The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes to those statements included elsewhere in

this Quarterly Report on Form 10-Q, and with management's discussion and analysis of our financial condition and results of operations in our Annual Report on Form 10-K for the year ended December 31, 2008, which was filed with the SEC on March 2,2009. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in Part II, Item 1A "Risk Factors" and elsewhere in this report.

Overview

We design, develop, manufacture and market proprietary, high-voltage, analog integrated circuits ("ICs") for use in electronic power supplies, also known as switched-mode power supplies. Our ICs are used principally in AC-DC power supplies in a wide variety of end products, primarily in the consumer, communications, computer and industrial electronics markets. For example, our ICs are commonly used in such end products as mobile-phone chargers, desktop computers, home entertainment equipment, appliances, utility meters and LED light fixtures.

We believe that our products enable power supplies superior to those designed with alternative technologies. We differentiate our ICs through innovation aimed at helping our customers meet the desired performance specifications for their power supplies while minimizing complexity, component count, time-to-market and overall system cost. We invest significant resources in research and development in an effort to achieve this differentiation.

While the size of the power-supply market fluctuates with changes in macroeconomic conditions, the market has generally exhibited only a modest growth rate over time, as growth in the unit volumes of power supplies has largely been offset by reductions in the average selling price of components in this market. Moreover, this market has even experienced a decrease in the unit volumes of power supplies during the recent economic downturn. Therefore, the growth rate of our revenues, income and cash flow depends primarily on our penetration of the power supply market, as well as our success in expanding the addressable market by introducing new products that address a wider range of applications. Our growth strategy includes the following elements:

• Increase the penetration of our ICs in the "low-power" AC-DC power supply market. The vast majority of our revenues come from power-supply applications requiring 50 watts of output or less. We continue to introduce more advanced products that make our IC-based solutions more attractive in this market. We have also increased the size of our sales and field-engineering staff considerably over the past several years, and we continue to expand our offerings of technical documentation and design-support tools and services in order to help our customers use our ICs. These tools and services include our PI Expert™ design software, which we offer free of charge, and our transformer-sample service.

• Capitalize on the growing demand for more energy-efficient electronic products and lighting technologies. We believe that energy-efficiency is becoming an increasingly important design criterion for power supplies due largely to the emergence of standards and specifications that encourage, and in some cases mandate, the design of more energy-efficient electronic products. While power supplies built with competing technologies are often unable to meet these standards cost-effectively, power supplies incorporating our ICs are generally able to comply with all known efficiency specifications currently in effect.

Additionally, technological advances combined with concerns about the inefficiency of traditional incandescent lighting are resulting in the adoption of alternative lighting technologies such as light-emitting diodes (LEDs). We believe this presents a significant opportunity for us because our ICs are used in power-supply circuitry for high-voltage, or offline, LED lighting applications.

• Expand our addressable market to include "high-power" applications. We believe we have developed new technologies and products that enable us to bring the benefits of highly integrated power supplies to applications requiring more than 50 watts of output. These include such applications as main power supplies for flat-panel TVs, high-efficiency main power supplies for PCs and servers, LED streetlights and power adapters used with notebook computers.

Our business is characterized by short-term orders and short customer lead times, and a high percentage of our revenues typically comes from "turns business," or orders booked and shipped within the same quarter. Customers typically can cancel or reschedule orders without significant penalty. We plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. As a result, our quarterly and annual operating results may fluctuate significantly in the future.

Also, our operating results are subject to external factors such as global economic conditions, supply-chain dynamics and other fluctuations, which can cause our operating results to be volatile. For example, like many semiconductor companies, we experienced a sharp decrease in demand for our products beginning in the fourth quarter of 2008 as a result of the global economic downturn. As a result, our net revenues in the fourth quarter of 2008 and the first quarter of 2009 were 19% and 22% lower, respectively, than the corresponding prior-year periods. Since the first quarter of 2009 we have experienced a sharp increase in demand for our products reflecting an improvement in business conditions industry-wide and, we believe, increased penetration of our products into our addressable markets. Although still lower than the corresponding period in 2008, our net revenues for the three months ended June 30, 2009 were 22% higher than net revenues for the prior quarter. Our revenues for the three months ended September 30, 2009 were an additional 22% higher than revenues for the prior quarter, and 12% higher than the corresponding period in the previous year. For the nine months ended September 30, 2009 our net revenues decreased by 6% compared with the nine months ended September 30, 2008.

Because our industry is intensely price-sensitive, our gross profit margin (gross profit divided by net revenues) is subject to change based on the relative pricing of solutions that compete with ours. Variations in product and customer mix can also cause our gross profit margin to fluctuate. Also, because we purchase a large percentage of our silicon wafers from foundries located in Japan, our gross profit margin is influenced by fluctuations in the exchange rate between the U.S. dollar and the Japanese yen. All else being equal, a 10% change in the value of the U.S. dollar compared to the Japanese yen would eventually result in a corresponding change in our gross profit margin of approximately one percentage point. Also, although our wafer fabrication and assembly operations are outsourced, as are the majority of our test operations, a portion of our production costs are fixed in nature. As such, our unit costs and gross profit margin are impacted by the volume of units we produce.

For the three months ended September 30, 2009, our gross profit was $29.1 million, or 49% of net revenues, compared with $29.2 million or 54% of net revenues, in the three months ended September 30, 2008. For the nine months ended September 30, 2009, our gross profit was $74.3 million or 50% of net revenues, compared with $86.1 million, or 54% of net revenues, in the nine months ended September 30, 2008. The reduction in our gross profit margin was driven primarily by lower fixed-cost absorption due to reduced production volumes, the stronger Japanese yen compared to the U.S. dollar, and increased sales of recently introduced products, which tend to have lower gross profit margin than earlier-generation products. While we cannot predict the future direction of our gross profit margin because many of the factors influencing it are outside of our control, we are working to increase our gross margin through a combination of product-cost reductions and the development of new products and technologies aimed at increasing the value of our ICs to customers.

In response to the economic downturn, we implemented a variety of measures to reduce our operating expenses. These included a modest headcount reduction, curtailment of certain employee benefits, restrictions on hiring, travel and use of outside consultants and contractors, and a number of other steps. We also took steps to reduce future operating expenses related to stock-based compensation; these steps included the repurchase of approximately 2.5 million "underwater" employee stock options via a tender offer executed in December 2008, and a modification of our employee stock purchase plan that shortened the offering period from 24 months to six months. These various steps affected our operating expenses for the nine months ended September 30, 2009, which were decreased by 10% compared with the nine months ended September 30, 2008. We continually evaluate our operating expenses in light of business conditions and our operational needs. While our operating expenses may fluctuate from quarter to quarter, over time our aim is to increase them at a rate lower than that of our net revenues.

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.

Our critical accounting policies are as follows:

• revenue recognition;

• stock-based compensation;

• estimating sales returns and allowances;

• estimating distributor pricing credits;

• estimating write-downs for excess and obsolete inventory

• income taxes; and

• goodwill and intangible assets.

Our critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain. A brief description of these critical accounting policies is set forth below. For more information regarding our accounting policies, see Note 2, "Summary of Significant Accounting Policies," in our notes to condensed consolidated financial statements.

Revenue recognition

Product revenues consist of sales to OEMs, merchant power supply manufacturers and distributors. Shipping terms to international OEM customers and merchant power supply manufacturers from our facility in California are DAF. As such, title to the product passes to the customer when the shipment reaches the destination country and revenue is recognized upon the arrival of the product in that country. Shipping terms to international OEMs and merchant power supply manufacturers on shipments from our facility outside of the United States are EXW, meaning that title to the product transfers to the customer upon shipment from our foreign warehouse. Shipments to OEMs and merchant power supply manufacturers in the Americas are FOB point of origin meaning that revenue is recognized upon shipment, when the title is passed to the customer.

We apply the provisions of ASC 605-10-25 and all related appropriate guidance. We recognize revenue when all of the following criteria have been met:
(1) persuasive evidence of an arrangement exists, (2) delivery has occurred,
(3) the price is fixed or determinable, (4) collectability is reasonably assured. We generally use customer purchase orders to determine the existence of an arrangement. We consider delivery to have occurred when title and risk of loss have transferred to the customer. We consider the price to be fixed based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based on the creditworthiness of the customer as determined by credit checks as well as the customer's payment history.

We make sales to distributors and retail partners and recognize revenue based on a sell-through method. Sales to distributors are made under terms allowing certain rights of return on our products held by the distributors. As a result of these rights, we defers the recognition of revenue and the costs of revenues derived from sales to distributors until such distributors resell our products to our customers. We determine the amounts to defer based on the level of actual inventory on hand at our distributors as well as inventory in transit to our distributors. The gross profit that is deferred as a result of this policy is reflected as "deferred income on sales to distributors" in the accompanying condensed consolidated balance sheets. The total deferred revenue as of September 30, 2009 and December 31, 2008 was approximately $15 million and $9.7 million. The total deferred cost as of September 30, 2009 and December 31, 2009 was approximately $7.7 million and $4.9 million.

Stock-based compensation

We adopted SFAS No. 123(R), Share-Based Payment ("ASC 718-20") effective January 1, 2006. Under the provisions of ASC 718-20, we recognize the fair value of stock-based compensation in financial statements over the requisite service period of the individual grants, which generally equals a four-year vesting period. We elected the modified prospective transition method for adopting ASC 718-20, under which the provisions of ASC 718-20 apply to all awards granted or modified after the date of adoption. The unrecognized expense of awards not yet vested at the date of adoption is recognized in our financial statements in the periods after the date of adoption using the same value determined under the original provisions of ASC 718-20, Accounting for Stock-Based Compensation. For stock option awards granted subsequent to December 31, 2005, we recognize compensation expense on a straight-line basis over the requisite service period. We use estimates in determining the fair value of these awards. Changes in these estimates could result in changes to our compensation charges.

Estimating sales returns and allowances

Net revenues consist primarily of product revenues reduced by estimated sales returns and allowances. To estimate sales returns and allowances, we analyze, both when we initially establish the reserve and then each quarter when we review the adequacy of the reserve, the following factors: historical returns, current economic trends, levels of inventories of our products held by our distributors, and changes in customer demand and acceptance of our products.

This reserve represents a reserve of the gross profit on estimated future returns and is reflected as a reduction to accounts receivable in the accompanying condensed consolidated balance sheets. Increases to the reserve are recorded as a reduction to net revenues equal to the expected customer credit memo, and a corresponding credit is made to cost of revenues equal to the estimated cost of the product to be returned. The net difference, or gross margin, is recorded as an addition to the reserve. Because the reserve for sales returns and allowances is based on our judgments and estimates, particularly as to future customer demand and level of acceptance of our products, our reserves may not be adequate to cover actual sales returns and other allowances. If our reserves are not adequate, our future net revenues and cost of revenues could be adversely affected.

Estimating distributor pricing credits

Historically, between one-half and two-thirds of our total sales have been made to distributors. Frequently, distributors need a cost lower than our standard sales price in order to win business. After the distributor ships product to its customer, the distributor submits a "ship and debit" claim to us in order to adjust its cost from the standard price to the approved lower price. After verification by us, a credit memo is issued to the distributor to adjust the sell-in price from the standard distribution price to the pre-approved lower price. We maintain a reserve for these credits that appears as a reduction to accounts receivable in our condensed consolidated balance sheets. Any increase in the reserve results in a corresponding reduction in our net revenues. To establish the adequacy of our reserves, we analyze historical ship and debit amounts and levels of inventory in the distributor channels. If our reserves are not adequate, our net revenues could be adversely affected.

From time to time we reduce our distribution list prices. We give our distributors protection against these price declines in the form of credits on products they hold in inventory. These credits are referred to as "price protection." Since we do not recognize revenue until the distributor sells the product to its customers, we generally do not need to provide reserves for price protection. However, in rare instances we must consider price protection in the analysis of reserve requirements, as there may be a timing gap between a price decline and the issuance of price protection credits. If a price protection reserve is required, we will maintain a reserve for these credits that appears as a reduction to accounts receivable in our condensed consolidated balance sheets. Any increase in the reserve results in a corresponding reduction in our net revenues. We analyze distribution price declines and levels of inventory in the distributor channels in determining the reserve levels required. If our reserves are not adequate, our net revenues could be adversely affected.

Estimating allowance for doubtful accounts

We maintain an allowance for losses we may incur as a result of our customers' inability to make required payments. Any increase in the allowance for doubtful accounts results in a corresponding increase in our general and administrative expenses. In establishing this allowance, and in evaluating the adequacy of the allowance for doubtful accounts each quarter, we analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. If the financial condition of one or more of our customers deteriorates, resulting in their inability to make payments, or if we otherwise underestimate the losses we incur as a result of our customers' inability to pay us, we could be required to increase our allowance for doubtful accounts, which could in turn adversely affect our operating results.

Estimating write-downs for excess and obsolete inventory

When evaluating the adequacy of our valuation adjustments for excess and obsolete inventory, we identify excess and obsolete products and also analyze historical usage, forecasted production based on demand forecasts, current economic trends, and historical write-offs. This write-down is reflected as a reduction to inventory in the condensed consolidated balance sheets, and an increase in cost of revenues. If actual market conditions are less favorable than our assumptions, we may be required to take additional write-downs, which could adversely impact our cost of revenues and operating results.

Income taxes

We follow the liability method of accounting for income taxes which requires recognition of deferred tax liabilities and assets for the expected future tax consequence of temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We recognize valuation allowances to reduce any deferred tax assets to the amount that we estimate will more likely than not be realized based on available evidence and management's judgment. We limit the deferred tax assets recognized related to certain of our officers' compensation to amounts that we estimate will be deductible in future periods based upon Internal Revenue Code Section 162(m). In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our results of operations and financial position.

Goodwill and intangible assets

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets ("ASC 350-10"), we evaluate goodwill for impairment on an annual basis, or as other indicators of impairment emerge. The provisions of ASC 350-10 require that we perform a two-step impairment test. In the first step, we compare the implied fair value of our single reporting unit to its carrying value, including goodwill. If the fair value of our reporting unit exceeds the carrying amount no impairment adjustment is required. If the carrying amount of our reporting unit exceeds the fair value, step two will be completed to measure the amount of goodwill impairment loss, if any exists. If the carrying value of our single reporting unit's goodwill exceeds its implied fair value, then we record an impairment loss equal to the difference, but not in excess of the carrying amount of the goodwill.

ASC 350-10 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives, and reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("ASC 360-10"). We review long-lived assets, such as acquired intangibles and property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We measure recoverability of assets to be held and used by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, we recognize an impairment charge by the amount by which the carrying amount of the asset exceeds the fair value of the asset. We would present assets to be disposed of separately in the balance sheet and would report the assets at the lower of the carrying amount or fair value less costs to sell, and would no longer depreciate the assets and liabilities of a disposed group classified as held for sale. Currently, we have no impairment of long-lived assets nor any assets held for disposal.

Results of Operations

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



                                                   Percentage of                    Percentage of
                                              Total Net Revenues for           Total Net Revenues for
                                                Three Months Ended                Nine Months Ended
                                                   September 30,                    September 30,
                                              2009              2008           2009              2008
Net revenues                                    100.0 %           100.0 %        100.0 %           100.0 %
Cost of revenues                                 51.5              45.8           50.4              46.0

Gross profit.                                    48.5              54.2           49.6              54.0

Operating expenses:
Research and development                         11.4              13.1           14.9              14.3
Sales and marketing                               9.6              13.1           12.0              14.0
General and administrative                        9.1              11.9           11.2              11.3

Total operating expenses                         30.1              38.1           38.1              39.6

Income from operations                           18.4              16.1           11.5              14.4
Total other income                                0.3               3.0            1.2               3.7

Income before provision for income taxes         18.7              19.1           12.7              18.1

Provision for income taxes                        3.5               4.9            3.4               4.0

Net income                                       15.2 %            14.2 %          9.3 %            14.1 %

Comparison of the Three Months and Nine Months Ended September 30, 2009 and 2008

Net revenues. Net revenues for the three months ended September 30, 2009 were $60.0 million compared with $53.8 million for the three months ended September 30, 2008, an increase of 12%. The increase was driven by higher revenues from the consumer, communications and industrial end markets, including applications such as appliances, home entertainment equipment, mobile-phone chargers, LED lights and utility meters. We believe the growth in our net revenues reflects increased penetration of our ICs in the AC-DC power supply market and, to a lesser extent, increased demand for consumer appliances and entertainment equipment in China as a result of government subsidies of consumer purchases.

Net revenues for the nine months ended September 30, 2009 were $149.6 million compared with $159.3 million for the comparable period of 2008, a decrease of 6%. The decrease was driven primarily by the global economic downturn, which caused a sharp decline in demand for our products in the fourth quarter of 2008 and first quarter of 2009.

Our net revenue mix by product family and by the end markets for the three and nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008 were as follows:

                                                  Three Months Ended                      Nine Months Ended
                                          September 30,        September 30,        September 30,      September 30,
Product Family                                2009                 2008                 2009               2008
TinySwitch                                     43%                  44%                  44%                45%
LinkSwitch                                     32%                  28%                  31%                27%
TOPSwitch                                      24%                  26%                  24%                26%
Other                                           1%                   2%                   1%                 2%




                              Three Months Ended                     Nine Months Ended
. . .