Good afternoon. My name is Heidi, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Power Integrations Second Quarter 2017 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the call over to the Director of Investor Relations, Mr. Joe Shiffler. You may begin your conference, sir.

Thank you, Heidi. Good afternoon, everyone. Thanks for joining us. With me on the call today are Balu Balakrishnan, President and CEO of Power Integrations; and Sandeep Nayyar, our Chief Financial Officer. Our second quarter results are calculated using the sell-in method of revenue recognition on sales to distributors reflecting our adoption of ASC 606 effective January 1 of this year. On today's call and in our press release comparisons to prior year results make use of recast financial information calculated as if the new accounting standard has been in effect for the prior periods. Recast data for 2015 and 2016 can be found in the historical financial tables posted on our investor website, which is investors.power.com. Also during the call today, we will refer to financial measures not calculated according to generally accepted accounting principles. Please refer to today's press release, which is posted on our investor website for an explanation of our reasons for using such non-GAAP measures as well as tables reconciling these measures to our GAAP results. Our discussion today, including the Q&A session, will include forward-looking statements, denoted by words like will, would, believe, should, expect, outlook, forecast, and similar expressions that look towards future events or performance. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those projected or implied in our statements. Such risks and uncertainties are discussed in our press release and in our most recent Form 10-K filed with the SEC on February 8, 2017. Finally, this call is the property of Power Integrations, and any recording or rebroadcast is expressly prohibited without the written consent of Power Integrations. And now I'll turn the call over to Balu.

Thanks, Joe, and good afternoon. Our second quarter revenues were a record $107.6 million, up 10% year-over-year. That is our fifth consecutive quarter of double-digit growth, and brings our growth rate to 14% for the first half of 2017. We also saw a significant increase in our gross margin in the second quarter, grew our non-GAAP earnings per share by 13% from a year ago, and generated $24 million in cash flow from operations in the quarter. Our second quarter results showcase the diversity of the growth drivers across our business. We achieved double-digit top line growth in the quarter, despite an inventory correction in the Communications category, where distributors serving the China handset supply chain cut back purchases following the recent softness in that market. The impact of this correction was more than offset by year-over-year growth of better than 20% in the consumer category, and more than 15% in the industrial market. In consumer, our growth is being driven in part by strong demand for convenience and comfort appliances in emerging markets, but also by expanding dollar content as OEMs incorporate more electronic controls and intelligence into their products, all while trying to comply with stringent energy efficiency requirements. The reliability and efficiency benefits of our highly integrated products have earned us a substantial share of the worldwide appliance market, giving us a strong incumbent position from which to capitalize on these strengths. While the long vending product families like TOPSwitch, TinySwitch and LinkSwitch, continue to do extremely well in appliances, InnoSwitch strengthens our position by further enhancing reliability and efficiency, while increasing our dollar content, thanks to its higher level of integration. We won several appliance designs in Q2 with InnoSwitch products, including an electric fan for a major U.K. customer and a dishwasher for a Chinese…

Thanks, Balu, and good afternoon. In my remarks, I will quickly touch on a few financial highlights, focusing mainly on the non-GAAP numbers, which are reconciled to the corresponding GAAP figures in the tables accompanying our press release. Then we will open it up for the Q&A session. Second quarter revenues were $107.6 million, up 3% compared to the prior quarter. The sequential growth was driven by double-digit increase in the consumer category, reflecting seasonal strength in air-conditioning and continued design win momentum across a variety of appliance and consumer electronic applications. Industrial revenues also contributed to the sequential increase with growth in high single digits, driven by high-power applications, building automation and metering applications. The computer category also increased in high single-digit sequentially, which is typical following the seasonally weak March quarter. Communication was the only category with a sequential decline, primarily reflecting the work done of the channel inventory, in wake of recent softness in the China handset market. Revenue mix for the quarter was 41% Consumer, 33% Industrial, 22% Communications and 4% Computer. The relative strength of the higher-margin consumer and industrial markets drove a sequential increase in non-GAAP gross margin, which expanded by 170 basis points sequentially to 50.9%. Also a factor in the increase was the post election rise in the dollar versus the yen, which had a beneficial impact on the cost of wafers from our Japanese foundries. Non-GAAP operating expenses were $32.7 million, up $600,000 from the prior quarter, but below our forecast, due mainly to the timing of headcount additions. As expected, the sequential increase was driven by annual merit increases as well as our annual worldwide sales conference, which took place in May. Non-GAAP operating margin for the quarter was 20.5%, a sequential increase of 200 basis points. Non-GAAP net income…

Thanks, Sandeep. We'll open it up now for Q&A. Heidi, would you please give the instructions for the Q&A session?

[Operator Instructions] And your first question comes from the line of Tore Svanberg with Stifel. Your line is now open. Please go ahead.

Yes, thank you. First question, Balu, could you elaborate a little bit on the inventory correction in China? It does sound like you are expecting Communications to rebound in September, so is this a fairly short-lived correction or are there any other dynamics going on?

You're correct. It is a short-lived correction. And we also helped that by cleaning up some of the overbookings at distributors. And we think we are pretty much back to normal. There may be some lingering effects in Q3. But overall, we think Q3 will be a growth quarter for Communications.

Very good. And moving on to the Industrial business, it sounds like there is a lot of things still in the come there. Should we start to think about this being more of a 10% grower for you? I'm thinking especially what you said about the DC transmission upgrade in China and some of the success InnoSwitch is having, so is that a market now that could potentially grow in the double digits going forward?

I believe so. There are, certainly, areas of market that are growing really well, high-power is one of them. We should do very well this year, and meters and e-bikes and so on, and also the tools. So I think Industrial looks really, really strong for us going forward.

Okay. Then the last question is on the Capex, so is that in relation to the growth that you're seeing in OEM markets or is it more related to some specific programs because it is a pretty big jump, just trying to get some more color there.

Tore, typically, if you remember, we spend about $20 million. Last year, we spent on an average, last year, we spent about $12 million. If you take last year and this year, we are slightly ahead of that. And we are basically doing this to add to our capacity as we look ahead to our growth, and that is why – adding capacity, and when we need it, you have to do it a bit in advance. So that is where – but if you look at it on an average basis, yes, it is a little more than normal. But if you average out the two, it is not totally out of whack.

Okay. And just one last question, you mentioned an additional foundry partner, is that something that you've been planning for a while or has that been more of a recent decision?

No, we have been planning it for a period of time. And we are not yet ready to disclose who it is, but it is a Japanese company. So it has the same kind of, yen relationship, if you will. And we expect this foundry to start production in reasonable quantities starting first quarter of the next year, 2018.

Very good. Thank you very much.

You are welcome.

Your next question comes from the line of David Williams with Drexel Hamilton. Your line is now open. Please go ahead.

Good afternoon, and thanks for taking the question. I guess, my first question really is maybe if you could give us a little color on the magnitude of what you expect maybe for the snapback in 3Q for the Communications segment after the digestion of the inventory?

I mean – if you look at it, we should see some reasonable growth back in the third quarter. I mean, you saw us decline in that category quite a bit, but I think we should rebound nicely in the next quarter.

And then secondly, are you still on allocation with any of your suppliers. I think last quarter, you talked about a few segments, maybe a few areas that you were on allocation with, have you been able to clear that up with the new capacity, and when do you expect the new capacity to be online?

We think we are almost getting back to normal on those specific products, and we expect in the next two or three months, we'll be pretty much back to normal on our lead times. And that is one the reasons we added capacity. The other reason is longer-term growth prospects.

Great. And then maybe lastly, on the margin for Q3, how much of that would you contribute to the yen, and how much of that impact do you think is from the mix portion of that?

So if you look at it, the yen got – was probably benefiting about, let's say, 50 basis points, and mix probably contributed a little over 100 basis points. It is hard to look at it just by the end application because it is mixed between mix. But directionally, that is what I think you would look at. The yen basically and the mix, you look – this is for Q2, right, you're talking about or you are looking for Q3?

Yes, for Q3.

So for Q3, it is basically, if you really look at it, it is the – it is about half and half going. I mean, basically, if you look at it, we're going downwards. The mix is going unfavorable whereas the yen is still benefiting.

Yes. So we'll get about roughly 50 basis points of benefit from the yen, but it is more than offset by the mix change because of expected growth in Communications business.

Your next question comes from the line of Ross Seymore with Deutsche Bank. Ross, your line is now open. Please go ahead.

Yes. I really want to – my first question, on the Capex side of things. Again, it is similar to what Tore asked before. And Sandeep, you gave the kind of a blend over the two-quarter average. So it is not so much the increase in the single quarter I'm focused on. But overall, is this just spending because you're growing double digits? And if you look at a year, year and a half, two years ahead, this kind of double-digit growth rate necessitates more capacity or is there something more binary that you're spending ahead of from a design win, news market, new products, something else you can provide color on?

I would say that this year is a little bit more than normal because we are trying to bring on an extra foundry and an extra subcontractor for test and assembly. And when you do that, there is always some expenses. And this sets us up very nicely for more than sufficient capacity for not only our growth but also have enough upside capacity because it is not going to be uniform every year. Some years, we'll grow a lot more than other years. And so it is important to have that excess capacity to handle upside.

Okay. So I guess is the upside just the continuation of solid growth or is the upside something that's like – I guess a little more binary or do you completely misunderstand my question, you just don't really want to answer that part?

So yes, any time you add a new foundry and a subcontractor, it is somewhat of a binary addition in cost. And that provides us with a capacity for the future. So the addition is binary if that is the question.

Got it. Okay, thank you. Sorry to be so pointed on that. Next question, maybe for Sandeep, it sounds like from the revenue mix and the gross margin implications, obviously, consumer – or excuse me, Communications is going to become a bigger part of your mix going into the third quarter, any sort of even directional commentary on your other segments quarter-over-quarter?

Well, I think, we will continue to grow. But I think the growth is disproportionately a little bit more because you'll see the decline in the Communications was quite steep, and we will climb back. So as a percentage of revenue, Communications would increase. And typically, what happens in the third quarter is that Consumer comes down because air conditioner typically becomes a little softer after having a very strong second quarter. So you should see – really what will happen is that Consumer comes down and Communications goes up as a percentage of total revenue. That should be the directional.

Got it. And then my final question on the Consumer side, knowing that you do have the seasonal pattern in the third quarter. But in aggregate, that second quarter being up roughly 25% year-over-year, so is the strength in that new product-driven? Is InnoSwitch starting to penetrate that market? Or is there another dynamic in there that's driving such impressive growth?

Well, this is a combination of a number of things, including the InnoSwitch. But InnoSwitch is still relatively small, I would say. We expect InnoSwitch revenue outside of Communications to be in the mid-single-digit millions this year. And that is certainly helping. But the biggest change on our increase is coming from air-conditioning. Air-conditioning has grown relative to last year. This year it is expected to grow for us nearly 50% in unit volume. And this is driven by not only consumption within China but also consumption in places like India where there is a much larger middle class who can afford these room air conditioners. They don't have central air-conditioning, so each house could easily have 2 or 3 or 4 air conditioners. So there is a huge increase in demand for air-conditioning. And our customers in China are gaining a huge share and also their SAM is growing across the geographies. The other thing, of course, that is helping is the global warming. We've had a very warm year. And so people who can afford air-conditioning, they are putting air conditioners in. So that is the big one. But we've also seen significant growth in all of the other appliances. Like major appliances has been a strong growth for us, small appliances, things like coffee makers, shavers and so on. Those have also grown very well.

Got it. Thank you very much.

You are welcome.

Your next question comes from the line Edgar Roesch with Sidoti and Company. Edgar your line is now open. Please go ahead.

Thank you and congrats on a great quarter. I wanted to ask you, is it fair to say that you had some visibility on the inventory correction in the Communications segment coming out of the Q1?

Yes, we did. We definitely saw a slowdown in the end customer demand. We realized that there was more inventory at the distributors than needed given the softness. So we are very careful to make sure that we clean up that extra inventory during the quarter in Q2. And that is why we feel now that inventory is back to normal. If you look at the number of weeks, we are at 6.5...

6.6 weeks.

6.6 weeks, which is very close to our normal inventory level.

And that's why when we guided the quarter also, we had shown that the margin improvement would happen because we knew about the mix directionally. And that's why we had given the guidance on the margin accordingly, too.

Yes, the reason we're able to do Edgar is because we had a lot of the revenue booked in the beginning of the quarter, our turns was less than 10% in Q2.

Got it. Thank you and in the midst of that correction in inventory, did you see pricing deteriorate in that end market at all or did suppliers and competitors maintain discipline pretty well?

Well, we are a single-sourced product. So really, this doesn't have any impact necessarily on pricing. It is not easy to just switch to somebody else.

Good. Okay. I was wondering on the side where you're signing up some new partners on the foundry and on the test and equipment – test and assembly side, would that suggest maybe some cost savings, operating cost savings? I know you have to spend on the Capex side, but might you be able to save some extra money on producing the products at all?

No, that's really not related to that. It is really related to adding more capacity. So when – we have a lot of proprietary packages that we use. So when we bring on a new assembly and test partner, we not only have to buy equipment that's specific to our packages, but also we have to buy testers and handlers, which we always have owned. We own all of our testers and handlers because we use high-voltage technologies so it requires some specialized testing. So we always own them. But that's the expenditure on the subcontractor for assembly and test. On the foundry side, the only thing we really buy on equipment that are unique to us, there is usually one or two pieces of equipment that the foundry may or may not have, and if they don't have it, we usually buy it for them. And so it is more of a capacity expansion not a cost-reduction exercise.

Understood. Okay, maybe the last one is for Sandeep, I was interested, you upped your repurchase, the amount that you can buy back in stock. And I was wondering, are you still setting a quarterly range ahead of time, and seeing where the stock trades relative to that range, is that still the way you approach it?

Yes. So basically, it is pretty fair to assume that the board – they have definitely adjusted the matrix. It is a matrix that the board – we have a discussion with the board. And obviously, we, as a team, take into consideration confidence in our outlook, the market conditions, the current valuation. Having said all of that, we are very opportunistic and we will continue to be opportunistic and keep using the price sensitivity approach that we have used in the past.

Great. Thank you for the help.

You are welcome.

[Operator Instructions] And your next question comes from the line of Tore Svanberg with Stifel. Your line is now open. Please go ahead.

Yes, thank you. I just had a couple of follow-ups. First of all, on USB PD, it sounds like that market is really starting to come together. And Balu, I know you kind of support all fast charge standards out there, but are you starting to see USB PD kind of breaking out on a lot of your designs?

Yes. There is a lot of design work going on in USB PD, but the standard has had some changes in the last few months, primarily driven by some of the OEMs, both the cell phone OEMs and also the tablet and notebook OEMs, who have asked for some modifications to the USB standard to make it more suitable for their own products. And so the good news is more and more of the OEMs have now decided to move to USB PD because of the improvements that have been made to USB PD standard. The bad news is it has delayed the implementation of USB PD to some extent. But there is a lot of design activity. But in terms of revenue, it is been delayed a little bit. And we think that the real growth in USB PD revenue will happen in the second half of next year.

Very good. And then one last question, you mentioned InnoSwitch, the second-generation product offering it now, and I assume that means revenues probably within the next 6 to 12 months. You talked in the past about getting revenues from laptops and also from tablets. Now I assume you would report not the revenue in your computing segment, but what about tablet revenue, in which bucket would that go?

The tablets and notebooks will go into the Computer revenues. And once again, we think the next generation of switches are a very good fit for that. And the USB PD will be the catalyst to convert that market to InnoSwitch. The notebook and tablets currently use the older – their legacy technologies, which has been standard for a long time now. But all of that will have to change with USB PD. And I think InnoSwitch, the next generation of InnoSwitch is a very good fit in terms of efficiency, in terms of form factors, in terms of lower consumption, and just having all the hooks to implement USB PD. So this is a great opportunity for us to get significant share of the tablet and notebook market starting, I would say, the middle of the next year.

It sound good. Thank you for all the color.

Thank you. Thank you Tore.

[Operator Instructions] There are no further questions at this time. I will turn the call back over to you, Mr. Shiffler.

Okay, there must be another semiconductor company reporting. Thanks, everyone, for listening. There will be a replay of this call available on our website shortly. That is investors.power.com. Thanks again for listening, and good afternoon.

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.