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

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

Good afternoon. My name is Jody and I will be your conference operator today. At this time, I would like to welcome everyone to the Power Integrations' Fourth Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. Thank you.

Director of Investor Relations, Joe Shiffler, you may begin your conference..

Thank you. Good afternoon and thanks for joining us for this rear morning conference call. With me today, as usual, are Balu Balakrishnan, President and CEO of Power Integrations; and Sandeep Nayyar, our Chief Financial Officer.

As explained in last night's press release, Power Integrations adopted FASB's new revenue recognition standard effective January 1 of this year.

The new standard requires us to switch from the sell-through method of accounting for distribution sales to the sell-in method, under which revenues are recognized upon shipment instead of being deferred until the product is sold to an end customer.

In order to help bridge between the two accounting methods and ensure comparability between periods, we have made available the past eight quarters worth of financial data recast as if the new standard had been in effect for those periods.

While the effects of the accounting change are small, the recast data itself is voluminous as it includes full income statements, balance sheets, cash flow statements and non-GAAP reconciliations.

We chose to have the conference call this morning in order to give you a chance to look at the data and perhaps incorporate it in your financial models prior to the call.

If you haven't yet had a chance to look for the recast data, you can find it in the spreadsheet on our investor website, investors.power.com, and a document labeled Recast Financials and also in the Form 8-K that we filed yesterday.

Our discussion of the Q4 results on the call today and in last night's press release is based on the results under the old revenue recognition rules which were in effect until the end of the quarter, and which were the basis for the Q4 guidance that we gave back in October.

When we discuss the outlook for Q1 of 2017, we will of course be talking in terms of the new sell-in revenue model. Having said all that, during the call today we will refer to financial measures not calculated according to Generally Accepted Accounting Principles.

Please refer to our press release 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 our 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 morning. Our quarterly revenues exceeded the $100 million mark again this quarter coming in just over $101 million. That's up 16% year-over-year and brings our full year growth rate to 13%, well above the analog semiconductor industry, which is estimated to have grown at a mid-single-digit rate in 2016.

Our growth in 2016 was broad-based, coming from communications, consumer, and industrial end markets, each with its own unique secular drivers. In communications, revenues grew nearly 30% in 2016, led by the ongoing ramp of our InnoSwitch products in smartphone chargers.

Smartphone OEMs continue to specify chargers that deliver significantly more power than the 5 watt chargers that were standard issue just a couple of years ago.

Rising power levels create serious challenges for our power supply designers, requiring much higher levels of integration and energy efficiency in order to maintain the small contractors to which we are all accustomed.

Our InnoSwitch products satisfy these demands extremely well and have been widely adopted by smartphone OEMs and their charger suppliers. As a result, InnoSwitch has ramped faster than any product in our history, going from just $5 million in 2014 to more than $40 million in 2016 with nearly all of that revenue coming from smartphone applications.

The consumer end market, our largest revenue category, was also a major contributor in 2016 with growth in the mid-teens. Growth was driven by appliances, where we are not only winning strong market share, but also seeing rising dollar content as appliances continue to evolve from mechanical machines into intelligent electronic devices.

Industrial revenues also added to our growth in 2016 with revenues up mid-single-digits for the year.

Here again, a key theme is the electronification of products such as utility meters and light bulbs, which until recently never needed power supplies and applications like bicycles, scooters, and lawn equipment that have historically been powered by liquid fuels, raw alternating current or plain old manpower, but are now utilizing DC motors with rechargeable batteries.

We believe all of these themes will endure into 2017 and beyond. Rapid charging continues to be an important trend in the mobile device market with perhaps only 30% of the smartphone market now having adopted higher powered chargers.

We expect this penetration rate to raise considerably over the next few years, particularly with new charging technologies such as USB-PD with type-C connectors on the verge of mass adoption. Meanwhile, the conversion of consumer appliances into sophisticated electronic devices has been ongoing for many years but still has a long way to go.

While most brand-name appliances already utilize basic electronic controls and displays, the conversion to electronically controlled motors and LED lighting are still ongoing and the incorporation of connectivity and other forms of electronic intelligence is just beginning.

All of this adds up to a growing addressable market for Power Integrations, which we are well-positioned to capture given our strong incumbent position in the appliance market. Similarly, in the industrial category, the trends I just described are still in the relatively early stages.

We expect meaningful growth this year in applications like charges for E-bikes and power tools. And while LED light bulbs are now commonplace, the conversion to LED lighting in commercial, industrial and street lighting is still in the early innings.

Not to mention the incorporation of connectivity and other forms of intelligence in lighting systems, all of which will require additional power supply content.

Indeed, the greater secular trend of home and building automation is quickly emerging as a revenue opportunity for us, and our products are now being designed into a variety of embedded devices such as connected thermostats, smoke detectors, and power strips.

Such applications demand reliability and low standby energy consumptions, making them ideal targets for our products. While the drivers of the last year's growth are continuing into the new year, and beyond, we also expect to layer-on new revenue streams in the years ahead.

Our next-generation InnoSwitch will address higher power levels than the first-generation products and will enable us to bring the benefits of InnoSwitch to a wider range of applications beginning in the later part of the year. We also have a strong pipeline of new products on the way, some of which will address markets we don't currently serve.

In all, we expect to increase our addressable market opportunity to more than $4 billion over the next 12 months to 18 months from its current level of about $3 billion. In conclusion, 2016 was an outstanding year for Power Integrations.

And we enter 2017 with momentum fueled by innovative products, dynamic secular trends across all of the key end markets, and the continuing global push for greater efficiency and cleaner energy -- forms of energy. And now I'll turn it over to Sandeep for a review of the financials..

Thanks, Balu and good morning. As Joe mentioned in the introduction, my recap of the Q4 results will be based on the sell-through accounting method which was in effect until the end of 2016 and which was the basis for our Q4 guidance.

I will then comment briefly on the recast data we released yesterday which presents the past two years of results as if the sell-in method had been in effect. Finally, I will touch on the Q1 outlook which is based on the sell-in method. Looking first at the Q4 results, revenues were $101.1 million, up 16% year-over-year.

As expected, revenues were down 3% sequentially, with lower industrial and consumer revenues more than offsetting sequential growth in the communication and computing end markets. Revenue mix for the quarter was 35% consumer, 30% communications, 29% industrial, and 6% computer.

From a gross margin standpoint, that's a less favorable mix than we had in Q3, resulting in a decline of 40 basis points in our non-GAAP gross margin, which came in at 50.2%.

Non-GAAP operating expenses were flat on a sequential basis at $30.7 million, coming in slightly below our projections due mainly due to the timing of head count additions and capital expenditures. Non-GAAP operating margin was 19.8% for the quarter.

We recognized a non-GAAP tax rate of 1.2% for the quarter in order to bring our full effective tax rate to 3.4%. Non-GAAP net income for the fourth quarter was $20.2 million or $0.67 per diluted share. That's up from $0.58 in the year ago quarter, an increase of 16%.

We generated $27.7 million in cash flow from operations in the quarter, with capital expenditures of $4 million. Cash and investments on the balance sheet totaled $250.5 million at quarter end, up about $24 million during the quarter.

Internal inventories increased modestly to 93 days on hand, up six days from the last quarter, but still below our target range of 110 plus or minus 15 days. And we do anticipate continuing to build inventory gradually, over the next several quarters. Distribution inventory ended the quarter at 5.8 weeks, unchanged from the prior quarter.

Looking at the full year, 2016 was an outstanding year for our company, with revenue growth of 13% and just a 4% increase in our non-GAAP operating expenses.

While our success in the lower margin communication end market resulted in the lower gross margin percentage for the year, our top line growth, combined with expense discipline, enabled our non-GAAP operating margin to expand by 130 basis points and resulted in a 23% increase in non-GAAP earnings per share.

We generated $98 million in operating cash flow, with just $12 million in CapEx and added more than $75 million in cash and short-term investments to our balance sheet. Reflecting the strength of our balance sheet, our Board of Directors has declared $0.01 per share increase in our quarterly dividend to $0.14 per share.

Before I discuss the Q1 outlook, I will like to set the table by commenting briefly on the change in the accounting rules and its impact on our results, as I'm sure many of you have not yet had a chance to review the recast data that we made available yesterday.

As we explained on past conference calls, the new rules require us to recognize all of our distribution sales on a sell-in basis rather than sell-through. Roughly 75% of our sales go through distribution and about 90% of that was previously recognized on sell-through. So the percentage of our revenue that is affected is substantial.

But as you can see in the recast data, the effect on our numbers is immaterial on a full-year basis. Full year revenues for 2015 changed by less than $1 million when converted to sell-in, while the change for 2016 was just over $2 million or well below 1% of sales. Differences in gross margin percent and net income are correspondingly small.

The only other notable change is on our balance sheet where we previously recorded a liability representing deferred income on products shipped to the distributors but not yet sold through. With the change in the methodology, this liability is extinguished with the balance added to retained earnings at year-end.

While the impact of the new standards on annual revenues is small, the new rules will have some effect on the quarter-to-quarter seasonality of our revenues. Generally speaking, sell-through in March quarter is muted by the Lunar New Year break in Asia, but distributors do tend to take on inventory during the quarter ahead of production ramps in Q2.

Where this revenue would have been deferred to future periods under the old standards, it will now be recognized upon shipment. This pattern would make Q1 a stronger quarter in terms of sequential growth than what we typically saw under the old standard, with a lower sequential growth rate in the second quarter naturally following from that.

The new pattern is reflected in our outlook for the first quarter, which calls for revenues to be flat plus or minus 3%, compared to the recast fourth quarter revenues. Were the sell-through methods still in effect, our Q1 revenue forecast would be lower by approximately $3 million, which would have been a sequential decline of about 2%.

Note that on a year-over-year basis, the midpoint of Q1 range would be up 16% compared to the recast numbers of $88 million in Q1 of 2016. We expect non-GAAP gross margin to be between 49% and 49.5% in the March quarter with the sequential decline reflecting the strength of the Japanese yen versus the U.S. dollar through most of 2016.

A stronger yen results in higher wafer cost from our Japanese foundries, impacting our gross margin as higher cost wafers eventually flow through our inventory. The stronger yen negatively impacted our gross margin by roughly 50 basis points in the fourth quarter, with an additional 100 basis points to come in the first quarter of 2017.

However, while the dollar has not fully recovered to the level of early 2016 versus the yen, the post-election recovery in the dollar should provide a benefit to our gross margin in the second half of the year.

This effect, combined with a number of cost reduction initiatives currently in process, should enable us to return to somewhere around the 50% level by the fourth quarter.

We expect non-GAAP operating expenses in the first quarter to be sequentially higher, reflecting a resumption of FICA taxes as well as the timing of head count additions and capital expenditures that we had expected to occur in the previous quarter. Specifically, we expect non-GAAP expenses to be in the range of $31 million to $32 million.

Lastly, our effective tax rate for the quarter should be around 5%. And, with that, I'll turn it back over to Joe..

Thanks, Sandeep. We'll open it up now for questions-and-answers.

Operator, would you please give the instructions for the Q&A session?.

Our first question comes from the line of David Williams with Drexel Hamilton. Your line is open..

Hey. Good morning and thanks for taking my question.

I guess first off, whenever we are thinking about the gross margin, and thank you for the color, linearly, how much, I guess, impact are you seeing from a mix shift perspective going through the year and how are you kind of thinking, I guess, about the infrastructure revenue, some of the industrial revenue, and the comp business? How should we think about margins as we go through maybe this year and into next year in terms of what kind of lift you could get as you start seeing higher dollar or higher margin segments start to pick up a bit?.

Thanks, David. Good morning. The way we are modeling at this point of time because it's a little early for the whole year, yen and mix are obviously the things that can impact us.

The way we are modeling at this point of time is that the second quarter would be kind of similar to the first quarter, and then gradually uptick in the third quarter and gradually coming to the 50% level by the fourth quarter.

The mix if you look at the whole year, I think would be relatively similar to the mix of 2016, though with a slight slant for the full year I would say towards communication and the computer segment, with a continued strength in rapid charging, and with the introduction of the next-generation InnoSwitch, which will probably have meaningful revenues by the fourth quarter, helping us in the computer segment..

Okay. Great. And then from a revenue perspective, we have heard several other suppliers talk about handset delays they are seeing out of some Asia OEMs.

Are you experiencing any of that? And is that may be tempering some growth that you might have otherwise seen in 1Q?.

I think there have been some shortages at some of the customers. But so far, that has not been a major impact for us. There could be some, but we don't think it's going to be very significant.

We think the communications will grow through the year, and as a percentage, communications will grow slightly this year, and so will the computer because of our entry into new markets like monitors and notebooks..

Great. I appreciate that.

And then maybe if you could just kind of rank order where you expect to see the growth this year amongst your major submarkets?.

I would say communications will still be our number one growth. As a percentage, computer could be higher, but in magnitude, computer is only 6%. So, the growth there will be in dollars, will be smaller. But we have one designs in monitors with our next-generation Inno 3 product. In fact it's a Tier 1 monitor and TV manufacturer.

So we have one designs in both monitors and TVs. The monitor of course goes into computer segment, so we expect the computer segment to grow nicely. But we also expect industrial and consumer segments to grow..

Great. Thanks for that. I will jump back in the queue..

Our next question comes from the line of Ross Seymore of Deutsche Bank. Your line is open..

Hi, guys.

Now that you have changed to a sell in revenue recognition, do you by default have a little more visibility, the full-year you just talked about, the end market exposure but do you have more visibility even on a quarter-by-quarter basis in how you get to the flat revenues sequentially from an end market perspective?.

It's basically pretty hard to get a full year as you know and that's part of the reason we don't give. What we do is we model how the end markets are going to behave based on the markets being normal with our market share and do what I call probabilities, and based on these models, that's where we come to the end market mix.

But as you know, it's difficult to predict for the whole year in our business. It's just the probabilities put together and the strength that we are seeing in the InnoSwitch, in rapid charging, plus the design wins that Balu has talked about and the potential of success, we continue to see.

However we believe we will continue to grow in the consumer end side with the success we have in consumer with appliances and have success in our industrial segment with high-power and led lighting and meters and tools..

Ross, just to clarify from a revenue point of view it's obviously easier because we know how much we ship. So we will know our revenue a little bit earlier. From a POS point of view we still have to wait for the distributors to report to us. So POS will still take a few days after the quarter. But revenue will be known a little bit earlier..

That's helpful. I guess as my follow-up, on the gross margin side of things Sandeep your trajectory throughout the year is helpful that you gave to an earlier question. If we dig a little bit into the mix side I know you have different end markets growing and they carry different margins and if comps is growing faster generally that's a headwind.

But correct me if I'm wrong, but I seem to recall the second generation of the InnoSwitch was going to be not only higher power, I address higher power but also have a lower cost basis to it.

I know that's late in the year, but how do we think about a not end market but rather a product driven mix effect on gross margin? Is that going to be a positive or negative as we go through 2017 and maybe even into 2018?.

Well it will be a positive for the reasons you mentioned and that's why we think in Q4 we should get to the low end of our model which is roughly around 50%, assuming the yen stays where it is and everything else being equal. And going into next year, 2018, we think we will stay at the low-end of our range, the 50% to 55% range.

Again knowing what we know and knowing everything else being equal, we think we can stay within our range but on the low-end of it..

Great. I guess my final question would be you highlighted earlier in your transcript about how you grew relative to the analog market, by roughly seven points, eight points faster than the market last year which was impressive.

If we think about that in a relative basis in 2017, what do you think would cause that delta versus the broader market to either expand further or shrink on a year-over-year basis?.

So, as we have said we have a lot of secular drivers that are enabling us to grow. And we are also expanding on our SAM as Balu indicated on his script, which has enabled us to grow faster. However as we have said consistently, to look at our business on a three year to five year horizon, on an average we will grow low double-digit..

Great. Thank you..

You're welcome, Ross..

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

Yes. Thank you. First question for Balu. Balu, you talked about fast charging, the penetration now being about 30% but you're also expecting pretty hefty penetration here in 2017. Could you add a little bit more color on that? And you also sound like USB-PD is finally moving.

Any data points you can share with us there?.

Absolutely. Clearly, everybody is moving towards fast charging. It is become pretty much a requirement for next-generation phones if they don't already have it. So the adoption is definitely accelerating as we see it. And I think we have mentioned this before.

Until very recently, people have had their own protocols or a combination of protocols, but we are definitely seeing a trend where most of the cell phone companies or cell phone OEMs are now focusing in on USB-PD standard. Some of them have already adopted it.

And I think the first USB-PD charger came with the Pixel phone from Google, which by the way uses our product. But we are clearly seeing a trend where people are abandoning their proprietary protocols and moving towards USB-PD. And USB-PD itself has been evolving.

And I think it's gotten to the point where it has stabilized and it has actually added some additional features specifically for fast charging or direct charging. And so we see that trend will continue. And the advantage of that for us is the content is even higher. It requires variable voltage, programmable voltage.

All of that is going to be very helpful to us. It also means that they have to redesign existing chargers with designs over to USB-PD. So we see this as a long-term trend that will help us continue to grow in the cell phone market for the next several years..

Very good. And you mentioned that design win with Inno 2 for the monitor. Should we expect also Inno 2 to get some design wins? I think you've mentioned before you're targeting tablets as well.

Is that something that we could already see this year?.

Yes. Just to clarify. The next generation we call as Inno 3. The current generation is Inno 2 because we had an InnoSwitch internally. So the Inno 3, we haven't launched it broadly yet, because we are focusing on some high-volume opportunities. We have about 40 designs that are in progress. And a few of them actually have gone into production.

And this few production designs are with a Tier 1 TV and monitor manufacturer. And it is – we've got the design win. We expect this to go into production and generate revenue by the end of the year. And so we are excited about that, because this one actually goes into computer and the consumer market. Now, I think I have mentioned this before.

The Inno 3 dramatically expands the power level of the InnoSwitch. The Inno 2 only went up to 20 watts or 25 watts. Inno 3 will go to about 50 watts to 55 watts. And that allows us to get into a number of new applications, including notebooks and tablets.

So we do expect some revenue from those areas by the – let's say Q4 of this year we should start seeing revenue. It takes about six to nine months for people to go into full production. So we are seeing lot of design activity in those areas, and we will keep you updated on the progress..

Yes, thank you for that Balu.

And then on the industrial market, especially the high-power part of industrial, that business can be a little bit volatile depending on the programs it's tied to, but how should we think about high-power in the industrial bucket for 2017?.

We think 2017 will be a really good year for high-power. We are modeling double-digit growth, driven by high-voltage DC transmission systems that are being installed in China.

China has a very aggressive plan to put a new, brand-new grid in the entire country using high-voltage DC transmission, and I think that's going to be a significant driver for us. But we are also seeing a growth in the wind power and solar energy.

And all of those will enable us to grow high-power revenue based on current forecast in double digits this year..

Very good. Last question for Sandeep, and Sandeep thank you for all the recast information. It's really helpful. How should we think about OpEx in 2017? I know, in the past you've kind of talked about growing OpEx at 60% of your revenue growth rate.

So as we look at 2017, should we still think about that same number?.

The way I would look at it is we've given you guidance for Q1. In Q2, you will see a sequential growth because that's where the merit increase happens, and then Q3 and Q4 kind of flattens out.

Our long-term model is the 60% but as you can see in 2016, we spent a little less, and that was because of the timing of head count additions, which will flow into this year. But the long-term model is pretty much there. So this year it could be a little bit more, because we spent a little less in 2016.

But on average if you look on a three to five-year horizon, the model still is at 60%..

Sounds good. Thank you very much..

Thanks, Tore..

We do have a follow-up question from the line of Ross Seymore of Deutsche Bank. Your line is open..

Hi, guys. Just a couple of housekeeping ones, looks like the stock-based comp guide for the first quarter is down.

Can you explain a little bit about what's going on there, and then any full-year guidance on that? And then the second question would be what are your expectations for CapEx for the year?.

So, typically Ross, the reason of being a little down is the timing, because the majority of the employee grants happens in the second quarter. So I think it's just a timing issue of how that flows.

As far as capital expenditures – and the other reason is if you look at it in 2016, our performance PSUs performed at a pretty high level because of how our performance was. So when you start off the year you are estimating at certain levels and that's another reason.

As far as capital expenditures, for the last two years we have been spending at about $12 million, if you remember our average is $18 million to $20 million.

This year we will be spending about $25 million or $30 million because of the investments we're making, not only to add capacity, but also to make some investments in our infrastructure as we look to grow our company..

Great. Thank you..

Thank you, Ross..

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

Okay. Thank you. 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 day..

This concludes today's conference call. You may now disconnect..