Power Integrations Inc (POWI) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to Power Integrations' second quarter 2010 financial conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions). I would now like to turn the conference over to your host, Joe Shiffler. Please go ahead.

Thank you. Good afternoon, and thank you for joining us to discuss Power Integrations' quarterly financial results. With me on the call today are Balu Balakrishnan, President and CEO of Power Integrations, and Sandeep Nayyar, who joined the Company in June as our new Chief Financial Officer. During today's call we will make reference to financial measures that are not calculated according to Generally Accepted Accounting Principles. Please refer to today's Press Release, which is available on our investor website at Investors. PowerInt.com, for an explanation of our reasons for using such non-GAAP measures, as well as tables reconciling these measures to our GAAP results.

Also our discussion today, including the Q&A session, will include forward-looking statements reflecting managements' current forecast of certain aspects of the Company's future business. Forward-looking statements are denoted by words such as will, would, believe, should, expect, outlook, estimate, plan, anticipate, suggest, project, forecast, and similar expressions that look towards future events or performance. Forward-looking statements are based on current information that is by its nature dynamic, and subject to rapid and even abrupt changes. Our forward-looking statements are subject to risks and uncertainties which may cause actual results to differ materially from those projected or implied in our statements. Such risks and uncertainties are discussed on today's press release and under the caption Item 1A Risk Factors in part two of our most recent Form 10-Q, filed with the Securities and Exchange Commission on May 6th, 2010.

This conference call is the property of Power Integrations and any recording or rebroadcast of this conference call is expressly prohibited without the written consent of Power Integrations. With that I will turn the call over to Balu.

Thanks, Joe, and good afternoon. Power Integrations had an excellent quarter, posting our fourth straight quarter of record revenues and net income. Revenues were $79.9 million, up 12% sequentially, and above the high end of our projected range. Our revenues have essentially doubled over the past five quarters, and we are now 48% higher than our pre-downturn peak.

Both of these metrics are well ahead of the broader analog semiconductor group, demonstrating the strength of our growth drivers in our business, especially the increasing focus on energy efficiency in the power supply market. We also had an excellent quarter from a profitability standpoint, with significant increases in gross margin and operating margin. Non-GAAP gross margin was 52.2%, up more than 1.5 points sequentially and well above our expectations. Our non-GAAP operating margin increased more than 3 percentage points from the prior quarter and to an all-time high of 26.7%. The combination of strong revenues and margins enabled us to deliver record non-GAAP earnings of $0.60 per share. That's an increase of 76% since our pre-downturn peak in the third quarter of 2008 compared with a revenue increase of 48% over the same time frame.

This demonstrates not only the leverage in our model, but also the accretiveness of our stock buy back, which has resulted in the reduction of approximately 10% in our share count over the same period. Now, if you have looked at our press release, you have seen that our third quarter outlook calls for revenues to be essentially flat, plus or minus a couple of million dollars. However, our outlook is not necessarily reflective of true demand patterns for a couple of reasons.

First, our sales in Europe were exceptionally strong in the second quarter, growing more than 25% sequentially in what we thought would be a flattish quarter in that region. We believe that the upside was largely due to a transition in our distribution network that caused some sales to be pulled into Q2. Specifically, in order to improve our distribution coverage in Europe, we are consolidating more of our business with Avnet, our largest worldwide distributor. As part of the transition, we discontinued several smaller distributors last quarter, and we observed a large number of end customers taking extra shipments from the outgoing distributors ahead of the change over. While it is difficult to measure this effect precisely, we believe about $2 million of sales were pulled into the second quarter, providing some upside to Q2 at the expense of Q3.

Note that the $2 million swing has about 5% impact on our sequential growth rates for the third quarter. Our third quarter outlook is also slightly constrained by shortages of our LinkSwitch-II products, which have ramped faster than even our most optimistic expectations. LinkSwitch sales have tripled over the past year, reaching 20% of our total revenues in the second quarter, after barely two years in the market. Demand for the third quarter is higher still, and while we are making every effort to deliver on time, our outlook assumes that we will be up, we will come up a little short in term of supply. We have significant additional capacity coming online all over the next few months, and we expect supply constraints to be resolved by the end of the year.

Excess demand is obviously the right kind of problem to have, and it is a direct result of the success we are having in the Power Supply market. The push for higher levels of energy efficiency is transforming the market, stimulating an unprecedented level of design activity, and giving us more opportunities than ever before. We have been positioning our product portfolio for this opportunity for many years now, and we believe that we have a competitive advantage in virtually any design that includes a tight efficiency specification. This trend has been the most important driver behind our outperformance over the past couple of years, and we believe that it shows no sign of slowing down.

Efficiency standards such as Europe's EcoDesign standards are driving design activity across a broad range of end markets including appliances, consumer electronics, cell phone chargers and other external adapters. The California Energy Commission, EnergyStar, and most recently, China have all introduced tough requirements for energy consumption of flat panel TVs. Meanwhile, the 80 Plus standards for our computers are driving significant interest in our new high power products including our Hiper Family of power commercial products and our new CAPZero product, whose sole function is to reduce stand by power losses. CAPZero has already been designed into multiple desktop PCs as well as a high volume notebook adapter and we are seeing tremendous interest in a wide range of end markets, particularly customers designing products to meet the Europe's new limit on stand by power consumption.

The push to save energy is also driving change in lighting markets, inspiring a huge amount of innovation and investment in energy technology for general lighting. LED lighting is our fastest-growing revenue stream, and is quickly becoming a significant contributor to the top line. We won more than 50 LED lighting designs during the second quarter alone, and revenues in the first half of the year have already exceeded last year's total. Thus far, we have achieved strong market share in lighting using our standard power conversion products, the same products used in cell phone chargers, PCs, and so on. However, in June, we introduced LinkSwitch-PH, and LinkSwitch-PL our first product families designs specifically for LED lighting. These new products bring in unprecedented level of integration to LED power supplies, reducing total component count dramatically compared with the competing solutions in the market.

Fewer components means higher reliability, and reliability is crucial in this market, because the power supply is likely to be the limiting factor in the lifetime of an LED lamp. Most importantly, we enable designers to avoid using electrolytic capacitors and opticouplers, usually the weakest link in any power supply design. LinkSwitch-PH and PL also incorporate Power Factor Connection, or PFC, which is increasingly being required in LED lights, and would otherwise require additional circuitry, adding costs and complexity. In fact, we believe these are the first chips ever to incorporate the high voltage MOS-SET, power conversion controller and PFC functionality all into a single integrated circuit.

And last but not least, our new products help solve one of the most difficult challenges facing LED lighting designers, the lack of compatibility with millions of old-fashioned dimmer switchers installed in many of our homes today. LinkSwitch-PH and PL overcome this problem, enabling smooth flicker-free dimming, virtually indistinguishable from a standard incandescent lamp. We are getting very good feedback from customers on these new products, and we expect to have our first customers going into production as early as this quarter. I would add that with these two product introductions, we are on pace to achieve our goal of eight new product families this year, a record number for the Company.

Lastly, I'd like to highlight a key development in our patent litigation with Fairchild Semiconductor. As you may recall, a jury found back in 2006 that Fairchild infringed four of our patents and we were subsequently awarded damages of $6.1 million. Late last month, federal court ruled that Fairchild's infringement was willful, stating that Fairchild engaged in quote, blatant copying of our technology. And that Fairchild's own personnel clearly recognized the value of our inventions. In light of Court's ruling, we now intend to ask the Court to grant us enhanced damages and compensation for attorney fees.

Now I would like to introduce our new Chief Financial Officer, Sandeep Nayyar. Sandeep joined Power Integrations in June after eight years as the senior most finance executive at Applied Bio Systems, a $2 billion life sciences company. He also spent 11 years at Quantum Corporation, rising through a succession of financial leadership roles, including Vice President of Finance for Quantum's $3 billion disk drive business. Sandeep has exactly the mix of experience and skills we were hoping to find in a CFO, and we are delighted to were hoping to find in a CFO and we are delighted to him on board. Sandeep?

Thanks, Balu. Let me say first how thrilled I am to join the POWI team. This is without a doubt one of the most exciting stories in semiconductors, with a unique set of secular growth opportunities and a great track record of innovation and execution. We are also fortunate to have a very high caliber investor base, and Investor Relations will be an important aspect of my job as CFO. I look forward to getting on the road and meeting many of you beginning this quarter. It is always nice to start off on the right foot, and I'm excited that you have such strong results to report here on my first quarterly conference call. I think the Q2 results are very straightforward so I will quickly run through some of the details and then make a few comments on the outlook before we go to Q&A.

First on revenues, our growth was broad based with all four end markets contributing to our 12% sequential increase. The consumer market led the way with a growth of better than 20%, coming from a broad range of consumer electronics and appliance applications. Industrial revenues grew in the low teens, also driven by wide range of applications, most notably LED lighting. Revenues from the computer market were up nearly 10%, driven by a good quarter in the desk top market. While communication revenues increased by a low single digit percentage.

Looking at the mix, the consumer and industrial markets constituted 40% and 20% of sales respectively for a total of 60%, which is the highest level in our history. These markets tend to be richer from a gross margin perspective, which contributed to a better than gross margin performance. Communication revenues comprised 28% of sales, while revenues from the computer market were 12%. In terms of sales channel, sales through the distribution channel accounted for 70% of revenues in the quarter, while direct sales comprised 30%. Two distributors, Avnet and ATM were our only 10% customers during the quarter, comprising 15% and 12% of sales respectively. Gross margin for the quarter on a GAAP basis was 52%. Excluding stock-based compensation, gross margin was 52.2%, our highest level in more than a year and an increase of 170 basis points from the prior quarter.

As I mentioned a moment ago, favorable end market mix was a significant driver of the increase, along with the benefit from higher production volumes. Operating expenses on a GAAP basis were $22.7 million, falling in the lower half of the forecasting range. Excluding stock-based compensation expenses of $2.3 million, non-GAAP operating expenses were $20.3 million, up $1.1 million from the prior quarter, and in line with our forecast. Patent litigation expenses were the biggest driver of the increase, rising nearly $0.5 million sequentially to $1.5 million. The remaining increases were in the R&D sales and marketing line, and were mainly the result of product development, a handful of new hires, and annual salary increases, which took effect in April.

The higher gross margin, combined with expense leverage, gave us a big increase in operating margin. Non-GAAP operating margin was up more than 300 basis points sequentially, reaching the highest level in our history at 26.7%. On a GAAP basis, operating margin was 23.6%. Non-GAAP net income was a record $17.7 million or $0.60 per diluted share, a sequential increase of $0.11 per share, and a 140% jump from a year ago. Earnings on a GAAP basis were $0.53 per share.

Cash flow from operations was $35.1 million for the quarter, driven mainly by strong profitability and a significant decline in accounts receivable as day sales outstanding dropped to an abnormally low 21 days, compared to 35 days in the prior quarter. The decrease was primarily due to the timing of settlement of distributor claims as well as very strong collections during the quarter. Inventories increased by $4.3 million, consistent with our effort to improve product availability, and get closer to our preferred levels of around 90 days of inventory. We had approximately 84 days on hand at the end of June.

Capital expenditures, net of disposition were $8.7 million. That was mainly for capacity addition, but also included $1.8 million for the construction of our new 600 kilowatts solar power installation which was recently completed, and it is scheduled today be switched on later this week. We utilized $7.9 million for share repurchases during the quarter buying back 225,000 shares and we paid out $1.4 million in dividends. Net-net, cash and investments on the balance sheet increased by about $19 million to $229 million.

Turning to the third quarter outlook, as Balu explained we expect revenues to be between $78 million and $82 million. We expect gross margin to be in the 51% to 52% range on a GAAP basis with the 52% in the second quarter. We expect GAAP operating expenses to be $24 million, plus or minus $0.5 million dollars including stock-based compensation of about $2.7 million. That implies non-GAAP OpEx of $20.8 million to $21.8 million up from $20.3 million in the second quarter. The increase is driven by a small acquisition mentioned on the last quarter call, which will add about $0.75 million to our quarterly R&D expense run rate, beginning this quarter. We expect our GAAP tax rate going forward to be around 20%, while our non-GAAP tax rate should remain around 18%, with a potential for about a 2 point improvement to both numbers if Congress renews the R&D tax credit. With that I will turn it back to Joe. Thanks, Sandeep. We're ready to open it up for questions, and in the interests of time, I would ask each caller to adhere to a limit of two questions at a time. If time permits, we will be happy to circle back for a second round to answer your questions. Operator, would you please open up the lines for questions?

(Operator Instructions). Our first question comes from Ross Seymore from Deutsche Bank.

Congrats on the strong results. The first question, I got the math on the pull in into the second quarter from the third. What do you suspect that process means for the third quarter versus the fourth quarter? Is there still some of that pulling going on as you transition distributors, so it may very well impact the fourth quarter as well?

This is Balu. This is a one-time event. This was the result of discontinuing about half a dozen distributors in Europe, and replacing them with Avnet, which is our worldwide distributor, to get better coverage. And apparently some of the distributors gave incentive to customers to buy ahead of time to avoid any disruption, and that caused this pull in, and it was only in Q2. It won't happen again in Q3.

So they pretty much cleared out the inventory so they couldn't incentivize anymore even if they wanted it.

They're no longer our distributor.

Okay. You transitioned all the way.

Yes.

The last question, a more simple one, the turns required, that has been flipping around at low levels, what was it in the second quarter and what is it to hit your guidance in the third?

As we have indicated in our last call, we expect our guidance to be somewhere in 15% to 20% range. I think going into the coming quarter we expect it to be similar in the 15% to 20% range.

Great. Thank you.

Thank you.

Our next question comes from Vernon Essi with Needham & Company.

Thank you very much. Nice results and welcome aboard Sandeep.

Thank you.

Wondering if you can discuss a trend here, a little reversal here in the direct sales, it ticked down a little bit sequentially, just wondering in terms of dollars, is there anything to read into that in terms of how your customers are ordering or moving more toward distributors?

Vern, it is Joe. The real driver of that is just the end-market mix, as you saw the consumer and the industrial markets were the strongest markets during the quarter and those tend to be very distribution heavy versus the communications market, which is of course dominated by cell phone chargers and that's primarily a direct business.

Just to add, the pull-in we had is all distributor business. In dollar terms, it's about the same.

Right. Okay. And then switching gears, obviously LED being a very nice break out for you. You did about $7 million revenue last year, and I appreciate the first half beating that number, can you give us an understanding as to how that's growing into the year, and how that might look in the second half of the year.

We are still on track to not beat but be closer to the higher end of the $10 million to $15 million guidance we gave earlier.

Okay. So you feel comfortable at the high -- I hope you do. You are already at $7 million to $12 million to $15 million.

Given the $12 million to $15 million last quarter, and right now I think we are tracking to the higher end of that number.

All right, thank you.

You're welcome.

Thank you. Our next question comes from Steven Smigie with Raymond James, one moment please. Your line is open.

Okay. Great. Thank you. My congratulations on the good numbers. Just to follow up on Ross' question, about the implications for the fourth quarter, let's just say, I don't know instead of having the pull forward, you might have had a mid 80s revenue guidance. Typically, you guys might be down historically, 1% in Q4, does this mean that you will not have that sequential drop here and might be even be up sequentially in Q4 because of the pull forward?

It's too early to tell, Steve. We have pretty good backlog for Q4 right now, but we have still two more months to go. So I don't have a good feeling for how Q4 is going to turn out.

Okay. So I was wondering if you could talk about share count as well. You have added a pretty seasoned new executive there. You are doing share buy back but would there be option grants that might take share count up here, and the share price options in the money, et cetera?

As you know, the cash equivalents get changed based on what the stock price is, and at this point, there are roughly around 29.5 million shares. That could go up somewhere around 30.2, 30.3 range. But again, the price, the price has impact.

Okay. Great. If I could just squeeze in one more question. You guys obviously had tremendous growth this year. What does that imply about 2011? As you saw here, you could have a quarter pull forward. Has there been any pull-forward on an annual basis where revenue that normally might have been in 2011 got pulled into 2010, or the design wins are so strong that is more of a secular move?

We have no reason to believe there will be a pull in on the annual basis. We know that some of our customers have a little bit of inventory now. I would say we don't think it is excessive at least not the direct customers. So, it will all depend upon multiple factors. One is the economy itself, which will influence the overall demand, but as far as the Power Integrations go, we have a number of things that will help us grow, with everything else being equal. We have LED, that will continue to grow. We have high-power, which will be mostly all new incremental growth. We have very little high Power revenue this year, but we expect to have material revenue next year. The energy efficiency continues to drive our growth, and we are getting a lot of market share. So we think 2011 will be a very good year, and it may not be in a -- I am pretty sure not as strong as this year, because they're coming out of the recession, but it will be a very good growth year assuming that the economy continues to perform well.

Okay. Great. Thank you very much.

You're welcome.

Thank you. Our next question comes from Tore Svanberg with Stifel Nicolaus.

Yes. Hi, this is Evan White calling in for Tore Svanberg. Sandeep, welcome aboard. I just had a couple of questions about your many fascinating constraints that you mentioned. I was wondering if you could give us a little bit more insight as to what that means, and I'll ask my next question then.

We don't have a capacity constraint overall. In fact we have more capacity than demand as we expected for the foreseeable future. The constraint we have is on LinkSwitch-II, and even though we have been adding capacity for LinkSwitch-II, the demand seems to be growing faster than our ability to add capacity. Primarily, LinkSwitch-II we are installing and qualifying the various products at all of our foundries, but it is not fully qualified in all foundries yet. So, we are very close.

We think by Q4, we would be out of the capacity constraint on LinkSwitch-II, so by the end of the year, we expect to be caught up on LinkSwitch-II. And once again, we have plenty of capacity. That's not a problem. The overall capacity is not a problem.

Great. Thank you very clarifying that. My next question is about your high power products. I was wondering if you can talk about any or maybe the level of design activities you are seeing in the flat panel TV area, and what the timing might be for any kind of revenue from that? And applications.

Yes. We introduced the product called HiperPLC last year, and we have a couple of design wins on that. But the, the recent high power design win is the with the PC main power supply with the two that we introduced and that will generate roughly, we think in the $1 million to $2 million range in the second half, but most of it is in the fourth quarter. As far as flat-panel TV, we have a number of design wins in standby, with the TinySwitch and TopSwitch, and that is growing very nicely, and in the long-term, we will be addressing the main power supply with additional products.

Thank you very much.

You're welcome.

Thank you. Our next question comes from Auguste Richard with Piper Jaffray.

Yes. Thanks for taking my question. Balu, can you talk a little bit about the costs around LinkSwitch-II and how those are coming along.

Yes. So, we have been continuing to reduce the costs on LinkSwitch-II. In fact that has helped us a little bit. But it is still a headwind for us because the overall gross margin on the LinkSwitch-II is below the corporate average, especially in the communications area. In the industrial and appliances area, gross margins in general are higher, and it's also true for LinkSwitch II. We will continue to do so and there is a, a significant cost reduction coming from going to a new process that we have started in this quarter. We will get a slight benefit in Q4, be you will see it more significant benefit in Q1 of next year.

Okay. So the new, the new die is qualled is at this point, you just need to flow it through your inventory?

Yes. One of the products we have just qualling, is we have started production, but we have a number of products, a dozen or so LinkSwitch-II products, and we will gradually transfer them to the new process, and over the next several quarters, we will transfer a bulk of the volume into the new process, which should have a significant benefit.

What do you need for, to do the midpoint of guidance, what's your turns requirement?

It is about the same as last quarter, 15% to 20%. It is a range because it is very hard for us to tell how much sell-through there will be.

Got it. And then just the last one for me and I will go away, what were the turns in the Q2?

Around 20%, Gus.

Around 20%. Thank you very much.

Thank you.

Our next question comes from Arnab Chanda with Roth Capital Partners.

Thank you. Balu, could you talk about -- you obviously had somewhat of a pull-in for Q2, did you see that just with the distributor in Europe, or was this, are there some changes occurring in the distribution channel in other geographies too. And same question for the OEM and I have a follow up. Thank you.

The one we know clearly is from Europe, and that is where we made the major changes in the last quarter. Where we replaced approximately about half a dozen regional distributors with Avnet primarily to get much better coverage. Avnet has a stronger presence in these locations. So this was clearly, you can very clearly see by looking at the run rate of these customers, typically Europe is flat to slightly down in Q2, but this time it grew 25% sequentially, which raised a question mark and when we went back and checked, it was clearly customers buying ahead of time to prevent any disruptions, and also taking advantage of the incentives they got from the distributors that were leaving.

Okay. And then, a question for Sandeep, welcome aboard. Maybe this is not a fair question, but if not Balu can answer it. If you look at your gross margin, you had a pretty nice recovery here, I know there's an exchange rate applying to that too. Can you talk a little bit about where you think that is, next year or so, how we should think about that?

As we indicated here, we got a benefit -- the mix of the end-market mix made a big difference for us, because as you know, we get higher margins on the consumer segment compared to the communications side and the industrial side. So it depends on where the end-market mix is, so I think, the lower end of the 50 to 55 range is what I think is a fair way to look at it, in the near term.

The industrial is the highest margin, then it's consumer, and cell phones is the lowest margin for us, because of the concentration of customers.

So as you get into LED, the margins can go up right, from here on?

Correct. It still depends on the total mix. The LED is the higher margin.

Okay. Great. Thank you for the clarification.

Thank you. Our next question comes from Sumit Dhanda with Banc of America.

Hi. A couple of questions, Balu, I remember last quarter you had said that there were $3 million or $4 million of delinquencies, that you couldn't ship. Did you ship them in Q2 and I guess if so, was the underlying trend not quite as strong as the reported number, or how should we think about the delinquencies you couldn't ship in the first quarter.

You're right. We were delinquent in LinkSwitch-II in the first quarter, primarily because we didn't have the right mix of products. At that time, we were not constrained as much by LinkSwitch-II capacity as we did anticipate what products to build. But we also explained that was mostly going into distributors. It was not clear that if we had actually shipped them that we would have recognized all of that revenue. We might have recognized a part of it. And we obviously shipped that in Q2. We also had some delinquency in Q2 also. And we now have some delinquency in Q3. But the big difference is the delinquency in Q3 is almost entirely direct customers, which means that if we are able to ship it, that would be considered -- that will become revenue. Having said that, we do expect to be able to catch up a little bit. That's why we have given the range. Our forecast includes our judgment on what we can do in terms of building it up for a LinkSwitch-II, but we don't think it will be completely caught up.

Okay. Then a couple of metrics which you reported last quarter, distribution inventory at 6.5 weeks, and lead times I think you said were 12 weeks, could you update us on where those metrics stood at the end of the second quarter?

In LinkSwitch-II, it is 12 weeks or higher, depending on the product. But on all of the other products it is lower, even though it's well above our normal lead time. I would say for most of the products, is in the eight to ten week range.

So just to be clear, the lead times came down, and then your distribution inventory, that seems like the deferred line went up, so is it fair to assume distribution weeks of inventory went up?

It was actually flat quarter-over-quarter.

Okay. And one last one for me, on booking trends, in Q2 and so far it is through the month of July, has it been fairly linear, has July gotten off to a strong start, could you compare that, versus trends in April which is a very strong month for you?

April was an unusually strong month, but it's not totally unexpected because we increase the lead times to 12 weeks which means we had to book four weeks of inventory almost overnight. So our April bookings was about 2X the March bookings, and May got corrected to some extent and June was lower and July was even lower. So basically, it's been trending, but that's not surprising at all. If you look at the overall booking we had in Q2, it was 50% more than Q1. And so if I average the last four months, the bookings rate is well above the shipment rate.

Okay. Thank you so much.

Thank you. Our next question comes from Alex Gauna with JMP Securities.

Thanks very much for taking my question, and nice quarter. Let me ask you I believe you mentioned about 50 design wins on the quarter for LED drive technology. Can you give me an idea of how many design wins are up for bid in a given quarter and what effect the introduction in the new LinkSwitch products has had on your win rate and maybe what kind of number of new designs you have up for grabs in the second half of the year?

We have about a thousand customers we are working with, out of which about 250 of them are already in production. Of course all with existing products. With the new products introduced, we expect some design wins this quarter, and we expect that to hopefully help us grow our revenue even faster. This is a very, very large number of customers that we are working with.

Okay, and where are you seeing the most competition out of in this product area?

Primarily from discrete solutions, with controllers and external [MOSFETS] and so on. And especially with the power factor, and with the power factor is required, you sometimes require two controllers and two MOS sets and a whole bunch of external components, but with our device, you have a single [monolithic] chip that does both power conversion and power factor correction, with very few components.

Okay. One more if I could, with the LinkSwitch-II, if I understood you correctly, as you make the conversion costs down process, you are expecting a beneficial impact to gross margin maybe in the late Q4, Q1 time frame; is that correct, and how big of an influence can that be?

What these cost reductions will do is bring the LinkSwitch-II average gross margin in line with our corporate gross margin and that will take several quarters because when we convert products to the new technology, we will have to convert a few products at a time and then we have to gradually ramp up the new technology. So that whole process will take several quarters. In about four or five we have converted a large portion of the LinkSwitch-II and that will bring the LinkSwitch-II to the same level of gross margin as all other products.

What applications would benefit from the new process for LinkSwitch-II and increased supply?

The process doesn't change the application, it just cost-reduces the product, but LinkSwitch-II, the primary applications are in cell phones in communications area, and appliances and in industrial.

Kind of across the Board.

Because you have to remember that our products are really delineated by the power level, not by application, because a power supply is a power supply. The first time they're introducing a very market specific product is LinkSwitch-PH and PL. That's primarily because LED is required two unique requirements, one is the power factor correction, and the other one is dimming, and that is very unique to the application. Other than those two products, all others are generic across many, many applications.

Okay. Thank you.

Thank you. The next question comes from Brian Piccioni with BMO Capital Markets.

Can you hear me okay?

Yes.

I'd like to follow on with the questioning regarding LEDs. You have fairly close discussions with your customer base. Do you have a sense for what size of an addressable market this might be for Power Integrations over time?

That's a very good question and it depends upon which data you look at. There's a very wide range, depending on how optimistic or how pessimistic the analysis is done. There are a couple of ways to look at it. Last year, think the addressable was about $40 or so million, $30 million to $40 million, and this year, we expect this market to grow to about $80 million. It's a very approximate number. The overall replacement market is very huge, because there about 25 billion to 30 billion incandescent lamps in the world that will be replaced over time with more energy-efficient technologies, and if you say that LED will eventually replace them, who knows how long it will take, maybe 10, 20 years, or something like that.

And even if you put an ASP, which is our ASP, which is about $0.30 or so which is in the middle of the power range, equivalent to a 60-watt incandescent replacement, you're really talking about a huge market of about $10 billion replacement market. If you average that over let's say 20 years, that could be $0.5 billion on the average per year. It is obviously not $0.5 billion now. So that's kind of the market size you are talking about, but the big question is how is that market going to expand over time. Is it going to be a hockey stick; is it going to be linear? I think to a large extent, it will depend upon how quickly the cost of the LED comes down. But independent of that it is a huge, huge long-term driver for us.

And actually that's a segue to the follow up that I had. Right now, the cost of the LED itself is a significant consideration for consumers, the way they look at it. As the price of the LED comes down, there must be pricing pressure on to what you can get for an ASP, and will that be an issue, or do your current integration plans kind of offset whatever pricing pressure you expect to see over time?

For the foreseeable future, I think the LED will dominate the cost of a lighting fixture or a replacement bulb. So, the power supply is the relatively small fraction of the cost but more important factor is the LEDs last so much longer than a power supply there's a tremendous push to increase the reliability of the power supply. There are three factors that affect reliability, one is the number of components, which of course we reduced drastically by using a single monolithic chip to do everything.

Number two is the electrolytic capacitor that is required by most of the designs that are in place today, which we allow our customers to eliminate. That is the weakest component in terms of lifetime. The second weakest component is the opticoupler, which is also eliminated by the products that we introduced, the LinkSwitch-PL and PH. So at the moment the focus is not as much on cost but rather the reliability of the power supply. So I think for the foreseeable future, for several years to come, it will be driven by more by performance than costs.

Congratulations on your results.

Thank you. Our next question comes from Ross Seymore with Deutsche Bank.

One quick follow up, more of an accounting issue, the OpEx you guided to, what should we think about litigation as a part of that and how should we consider litigation going forward?

This quarter, litigation, as I indicated early was about $1.5 million at least for the foreseeable couple of quarters, I think that's the range you should look into.

So that's inclusive in overall OpEx guidance for 3Q.

That is correct.

So Ross, you know, that it is a big variable, it varies from quarter to quarter. That's an average number that we are using.

What would be the timetable to when that could be going for treble damages, et cetera, when that could actually be decided upon?

That's a very good question because the judge who was on this case just retired. And so they have to appoint a new judge and the new judge has not been appointed, and that judge is the one who is going to decide on the enhancement, how much to enhance the damages. So nobody really knows when it is going to happen but our expectation is that the judge will be appointed some time in August and we will have some response before the end of year from that.

Hope you're right.

Thanks.

Thank you. (Operator Instructions). Our next question comes from Steve Smigie with Raymond James.

Great. Thank you. Just to follow up on the gross margin trends here, the yen seems to be appreciating against the dollar, and you've said in the past, you've indicated that does have some impact, the next question, just a little bit earlier. But my calculation, there could be, based on what we saw happen this quarter, there could be a 50 basis point headwind to the gross margin, typically that takes a couple of quarters and it would seem like Q4 impact. Am I right in thinking about that? And I guess that's the question.

I think that's your analysis is pretty fair, I think the impact for Q4 about half a point is probably realistic.

Okay. Great, with regard to cash flow, obviously very nice. You guys have been doing share buy backs, we assume that's going to continue and you did a small acquisition. Should we assume you are going to do more acquisitions going forward as well?

Yes, we look at all three uses of money, stock buy backs, dividend and M&A. We will continue to do that every quarter. And our track record shows that we have done all three of them.

Great. Okay. Thank you.

Thank you. I am showing no further questions at this time, gentlemen.

Okay. Thank you. We will wrap up the call. Thanks everyone for listening. There will be a webcast archived on our Web site at Investors.PowerInt.com, and thanks everyone for listening.

Thank you for your participation in today's conference. This concludes the conference and you may now disconnect.