June 29, 2007

Research Associate: Debasish Bhowmik,M.Fin.

Editor: R.C. Fuhrmann, CFA

Sr. Ed.: Ian Madsen, CFA; ;1-800-767-3771,9417

Canal Street, Suite 1101Chicago, IL 60606

Power Integrations Inc. / (POWI.PK-OTC) / $26.20

Note: This report contains substantially new material. Subsequent reports will have changes highlighted.

Reason for Report: FY06 Earnings Update; Reduced 2Q07 Revenue Guidance

Previous Edition:May 24, 2007

Recent Events

On June 5, 2007, POWI.PK announced financial results for fiscal year 2006. As previously disclosed, the Company’s net revenue totaled $162.4 million, up 13.0% y/y. Pro forma EPS excluding stock based compensation was $0.71.

Overview

Analysts have identified the following issues for evaluating the investment merits of POWI.PK:

Key Positive Arguments / Key Negative Arguments
Fundamentals
  • Analysts expect present design win momentum to accelerate in the coming quarters.
  • The Company is seen as witnessing accelerating growth in its Industrial segment.
  • Analysts consider POWI.PK the dominant player in the power conversion market.
Strong Product Mix
  • Analysts expect the Company to achieve higher sales growth through its solid product portfolio, new patents and product launches along with the recently adopted worldwide energy standards.
Fruitful Cost Curtailing measures
  • In the environment of rising pricing pressure, POWI.PK has strongly managed its operating margin by reducing operating expense through various cost-cutting initiatives.
/ Fundamentals
  • POWI.PK is an analog supplier that relies exclusively on third party foundry partners. Any interruption of third party foundry suppliers may have a detrimental effect on its business, according to analysts.
Customer Base
  • POWI.PK’s customer base is highly concentrated. Its top-ten customers accounted for approximately 71% of 2004 revenue. The loss of any one of the customers could adversely affect the Company, according to analysts.
Economic Threats
  • POWI.PK is witnessing weakening demand, increased competition and pricing pressures, which analysts believe could keep revenue range bound.

Power Integrations, Inc. (POWI.PK or the Company) is the leading supplier of high-voltage analog integrated circuits used in power conversion. The Company's breakthrough integrated-circuit technology enables compact, energy efficient power supplies in a wide range of electronic products, in both AC-DC and DC-DC applications. Products are sold to original equipment manufacturers and merchant power supply manufacturers through a direct sales staff, independent sales representatives, and distributors. Headquartered in San Jose, California, the Company’s customers are located primarily in North America, Europe and Asia. Power Integrations was founded in 1988. For more information about the Company, please visit its website at

Note: Due to continued stock option investigation, the Company’s results were pending since 4Q06. On June 5, 2007, the Company released its FY06 financial results. Previously, on May 15, 2007, the Company released its preliminary results for 1Q07. Full results are pending for 1Q07. The Company has virtually completed its review procedures for the first quarter of 2007, and intends to report final results for 1Q07 as soon as practicable.

The Company’s fiscal year ends on December 31.

Revenue

Provided below is a summary of revenue as compiled by Zacks Digest:

Total Revenue / 4Q05A / 2005A / 4Q06A / 2006A / 1Q07A / 2Q07E / 3Q07E / 2007E / 2008E
Zacks Consensus / $44.0 / $48.0 / $186.0
Digest Average / $37.9 / $144.1 / $41.3 / $162.4 / $45.3 / $42.3↓ / $47.0↓ / $184.7↓ / $217.8↓
Digest Low / $37.9 / $144.1 / $41.3 / $162.4 / $45.3 / $42.0 / $45.5 / $181.3 / $205.0
Digest High / $37.9 / $144.1 / $41.3 / $162.5 / $45.3 / $43.0 / $48.7 / $189.0 / $232.0
Y/Y Growth / 5.5% / 9.0% / 12.7% / 28.5% / 1.8% / 6.0% / 13.7% / 17.9%
Q/Q Growth / 3.8% / -6.9% / 9.7% / -6.6% / 11.1%

Zacks Digest 4Q06 revenue stood at $41.3 million, versus $37.9 million in 4Q05, down 6.9% q/q and up 9.0% y/y. FY06 revenue stood at $162.4 million, versus $144.1 million in FY05, up 12.7% y/y.

Guidance

The Company revised its revenue guidance for 2Q07 and expects revenue for 2Q07 to be between $41.0 million and $43.0 million, versus the Company's previous guidance of $44.0 million to $46.0 million. The revision to the Company's guidance is principally the result of lower-than-expected shipments to suppliers of chargers for a major cell-phone OEM. The Company lost its business to a competitor (BCD semiconductor) at one of the Company’s largest end customers in the mobile phone end market.

Outlook

The Company offered some design wins updates, one with Nokia (for chargers), and the other for Microsoft X-Box. One analyst (First Albany) estimates Nokia design win has a market opportunity of 240 million units a year, or approximately $60.0 million.

One analyst (American Technology) believes POWI.PK is closely working with the subcontractors on a custom solution, which will enable POWI.PK to win back the business in 2008. Most analysts expect the Company’s lost business at Samsung will be partially offset by the new wins with Nokia and Microsoft X-Box. Though the firm has reduced its revenue estimates, it believes from 2007 to 2008, revenue growth will accelerate from 13.0% to 18.0%.

One analyst (B. of America) opinesthat due to the loss of several sockets within Samsung phones to BCD Semiconductor, POWI.PK will lose ~75.0% of its cell phone business at Samsung, or a total revenue impact of ~10.0 million in FY07 or ~5.0% of FY07 revenue. The Company expects to introduce a newly integrated low cost solution that is at per from a cost standpoint with BCD’s offering. This could result in POWI regaining its market share at Samsung in 2008.

For more details on revenue by individual analysts, please refer to the ‘Consensus’ tab of the POWI spreadsheet.

Margins

According to Zacks Digest, gross profit in 4Q06 was $22.3 million, an 8.3% decrease versus $24.4 million in 3Q06. Gross margin in 4Q07 was 54.1%, reflecting a decrease of 80 basis points q/q, and increase of 290 basis points y/y. Digest average FY06 gross margin was 55.1%. FY06 GAAP gross margin as reported by the Company was 54.6%, which included a positive impact of approximately one percentage point from the ship and debit settlements recorded by the Company in 2Q06.

Provided below is a summary of margins as complied by Zacks Digest:

Margins / 4Q05A / 2005A / 4Q06A / 2006A / 1Q07E / 2Q07E / 3Q07E / 2007E / 2008E
Gross Margin / 51.2% / 49.5% / 54.1% / 55.1% / 55.3%↓ / 54.5%↓ / 54.0%↓ / 54.4%↓ / 54.0%↑
Operating Margin / 14.5% / 15.7% / 13.1% / 13.2% / 19.1%↓ / 19.4%↓ / 22.0%↓ / 20.8%↑ / 23.4%↑
Pre-Tax Margin / 17.4% / 18.0% / 16.9% / 16.9% / 22.7%↓ / 23.4%↓ / 25.8%↓ / 24.6%↓ / 27.2%↓
Net Margin / 14.5% / 14.5% / 14.2% / 13.8% / 18.3%↑ / 18.7%↑ / 20.6%↑ / 19.5%↑ / 21.2%↑

R&D expense in 4Q06 as per Digest average was $5.2 million or 12.5% of revenue, up 0.2% q/q and 29.1% y/y. R&D expense in FY06 was $20.1 million, or 12.4% of revenue, up 22.5% y/y. S&M expense in 4Q06 was $5.5 million, up 4.7% q/q and 10.2% y/y. G&A expense in 4Q06 was $9.5 million. S&M and G&A expenses in FY06 were $20.2 million and $38.3 million, respectively.

GAAP FY06 operating expenses as reported by the Company was $84.8 million, which includes $14.2 million stock-based compensation, $13.7 million expenses related to the Company’s special investigation and the related financial restatement, and $7.0 million expenses related to patent litigation.

The Company’s operating margin in 4Q06 was 13.1%, down 130 basis points y/y. FY06 operating margin was 13.2%.

The Company expects 1Q07 GAAP gross margin of between 54.0% and 55.0%, including stock based compensation. Operating expenses are expected to be between $18.0 million and $19.0 million, including $2.5 million to $3.0 million of stock-based compensation expenses. Operating expenses are expected to include approximately $0.6 million in expenses related to patent litigation, and $2.0 million to $2.5 million in expenses related to the Company's restatement and ongoing efforts to complete its outstanding SEC filings.

Guidance

Gross margin is expected in the range of 53.0%–55.0% in 2Q07. The Company expects gross margin to remain relatively steadythroughout 2007. 2Q07 operating expenditure is expected to be in the range of $17.0–18.0 million, and willinclude $2.0–$3.0 million of ESO, $0.6–$0.8 million in expenses related to patent litigation and approximately $1.0 million related to the Company’s restatement and outstanding SEC filings.

Accordingly to POWI.PK, legal expenses are unlikely to increase in 2Q-3Q07, but could rise by year end CY07 or at the start of CY08.

Outlook

One analyst (American Technology) believes the lost business has a gross margin below the corporate average, while the new business should have a gross margin at least in line with the corporate average. As a result of the lawsuit against BCD, litigation expense should continue to 2008. However, another analyst (B. of America) expects operating margin to improve in 2007, as legal expenses related to patent litigation should wind down.

One analyst (Deutsche Bank)believes the Company’s move to advanced geometries and continued operating expenditure control could potentially result in further improvements to margins.

According to analysts,gross margin expansions in 2H07 may be moderately impacted by sales mix shift towards Tier-I customers.

For more details on margins, please refer to the ‘Consensus’ tab of the POWI spreadsheet.

Earnings per Share

Provided below is a summary of EPS as complied by Zacks Digest:

EPS / 4Q05A / 2Q05A / 4Q06A / 2006A / 1Q07E / 2Q07E / 3Q07E / 2007E / 2008E
Digest Average / $0.18 / $0.68 / $0.16 / $0.59 / $0.25↑ / $0.24 ↓ / $0.29 ↓ / $1.10 / $1.39↓
Digest Low / $0.18 / $0.68 / $0.10 / $0.31 / $0.10 / $0.13 / $0.17 / $0.58 / $0.85
Digest High / $0.18 / $0.68 / $0.25 / $1.09 / $0.32 / $0.31 / $0.38 / $1.37 / $1.69
Y/Y Growth / 7.9% / -11.1% / -12.9% / 538.5% / 15.5% / 79.1% / 85.4% / 26.3%
Q/Q Growth / 0.0% / -2.6% / 57.0% / -3.0% / 20.8% / 0.0%
Zacks Consensus / $0.18 / $0.22 / $0.81 / $1.12

Zacks Digest pro forma EPS in 4Q06 was $0.16, down 2.6% q/q and 11.1% y/y. FY07 Digest average EPS was $0.59, down 12.9% y/y.

Outlook

Zacks Digest projects EPS of $1.10 for 2007 and $1.39 for 2008, representing y/y increases of 85.4% and 26.3% in 2007 and 2008, respectively. Estimated 3-year compounded annual growth rate (CAGR) based on 2005 EPS is 26.8%.

Highlights from the chart are as follows:

  • 2007 forecasts (7 analysts) range from $0.58 (Deutsche Bank) to $1.37 (Citigroup); the average is $1.10.
  • 2008 forecasts (6 analysts) range from $0.85(Deutsche Bank) to $1.69 (Citigroup); the average is $1.39.
  • Most of the analysts have decreased their EPS estimates for FY07 and FY08, due to the Company’s lower revenue guidance. However, according to one analyst (American Technology), the Company’s EPS growth will accelerate from 11.0% in 2007 to 20.0% in 2008.

For more details on earnings per share by individual analysts, please refer to the ‘EPS’ tab of the POWI spreadsheet.

Target Price/Valuation

Of the 7 analysts covering POWI.PK, 5 gave positive ratings,and 2 gave neutral ratings. There is no negative rating on the stock. The Zacks average target price is $32.83 (↑from the previous Digest report of $31.14; 25.3% upside from the current price). The price target ranges from $26.00 (0.76% downside from the current price) (Piper Jaffray) to $36.00 (37.40% upside from the current price) (B. of America). Most analysts have used estimated EPS multiples to arrive at target prices.

Provided below is a summary of valuation and ratings as compiled by Zacks Research Digest:

Rating Distribution
Positive / 71.4%
Neutral / 28.6%
Negative / 0.0%
Digest High / $36.00
Digest Low / $26.00
Avg. Target Price / $32.83↑
Analysts with Target Price/Total No. / 6/7

Metrics detailing current management effectiveness are as follows:

Metric (ttm) / Company / Industry / S&P 500
Return on Assets (ROA) / 3.79% / 11.50% / 8.29%
Return On Investments (ROI) / 4.38% / 14.03% / 12.20%
Return on Equity (ROE) / 4.38% / 15.41% / 20.66%

ROA,ROI and ROE of 3.79%, 4.38% and 4.38%, respectively, of the Company are below the market averages (as measured by the S&P 500) of 8.29%,12.20% and 20.66%, respectively.

For more details on target price by individual analysts, please refer to the ‘Valuation’ tab of the POWI spreadsheet.

Capital Structure/Solvency/Cash Flow/Governance/Other

Balance Sheet

The Company’s reported cash and investments in 4Q06 was $128.7 million, an increase of about $5.8 million from the prior quarter. Inventories of $28.3 million increased $1.5 million from the prior quarter.

Patent-Infringement lawsuit against BCD Semiconductor

On June 14, 2007, POWI.PK announced it has filed a patent-infringement lawsuit against BCD Semiconductor. The suit, filed in the U.S. Federal District Court, alleges that certain PWM controller chips produced by BCD infringe upon Power Integrations U.S. patent nos. 5,313,381, 6,107,851 and 6,249,876. The Company is seeking damages as well as an injunction against the infringing products.

With regard to the ongoing litigation with Fairchild, the Company is planning to seek an injunction against infringing Fairchild parts, and an enhancement of the damage award based on the finding of willful infringement.

Potentially Severe Problems

POWI.PK launched an internal investigation into its Board of Directors’s practice of issuing management stock option compensation. Any negative outcome or a negative earning restatement could have a negative impact on the stock.

According to analysts, the commercial success of the Company’s products is dependent on Power Integrations’s ability to defend its intellectual property against infringement. A negative ruling in the Company’s patent lawsuit against Fairchild Semiconductor could potentially have negative affects on the Company.

Long-Term Growth

Analysts have projected long-term growth rates for the Company that range from 15.0% (First Albany) to 25.0% (Piper Jaffray). The Digest average is 20.0%. The Company’s growth is projected to be driven by continued design wins, especially in the large communication segment. Analysts believe the Industrial segment could be a catalyst for sales growth, as demand in this segment continues to accelerate alongside rising adoption rates.

According to analysts, the Company continues to introduce new products that broaden its opportunity beyond its traditional market of cell phones. Applications such as DVD players, digital TVs, household appliances, cordless phones, and industrial controls, have expanded the Company’s addressable market by over 50.0%.

With worldwide energy standards becoming more stringent, analysts are optimistic about Power Integrations’s EcoSmart technology. In particular, several new government standards are being enacted that will force new products to adopt newer technologies, displacing the inefficient legacy linear transformers. The standards imposed by the California Energy Commission will become mandatory for all external power supplies by 2007. This is seen as a critical event for the Company,given that California is the seventh largest economy in the world and usually the pioneer in leading edge legislation that many other states usually adopt later. The Company is expected to benefit from such mandatory requirements as its integrated power products conform to these new standards. As customers begin to design-in integrated power ICs that are in conformance with these new energy efficiency standards, the Company would be able to capitalize on the conversion.

However, risks to growth include ongoing concerns about the CEC’s power standard, with analysts noting that the standard is being appealed in an effort to either stay/delay/cancel the legislation. If the CEC standard is not enforced, it could jeopardize growth in the Communications, Computing, and Industrial segments ofthe Company. Additionally, analysts caution investors that POWI.PKcould face increased competition in the coming years, which could challenge its historical position of being the dominant player in the power conversion market.

Upcoming Events

None Scheduled

Individual Analyst Opinions

POSITIVE RATINGS (71.4%)

American Technology – Buy($35.00): 06/15/07–The analyst has reiterated a Buy rating and increased the target price from $31.00 to $35.00. INVESTMENT SUMMARY: The firm remains positive as it believes aside from the loss at Samsung, the rest of the business is on the track. According to the firm, the Company’s miss should not be viewed as a negative impact on mobile phone demand. Based on secular growth drivers in 2007 and favorable patent litigation driving new business, the investors should buy the stock.

B. of America – Buy ($36.00): 06/15/07 – The analyst has maintained a Buy rating with a target price of $36.00. INVESTMENT SUMMARY: The firm remains positive on POWI.PK as it believes current valuation offers an attractive entry point for investors. Details pertaining to additional design activities/wins to efficiency regulations, especially in the handset market, will act as a catalyst for the stock. Again, re-listing of the stockin the NASDAQ and the completion of the ongoing litigation with Fairchild willserve as catalysts for the stock.

Citigroup – Buy ($34.00): 06/14/07 – The analyst has maintained a Buy rating with a target price of $34.00. INVESTMENT SUMMARY: According to the firm, the secular revenue tailwinds, structurally resetting gross marginsand NASDAQ re-listing are positive catalysts for the stock, which will drive the share performance. The firm sees a favorable risk/reward profile for the stock.

Deutsche Bank – Buy ($33.00): 06/14/07: The firm has maintained a Buy rating, but decreased the target price from $35.00 to $33.00. INVESTMENT SUMMARY: Though the firm expects the shares of the Company to come under pressure, it would like to take position on POWI.PK as the Company’s secular growth continues to accelerate.

First Albany – Buy ($33.00): 06/22/07–The firm has maintained a Buy rating with a target price of $33.00. INVESTMENT SUMMARY: According to the firm, the design win at Nokia is indicative of the Company’s ability to compete in the most competitive markets. The firm believes POWI.PK is well positioned for growth.

NEUTRAL RATINGS (28.6%)

Ferris, Baker Watts– Neutral: 06/15/07 – The analyst has maintained a Neutral rating on the stock.

Piper Jaffray – Market Perform ($26.00): 06/15/07 – The firm has downgraded its rating from Outperformto Market Perform, and decreased the target price from $31.00 to $26.00. INVESTMENT SUMMARY: The firm is concerned with the Company’s near-term business risks and uncertainties. However, for the longer term, the Company’s patent portfolio remains solid and its ability to diversify its revenue base and design win momentum will fuel growth acceleration.

NEGATIVE RATINGS (0.0%)

There is no negative rating on the stock at this point of time.

Research Associate:Debasish Bhowmik

Reviewed By: RC Fuhrmann

Copy Editor:Oindrila Banerjee

Zacks Investment Research Page 1