All right. Thanks again guys. Thank you..

You're welcome, Tore..

Thanks Tore..

Your next question comes from Ross Seymore with Deutsche Bank. Your line is open..

Hi, guys. Also just a couple follow-ups here. The inventory side of things, Sandeep, I know you said it will take a couple quarters to get it back up to your target level.

Can you remind us what that target level is?.

It's 110 days plus or minus 15 days. As you know for us inventory is like an asset being able to supply at very short notice, so we actually want to build up to the 110 days, 120 days..

And as far as cash usage in general goes, you guys are back up to close to $8 per share in cash on the balance sheet.

Can you just talk about the possible uses of that cash and potentially what your CapEx should be for 2017 as an offset to that?.

So if you look, we have had a four-pronged approach, where we first have invested internally, as you have seen that with the increase in the R&D spend over the years. We have been also very strategic and opportunistic in terms of what acquisitions we do close to our core because we do acquisitions, which are very close.

And as you know, over the last four years or five years, we have spent nearly $220 million on these acquisitions. We also are very opportunistic in buyback and you can see it – in our history, where we have spent in the last six years, seven years over $300 million at an average price of $27 and change.

And we also provide a dividend to our shareholders as another means of returning value. So, I think the four-pronged approach is what we will continue to do and obviously, we like to keep our powder dry for any good opportunities..

And then on the CapEx side for next year?.

On that CapEx side, historically if you look, at an average, we have spent about $20 million, this year will be a little under, but next year, I believe because of the growth and the investments we are making in new products, new packages, it will be a little over the average that we have talked about.

So, this year I would think it's like $13 million to $15 million, next year more like a $25 million, but that's an early estimate. We haven't done our plans yet..

Okay.

And I guess my last question, if you aggregate up the dynamics that you see from the bookings that you have, the new products that you're going to launch, if we put that into an end-market framework over the course of 2017 as a whole, which do you think would be the faster and slower growing or even shrinking potentially sub-segments of your business by end market..

So, I think the key drivers of the end market mix directionally, because since I haven't done the plan is going to be communication with the continued success in rapid charging and also the success in LED lighting and high power driving the industrial segment.

The computer segments will come back with what Balu indicated with our entry in the second half into the notebook and tablets. I believe next year directionally would be a growth year for all of our end markets..

We also expect the appliance market to continue to grow for the reasons I mentioned..

Thanks..

Basically the consumer market..

Thank you..

You're welcome..

There are no further questions at this time. I will turn the call back over to the presenters..

Okay. Thanks, everyone, for listening. There will be a replay of this call available on our website investors.power.com. Thanks again for listening and good afternoon..