Monolithic Power Systems, Inc.
MONOLITHIC POWER SYSTEMS INC (Form: 10-Q, Received: 11/03/2010 16:07:30)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
FORM 10-Q
 

 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2010
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission file number: 000-51026
 

 
Monolithic Power Systems, Inc.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 
Delaware
77-0466789
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
 
6409 Guadalupe Mines Road, San Jose, CA 95120 (408) 826-0600
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE AND TELEPHONE NUMBER)
 

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ¨     No   ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer   ¨     Accelerated filer   x     Non-accelerated filer   ¨     Smaller reporting company   ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x
 
There were 35,840,935 shares of the registrant’s common stock issued and outstanding as of October 29, 2010.
 
 
1

 

 
 
MONOLITHIC POWER SYSTEMS, INC.

 
TABLE OF CONTENTS   PAGE
PART I. FINANCIAL INFORMATION
 
3
    ITEM 1.
FINANCIAL STATEMENTS
 
3
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
3
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 
4
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
5
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
6
    ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
16
    ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
26
    ITEM 4.
CONTROLS AND PROCEDURES
 
26
PART II. OTHER INFORMATION
 
27
    ITEM 1.
LEGAL PROCEEDINGS
 
27
    ITEM 1A.
RISK FACTORS
 
27
    ITEM 6.
EXHIBITS
 
39
 
 
2

 

 PART I. FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
MONOLITHIC POWER SYSTEMS, INC.
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value and share amounts)
(Unaudited)
 
   
September 30, 2010
   
December 31, 2009
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 44,275     $ 46,717  
Short-term investments
    140,731       118,914  
Accounts receivable, net of allowances of $0 in both 2010 and 2009
    32,289       15,521  
Inventories
    19,459       19,616  
Deferred income tax assets, net - current
    8       5  
Prepaid expenses and other current assets
    2,904       2,726  
Total current assets
    239,666       203,499  
Property and equipment, net
    32,461       17,968  
Long-term investments
    19,415       19,445  
Deferred income tax assets, net - long-term
    175       175  
Other assets
    715       734  
Total assets
  $ 292,432     $ 241,821  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 17,755     $ 7,787  
Accrued compensation and related benefits
    7,094       8,454  
Accrued liabilities
    8,563       7,681  
Total current liabilities
    33,412       23,922  
                 
Non-current income tax liability
    4,915       4,915  
Other long-term liabilities
    756       27  
      Total liabilities
    39,083       28,864  
Stockholders' equity:
               
Common stock, $0.001 par value, $36 and $35 in 2010 and 2009, respectively;
shares authorized: 150,000,000; shares issued and outstanding: 35,823,034
and 35,165,316 in 2010 and 2009, respectively
    188,840       175,518  
Retained earnings
    63,066       37,085  
Accumulated other comprehensive income
    1,443       354  
Total stockholders’ equity
    253,349       212,957  
Total liabilities and stockholders’ equity
  $ 292,432     $ 241,821  
 
See accompanying notes to condensed consolidated financial statements.
 
 
3

 
 
MONOLITHIC POWER SYSTEMS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenue
  $ 65,843     $ 47,966     $ 171,783     $ 118,461  
Cost of revenue
    29,857       18,868       74,067       48,122  
Gross profit
    35,986       29,098       97,716       70,339  
Operating expenses:
                               
Research and development
    11,291       10,080       34,116       27,929  
Selling, general and administrative
    10,296       9,438       32,304       26,567  
Litigation expense
    964       2,811       4,759       7,090  
Litigation provision reversal, net
    -       (6,356 )     -       (6,356 )
Total operating expenses
    22,551       15,973       71,179       55,230  
                                 
Income from operations
    13,435       13,125       26,537       15,109  
Other income (expense):
                               
Interest and other income
    240       161       925       827  
Interest and other expense
    (159 )     (76 )     (163 )     (355 )
Total other income, net
    81       85       762       472  
                                 
Income before income taxes
    13,516       13,210       27,299       15,581  
Income tax provision
    297       648       1,317       561  
Net income
  $ 13,219     $ 12,562     $ 25,982     $ 15,020  
Basic net income per share
  $ 0.37     $ 0.36     $ 0.72     $ 0.44  
Diluted net income per share
  $ 0.35     $ 0.34     $ 0.68     $ 0.41  
                                 
Weighted average common shares outstanding
    36,185       34,552       35,968       34,082  
Stock options
    1,542       2,695       2,162       2,273  
Diluted weighted-average common equivalent shares outstanding
    37,727       37,247       38,130       36,355  
 
See accompanying notes to condensed consolidated financial statements.
 
 
4

 
 
MONOLITHIC POWER SYSTEMS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
   
Nine months ended September 30,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net income
  $ 25,982     $ 15,020  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    5,624       4,867  
Loss on disposal of property and equipment
    52       17  
Amortization and realized gain on debt instruments
    466       263  
Credit loss on auction-rate securities
    -       70  
Tax benefit from stock option transactions
    3,105       1,837  
Excess tax benefit from stock option transactions
    (1,399 )     (534 )
Stock-based compensation
    13,725       10,431  
Changes in operating assets and liabilities:
               
Accounts receivable
    (16,767 )     (10,378 )
Inventories
    204       (1,468 )
Prepaid expenses and other assets
    (173 )     (152 )
Accounts payable
    8,918       3,798  
Accrued and long-term liabilities
    1,517       (5,117 )
Accrued income taxes payable and noncurrent tax liabilities
    (1,709 )     (1,265 )
Accrued compensation and related benefits
    (1,386 )     (1,555 )
Deferred rent
    92       (204 )
Net cash provided by operating activities
    38,251       15,630  
                 
Cash flows from investing activities:
               
Property and equipment purchases
    (18,572 )     (7,328 )
Purchase of short-term investments
    (175,132 )     (105,026 )
Proceeds from sale of short-term investments
    153,003       45,886  
Proceeds from sale of long-term investments
    250       1,300  
Changes in restricted assets
    (19 )     7,360  
Net cash used in investing activities
    (40,470 )     (57,808 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock
    13,265       8,414  
Proceeds from employee stock purchase plan
    1,885       1,794  
Repurchase of common stock
    (16,998 )     -  
Excess tax benefits from stock option transactions
    1,399       534  
Net cash provided by (used in) financing activities
    (449 )     10,742  
                 
Effect of change in exchange rates
    226       163  
Net decrease in cash and cash equivalents
    (2,442 )     (31,273 )
Cash and cash equivalents, beginning of period
    46,717       83,266  
Cash and cash equivalents, end of period
  $ 44,275     $ 51,993  
                 
Supplemental disclosures for cash flow information:
               
Cash paid for taxes
  $ 121     $ 429  
Supplemental disclosures of non-cash investing and financing activities:
               
Liability accrued for equipment purchases
  $ 1,686     $ 393  
Temporary impairment of auction-rate securities
  $ (220 )   $ (360 )
 
See accompanying notes to condensed consolidated financial statements.
 
 
5

 
 
MONOLITHIC POWER SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
 
1. Basis of Presentation — The accompanying unaudited condensed consolidated financial statements have been prepared by Monolithic Power Systems, Inc. (the “Company” or “MPS”) in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in its Form 10-K filed with the SEC on February 16, 2010.
 
In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The financial statements contained in this Form 10-Q are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or for any other future period.

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2009-13, " Multiple-Deliverable Revenue Arrangements " ("ASU 2009-13"). The new standard changes the requirements for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable to be based on the relative selling price. ASU 2009-13 is effective for fiscal years beginning on or after June 15, 2010. The Company is currently evaluating ASU 2009-13 and the impact, if any, that it may have on its results of operations or financial position.

In January 2010, the FASB issued ASU No. 2010-06, “ Disclosures About Fair Value Measurements ”, which amends ASC No. 820, “ Fair Value Measurements ”. ASC No. 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles in the United States of America, and requires that assets and liabilities carried at fair value be classified and disclosed in one of the three categories as defined in Note 8 Fair Value Measurements. ASU No. 2010-06 adds new requirements for disclosures about transfers into and out of Levels 1 and 2 and requires separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. The ASU also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. This ASU is effective for the first reporting period (including interim periods) beginning after December 15, 2009. The Company has adopted this standard effective January 1, 2010 and has and will make the appropriate disclosures, as required.
 
2. Stock-Based Compensation — The Company has two stock option plans and an employee stock purchase plan—the 1998 Stock Option Plan, the 2004 Equity Incentive Plan and the 2004 Employee Stock Purchase Plan. The Company recognized stock-based compensation expenses for the three and nine months ended September 30, 2010 and 2009, as follows (in thousands):
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Non-Employee
  $ (1 )   $ 11     $ (11 )   $ 112  
ESPP
    80       104       474       501  
Restricted Stock
    2,210       642       7,331       2,033  
Stock Options
    1,873       2,409       5,931       7,785  
TOTAL
  $ 4,162     $ 3,166     $ 13,725     $ 10,431  
 
 
6

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
2004 Equity Incentive Plan
 
The Company’s Board of Directors adopted the Company’s 2004 Equity Incentive Plan in March 2004, and the Company’s stockholders approved it in November 2004. Options granted under the 2004 Plan have a maximum term of ten years. New hire grants generally vest over four years at the rate of 25 percent one year from the date of grant and 1/48 th monthly thereafter. Refresh grants generally vest over four years at the rate of 50 percent two years from the date of grant and 1/48 th monthly thereafter. There were 800,000 shares initially reserved for issuance under the 2004 Plan. The 2004 Plan provides for annual increases in the number of shares available for issuance beginning on January 1, 2005 equal to the least of: 5% of the outstanding shares of common stock on the first day of the year, 2,400,000 shares, or a number of shares determined by the Board of Directors. The following is a summary of the 2004 Plan, which includes stock options and restricted stock awards and units:
 
Available for Grant as of December 31, 2009
    2,023,943  
2010 Additions to Plan
    1,758,265  
2010 Grants
    (1,257,840 )
2010 Cancellations
    433,317  
Available for Grant as of September 30, 2010
    2,957,685  
 
A summary of the status of the Company’s stock option plans at September 30, 2010 and changes during the nine months then ended is presented in the table below: 
 
   
Stock Options
   
Weighted
Average
Exercise Price
   
Weighted
Average
Remaining
Contractual
Term (Years)
   
Aggregate
Intrinsic Value
 
Outstanding at December 31, 2009
    7,410,914     $ 13.48       5.04     $ 77,918,848  
    Options granted (weighted-average fair value of $9.01 per share)
    356,000     $ 20.07                  
    Options exercised
    (1,351,736 )   $ 9.81                  
    Options forfeited and expired
    (453,479 )   $ 15.62                  
Outstanding at September 30, 2010
    5,961,699     $ 14.55       4.54     $ 18,917,299  
Options exercisable at September 30, 2010 and expected to become exercisable
    5,620,666     $ 14.39       4.51     $ 18,577,193  
Options vested and exercisable at September 30, 2010
    3,682,180     $ 12.86       4.13     $ 16,709,991  
 
 
7

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
The total fair value of options that vested during the three months ended September 30, 2010 and 2009 was $1.9 million and $2.4 million, respectively, and the total fair value of options that vested during the nine months ended September 30, 2010 and 2009 was $6.0 million and $7.8 million, respectively. The total intrinsic value of options exercised during the three months ended September 30, 2010 and 2009 was $1.0 million and $7.1 million, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2010 and 2009 was $16.8 million and $13.4 million, respectively. Net cash proceeds from the exercise of stock options were $1.5 million for the three months ended September 30, 2010 and $4.7 million for the three months ended September 30, 2009. Net cash proceeds from the exercise of stock options were $13.3 million for the nine months ended September 30, 2010 and $8.4 million for the nine months ended September 30, 2009. At September 30, 2010, unamortized compensation expense related to unvested options was approximately $11.5 million. The weighted average period over which compensation expense related to these options will be recognized is approximately 2.0 years.

The employee stock-based compensation expense recognized under ASC 718-10-30 Compensation – Stock Compensation –Overall - Initial Measurement, was determined using the Black-Scholes option pricing model. Option pricing models require the input of subjective assumptions and these assumptions can vary over time. The Company used the following weighted-average assumptions to determine the fair values of stock option awards granted during the three and nine months ended September 30, 2010 and 2009: 
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Expected term (years)
    4.0       4.1       4.1       4.1  
Expected volatility
    55.2 %     60.6 %     56.0 %     60.8 %
Risk-free interest rate
    1.4 %     2.0 %     1.8 %     1.8 %
Dividend yield
    -       -       -       -  
 
In estimating the expected term, the Company considers its historical stock option exercise experience, post vesting cancellations and remaining contractual term of the options outstanding. In estimating the expected volatility, the Company uses its own historical data to determine its estimated expected volatility. The Company uses the U.S. Treasury yield for its risk-free interest rate and a dividend yield of zero as it does not issue dividends. The Company applies a forfeiture rate that is based on options that have been forfeited historically.
 
Restricted Stock

A portion of the Company’s shares of common stock were issued under restricted stock purchase agreements. Under these agreements, in the event of a termination of an employee, the Company has the right to repurchase the common stock at the original issuance price of $0.001 per share. The repurchase right expires over a 48 month period as the restricted stock award vests. A summary of the Company’s restricted stock awards is presented in the table below: 
 
   
Restricted
Stock Awards
   
Weighted
Average
Grant Date
Fair Value
Per Share
   
Weighted
Average
Remaining
Recognition
Period (Years)
 
Outstanding at December 31, 2009
    6,550     $ 16.62       0.14  
Awards released
    (6,550 )     16.62          
Outstanding at September 30, 2010
    -     $ -       -  

 
8

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)


The Company also grants restricted stock units, which vest generally over four years as determined by the Company’s Compensation Committee, and are issued upon vesting. Before vesting, these restricted stock units are not eligible for dividends, if and when declared. A summary of the restricted stock units is presented in the table below:
 
   
Restricted
Stock Units
   
Weighted
Average
Grant Date
Fair Value
Per Share
   
Weighted
Average
Remaining
Recognition
Period (Years)
 
Outstanding at December 31, 2009
    289,896     $ 18.67       2.22  
Awards granted
    901,840       20.19          
Awards released
    (174,784 )     19.04          
Awards forfeited
    (29,838 )     18.53          
Outstanding at September 30, 2010
    987,114     $ 20.00       2.18  

The total fair value of restricted stock awards and units that vested was $1.5 million for the three months ended September 30, 2010 and $0.6 million for the three months ended September 30, 2009, respectively. The total fair value of restricted stock awards and units that vested was $4.2 million for the nine months ended September 30, 2010 and $2.0 million for the nine months ended September 30, 2009, respectively. The intrinsic value related to restricted stock awards and units released for the three months ended September 30, 2010 and 2009 was $1.2 million and $1.7 million, respectively, and the intrinsic value related to restricted stock awards and units released for the nine months ended September 30, 2010 and 2009 was $3.7 million and $3.3 million, respectively. The intrinsic value related to restricted stock awards and units outstanding at September 30, 2010 and 2009 was $16.1 million and $7.0 million, respectively. At September 30, 2010, the unamortized compensation expense related to unvested restricted stock awards and units was approximately $12.0 million with a weighted average remaining recognition period of 2.2 years.

On February 25, 2010, the Board granted 416,000 performance units to the Company’s executive officers. These performance units generally vest over four years, with a graded acceleration feature that allows all or a portion of these awards to be accelerated if certain performance conditions are satisfied. The amount of shares to be accelerated is based on achieving certain performance targets, with the minimal acceleration occurring if performance exceeds at least 110% of non-GAAP earnings per share as set forth in the Company’s annual operating plan approved by the Board, as determined by the Compensation Committee in its sole discretion. The Compensation Committee has the discretion not to accelerate any shares, if it so chooses, even if the performance targets are met. Based on the Company’s performance-to-date and its expected performance for the remainder of the year, it is probable that the certain performance targets will be exceeded and a portion of the unvested shares will be accelerated and released in February 2011. The Company recorded expenses related to this award in the amount of $1.3 million and $5.1 million for the three and nine months ended September 30, 2010, respectively.
 
2004 Employee Stock Purchase Plan
 
Under the 2004 Employee Stock Purchase Plan (the Purchase Plan), eligible employees may purchase common stock through payroll deductions. Participants may not purchase more than 2,000 shares in a six-month offering period or stock having a value greater than $25,000 in any calendar year as measured at the beginning of the offering period in accordance with the Internal Revenue Code and applicable Treasury Regulations. A total of 200,000 shares of common stock were reserved for issuance under the Purchase Plan.  The Purchase Plan provides for an automatic annual increase beginning on January 1, 2005 by an amount equal to the least of: 1,000,000 shares, 2% of the outstanding shares of common stock on the first day of the year, or a number of shares as determined by the Board of Directors. For the three months ended September 30, 2010 and 2009, 57,147 shares and 77,600 shares, respectively, were issued under the Purchase Plan. For the nine months ended September 30, 2010 and 2009, 114,387 shares and 161,026 shares, respectively, were issued under the Purchase Plan. The following is a summary of the Purchase Plan and changes during the nine months ended September 30, 2010:
 
Available Shares as of December 31, 2009
    2,553,012  
2010 Additions to Plan
    703,306  
2010 Purchases
    (114,387 )
Available Shares as of September 30, 2010
    3,141,931  

 
9

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)

 
The Purchase Plan is considered compensatory under ASC 718-50-25-2, Compensation – Stock Compensation - Employee Share Purchase Plans - Recognition, and is accounted for in accordance with ASC 718-50-30-2 Compensation – Stock Compensation - Employee Share Purchase Plans - Initial Measurement - Look-Back Plans . The intrinsic value for stock purchased was $0.1 million and $0.9 million for the three months ended September 30, 2010 and 2009, respectively. The intrinsic value for stock purchased was $0.3 million and $1.0 million for the nine months ended September 30, 2010 and 2009. The unamortized expense as of September 30, 2010 was $0.2 million, which will be recognized over 0.4 years. The Black-Scholes option pricing model was used to value the employee stock purchase rights. For the three and nine months ended September 30, 2010 and 2009, the following weighted average assumptions were used in the valuation of the stock purchase rights:
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Expected term (years)
    0.5       0.5       0.5       0.5  
Expected volatility
    37.9 %     61.0 %     39.5 %     79.8 %
Risk-free interest rate
    0.2 %     0.3 %     0.2 %     0.4 %
Dividend yield
    -       -       -       -  

Cash proceeds from employee stock purchases for the three months ended September 30, 2010 and 2009 was $0.8 million and $0.9 million, respectively. Cash proceeds from employee stock purchases for the nine months ended September 30, 2010 and 2009 was $1.9 million and $1.8 million, respectively.
 
3. Inventories - Inventories consist of the following (in thousands):
 
   
September 30, 2010
   
December 31, 2009
 
Work in progress
  $ 10,248     $ 11,082  
Finished goods
    9,211       8,534  
Total inventories
  $ 19,459     $ 19,616  
 
4. Accrued Liabilities - Accrued liabilities consist of the following (in thousands):
 
   
September 30, 2010
   
December 31, 2009
 
Deferred revenue and customer prepayments
  $ 3,468     $ 2,109  
Legal expenses and settlement costs
    1,547       2,940  
Stock rotation reserve
    1,070       864  
Warranty
    463       294  
Other
    2,015       1,474  
Total accrued liabilities
  $ 8,563     $ 7,681  
 
A roll-forward of the warranty reserve for the nine months ended September 30, 2010 and 2009 is as follows:
 
   
Nine months ended September 30,
 
   
2010
   
2009
 
Balance at beginning of year
  $ 294     $ 764  
Warranty costs
    (75 )     (81 )
Unused warranty provision
    (169 )     (381 )
Warranty provision for product sales
    413       284  
Balance at September 30, 2010
  $ 463     $ 586  

 
10

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
5. Net Income per Share and Comprehensive Income   — Basic net income per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per share is calculated using the treasury stock method and reflects the potential dilution that would occur if outstanding securities or other contracts to issue common stock were exercised or converted into common stock.  For the three and nine months ended September 30, 2010 and 2009, the Company had securities outstanding, which could potentially dilute basic net income per share in the future, but were excluded from the computation of diluted net income per share in the periods presented, as their effect would have been anti-dilutive. The following table shows the number of shares of common stock issuable upon conversion or exercise of outstanding stock options:
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Stock Options
    2,848,219       1,096,555       1,762,195       3,446,134  
 
The following table sets forth the components of other comprehensive income, net of income tax effect (in thousands):
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Net income
  $ 13,219     $ 12,562     $ 25,982     $ 15,020  
Other comprehensive income (loss):
                               
Change in value of temporary impairment of auction-rate securities
    45       30       220       360  
Unrealized gain (loss) on available-for-sale securities
    (4 )     31       153       15  
Foreign currency translation adjustments
    612       74       716       129  
Comprehensive income
  $ 13,872     $ 12,697     $ 27,071     $ 15,524  
 
6. Segment Information
 
As defined by the requirements of ASC 280-10-50 Segment Reporting – Overall - Disclosure , the Company operates in one reportable segment: the design, development, marketing and sale of high-performance, mixed-signal analog semiconductors for the communications, computing, consumer, and industrial markets. Geographic revenue is based on the location to which customer shipments are delivered. For the three and nine months ended September 30, 2010, the Company derived substantially all of its revenue from sales to customers located outside North America. The following is a list of customers whose sales exceeded 10% of revenue for the three and nine months ended September 30, 2010 and 2009.
 
     
Three months ended September 30,
   
Nine months ended September 30,
 
Customers
   
2010
   
2009
   
2010
   
2009
 
A       18 %     12 %     13 %     14 %
B       *       *       10 %     *  
C       *       11 %     *       11 %
D       *       12 %     *       10 %
 
(*) represents less than 10%
 
 
11

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
The following is a summary of revenue by geographic region based on customer ship-to location (in thousands):
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
Country
 
2010
   
2009
   
2010
   
2009
 
China
  $ 31,285     $ 20,703     $ 82,430     $ 48,257  
Korea
    9,640       8,038       28,544       24,237  
Taiwan
    9,286       5,812       20,182       15,207  
Europe
    5,369       5,843       15,449       13,825  
Japan
    4,967       3,498       10,274       8,268  
USA
    1,833       1,779       7,093       4,306  
Other
    3,463       2,293       7,811       4,361  
Total
  $ 65,843     $ 47,966     $ 171,783     $ 118,461  
 
The following is a summary of revenue by product family (in thousands):
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
Product Family
 
2010
   
2009
   
2010
   
2009
 
DC to DC Converters
  $ 55,230     $ 36,723     $ 141,082     $ 87,576  
Lighting Control Products
    9,380       8,511       24,324       20,544  
Audio Amplifiers
    1,233       2,732       6,377       10,341  
Total
  $ 65,843     $ 47,966     $ 171,783     $ 118,461  
 
The following is a summary of long-lived assets by geographic region (in thousands):
 
   
September 30, 2010
   
December 31, 2009
 
China
  $ 29,546     $ 15,440  
United States
    2,789       2,484  
Taiwan
    130       75  
Japan
    87       75  
Other
    62       34  
 TOTAL
  $ 32,614     $ 18,108  
 
7. Litigation
 
The Company and certain of its subsidiaries are parties to other actions and proceedings incident to the Company's business in the ordinary course of business, including litigation regarding its intellectual property, challenges to the enforceability or validity of its intellectual property and claims that the Company’s products infringe on the intellectual property rights of others. The pending proceedings involve complex questions of fact and law and will require the expenditure of significant funds and the diversion of other resources to prosecute and defend. The results of legal proceedings are inherently uncertain, and material adverse outcomes are possible.
 
 
12

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)

 
8. Fair Value Measurements
 
The Company adopted the provisions of ASC 820-10 Fair Value Measurements and Disclosures – Overall, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles in the United States of America, and requires that assets and liabilities carried at fair value be classified and disclosed in one of the three categories noted below. The Company also adopted the provisions of ASC 820-10-35-51 Fair Value Measurement and Disclosure – Overall – Subsequent Measurement – Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly , effective April 1, 2009 , which provides additional guidance for estimating fair value in accordance with ASC 820-10 Fair Value Measurements and Disclosures – Overall , when the volume and level of activity for the asset or liability have significantly decreased. Effective January 1, 2010, the Company adopted the provisions of ASU 2010-06, “ Disclosures About Fair Value Measurements ”, which adds new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements.
 
The following table details the fair value measurements as of September 30, 2010 within the fair value hierarchy of the financial assets that are required to be recorded at fair value (in thousands):
 
   
Fair Value Measurements at September 30, 2010 Using
 
         
Quoted Prices
in Active
Markets for
Identical Assets
   
Significant
Other
Observable
Inputs
   
Significant
Unobservable
Inputs
 
   
Total
   
Level 1
   
Level 2
   
Level 3
 
Government Agencies / Treasuries
  $ 139,791     $ 139,791     $ -     $ -  
Commercial Paper / Corporates
    8,939       8,939       -       -  
Long-term available-for-sale auction-rate securities
    19,415       -       -       19,415  
    $ 168,145     $ 148,730     $ -     $ 19,415  
 
At September 30, 2010, the Company had $139.8 million in US government agencies and treasuries, $131.8 million of which are classified as short-term investments and $8.0 million which are classified as cash equivalents on the Condensed Consolidated Balance Sheet. At September 30, 2010, the Company also held $8.9 million in corporate notes and commercial paper. From these investments, there was $18,000 in unrealized losses. The impact of gross unrealized gains and losses was not material. At September 30, 2010, the Company also had $20.3 million in face value of auction-rate securities, all of which are classified as long-term available-for-sale investments.
 
At September 30, 2010, the Company had $10.3 million invested in money market funds.
 
The Company adopted the provisions of ASC 320-10-35 Investments – Debt and Equity Securities – Overall – Subsequent Measurement and ASC 320-10-50 Investments – Debt and Equity Securities – Overall – Disclosure, effective April 1, 2009 and used the guidelines therein to determine whether the impairment on its available-for-sale securities is temporary or other-than-temporary. Temporary impairment charges are recorded in accumulated other comprehensive income (loss) within stockholders’ equity and have no impact on net income. Other-than-temporary impairment exists when the entity has the intent to sell the security or it will more likely than not be required to sell the security before anticipated recovery or it does not expect to recover the entire amortized cost basis of the security. Other-than-temporary impairment charges are recorded in other income (expense) in the Condensed Consolidated Statement of Operations.
 
 
13

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
The following table provides a reconciliation of the beginning and ending balances for the assets measured at fair value using significant unobservable inputs (Level 3) (in thousands):

   
Auction-Rate
Securities
   
Put
Right
   
Total
 
Ending balances at December 31, 2009
  $ 35,570     $ 725     $ 36,295  
Sales and Settlement
    (225 )     -       (225 )
Unrealized Gain
    185       -       185  
Gain (loss) from UBS auction rate securities and put right
    160       (160 )     -  
Ending balances at March 31, 2010
  $ 35,690     $ 565     $ 36,255  
Sales and Settlement
    (8,100 )     -       (8,100 )
Unrealized Loss
    (10 )     -       (10 )
Gain (loss) from UBS auction rate securities and put right
    230       (230 )     -  
Ending balances at June 30, 2010
  $ 27,810     $ 335     $ 28,145  
Sales and Settlement
    (8,775 )     -       (8,775 )
Unrealized Gain
    45       -       45  
Gain (loss) from UBS auction rate securities and put right
    335       (335 )     -  
Ending balances at September 30, 2010
  $ 19,415     $ -     $ 19,415  
 
During the three months ended September 30, 2010, the Company sold $8.8 million in auction rate securities at par. Of this amount, $8.6 million was classified as short-term investments and the remaining $0.2 million was classified as long-term investments.
 
In October 2008, the Company accepted an offer to participate in an auction-rate security rights offering from UBS to sell up to $18.2 million in face value of eligible auction-rate securities commencing in June 2010. Between October 2008 and June 2010, $9.6 million of these auction-rate securities were called at par. On June 30, 2010, the Company exercised the UBS put right and sold the remaining $8.6 million in auction rate securities at par, for which the sale was completed and proceeds were received on July 1, 2010. At December 31, 2009, both the impairment related to these auction-rate securities and the corresponding put right were valued at $0.7 million. The change in the impairment and the fair value of the put right was recorded in accordance with the provisions of ASC 320-10-35 and ASC 320-10-50 in other income (expense) in the Condensed Consolidated Statement of Operations.
 
The Company’s Level 3 assets consist of government-backed student loan auction-rate securities, with interest rates that reset through a Dutch auction every 7 to 35 days and which became illiquid in 2008. At September 30, 2010, the Company’s investment portfolio included $19.4 million, net of impairment charges of $0.9 million, in government-backed student loan auction-rate securities. The underlying maturity of these auction-rate securities is up to 37 years. Although it is unclear as to when these investments will regain their liquidity, management has concluded that as of September 30, 2010 and December 31, 2009, the cumulative impairment of $0.9 million and $1.1 million, respectively, was temporary based on the following analysis:

·  
The decline in the fair value of these securities is not largely attributable to adverse conditions specifically related to these securities or to specific conditions in an industry or in a geographic area;
·  
Management possesses both the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value;
·  
Management believes that it is more likely than not that the Company will not have to sell these securities before recovery of its cost basis;
·  
Except for the credit loss of $70,000 recognized during the year ended December 31, 2009 for the Company’s holdings in auction rate securities described below, the Company does not believe that there is any additional credit loss associated with other auction-rate securities because the Company expects to recover the entire amortized cost basis;
·  
The majority of the securities remain AAA rated, with $8.7 million of the auction rate securities having been downgraded by Moody’s to A3-Baa3, during the year ended December 31, 2009 and there have been no downgrades during the nine months ended September 30, 2010; and
·  
All scheduled interest payments have been made pursuant to the reset terms and conditions.

 
14

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
Based on the guidance of ASC 320-10-35 and ASC 320-10-50, the Company evaluated the potential credit loss of each of the auction-rate securities that are currently held by the Company. Based on such analysis, the Company determined that those securities that are not 100% FFELPS guaranteed are potentially subject to credit risks based on the extent to which the underlying debt is collateralized and the security-specific student-loan default rates. The Company’s portfolio includes three such securities, one of which has a senior parity ratio of approximately 125%, which is substantially above the expected student-loan default rate for that security. Conversely, the senior parity ratio for the other two securities is approximately 105%. If, therefore, the student-loan default rate and borrowing rate for these issuers increases, the remaining balance in these trusts may not be sufficient to cover the senior debt. The Company therefore concluded that there is potential credit risk for these two securities and as such, used the discounted cash flow model to determine the amount of credit loss to be recorded. In valuing the potential credit loss, the following parameters were used: 20 year expected term, cash flows based on the 90-day t-bill rates for 20 year forwards and a risk premium of 5.9%, the amount of interest that the Company was receiving on these securities when the market was last active. As of September 30, 2010 and December 31, 2009, the potential credit loss associated with these securities was $70,000, which the Company deemed other-than-temporary and recorded in other expense in its Condensed Consolidated Statement of Operations during 2009.
 
Unless another rights offering or other similar offers are made to redeem at par and accepted by the Company, the Company intends to hold the balance of these investments through successful auctions at par, which the Company believes could take approximately 2.0 years.
 
The valuation of the auction-rate securities is subject to fluctuations in the future, which will depend on many factors, including the collateral quality, potential to be called or restructured, underlying final maturity, insurance guaranty, liquidity and market conditions, among others. To determine the fair value of the auction-rate securities at December 31, 2009, March 31, 2010, June 30, 2010 and September 30, 2010, the Company used a discounted cash flow model, for which there are three valuation parameters, including time-to-liquidity, discount rate and expected return. The following are the values used in the discounted cash flow model:
 
   
December 31, 2009
 
March 31, 2010
 
June 30, 2010
 
September 30, 2010
Time-to-Liquidity
 
24 months
 
24 months
 
24 months
 
24 months
Expected Return (Based on the 2-year treasury rate, plus a contractual penalty rate)
 
2.4%
 
2.4%
 
2.7%
 
2.2%
Discount Rate (Based on the 2-year LIBOR, the cost of debt and a liquidity risk premium)
 
5.2% - 10.0%, depending on the credit-rating of the security
 
4.6% - 9.4%, depending on the credit-rating of the security
 
3.8% - 8.6%, depending on the credit-rating of the security
 
3.2% - 8.0%, depending on the credit-rating of the security
 
The gross accumulated impairment charge was $0.9 million as of September 30, 2010, of which $0.8 million was recorded as temporary and $0.1 million was previously recorded as other-than-temporary. The gross accumulated impairment charge was $1.8 million as of December 31, 2009, of which $1.1 million was recorded as temporary and the remaining $0.7 million was recorded as other-than-temporary.
 
If the auctions continue to fail, the liquidity of the Company’s investment portfolio may be negatively impacted and the value of its investment portfolio could decline. 
 
 
15

 
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Continued) (Unaudited)
 
 
9. Income Taxes
 
The income tax provision for the three and nine months ended September 30, 2010 was $0.3 million or 2.2% of the Company’s income before income taxes and $1.3 million or 4.8% of the pre-tax income, respectively. This differs from the federal statutory rate of 34% primarily because the Company’s foreign income was taxed at lower rates and because of the benefit that the Company realized as a result of the disqualifying disposition of incentive stock options and employee stock plan purchases. The income tax provision for the three and nine months ended September 30, 2009 was $0.6 million or 4.9% of the Company’s income before income taxes and $0.6 million or 3.6% of the pre-tax income, respectively. This differed from the federal statutory rate of 34% primarily because the Company’s foreign income was taxed at lower rates and because of the benefit that the Company realized as a result of the disqualifying disposition of incentive stock options and employee stock plan purchases.

10. Stock Repurchase Program

On July 27, 2010, the Board of Directors approved a stock repurchase program that authorizes MPS to repurchase up to $50.0 million in the aggregate of its common stock between August 2, 2010 and December 31, 2011. As of September 30, 2010, the following shares have been repurchased through the open market and subsequently retired:
 
2010 Calendar Year   Shares Repurchased     Average Price per Share     Value (in thousands)  
August     983,189     $ 17.29     $ 16,998  
 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
This quarterly report on Form 10-Q contains forward-looking statements that involve many risks and uncertainties. These statements relate to future events and our future performance and are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. These include statements concerning, among others:
 
 
the above-average industry growth of product and market areas that we have targeted,
 
 
our plan to introduce additional new products within our existing product families as well as in new product categories and families,
 
 
our belief that we will continue to incur significant legal expenses that vary with the level of activity in each of our legal proceedings,
 
 
the impact of our outstanding litigation and changing market conditions on the revenue we derive from our CCFL product line,
 
 
the effect of auction-rate securities on our liquidity and capital resources,
 
 
the application of our products in the computer, consumer electronics, and communications markets continuing to account for a majority of our revenue,
 
 
estimates of our future liquidity requirements,
 
 
the cyclical nature of the semiconductor industry,
 
 
protection of our proprietary technology,
 
 
near term business outlook for 2010,
 
 
the factors that we believe will impact our ability to achieve revenue growth,
 
 
the percentage of our total revenue from various market segments, and
 
 
the factors that differentiate us from our competitors.
 
You can identify forward-looking statements by terms such as “would,” “could,” “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “targets,” “seek,” or “continue,” the negative of these terms or other variations of such terms. These statements are only predictions based upon assumptions that we believe to be reasonable at the time made, and are subject to risks and uncertainties. Therefore, actual events or results may differ materially and adversely from those expressed in any forward-looking statement. In evaluating these statements, you should specifically consider the risks described below in the section entitled “Risk Factors.” These factors may cause our actual results to differ materially from any forward-looking statements. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The following discussion and analysis should be read in connection with the information presented in our unaudited condensed consolidated financial statements and related notes for the quarter ended September 30, 2010 included in this report and our audited consolidated financial statements and related notes for the year ended December 31, 2009 included in our Annual Report on Form 10-K filed on February 16, 2010 with the Securities and Exchange Commission.
 
 
16

 
 
Overview
 
We are a fabless semiconductor company that designs, develops, and markets proprietary, advanced analog and mixed-signal semiconductors. We currently offer products that serve multiple markets, including flat panel televisions, wireless communications, telecommunications equipment, general consumer products, notebook computers, and set top boxes, among others. We believe that we differentiate ourselves by offering solutions that are more highly integrated, smaller in size, more energy efficient, more accurate with respect to performance specifications and, consequently, more cost-effective than many competing solutions. We plan to continue to introduce additional new products within our existing product families, as well as in new product categories.

We operate in the cyclical semiconductor industry where there is seasonal demand for certain of our products. We are not and will not be immune from current and future industry downturns, but we have targeted product and market areas that we believe have the ability to offer above average industry performance over the long term.
 
We work with third parties to manufacture and assemble our integrated circuits (“ICs”). This has enabled us to limit our capital expenditures and fixed costs, while focusing our engineering and design resources on our core strengths.
 
Generally, it is difficult for us to forecast revenue for the following reasons:
 
·  
Orders in the semiconductor industry can be cancelled or rescheduled without significant penalty to the customer. This is mitigated to a certain extent, as the typical lead times for our orders are fewer than 90 days.
 
·  
We are not able to predict, with certainty, the sales cycle for new products to gain traction in the market. Generally, it takes six to twelve months to achieve revenue, with volume production achieved three to six months after we receive an initial customer order for a new product.
 
We derive most of our revenue from sales through distribution arrangements or direct sales to customers in Asia, where the components we produce are incorporated into an end-user product. 89% of our revenue for the quarter ended September 30, 2010 and 84% of our revenue for the quarter ended September 30, 2009 was attributable to direct or indirect sales to customers in Asia. We derive a majority of our revenue from the sales of our DC to DC converter product family which services the consumer electronics, communications and computing markets. We believe our ability to achieve revenue growth will depend, in part, on our ability to develop new products, enter new market segments, gain market share, manage litigation risk, diversify our customer base and successfully secure manufacturing capacity.
 
Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, long-term investments, short-term investments, inventories, income taxes, warranty obligations and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making the judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Estimates and judgments used in the preparation of our financial statements are, by their nature, uncertain and unpredictable, and depend upon, among other things, many factors outside of our control, such as demand for our products and economic conditions.  Accordingly, our estimates and judgments may prove to be incorrect and actual results may differ, perhaps significantly, from these estimates.
 
 
17

 
 
We believe the following critical accounting policies reflect our more significant judgments used in the preparation of our consolidated financial statements.
 
Revenue Recognition.  We recognize revenue in accordance with Financial Accounting Standards Board (“FASB”) – Accounting Standards Codification (“ASC”) 605-10-S25 Revenue Recognition – Overall – Recognition . ASC 605-10-S25 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgment regarding the fixed nature of the fee charged for products delivered and the collectibility of those fees. The application of these criteria has resulted in our generally recognizing revenue upon shipment (when title passes) to customers. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely impacted.
 
Approximately 80% of our distributor sales are made through distribution arrangements with third parties. These arrangements do not include any special payment terms (our normal payment terms are 30-45 days, with a maximum of 90 days), price protection or exchange rights. Returns are limited to our standard product warranty. Certain of our large distributors have contracts that include limited stock rotation rights that permit the return of a small percentage of the previous six months’ purchases in return for a compensating new order of equal or greater dollar value.

We maintain a sales reserve for stock rotation rights, which is based on historical experience of actual stock rotation returns on a per distributor basis, where available, and information related to products in the distribution channel. This reserve is recorded at the time of sale. In the future, if we are unable to estimate our stock rotation returns accurately, we may not be able to recognize revenue from sales to our distributors based on when we sell inventory to our distributors. Instead, we may have to recognize revenue when the distributor sells through such inventory to an end-customer.

We generally recognize revenue upon shipment of products to the distributor for the following reasons (based on ASC 605-15-25-1 Revenue Recognition – Products – Recognition – Sales of Products When Right of Return Exists ):

(1)  
Our price is fixed and determinable at the date of sale. We do not offer special payment terms, price protection or price adjustments to distributors where we recognize revenue upon shipment
(2)  
Our distributors are obligated to pay us and this obligation is not contingent on the resale of our products
(3)  
The distributor’s obligation is unchanged in the event of theft or physical destruction or damage to the products
(4)  
Our distributors have stand-alone economic substance apart from our relationship
(5)  
We do not have any obligations for future performance to directly bring about the resale of our products by the distributor
(6)  
The amount of future returns can be reasonably estimated. We have the ability and the information necessary to track inventory sold to and held at our distributors. We maintain a history of returns and have the ability to estimate the stock rotation returns on a quarterly basis.

If we enter into arrangements that have rights of return that are not estimable, we recognize revenue under such arrangements only after the distributor has sold our products to an end customer.

Approximately 20% of our distributor sales are made through small distributors based on purchase orders rather than formal distribution arrangements.  These distributors do not receive any stock rotation rights and, as such, hold very little inventory, if any. We do not have a history of accepting returns from these distributors.

The terms in a majority of our distribution agreements include the non-exclusive right to sell, and the agreement to use best efforts to promote and develop a market for, our products in certain regions of the world and the ability to terminate the distribution agreement by either party with up to three months notice. We provide a one year warranty against defects in materials and workmanship. Under this warranty, we will repair the goods, provide replacements at no charge, or, under certain circumstances, provide a refund to the customer for defective products. Estimated warranty returns and warranty costs are based on historical experience and are recorded at the time product revenue is recognized.
 
In 2006, we signed a distribution agreement with a U.S. distributor. Revenue from this distributor is recognized upon sale by the distributor to the end customer because the distributor has certain rights of return which management believes are not estimable. The deferred revenue balance from this distributor as of September 30, 2010 and December 31, 2009 was $1.3 million and $0.9 million, respectively.
 
 
18

 
 
Warranty Reserves.  We currently provide a 12-month warranty against defects in materials and workmanship and will either repair the goods or provide replacement products at no charge to the customer for defective products. We record estimated warranty costs by product, which are based on historical experience over the preceding 12 months, at the time we recognize product revenue. Reserve requirements are recorded in the period of sale and are based on an assessment of the products sold with warranty and historical warranty costs incurred. As the complexity of our products increases, we could experience higher warranty claims relative to sales than we have previously experienced, and we may need to increase these estimated warranty reserves.
 
Inventory Valuation.  We value our inventory at the lower of the standard cost (which approximates actual cost on a first-in, first-out basis) or its current estimated market value.  We write down inventory for obsolescence or lack of demand, based on assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. On the contrary, if market conditions are more favorable, we may be able to sell inventory that was previously reserved.

Accounting for Income Taxes .   ASC 740-10 Income Taxes – Overall prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. In accordance with ASC 740-10, we recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We also recognize federal, state and foreign deferred tax assets or liabilities for our estimate of future tax effects attributable to temporary differences and carryforwards. We record a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and judgment, are not expected to be realized.
 
Our calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty or finality or uncertainty to an anticipated outcome, changes in accounting or tax laws in the U.S., or foreign jurisdictions where we operate, or changes in other facts or circumstances. In addition, we recognize liabilities for potential U.S. and foreign income tax for uncertain income tax positions taken on our tax returns if it has less than a 50% likelihood of being sustained. If we determine that payment of these amounts is unnecessary or if the recorded tax liability is less than our current assessment, we may be required to recognize an income tax benefit or additional income tax expense in our financial statements in the period such determination is made. We have calculated our uncertain tax positions which were attributable to certain estimates and judgments primarily related to transfer pricing, cost sharing and our international tax structure exposure.
 
As of September 30, 2010 and December 31, 2009, we had a valuation allowance of $14.6 million and $14.6 million, respectively, attributable to management’s determination that none of the deferred tax assets in the United States will be realized, except for certain deferred tax assets related to uncertain income tax positions. Should it be determined that all or part of the net deferred tax asset will not be realized in the future, an adjustment to increase the deferred tax asset valuation allowance will be charged to income in the period such determination is made. Likewise, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the valuation allowance for the deferred tax asset would increase income in the period such determination was made.
 
Contingencies .  We are engaged in legal proceedings regarding our intellectual property, challenges to the enforceability or validity of our intellectual property and claims that our products infringe on the intellectual property rights of others. In addition, from time to time, we become aware that we are subject to other contingent liabilities. When this occurs, we will evaluate the appropriate accounting for the potential contingent liabilities using ASC 450-20-25-2 Contingencies – Loss Contingencies - Recognition to determine whether a contingent liability should be recorded. In making this determination, management may, depending on the nature of the matter, consult with internal and external legal counsel and technical experts. Based on the facts and circumstances in each matter, we use our judgment to determine whether it is probable that a contingent loss has occurred and whether the amount of such loss can be estimated. If we determine a loss is probable and estimable, we record a contingent loss in accordance with ASC 450-20-25-2. In determining the amount of a contingent loss, we take into account advice received from experts for each specific matter regarding the status of legal proceedings, settlement negotiations (which may be ongoing), prior case history and other factors. Should the judgments and estimates made by management need to be adjusted as additional information becomes available, we may need to record additional contingent losses that could materially and adversely impact our results of operations. Alternatively, if the judgments and estimates made by management are adjusted, for example, if a particular contingent loss does not occur, the contingent loss recorded would be reversed which could result in a favorable impact on our results of operations.
 
 
19

 
 
Accounting for Stock-Based Compensation.  We have adopted the provisions of ASC 718-10-30 Compensation – Stock Compensation – Overall – Initial Measurement , under the modified prospective method. ASC 718-10-30 eliminates the alternative of applying the intrinsic value measurement to stock compensation awards issued to employees. Rather, the standard requires us to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period) .   We currently use the Black-Scholes option-pricing model to estimate the fair value of our share-based payments. The Black-Scholes option-pricing model is based on a number of assumptions, including historical volatility, expected life, risk-free interest rate and expected dividends. If these assumptions change, stock-based compensation may differ significantly from what we have recorded in the past. The amount of stock-based compensation that we recognize is also based on an expected forfeiture rate. If there is a difference between the forfeiture assumptions used in determining stock-based compensation costs and the actual forfeitures which become known over time, we may change the forfeiture rate, which could have a significant impact on our stock-based compensation expense.
 
Fair Value Instruments. ASC 820-10 Fair Value Measurements and Disclosures – Overall defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles in the United States of America, and requires that assets and liabilities carried at fair value be classified and disclosed in one of the three categories, as follows:

a.  
Level 1: Quoted prices in active markets for identical assets;
b.  
Level 2: Significant other observable inputs; and
c.  
Level 3: Significant unobservable inputs.
 
ASC 820-10-35-51 Fair Value Measurement and Disclosure – Overall – Subsequent Measurement – Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly provides additional guidance for estimating fair value in accordance with ASC 820-10 Fair Value Measurements and Disclosures – Overall , when the volume and level of activity for the asset or liability have significantly decreased.
 
Our financial instruments include cash and cash equivalents and short-term and long-term investments. Cash equivalents are stated at cost, which approximates fair market value based on quoted market prices. Short-term and long-term investments are stated at their fair market value.
 
At September 30, 2010, the face value of our holdings in auction rate securities was $20.3 million, all of which was classified as long-term available-for-sale investments. Investments in available-for-sale securities are recorded at fair value, and unrealized gains or losses (that are deemed to be temporary) are recognized through shareholders' equity, as a component of accumulated other comprehensive income in our consolidated balance sheet. We record an impairment charge to earnings when an available-for-sale investment has experienced a decline in value that is deemed to be other-than-temporary. Investments in trading securities are recorded at fair value and unrealized gains and losses are recognized in other income (expense) in our condensed consolidated statement of operations.
 
We adopted the provisions of ASC 320-10-35 Investments – Debt and Equity Securities – Overall – Subsequent Measurement and ASC 320-10-50 Investments – Debt and Equity Securities – Overall - Disclosure, effective April 1, 2009 and used the guidelines therein to determine whether the impairment is temporary or other-than temporary. Other-than-temporary impairment charges exist when the entity has the intent to sell the security or it will more likely than not be required to sell the security before anticipated recovery. During the year ended December 31, 2009, we recognized a credit loss of $70,000, which was deemed to be other-than-temporary in other income (expense) in our Condensed Consolidated Statement of Operations.
 
 
20

 
 
Based on certain assumptions described in Note 8, “Fair Value Measurements”, to our condensed consolidated financial statements and the Liquidity and Capital Resources section of “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this quarterly report on Form 10-Q, we recorded impairment charges on our holdings in auction-rate securities. The valuation of these securities is subject to fluctuations in the future, which will depend on many factors, including the collateral quality, potential to be called or restructured, underlying final maturity, insurance guaranty, liquidity and market conditions, among others.

Results of Operations
 
The table below sets forth the data from our Condensed Consolidated Statement of Operations as a percentage of revenue for the periods indicated:
  
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenue
    100.0 %     100.0 %     100.0 %     100.0 %
Cost of revenue
    45.3 %     39.3 %     43.1 %     40.6 %
                                 
Gross profit
    54.7 %     60.7 %     56.9 %     59.4 %
Operating expenses:
                               
Research and development
    17.2 %     21.0 %     19.9 %     23.6 %
Selling, general and administrative
    15.6 %     19.7 %     18.8 %     22.4 %
Litigation expense
    1.5 %     5.9 %     2.8 %     6.0 %
Litigation provision reversal, net
    0.0 %     (13.3 %)     0.0 %     (5.4 %)
Total operating expenses
    34.3 %     33.3 %     41.5 %     46.6 %
                                 
Income from operations
    20.4 %     27.4 %     15.4 %     12.8 %
Other income (expense):
                               
Interest and other income
    0.4 %     0.3 %     0.5 %     0.7 %
Interest and other expense
    (0.2 %)     (0.2 %)     (0.1 %)     (0.3 %)
Total other income, net
    0.2 %     0.1 %     0.4 %     0.4 %
                                 
Income before income taxes
    20.6 %     27.5 %     15.8 %     13.2 %
Income tax provision
    0.5 %     1.3 %     0.7 %     0.5 %
Net income
    20.1 %     26.2 %     15.1 %     12.7 %
 
Revenue.
 
    For the three months ended September 30,     For the nine months ended September 30,  
    2010    
2009
   
 
   
2010
   
2009
   
 
 
    (in thousands)    
Change
    (in thousands)     Change  
Revenue
  $ 65,843     $ 47,996       37.3 %   $ 171,783     $ 118,461       45.0 %
 
Revenue for the three months ended September 30, 2010 was $65.8 million, an increase of $17.9 million, or 37.3%, from $48.0 million for the three months ended September 30, 2009. Revenue for the nine months ended September 30, 2010 was $171.8 million, an increase of $53.3 million, or 45.0%, from $118.5 million for the nine months ended September 30, 2009. Sales during 2009 were generally weak, primarily from the deterioration in the general demand for electronic products as a result of a worldwide financial crises and associated macro-economic slowdowns. In 2010, we saw an increase in demand for our DC to DC products, with third quarter sales having increased by 76.6% year over year and the nine months sales having increased by 61.1% year over year. The increase was primarily because of higher demand for electronic products in the consumer and communications markets. Sales of our lighting control products also increased as a result of greater demand for our WLED solution for consumer electronics products. This was partially offset by a reduction in the demand for our CCFL products. Audio sales were down year over year due to lower demand and a decline in the average selling price for certain of our audio products.
 
 
21

 
 
The following table illustrates changes in our revenue by product family:
 
   
For the three months ended September 30,
         
For the nine months ended September 30,
       
   
2010
   
2009
   
 
   
2010
   
2009
   
 
 
   
(in thousands
Amount
   
% of
Revenue
   
(in thousands) Amount
   
% of
Revenue
     
Change
   
(in thousands)
Amount
   
% of
Revenue
   
(in thousands) Amount
   
% of
Revenue
     
Change
 
DC to DC Converters
  $ 55,230       83.9 %   $ 36,723       76.6 %     50.4 %   $ 141,082       82.1 %   $ 87,576       73.9 %     61.1 %
Lighting Control Products
    9,380       14.2 %     8,511       17.7 %     10.2 %     24,324       14.2 %     20,544       17.4 %     18.4 %
Audio Amplifiers
    1,233       1.9 %     2,732       5.7 %     (54.9 )%     6,377       3.7 %     10,341       8.7 %     (38.3 )%
    $ 65,843       100.0 %   $ 47,966       100.0 %     37.3 %   $ 171,783       100.0 %   $ 118,461       100.0 %     45.0 %
 
Gross Profit.  Gross profit as a percentage of revenue, or gross margin, was 54.7% for the three months ended September 30, 2010 and 60.7% for the three months ended September 30, 2009. Gross profit as a percentage of revenue, or gross margin, was 56.9% for the nine months ended September 30, 2010 and 59.4% for the nine months ended September 30, 2009. For the three and nine months ended September 30, 2010 and 2009, gross margin declined year-over-year. The decline in the gross margin was a result of changes in product mix, higher product costs, an increase in inventory reserves and declining average selling prices for certain of our products.

Research and Development.
 
      2010       2009    
 
      2010       2009    
 
 
   
(in thousands)
     
Change
   
(in thousands)
     
Change
 
Revenue
  $ 65,843     $ 47,966       37.3 %   $ 171,783     $ 118,461       45.0 %
Research and development (“R&D”) (including stock-based compensation of $1,647 and $1,409 for the three months ended September 30, 2010 and 2009, respectively, and $5,377 and $4,656 for the nine months ended September 30, 2010 and 2009, respectively)
    11,291       10,080       12.0 %     34,116       27,929       22.2 %
R&D as a percentage of revenue
    17.2 %     21.0 %             19.9 %     23.6 %        
 
R&D expenses were $11.3 million, or 17.2% of revenue, for the three months ended September 30, 2010 and $10.1 million, or 21.0% of revenue, for the three months ended September 30, 2009. R&D expenses were $34.1 million, or 19.9% of revenue, for the nine months ended September 30, 2010 and $27.9 million, or 23.6% of revenue, for the nine months ended September 30, 2009. The year-over-year increase was primarily due to an increase in variable compensation and stock-based compensation expenses.
 
Selling, General and Administrative.
 
   
For the three months ended September 30,
   
For the nine months ended September 30,
 
   
2010
   
2009
   
 
   
2010
   
2009
   
 
 
   
(in thousands)
    Change    
(in thousands)
    Change  
Revenue
  $ 65,843     $ 47,966       37.3 %   $ 171,783     $ 118,461       45.0 %
Selling, general and administrative (“SG&A”) (including stock-based compensation of $2,445 and $1,688 for the three months ended September 30, 2010 and 2009, respectively, and $8,083 and $5,558 for the nine months ended September 30, 2010 and 2009, respectively)
    10,296       9,438       9.1 %     32,304       26,567       21.6 %
SG&A as a percentage of revenue
    15.6 %     19.7 %             18.8 %     22.4 %        
 
SG&A expenses were $10.3 million, or 15.6% of revenue, for the three months ended September 30, 2010 and $9.4 million, or 19.7% of revenue, for the three months ended September 30, 2009. SG&A expenses were $32.3 million, or 18.8% of revenue, for the nine months ended September 30, 2010 and $26.6 million, or 22.4% of revenue, for the nine months ended September 30, 2009. For the three and nine months ended September 30, 2010, SG&A as a percentage of revenue declined compared to the corresponding period in the prior year due to the efficiencies of greater scale from increased revenues. Total SG&A expenses increased year over year due to higher stock-based compensation expenses, increased sales costs and higher sales commissions as a result of increased revenue in 2010.
 
 
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Litigation Expense.
 
   
For the three months ended September 30,
   
For the nine months ended September 30,
 
   
2010
   
2009
   
 
   
2010
   
2009
   
 
 
   
(in thousands)
    Change    
(in thousands)
    Change  
Revenue
  $ 65,843     $ 47,966       37.3 %   $ 171,783     $ 118,461       45.0 %
Litigation expense
    964       2,811       (65.7 )%     4,759       7,090       (32.9 )%
Litigation expense as a percentage of revenue
    1.5 %     5.9 %             2.8 %     6.0 %        
 
Litigation expenses were $1.0 million, or 1.5% of revenue, for the three months ended September 30, 2010 as compared to $2.8 million, or 5.9% of revenue, for the three months ended September 30, 2009. Litigation expenses were $4.8 million, or 2.8% of revenue, for the nine months ended September 30, 2010 as compared to $7.1 million, or 6.0% of revenue, for the nine months ended September 30, 2009. During the three and nine months ended September 30, 2010 and 2009, we incurred legal expenses primarily for the defense of our lawsuits involving O2Micro, which were resolved in the second quarter of 2010.
 
Litigation Provision Reversal, net.  Litigation provision reversal, net was $6.4 million for the three and nine months ended September 30, 2009. During the quarter ended September 30, 2009, we completed the litigation process with respect to the lawsuit related to TSE, a customer. The conclusion of this lawsuit resulted in recording a reversal of a litigation provision of approximately $7.4 million. This provision was recorded as a litigation provision in the second quarter of 2007 and the reversal of this provision was reflected in the Litigation Provision Reversal, net item in the Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2009. In connection with the completion of this lawsuit, the Company also jointly terminated an escrow agreement with TSE and retrieved the deposit of $7.4 million. This recovery was reduced by certain litigation stipulations for other parties involved in the case in the amount of $1.0 million.
 
Income Tax Provision.  The income tax provision for the three and nine months ended September 30, 2010 was $0.3 million or 2.2% of our income before income taxes and $1.3 million or 4.8% of the pre-tax income, respectively. This differs from the federal statutory rate of 34% primarily because our foreign income was taxed at lower rates and because of the benefit that we realized as a result of the disqualifying disposition of incentive stock options and employee stock plan purchases. The income tax provision for the three and nine months ended September 30, 2009 was $0.6 million or 4.9% of our income before income taxes and $0.6 million or 3.6% of the pre-tax income, respectively. This differed from the federal statutory rate of 34% primarily because our foreign income was taxed at lower rates and because of the benefit that we realized as a result of the disqualifying disposition of incentive stock options and employee stock plan purchases.
 
Liquidity and Capital Resources.

As of September 30, 2010, we had working capital of $206.3 million, including cash and cash equivalents of $44.3 million and short-term investments of $140.7 million compared to working capital of $179.6 million, including cash and cash equivalents of $46.7 million and short-term investments of $118.9 million as of December 31, 2009. We have financed our growth primarily with proceeds from cash generated from operating activities, proceeds from the exercise of stock options and proceeds from the purchase of shares through the Company’s employee stock purchase plan.
 
For the nine months ended September 30, 2010, net cash provided by operating activities was $38.3 million. Net cash increased over the prior year period primarily due to strong operating results and an increase in accounts payable for inventory purchases to meet customer demands. This was partially offset by an increase in accounts receivable, primarily from increased shipments at the end of the quarter for which the collections have not been received. For the nine months ended September 30, 2009, net cash provided by operating activities was $15.6 million. Net cash increased over the prior year period primarily due to strong collections during the second quarter of 2009, an increase in accounts payable, primarily for inventory purchased, and strong operating results during the second quarter of 2009.
 
For the nine months ended September 30, 2010, net cash used in investing activities was $40.5 million, primarily related to the purchase of short-term investments and equipment purchases for our Chengdu facility. For the nine months ended September 30, 2009, net cash used in investing activities was $57.8 million, primarily related to the purchase of short-term investments.
 
We use professional investment management firms to manage the majority of our invested cash. Our fixed income portfolio is primarily invested in municipal bonds, government securities, auction-rate securities and highly rated corporate notes. The balance of the fixed income portfolio is managed internally and invested primarily in money market funds for working capital purposes.
 
 
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We adopted the provisions of ASC 320-10-35 Investments – Debt and Equity Securities – Overall – Subsequent Measurement and ASC 320-10-50 Investments – Debt and Equity Securities – Overall - Disclosure, effective April 1, 2009 and used the guidelines therein to determine whether the impairment is temporary or other-than temporary. Temporary impairment charges are recorded in accumulated other comprehensive income (loss) within equity and have no impact on net income. Other-than-temporary impairment charges exist when the entity has the intent to sell the security or it will more likely than not be required to sell the security before anticipated recovery. Other-than-temporary impairment charges are recorded in other income (expenses) in the Condensed Consolidated Statement of Operations.
 
In October 2008, the Company accepted an offer to participate in an auction-rate security rights offering from UBS to sell up to $18.2 million in face value of eligible auction-rate securities commencing in June 2010. Between October 2008 and June 2010, $9.6 million of these auction-rate securities were called at par. On June 30, 2010, the Company exercised the UBS put right and sold the remaining $8.6 million in auction rate securities at par, for which the sale was completed and proceeds were received on July 1, 2010. At December 31, 2009, both the impairment related to these auction-rate securities and the corresponding put right were valued at $0.7 million. The change in the impairment and the fair value of the put right was recorded in accordance with the provisions of ASC 320-10-35 and ASC 320-10-50 in other income (expense) in the Condensed Consolidated Statement of Operations.
 
At September 30, 2010, the Company’s investment portfolio included $19.4 million, net of impairment charges of $0.9 million, in government-backed student loan auction-rate securities. The underlying maturity of these auction-rate securities is up to 37 years. Although it is unclear as to when these investments will regain their liquidity, management has concluded that as of September 30, 2010 and December 31, 2009, the cumulative impairment of $0.9 million and $1.1 million, respectively, was temporary based on the following analysis:

1.  
The decline in the fair value of these securities is not attributable to adverse conditions specifically related to these securities or to specific conditions in an industry or in a geographic area;
2.  
Management possesses both the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value;
3.  
Management believes that it is more likely than not that the Company will not have to sell these securities before recovery of its cost basis;
4.  
Except for the credit loss of $70,000 recognized in year ended December 31, 2009 for the Company’s holdings in auction rate securities described below, the Company does not believe that there is any additional credit loss associated with other auction-rate securities because the Company expects to recover the entire amortized cost basis;
5.  
The majority of the securities remain AAA rated, with $8.7 million of the auction rate securities having been downgraded by Moody’s to A3-Baa3 during the year ended December 31, 2009, and there have been no downgrades during the nine months ended September 30, 2010; and
6.  
All scheduled interest payments have been made pursuant to the reset terms and conditions.

Based on the guidance of ASC 320-10-35 and ASC 320-10-50, the Company evaluated the potential credit loss of each of the auction-rate securities that are currently held by the Company. Based on such analysis, the Company determined that those securities that are not 100% FFELPS guaranteed are potentially subject to credit risks based on the extent to which the underlying debt is collateralized and the security-specific student-loan default rates. The Company’s portfolio includes three such securities, one of which has a senior parity ratio of approximately 125%, which is substantially above the expected student-loan default rate for that security. Conversely, the senior parity ratio for the other two securities is approximately 105%. If, therefore, the student-loan default rate and borrowing rate increases for these issuers, the remaining balance in these trusts may not be sufficient to cover the senior debt. The Company therefore concluded that there is potential credit risk for these two securities and as such, used the discounted cash flow model to determine the amount of credit loss to be recorded. In valuing the potential credit loss, the following parameters were used: 20 year expected term, cash flows based on the 90-day t-bill rates for 20 year forwards and a risk premium of 5.9%, the amount of interest that the Company was receiving on these securities when the market was last active. As of September 30, 2010 and December 31, 2009, the potential credit loss associated with these securities was $70,000, which the Company deemed other-than-temporary and recorded in other expense in its Condensed Consolidated Statement of Operations during 2009.
 
Unless another rights offering or other similar offers are made to redeem at par and accepted by us, we intend to hold the balance of these investments through successful auctions at par, which we believe could take approximately 2.0 years.
 
 
24

 
 
The valuation of the auction-rate securities is subject to fluctuations in the future, which will depend on many factors, including the collateral quality, potential to be called or restructured, underlying final maturity, insurance guaranty, liquidity and market conditions, among others. To determine the fair value of the auction-rate securities at December 31, 2009, March 31, 2010, June 30, 2010 and September 30, 2010, we used a discounted cash flow model, for which there are three valuation parameters, including time-to-liquidity, discount rate and expected return. The following are the values used in the discounted cash flow model:
 
   
December 31, 2009
 
March 31, 2010
 
June 30, 2010
 
September 30, 2010
Time-to-Liquidity
 
24 months
 
24 months
 
24 months
 
24 months
Expected Return (Based on the requisite treasury rate, plus a contractual penalty rate)
 
2.4%
 
2.4%
 
2.7%
 
2.2%
Discount Rate (Based on the requisite LIBOR, the cost of debt and a liquidity risk premium)
 
5.2% - 10.0%, depending on the credit-rating of the security
 
4.6% - 9.4%, depending on the credit-rating of the security
 
3.8% - 8.6%, depending on the credit-rating of the security
 
3.2% - 8.0%, depending on the credit-rating of the security
 
From the second quarter of 2010 to the third quarter of 2010, we kept the time-to-liquidity constant at 2.0 years. There was a slight decrease in the spread between the 90-day libor and t-bill forward rates as well as a small decrease in the FFELPS-guaranteed student-loan credit default spread. We also sold $8.8 million in auction-rate securities at par. The net effect of the adjustments was a reduction in the overall impairment from $1.3 million at June 30, 2010 to $0.9 million at September 30, 2010.
 
From the first quarter of 2010 to the second quarter of 2010, we kept the time-to-liquidity constant at 2.0 years. The spread between the 90-day libor and t-bill forward rates remained relatively constant. We sold $8.1 million in auction rate securities at par. However, the FFELPs-guaranteed student-loan credit default spread increased slightly. The net effect of the adjustments was a reduction in the overall impairment from $1.5 million at March 31, 2010 to $1.3 million at June 30, 2010. The overall impairment decreased primarily because we sold a large amount of auction-rate securities back to UBS at par. This was partially offset by a slight increase in the FFELPS-guaranteed student-loan credit default spread.
 
From the fourth quarter of 2009 to the first quarter of 2010, we kept the time-to-liquidity constant at 2.0 years. We sold $0.2 million in auction-rate securities at par. The spread between the 90-day libor and t-bill forward rate decreased by 40 bps and the FFELPs-guaranteed student-loan credit default spread decreased by 13 bps. The net effect of the adjustments was a reduction in the overall impairment from $1.8 million at December 31, 2009 to $1.5 million at March 31, 2010.
 
Net cash used in financing activities for the nine months ended September 30, 2010 was $0.5 million, primarily from stock repurchases in the amount of $17.0 million, which was substantially offset by the proceeds from the exercise of stock options in the amount of $13.3 million. Net cash provided by financing activities for the nine months ended September 30, 2009 was $10.7 million, primarily from the issuance of common stock in the amount of $10.2 million.
 
On July 27, 2010, the Company’s Board of Directors approved a stock repurchase program that authorizes the Company to repurchase up to $50.0 million in the aggregate of its common stock between August 2, 2010 and December 31, 2011. As of September 30, 2010, the Company repurchased and subsequently retired 983,189 shares, at a cost of $17.0 million.
 
Although cash requirements will fluctuate based on the timing and extent of many factors such as those discussed above, we believe that cash generated from operations, together with the liquidity provided by existing cash and cash equivalents and short-term investments, will be sufficient to satisfy our liquidity requirements for at least the next 12 months. For further details regarding our operating, investing and financing activities, see our Condensed Consolidated Statements of Cash Flows.
 
 
25

 
 
Contractual Obligations and Off Balance Sheet Arrangements.
We lease our headquarters and sales offices in San Jose, California. The building that we are leasing was sold and the new landlord has exercised the right to terminate the lease, effective April 18, 2012. Certain of our facility leases provide for periodic rent increases. In September 2004, we signed an agreement with the Chinese local authority to construct a facility in Chengdu, China. We have the option to acquire this facility in Chengdu after a five-year lease term, which option becomes available to us in March 2011. At that time, we will likely enter into a purchase agreement for this facility. We constructed a 140,000 square foot research and development facility in Chengdu, China which was put into operation in October 2010. We also lease our sales offices in Japan, China, Taiwan and Korea.
 
The following table summarizes our lease obligations at September 30, 2010, and the effect such obligations are expected to have on our liquidity and cash flow over the next five years (in thousands).
 
   
Payments by Period
 
   
Total
   
2010
   
2011
   
2012
   
2013
 
Operating leases
  $ 2,453     $ 434     $ 1,523     $ 438     $ 58  
 
As of September 30, 2010, our total outstanding purchase commitments with vendors were $47.5 million, which includes wafer purchases from our two foundries and the purchase of assembly services primarily from multiple contractors in Asia. This compares to purchase commitments of $13.2 million as of December 31, 2009.
 
As of September 30, 2010, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the Securities and Exchange Commission’s Regulation S-K.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
For a discussion of market risks at December 31, 2009, refer to Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” in our annual report on Form 10-K for the fiscal year ended December 31, 2009 filed with the SEC on February 16, 2010. During the three and nine months ended September 30, 2010, there were no material changes or developments that would materially alter the market risk assessment performed as of December 31, 2009.
 
ITEM 4. CONTROLS AND PROCEDURES
 
Evaluation of disclosure controls and procedures.
 
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of the end of the period covered by this quarterly report on Form 10-Q.  In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.  In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
 
Based on our evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are designed at a reasonable assurance level and are operating effectively to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
 
Changes in internal control over financial reporting.
 
There were no changes in our internal control over financial reporting that occurred during the period covered by this quarterly report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 
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PART II. OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS
 
We and certain of our subsidiaries are parties to other actions and proceedings incident to our business in the ordinary course of business, including litigation regarding our intellectual property, challenges to the enforceability or validity of our intellectual property and claims that our products infringe on the intellectual property rights of others. The pending proceedings involve complex questions of fact and law and will require the expenditure of significant funds and the diversion of other resources to prosecute and defend. The results of legal proceedings are inherently uncertain, and material adverse outcomes are possible.   
 
ITEM 1A. RISK FACTORS
 
Our business involves risks and uncertainties. You should carefully consider the risks described below, together with all of the other information in this Form 10-Q and other filings with the Securities and Exchange Commission in evaluating our business. If any of the following risks actually occur, our business, financial condition, operating results and growth prospects would likely be materially and adversely affected. In such an event, the trading price of our common stock could decline, and you could lose all or part of your investment in our common stock. Our past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.  These risks, which have been updated from the risk factors previously disclosed in our Annual Report on Form 10-K  involve forward-looking statements and our actual results may differ substantially from those discussed in these forward-looking statements.
 
If we are unsuccessful in any of the legal proceedings involving us and any of our competitors, we could be prevented from selling many of our products and/or be required to pay substantial damages. An unfavorable outcome or an additional award of damages, attorneys’ fees or an injunction could cause our revenue to decline significantly and could severely harm our business and operating results.

If we are not successful in litigation that could be brought against us or our customers, we could be ordered to pay monetary fines and/or damages. If we are found liable for willful patent infringement, damages could be doubled or tripled. We and/or our customers could also be prevented from selling some or all of our products. Moreover, our customers and end-users could decide not to use our products or our products or our customers’ accounts payable to us could be seized. Finally, interim developments in these proceedings could increase the volatility in our stock price as the market assesses the impact of such developments on the likelihood that we will or will not ultimately prevail in these proceedings.
 
Given our inability to control the timing and nature of significant events in our legal proceedings that either have arisen or may arise, our legal expenses are difficult to forecast and may vary substantially from our publicly-disclosed forecasts with respect to any given quarter, which could contribute to increased volatility in our stock price and financial condition.
 
It is difficult for us to forecast our legal expenses for any given quarter, which adversely affects our ability to forecast our expected results of operations in general. If we fail to meet the expectations of securities or industry analysts as a result of unexpected changes in our legal expenses, our stock price could be impacted.
 
Our ongoing legal proceedings and the potential for additional legal proceedings have diverted, and may continue to divert, financial and management resources.
 
The semiconductor industry is characterized by frequent claims of infringement and litigation regarding patent and other intellectual property rights. Patent infringement is an ongoing risk, in part because other companies in our industry could have patent rights that may not be identifiable when we initiate development efforts. Litigation may be necessary to enforce our intellectual property rights, and we may have to defend ourselves against additional infringement claims. Such litigation is very costly. In the event any third party makes a new infringement claim against us or our customers, we could incur additional ongoing legal expenses. In addition, in connection with these legal proceedings, we may be required to post bonds to defend our intellectual property rights in certain countries for an indefinite period of time, until such dispute is resolved. If our legal expenses materially increase or exceed anticipated amounts, our capital resources and financial condition could be adversely affected. Further, if we are not successful in any of our intellectual property defenses, our financial condition cold be adversely affected and our business could be harmed. In addition, our management team may also be required to devote a great deal of time, effort and energy to these legal proceedings, which could distract management’s focus on our operations and adversely affect our business.

We will continue to vigorously defend and enforce our intellectual property rights around the world, especially as it relates to patent litigation. We will take the appropriate action in various courts throughout the world and may be required to post bonds to defend such intellectual property in certain countries for an indefinite period of time, until such dispute is resolved. If we are not successful in defending our intellectual property, we could lose revenue and the business could be harmed.
 
From time to time, we are faced with having to defend our intellectual property rights throughout the world. Should we become engaged in such proceedings, it could divert management’s attention from focusing on and implementing the business strategy. Further, should we not be successful in any of our intellectual property defenses, the revenue may be affected and the business could be harmed.
 
 
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We expect our operating results to fluctuate from quarter to quarter and year to year, which may make it difficult to predict our future performance and could cause our stock price to decline and be volatile.
 
Our revenue, expenses, and results of operations are difficult to predict, have varied significantly in the past and will continue to fluctuate significantly in the future due to a number of factors, many of which are beyond our control. We expect fluctuations to continue for a number of reasons, including:
 
 
a deterioration in general demand for electronic products as a result of worldwide financial crises and associated macro-economic slowdowns;
 
 
a deterioration in business conditions at our distributors, value-added resellers and/or end-customers;
 
 
adverse general economic conditions in the countries where our products are sold or used;
 
 
the timing of developments and related expenses in our litigation matters;
 
 
the possibility of additional lost business as a result of customer and prospective customer concerns about adverse outcomes in our litigations or about being litigation targets;
 
 
continued dependence on our turns business (orders received and shipped within the same fiscal quarter);

 
increases in assembly costs due to commodity price increases, such as the price of gold;
 
 
the timing of new product introductions by us and our competitors;
 
 
the acceptance of our new products in the marketplace;
 
 
our ability to develop new process technologies and achieve volume production;
 
 
our ability to meet customer product demand in a timely manner;
 
 
the scheduling, rescheduling, or cancellation of orders by our customers;
 
 
the cyclical nature of demand for our customers’ products;
 
 
inventory levels and product obsolescence;
 
 
seasonality and variability in the computer, consumer electronics, and communications markets;
 
 
the availability of adequate manufacturing capacity from our outside suppliers;
 
 
increases in prices for finished wafers due to general capacity shortages;
 
 
the potential loss of future business resulting from current capacity issues;
 
 
changes in manufacturing yields; and
 
 
movements in exchange rates, interest rates or tax rates.
 
Due to the factors noted above and other risks described in this section, many of which are beyond our control, you should not rely on quarter-to-quarter or year-over-year comparisons to predict our future financial performance. Unfavorable changes in any of the above factors may seriously harm our business and cause our stock price to decline and be volatile.
 
The market for government-backed student loan auction-rate securities has suffered a decline in liquidity which may impact the liquidity and potential value of our investment portfolio.
 
The market for government-backed student loan auction-rate securities with interest rates that reset through a Dutch auction every 7 to 35 days, became illiquid in 2008. At September 30, 2010, the Company’s investment portfolio included $19.4 million, net of impairment charges of $0.9 million, in government-backed student loan auction-rate securities. As of that date, $20.3 million, the face value of our auction-rate security investments, have failed to reset through successful auctions and it is unclear as to when these investments will regain their liquidity. The underlying maturity of these auction-rate securities is up to 37 years. 
 
Based on certain assumptions described in Note 8, “Fair Value Measurements”, to our condensed consolidated financial statements and the Liquidity and Capital Resources section of “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this quarterly report on Form 10-Q, we recorded temporary and other-than-temporary impairment charges on these investments. The valuation is subject to fluctuations in the future, which will depend on many factors, including the collateral quality, potential to be called or restructured, underlying final maturity, insurance guaranty, liquidity and market conditions, among others. We experienced our first failed auction in mid-February 2008.
 
 
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Should there be further deterioration in the market for auction-rate securities or if the accounting rules for these securities change, the value of our portfolio may decline, which may have an adverse impact on our cash position and our earnings. In addition, it is unlikely that we will be able to liquidate our auction-rate securities in the short term.
 
We may be unsuccessful in developing and selling new products or in penetrating new markets required to maintain or expand our business.
 
Our competitiveness and future success depend on our ability to design, develop, manufacture, assemble, test, market, and support new products and enhancements on a timely and cost-effective basis. A fundamental shift in technologies in any of our product markets could have a material adverse effect on our competitive position within these markets. Our failure to timely develop new technologies or to react quickly to changes in existing technologies could materially delay our development of new products, which could result in product obsolescence, decreased revenue, and/or a loss of market share to competitors.

As we develop new product lines, we must adapt to market conditions that are unfamiliar to us, such as competitors and distribution channels that are different from those we have known in the past. Some of our new product lines require us to re-equip our labs to test parameters we have not tested in the past. If we are unable to adapt rapidly to these new and additional conditions, we may not be able to successfully penetrate new markets.
 
The success of a new product depends on accurate forecasts of long-term market demand and future technological developments, as well as on a variety of specific implementation factors, including:
 
 
timely and efficient completion of process design and device structure improvements;
 
 
timely and efficient implementation of manufacturing, assembly, and test processes;
 
 
the ability to secure and effectively utilize fabrication capacity in different geometries;
 
 
product performance;
 
 
product availability;
 
 
the quality and reliability of the product; and
 
 
effective marketing, sales and service.
 
To the extent that we fail to timely introduce new products or to quickly penetrate new markets, our revenue and financial condition could be materially adversely affected.
 
We may be unsuccessful in developing and selling new products with margins similar to or better than what we have experienced in the past, which would impact our overall gross margin and financial performance.
 
Our success depends on products that are differentiated in the market, which result in gross margins that have historically been above the industry averages. Should we fail to develop and introduce sufficiently differentiated products that result in higher gross margins than industry averages, our financial condition could be materially adversely affected.
 
If demand for our products declines in the major end markets that we serve, our revenue will decrease.
 
We believe that the application of our products in the computer, consumer electronics and communications markets will continue to account for the majority of our revenue. If the demand for our products declines in the major end markets that we serve, our revenue will decrease. In addition, as technology evolves, the ability to integrate the functionalities of various components, including our discrete semiconductor products, onto a single chip and/or onto other components of systems containing our products increases. Should our customers require integrated solutions that we do not offer, demand for our products could decrease, and our business and results of operations could be adversely affected.
 
 
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Certain of our products go into tubes that contain mercury, which is the subject of environmental concerns.
 
Our CCFL products go into tubes that contain mercury, which is the subject of environmental concerns, particularly in Europe. Should environmental issues impair the widespread use of our CCFL-based products, and should we be unable to produce replacement products based on LED lighting fast enough to compensate for the loss of our CCFL-related business, our business and results of operations could be adversely affected.
 
We may not experience growth rates comparable to past years.
 
In the past, our revenues increased significantly in certain years due to increased sales of certain of our products. Due to increased competition, reduced global electronics demand, end-customer market downturn, market acceptance and penetration of our current and future products and ongoing litigation, we may not experience growth rates comparable to past periods, which could affect our stock price and results of operations.
 
We may not be profitable on a quarterly or annual basis.
 
Our profitability is dependent on many factors, including:
 
·  
our sales, which because of our turns business (i.e., orders received and shipped within the same fiscal quarter), is difficult to accurately forecast;
 
·  
consumer electronic sales, which has experienced and may continue to experience&#