POWER INTEGRATIONS INC, 10-K, 1998-03-24

POWER INTEGRATIONS INC
10-K, 1998-03-24
SEMICONDUCTORS & RELATED DEVICES

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC. 20549

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FORM 10-K

(MARK ONE)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 0-23441

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POWER INTEGRATIONS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

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<S> <C>
DELAWARE 94-3065014
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
</TABLE>

477 N. MATHILDA AVENUE, CALIFORNIA 94086
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(408) 523-9200
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

<TABLE>
<CAPTION>
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED
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NONE NONE
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SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)

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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Act of 1934
during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES [X] NO [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]

The aggregate market value of registrant's voting and non-voting common
equity held by nonaffiliates of registrant, based upon the closing sale price
of the common stock on February 27, 1998, as reported on the Nasdaq National
Market, was approximately $117,192,870. Shares of common stock held by each
officer, director and holder of 5% or more of the outstanding common stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes.

Outstanding shares of registrant's common stock, $.001 par value, as of
February 27, 1998: 12,084,240

DOCUMENTS INCORPORATED BY REFERENCE

Parts of the definitive Proxy Statement for registrant's 1998 Annual Meeting
of Stockholders to be filed with the Commission pursuant to Regulation 14A not
later than 120 days after the end of the fiscal year covered by this Form are
incorporated by reference into Part III of this Form 10-K Report.

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PART I

This report includes a number of forward-looking statements. Such statements
reflect the Company's current views with respect to future events and
financial performance and are subject to risks and uncertainties that could
cause the Company's actual results and financial position to differ
materially. These factors include, but are not limited to, the Company's
ability to maintain and establish strategic partnerships; the risks inherent
in the development and delivery of complex technologies; the Company's ability
to attract, retain and motivate qualified personnel; the emergence of new
markets for the Company's products and services, and the Company's ability to
compete in those markets based on timeliness, cost and market demand; and the
Company's limited financial resources. A further discussion of these and other
risk factors is contained in "Item 7--Management's Discussion and Analysis of
Financial Condition and Results of Operations--Risk Factors" and elsewhere in
this report.

ITEM 1. BUSINESS

OVERVIEW

Power Integrations, Inc. (the "Company") designs, develops, manufactures and
markets proprietary, high-voltage, analog integrated circuits ("ICs") for use
in AC to DC power conversion. The Company has targeted high-volume power
supply markets, including the cellular telephone, personal computer, cable and
direct broadcast satellite and various consumer electronics markets. The
Company's ICs cost effectively bring the benefits of high levels of
integration to AC to DC switching supplies. The Company believes that the
products in its TOPSwitch family of high-voltage ICs, introduced in 1994, are
the first highly integrated power conversion ICs to achieve widespread market
acceptance. An enhanced family, TOPSwitch-II, was introduced in April 1997.

INDUSTRY BACKGROUND

Virtually every electronic device that plugs into a wall socket requires
some type of power supply. These power supplies convert incoming high-voltage,
alternating current ("AC") provided by electric utilities into low-voltage
direct current ("DC") that can be used by electronic devices. Additionally,
rechargeable, portable products, such as cellular phones and laptop computers,
also need an AC to DC power supply to recharge their batteries.

Historically, AC to DC power supplies have used large, inefficient
transformers which operate at low frequencies to transform high-voltage
current to low-voltage current. In the 1970s, the invention of high-voltage
discrete semiconductors enabled the development of a new generation of AC to
DC power supplies. These new AC to DC "switching" power supplies ("switchers")
used a high-voltage discrete semiconductor along with other components to
generate high frequency pulses of power enabling the use of smaller, more
efficient transformers to lower the voltage. Although these discrete switchers
offered advantages over older technologies, over the years they have not kept
pace with the rapid integration in the electronic devices they power.

Recent market trends in electronics have created new requirements for power
supplies. The proliferation of portable electronic devices, particularly in
wireless communications and mobile computing, has created a global market
where consumers demand that new generations of electronic devices become
smaller and lighter. This expectation of increasingly compact systems has
driven end user demand for smaller, lighter power supplies. Another major
trend affecting power supplies is the growing awareness of the financial and
environmental costs of excess energy consumption. Growing environmental
concerns have resulted in government guidelines, such as the voluntary "Energy
Star" rating in the United States, as well as in many foreign countries, which
encourage the use of more energy efficient electronic devices from home
appliances to personal computers. In addition, manufacturers are aggressively
seeking to reduce manufacturing costs and time-to-market by decreasing
component count and simplifying system design.

As the pressures from these market forces have increased, the limitations of
discrete switchers have become more pronounced. Discrete switchers require
numerous components which limit the power supply designers'

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ability to reduce the size, increase the functionality and improve the
efficiency of switchers while at the same time meeting stringent market cost
requirements. In addition, discrete switchers involve a high level of system
complexity which limits the scalability of designs and increases time-to-
market and development risks for new products.

Despite these shortcomings, discrete switchers remain in widespread use in
the large market for high-voltage switchers within the 0.5 to 150 watt power
range. This market includes switchers for cellular phone chargers, personal
computers, cable and direct broadcast satellites and numerous other consumer
and industrial electronic devices. To address the shortcomings of discrete
switchers, attempts have been made to replace discrete switchers with
integrated switchers through the use of high-voltage analog ICs. Prior
attempts did not achieve widespread acceptance in the marketplace because they
were not as cost-effective as discrete alternatives. Consequently, the Company
believes that a substantial market opportunity exists for high-voltage ICs
that achieve a system cost that is better than or at parity with existing
solutions.

THE COMPANY'S HIGHLY INTEGRATED SOLUTION

The Company has developed a family of high-voltage ICs which the Company
believes are the first highly integrated power conversion ICs to achieve
widespread market acceptance. Since introducing its TOPSwitch products in
1994, the Company has shipped approximately 86 million TOPSwitch ICs. These
patented ICs achieve a high level of system integration by combining a
controller, MOSFET and a number of other electronic components into a single
analog IC. The Company's TOPSwitch products enable many power supplies in the
0.5 to 150 watt range to have a total cost equal to or lower than discrete
switchers. The Company's TOPSwitch products offer the following key benefits
to power supplies:

Fewer Components, Reduced Size and Enhanced Functionality

The Company's highly integrated TOPSwitch ICs enable the design and
production of cost-effective switchers that use up to 50% fewer components and
have enhanced functionality compared to discrete-based solutions. For example,
the Company's integrated circuits provide thermal and short circuit protection
without increasing system cost while discrete switchers must add additional
components and cost to provide these functions.

Improved Efficiency

The Company's integrated circuit also improves electrical efficiency which
reduces power consumption and excess heat generation. The Company's patented
low-loss, high-voltage device, combined with its control circuitry, improves
overall electrical efficiency during both full operation and stand-by mode.

Reduced Time-to-Market

The Company's integrated circuit enables a less complex system architecture
that greatly simplifies system design for power supply designers. This allows
manufacturers to leverage their existing TOPSwitch designs for new products,
which results in shorter time-to-market and reduced product development risk.

Wide Power Range and Scalability

Products in the Company's current TOPSwitch families of products share a
common proprietary architecture but vary in power capability to address a
power range of 0.5 to 150 watts. The Company's scalable architecture allows
switcher designers to leverage their existing TOPSwitch-based designs to
easily develop a wide range of products to address many different power supply
markets.

STRATEGY

The Company's objective is to be the leading provider of high-voltage power
conversion ICs. The Company intends to pursue the following strategies to
accelerate adoption of its products:

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Target High-Volume Markets. The Company's strategy is to use its technology
and products to deliver cost-effective integrated solutions to high-volume AC
to DC switching power supply markets. The Company's proprietary TOPSwitch
architecture was designed to be used cost effectively over a wide power range
in multiple applications. The scalable TOPSwitch architecture allows the
Company to leverage a small number of products across a broad range of high-
volume markets, thereby gaining economies of scale and enhancing the Company's
competitiveness.

Focus on Markets that Can Derive Significant Benefits from Integration. The
Company is initially focusing its efforts on those markets that are
particularly sensitive to size, portability, energy efficiency and time to
market issues. The Company achieved early success penetrating the cellular
phone fast charger market as the cellular phone industry has moved from stand-
alone desktop chargers to more portable travel chargers. The Company has also
achieved rapid growth in the desktop PC market due to the market's recent
demand for stand-by power capability. As other markets emerge as significant
opportunities for the Company's TOPSwitch products, the Company intends to
focus its resources on the development and penetration of these markets. See
"Risk Factors--Concentration of Applications."

Deliver Systems Solution and Provide Applications Expertise. To accelerate
market adoption of the TOPSwitch products, the Company offers its customers
comprehensive application design support. This system level support includes
extensive application notes and production-ready reference design boards. The
Company provides application engineering support out of the Company's
headquarters and through field application engineering labs located in
England, India, Japan, Korea, Singapore and Taiwan. The Company has committed
substantial resources to system support by dedicating approximately 15% of its
workforce to applications engineering. The Company believes its power supply
systems expertise and investment in field applications engineering provide it
with significant competitive advantages.

Extend Technological Leadership in High-Voltage Analog ICs. The Company's
technology leadership is based on high-voltage analog device structures and
wafer fabrication processes coupled with analog circuit designs that have
resulted in 22 U.S. patents and 33 foreign patents. These patents, in
combination with the Company's other intellectual property, form the basis of
the Company's TOPSwitch product families. The Company recently introduced an
enhanced TOPSwitch product family that provides improved power capability and
system cost advantages while preserving the design simplicity of the Company's
original TOPSwitch products. The Company continues to improve its high-voltage
analog device structures, wafer fabrication processes and analog circuit
designs and seeks to obtain additional patents to protect its intellectual
property.

Leverage Patented Technology in Strategic Partnerships. The Company has
established strategic partnerships with Matsushita Electronics Corporation and
an affiliate of Matsushita ("MEC"), and OKI Electric Industry Co., Ltd.
("OKI") in order to obtain high volume manufacturing resources, broader market
penetration and royalty revenues. The wafer manufacturing relationships with
MEC and OKI enable the Company to focus on product design and marketing while
minimizing fixed costs and capital expenditures. MEC and OKI also have
licensed the right to manufacture products for sale in certain geographic
regions and for internal consumption. See "Risk Factors--Dependence on Wafer
Suppliers" and "Risk Factors--Risks of Licensing Technology to Third Parties."

PRODUCTS

The Company has developed a series of product families that utilize its
high-voltage analog technology, analog IC design capabilities and power
conversion system expertise.

The TOPSwitch Product Families

The Company's TOPSwitch high-voltage analog IC products are able to meet the
power conversion needs of a wide range of applications within high volume
markets. Sales of TOPSwitch products accounted for 79% and 93% of the
Company's net revenues in 1996 and 1997, respectively.

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TOPSwitch. The TOPSwitch family consists of 13 products, the first of which
was introduced in 1994. The key benefits of the TOPSwitch family compared to
discrete switchers are fewer components, reduced size, enhanced functionality
and lower cost in many applications. The Company's TOPSwitch products achieve
a high level of system integration by combining a PWM controller, a high-
voltage MOSFET and a number of other electronic components into a single 3-pin
package. The TOPSwitch products are produced in two high-voltage versions--a
350 volt version which is required for the 115VAC switcher markets (e.g.
United States and Japan) and a 700 volt version which is required for the
230VAC switcher markets (e.g. Europe and International).

TOPSwitch II. The TOPSwitch II family currently consists of 11 products, the
first of which was introduced in April 1997. The TOPSwitch II products further
lower the switcher costs by improving the performance of TOPSwitch and
broadening the availability of a low cost package for low power applications.
The TOPSwitch II family utilizes the same proprietary architecture used in the
original TOPSwitch family, thereby enabling switcher designers experienced
with TOPSwitch to take advantage of the TOPSwitch II benefits without
implementing a new architecture.

Other Products

The Company's products also include the SMP family, the INT family and a
limited number of custom products. Sales of these products accounted for 21%
and 7% of the Company's net revenues in 1996 and 1997, respectively. The
Company expects revenue from these products to continue to decline as a
percentage of net revenues.

SMP. The SMP family is the original line of power conversion products
developed by the Company for the AC to DC power supply market. These products
are used in applications where switcher designers are willing to pay a premium
price for additional features such as variable frequency.

INT. The INT products are interface drivers for motor control applications
which utilize the Company's high-voltage process technology.

Custom Products. The Company also manufactures a limited number of custom
products, including a hook switch for telephones.

MARKETS & CUSTOMERS

The Company's strategy is to target high-volume power supply markets and to
initially focus on those markets that can derive significant benefits from its
TOPSwitch products. The following chart shows representative customers, which
in some cases are also end users, of the Company's TOPSwitch products in power
supplies in several major market segments.

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MARKET SEGMENT CUSTOMERS
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Cellular Phones
Battery Chargers................ Motorola, Inc. and its subsidiaries
("Motorola"), Nokia, Phihong Enterprises,
Samsung Electronics ("Samsung")
Desktop Computers
Stand-by Power.................. API (Sun Moon Star), Astec, Delta
Electronics, Intertek, Liteon
Cable and Direct Broadcast
Satellite
Set-top Decoders................ Amstrad, API, Grundig, Hughes, Nokia, Pace
Micro Technology, Scientific Atlanta
Cable Telephone................. ADC Telecom, Alltemated, Phillips, Tellabs
Acer, Lucky Goldstar, Sony
</TABLE>

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MARKET SEGMENT CUSTOMERS
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PC Peripherals
Multi-media Monitor (Audio).............. Lucky Goldstar, Sony
Universal Serial Bus..................... Nokia, Philips, Samsung, Sony
Removable Mass Storage................... Anam Instruments (End User: Iomega)
Consumer
TV....................................... Daewoo, Samsung, Sony
VCR...................................... Daewoo
DVD...................................... Malata, Samsung
Industrial
Utility Meters........................... General Electronics Corporation,
Schlumberger
Uninterrupted Power Supply............... Exide Electronics
</TABLE>

Current Primary Markets

Cellular Phones. Demand in the cellular phone market is driven by low-cost,
ease of use, portability and miniaturization. The Company believes that these
factors have created a substantial market opportunity for small, efficient
power supplies for battery chargers. The Company intends to continue its
penetration of this market with its integrated solution which enables a low-
cost, compact and efficient power supply.

Desktop Computers. Desktop computers consume energy while idle and turned on
to wait for communication functions such as receiving a fax. As the level of
communication functions performed by the computer increases, the computer's
power consumption during idle is becoming a significant cost for both users
and the economy. Therefore, computer manufacturers and governmental
authorities are promoting the use of stand-by power features in new PCs to
reduce the PCs' power consumption when idle. The Company's highly efficient
TOPSwitch products are currently being used in computers to provide this
stand-by power solution and meet the market demand for more energy-efficient
computers.

Cable and Direct Broadcast Satellite. Set-top decoders are rapidly changing
as broadcasters are providing more advanced capabilities and a greater number
of channels to consumers. This has created an opportunity for a scalable power
supply system solution which can be quickly redesigned to keep up with the
market's rapidly changing requirements. The scalable architecture of the
Company's TOPSwitch products addresses this need for a high-volume, versatile
solution.

Other Markets

Although the Company is currently focusing on the above key markets, the
Company also sells its products into a wide variety of other markets which
include PC peripherals, televisions, VCRs, industrial meters and kitchen
appliances. As these and other markets emerge as significant opportunities for
the Company's TOPSwitch products, the Company intends to focus its resources
on the development and penetration of these markets.

SALES, DISTRIBUTION AND MARKETING

The Company sells its products to OEMs and merchant power supply
manufacturers through a direct sales staff and through a worldwide network of
independent sales representatives and distributors. The Company currently
utilizes sales representatives throughout Asia and Europe. The Company's
international sales representatives also act as distributors. In the United
States, the Company currently utilizes one national distributor and a number
of regional sales representatives. The Company has sales offices in Atlanta,
Georgia and Newport Beach, California, as well as in England, India, Korea and
Taiwan. For the year ended December 31, 1997, direct sales and sales through
distributors were approximately equal as a percentage of net revenues. All
distributors are entitled to certain return privileges based on sales revenue
and are protected from price

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reductions affecting their inventories. The Company's distributors are not
subject to minimum purchase requirements and the sales representatives and
distributors can discontinue marketing any of the Company's products at any
time.

The Company's products are generally incorporated into a customer's power
supply at the design stage. The Company's sales and marketing efforts are
focused on facilitating the customer's use of the Company's products in the
design of new power supplies for specific applications. An important
competitive factor in achieving a design win is the Company's commitment to
provide comprehensive application design support. The Company publishes a
comprehensive Databook and Design Guide and provides to its current and
prospective customers extensive application notes and production-ready
reference design boards. In addition, the Company provides application
engineering support out of the Company's headquarters, and its field
application engineering labs located in England, India, Japan, Korea,
Singapore and Taiwan provide local resources to support customers in key
geographies. The Company focuses particular efforts on building relationships
with and providing support to industry-leading OEMs and merchant power supply
manufacturers. The Company has committed substantial resources to system
support by dedicating approximately 15% of its workforce to applications
engineering.

The Company's end user base is highly concentrated and a relatively small
number of OEMs, directly or indirectly through merchant power supply
manufacturers, accounted for a significant portion of the Company's revenue in
1996 and 1997. Motorola is presently the Company's largest end user. Although
the exact dollar amounts and percentages of sales to Motorola are difficult to
ascertain because most of such sales occur through distributors or indirectly
through sales to merchant power supply manufacturers which, in turn, sell
power supplies to Motorola, the Company estimates that direct and indirect
sales to Motorola accounted for approximately 20% of the Company's net
revenues for the year ended December 31, 1997. The Company estimates that its
top ten customers, including distributors which resell to Motorola and other
large OEMs and merchant power supply manufacturers, accounted for 64% and 67%
of the Company's net revenues for the years ended December 31, 1996 and 1997,
respectively. For fiscal 1995, three customers accounted for approximately
12%, 20% and 21% of net revenues. For fiscal 1996, no individual customer
accounted for more than 10% of net revenues. For the year ended December 31,
1997, Maxisum Ltd. and Phihong Enterprise accounted for 21% and 15% of the
Company's net revenues, respectively. No other customers accounted for more
than 10% of net revenues during 1997. In fiscal 1995, 1996 and 1997,
international sales comprised 65%, 72% and 81%, respectively, of the Company's
net revenues. See "Risk Factors--Customer Concentration and Competing Products
from Customers."

Sales of the Company's products are generally made pursuant to standard
purchase orders, which are frequently revised to reflect changes in the
customer's requirements. Product deliveries are scheduled upon the Company's
receipt of purchase orders. Generally, these orders allow customers to
reschedule delivery dates and cancel purchase orders without significant
penalties. For these reasons, the Company believes that purchase orders
received, while useful for scheduling production are not necessarily reliable
indicators of future revenues. See "Risk Factors--Unpredictable and
Fluctuating Operating Results."

In the Japanese market, the Company has a license agreement with MEC under
which MEC sells its versions of the Company's products. While the Company
continues to sell its products to its existing Japanese customers, in April
1997, the Company agreed not to pursue new business in Japan until after June
2000. The Company believes that this new arrangement will better meet the
Company's market penetration and financial objectives in Japan. The Company
supports MEC's sales efforts and the Company's existing Japanese customers
through its office in Japan. OKI also has the rights to sell its versions of
the Company's products in Japan but is currently not exercising these rights.
See "Risk Factors--Risks of Licensing Technology to Third Parties" and
"Intellectual Property and Other Proprietary Rights."

TECHNOLOGY

High-Voltage Transistor Structure and Process Technology

The Company has developed a proprietary high-voltage, power IC technology
which utilizes the Company's MOS transistor structure and proprietary process
and has resulted in 7 U.S. patents. The technology enables the

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Company to integrate cost effectively on the same monolithic IC, high-voltage
n-channel transistors with industry standard CMOS and bipolar components. The
IC device structure and the wafer fabrication process both contribute to the
cost effectiveness of the Company's high-voltage technology. The device
structure results in a transistor conduction capability that is significantly
higher than that of competing technologies. The IC device structure can be
implemented on low cost silicon wafers using a 3 micron CMOS process when
combined with the Company's proprietary implant process step. The Company has
focused its efforts on optimizing a single wafer fabrication process for its
TOPSwitch products. The same process can be adapted for power conversion
products that range from 20 to 800 volts.

IC Design and System Technology

The Company's proprietary IC designs combine complex control circuits and
high-voltage transistors on the same monolithic IC and have resulted in 15
U.S. patents. The Company's IC design technology takes advantage of the
Company's high voltage process to minimize the die size of both the high-
voltage device and the control circuits and improve the performance of the
Company's ICs versus alternative integration technologies. The combination of
the Company's IC design technology and the Company's system level expertise in
switchers has enabled the Company to develop the highly integrated TOPSwitch
ICs and scalable architecture for integrated switchers.

RESEARCH AND DEVELOPMENT

The Company's research and development efforts are focused on improving the
Company's high-voltage device structures, wafer fabrication processes, analog
circuit designs and system level architecture. By these efforts, the Company
seeks to further reduce the costs of its products, and improve the cost
effectiveness and enhance the functionality of its customers' power supplies.
The Company has assembled a multidisciplined team of highly skilled engineers
to meet its research and development goals. These engineers bring to the
Company expertise in high-voltage structure and process technology, analog
design and power supply systems architecture.

In 1995, 1996 and 1997, the Company spent $2.0 million, $3.5 million and
$5.3 million, respectively, on its research and development efforts. The
Company expects that it will continue to invest substantial funds in research
and development activities. The development of high-voltage analog ICs is
highly complex. There can be no assurance that the Company will develop and
introduce new products in a timely and cost effective manner or that its
development efforts will successfully permit the Company's products to meet
changing market demands. See "Risk Factors--New Products and Technological
Change."

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

The Company utilizes a combination of patents, trademarks, copyrights, trade
secrets and confidentiality procedures to protect its intellectual property
rights. The Company holds 22 U.S. patents and has generally filed for or
received foreign patent protection on these patents resulting in 33 foreign
patents and 15 foreign patent applications. The U.S. patents have expiration
dates ranging from 2006 to 2016. Seven of the U.S. patents are related to the
device structure of the high-voltage transistor, 10 are circuit patents that
have been utilized in the Company's products and 3 are circuit patents that
provide the foundation for the Company's TOPSwitch products. Two of the U.S.
patents cover specific system applications using TOPSwitch. The Company is
currently pursuing additional U.S. patent applications relating to
improvements and extensions of the Company's products. There can be no
assurance that the Company's pending United States or foreign patent
applications or any future United States or foreign patent applications will
be approved, that any issued patents will protect the Company's intellectual
property or will not be challenged by third parties, or that the patents of
others will not have an adverse effect on the Company's ability to do
business. Furthermore, there can be no assurance that others will not
independently develop similar or competing technology or design around any
patents that may be issued to the Company. The Company also holds nine
trademarks, five in the U.S., two in California and two in Japan.

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Certain equipment, processes, information and knowledge developed by the
Company and used in the design and manufacture of its products are regarded as
proprietary by the Company. The Company's trade secrets include a proprietary
high volume production process that produces the Company's patented high-
voltage ICs. The Company attempts to protect its trade secrets and other
proprietary information through non-disclosure agreements, proprietary
information agreements with employees and consultants and other security
measures. Despite these efforts, there can be no assurance that others will
not gain access to the Company's trade secrets, or that the Company can
meaningfully protect its intellectual property. In addition, effective trade
secret protection may be unavailable or limited in certain foreign countries.
Although the Company intends to protect its rights vigorously, there can be no
assurance that such measures will be successful.

The Company has granted perpetual non-transferable licenses to MEC and OKI
to use the Company's semiconductor patents and other intellectual property for
the Company's current high-voltage technology, including the Company's
TOPSwitch technology, and improvements on the existing technology to
manufacture and design products for internal use and for sale or other
distribution to Japanese companies and to subsidiaries of Japanese companies
in Asia. In the case of OKI, to the extent such products are not based on
TOPSwitch technology, sales or other distribution may be on a worldwide basis
to any third parties. In the case of MEC, to the extent products are not based
on the TOPSwitch technology, sales or other distribution may also be made to
Asian companies in Asia. MEC and OKI have granted the Company perpetual cross
licenses to the technology developed by MEC or OKI under their license rights.
Until after June 2000, the Company has agreed not to license the technology
licensed to MEC to other Japanese companies (other than OKI) or their
subsidiaries. The Company has also agreed not to sell its products in Japan to
new customers. In exchange for their license rights, MEC and OKI have paid
and, in the case of MEC, will continue to pay to the Company licensing fees
for a fixed period and pay or will pay royalties on products using the
licensed technology during fixed periods. In April 1997, the license agreement
with MEC was amended to explicitly include high-voltage device technology
being developed by the Company in return for an improved royalty structure
from MEC. To date, only MEC has sold products to third parties under its
license rights.

The Company also has granted a perpetual, non-transferable license to AT&T
Microelectronics to use certain of the Company's IC processes and device
technologies in the products AT&T sells. In addition, pursuant to an agreement
with MagneTek, Inc., the Company has granted MagneTek an exclusive, perpetual
royalty-free license to manufacture lighting products that incorporate certain
of the Company's technology.

The semiconductor industry is characterized by frequent litigation regarding
patent and other intellectual property rights. Any such litigation, whether or
not determined in the Company's favor or settled by the Company, would be
costly and would divert the efforts and attention of the Company's management
and technical personnel from normal business operations, which would have
material adverse effect on the Company's business, financial condition and
results of operations. Adverse determinations in litigation could result in
the loss of the Company's proprietary rights, subject the Company to
significant liabilities, require the Company to seek licenses from third
parties or prevent the Company from licensing its technology, any of which
could have a material adverse effect on the Company's business, financial
condition and results of operations. Moreover, the laws of certain foreign
countries in which the Company's technology is or may in the future be
licensed may not protect the Company's intellectual property rights to the
same extent as the laws of the United States, thus increasing the possibility
of infringement of the Company's intellectual property. See "Risk Factors--
Dependence on Proprietary Technology."

MANUFACTURING

The Company contracts with MEC and OKI to manufacture its wafers in Japan.
The Company's semiconductor products are assembled and packaged by independent
subcontractors in China, Malaysia and the Philippines. The Company performs
testing, finishing and shipping at its facility in Sunnyvale, California. This
fabless manufacturing model enables the Company to focus on its engineering
and design strengths, minimize fixed costs on capital expenditures, and still
have access to high-volume manufacturing capacity. The Company's products do
not require leading edge process geometries for them to be cost-effective and
thus, the Company

9
<PAGE>

can use MEC's and OKI's older, low-cost fabs for wafer manufacturing. The
Company uses a proprietary and sensitive implant process and must interact
closely with MEC and OKI to achieve satisfactory yields. Although the Company
generally utilizes standard IC packages for assembly, there are some materials
and aspects that are specific to the Company. The Company specifies a sole
source high-voltage molding compound that is difficult to process. This
compound, and its required processes, together with the other non-standard
materials and processes needed to assemble the Company's products require a
more exacting level of process control than normally required for standard
packages. As a result the Company must be involved with its contractors on an
active engineering basis to maintain and improve the process. The Company has
developed process monitoring equipment to support this effort and must provide
adequate engineering resources to provide similar support in the future.

The Company's wafer supply agreements with MEC and OKI expire in June 2000
and June 1998, respectively. Under the terms of the MEC agreement, minimum
annual and monthly purchase and sale commitments are established annually by
the mutual agreement of MEC and the Company. Pricing is also established by
the good faith agreement of MEC and the Company, subject to the Company's
right to most favored pricing. Under the terms of the OKI agreement, OKI has
agreed to reserve a specified amount of production capacity and to sell wafers
to the Company at fixed prices depending upon volume. The Company's agreements
with both MEC and OKI provide for the pricing of wafers in Japanese yen.

There can be no assurance that the Company will be able to reach an
agreement with either MEC or OKI to extend the term of their respective wafer
supply agreements. The Company's failure to reach, in a timely fashion, an
extension of either agreement or to enter into a wafer supply arrangement with
another manufacturer, could result in material disruptions in supply. Certain
contractual provisions limit the conditions under which the Company can enter
into such arrangements with other Japanese manufacturers or their subsidiaries
during the term of the agreement with MEC. In the event of a supply disruption
with OKI or MEC, if the Company were unable to qualify alternative
manufacturing sources for existing or new products in a timely manner or if
such sources were unable to produce devices with acceptable manufacturing
yields, the Company's business, financial condition and operating results
would be materially and adversely affected.

The Company depends on MEC and OKI to produce wafers at acceptable yields
and to deliver them to the Company in a timely manner. As the Company
continues to increase its product output, there can be no assurance that the
Company's foundries and assemblers will not experience a decrease in yields.
Moreover, there can be no assurance that acceptable yields will be
maintainable in the future. See "Risk Factors--Risks of Outside Manufacturing
and Assembly; Sole Source Risks."

COMPETITION

The high-voltage power supply industry is intensely competitive and
characterized by extreme price sensitivity. Accordingly, the most significant
competitive factor in the target markets for the Company's products is cost
effectiveness. The Company's products face competition from alternative
technologies, primarily discrete switchers. The Company believes that at
current pricing, the TOPSwitch families of products offer favorable cost
performance benefits compared to discrete switchers in many high-volume
applications over the power range of approximately 0.5 watts to 150 watts.
However, any significant erosion in the price of discrete components, such

10
<PAGE>

as high-voltage Bipolar and MOSFET transistors and PWM controller ICs, could
adversely affect the cost effectiveness of the TOPSwitch products. Also older
alternative technologies to switchers are more cost-effective than switchers
that use the Company's TOPSwitch products in certain power ranges for certain
applications. If power requirements for certain applications in which the
Company's products are currently utilized, such as battery chargers for
cellular telephones, drop below certain power levels, these older alternative
technologies can be used more cost effectively than TOPSwitch-based switchers.
The Company is continuing its efforts to use its extensive system level
expertise to enhance the cost effectiveness of TOPSwitch-based switchers in
the lower power ranges. There can be no assurance that the Company will be
successful in these efforts.

Recently, the Company's TOPSwitch product families have begun to meet
additional competition from hybrid and single high-voltage ICs similar to
TOPSwitch. These competing products are being developed or have been developed
and are being produced by companies such as Motorola, SGS-THOMSON
Microelectronics N.V. ("SGS"), Samsung and Sanken Electric Company, Ltd.
("Sanken"). The Company expects competition to increase as Motorola, SGS,
Samsung, Sanken and possibly other companies develop and introduce new
products. To the extent these competitors' products are lower in cost than the
Company's products, the Company's business, financial condition and results of
operations could be materially and adversely affected. Many of the Company's
emerging competitors, including Motorola, SGS, Samsung and Sanken, have
significantly greater financial, technical, manufacturing and marketing
resources than the Company. In the context of a market where a high-voltage IC
is designed into a customer's product and the provider of such ICs is
therefore the sole source of the IC for that product, greater resources and,
in particular, greater manufacturing resources, may be a significant factor in
the customer's choice of the IC because of the customer's perception of
greater certainty in its source of supply. See "Risk Factors--Customer
Concentration and Competing Products from Customers."

The Company's ability to compete in its target markets also depends on such
factors as the timing and success of new product introductions by the Company
and its competitors, the pace at which the Company's customers incorporate the
Company's products into their end user products, availability of wafer
fabrication and finished good manufacturing capability, the availability of
adequate sources of raw materials, protection of Company products by effective
utilization of intellectual property laws and general economic conditions.
There can be no assurance that the Company's products will continue to compete
favorably or that the Company will be successful in the face of increasing
competition from new products and enhancements introduced by existing
competitors or new companies entering this market. Failure of the Company to
compete successfully in the high-voltage power supply business would
materially and adversely affect the Company's business, financial condition
and results of operations. See "Risk Factors--Competition."

EMPLOYEES

As of December 31, 1997, the Company employed 140 full time personnel,
consisting of 58 in manufacturing, 36 in research and development, 35 in sales
and marketing and 11 in finance and administration.

11
<PAGE>

EXECUTIVE OFFICERS OF THE REGISTRANT

As of February 27, 1998, the executive officers of the Company, who are
elected by and serve at the discretion of the Board of Directors, were as
follows:

<TABLE>
<CAPTION>
NAME POSITION WITH THE COMPANY AGE
---- ------------------------- ---
<S> <C> <C>
Howard F. Earhart....... President, Chief Executive Officer and Director 58
Balu Balakrishnan....... Vice President, Engineering and New Business 43
Development
Clements Edward Pausa... Vice President, Operations 67
Vladimir Rumennik....... Vice President, Technology Development 52
Daniel M. Selleck....... Vice President, Worldwide Sales 51
Robert G. Staples....... Chief Financial Officer, Vice President, Finance and 50
Administration and Secretary
Clifford J. Walker...... Vice President, Corporate Development 46
Dr. Edward C. Chairman of the Board of Directors 56
Ross(1)(2).............
Dr. William Davidow(1).. Director 62
E. Floyd Kvamme(1)(2)... Director 60
Steven J. Sharp......... Director 56
</TABLE>
- --------
(1) Member of the Compensation Committee
(2) Member of the Audit Committee

Howard F. Earhart has served as President, Chief Executive Officer and as a
Director of the Company since January 1995. From 1990 to 1995 Mr. Earhart
served as an interim Chief Executive Officer for various high technology
companies including those discussed below. From July 1994 to March 1995, Mr.
Earhart served as Chief Executive Officer of Co-Active Computing, Inc., a
personal computer peer-to-peer network adapter company. From July 1994 to
January 1995, Mr. Earhart served as Chief Executive Officer of Reach Software,
a software company. From December 1993 to April 1994, Mr. Earhart served as
Chief Executive Officer of Quorum Software, a software company. From August
1993 to September 1994, Mr. Earhart served as acting Chief Executive Officer
of Digital-F/X, a hardware and software company. From September 1992 to April
1993, Mr. Earhart served as an advisor to the Chief Executive Officer of
Raster Graphics, an electrostatic plotter company. From August 1990 to January
1992, Mr. Earhart served as Chief Executive Officer of Springer Technologies,
a thin film magnetic head company. Mr. Earhart also served as President of the
Consumer Products Group of Memorex Corporation.

Balu Balakrishnan has served as Vice President, Engineering and New Business
Development of the Company since September 1997. From September 1994 to
September 1997, Mr. Balakrishnan served as Vice President, Engineering and
Marketing of the Company. Mr. Balakrishnan served as Vice President, Design
Engineering from April 1989 to September 1994. From April 1978 to April 1989,
Mr. Balakrishnan served as Design and Development Manager of National
Semiconductor's Interface and Advanced Peripherals Group.

Clements Edward Pausa has served as Vice President, Operations of the
Company since June 1997. From October 1994 to June 1997, Mr. Pausa served as a
Vice President of Alphatec Group, a semiconductor manufacturing services
company. From October 1990 to June 1997, Mr. Pausa served as a director of
consulting at Coopers & Lybrand LLP. From August 1969 to October 1990, Mr.
Pausa served as a Vice President of National Semiconductor. Mr. Pausa has
served as a director of Coopers & Lybrand LLP, since October 1990.

Vladimir Rumennik has served as Vice President, Technology Development of
the Company since April 1991. From February 1990 to March 1991, Mr. Rumennik
was Director of Technology Development of the Company. Prior to January 1990,
Mr. Rumennik was a manager at Signetics, a semiconductor company and a
subsidiary of Philips Semiconductor ("Signetics"). Mr. Rumennik has also held
positions at Philips Laboratories and Xerox Microelectronics Center.

12
<PAGE>

Daniel M. Selleck has served as Vice President, Worldwide Sales of the
Company since May 1993. From February 1984 to May 1993, Mr. Selleck held
various sales management positions with Philips Semiconductor including
European Regional Sales Manager and Western Area Sales Manager in the United
States.

Robert G. Staples has served as Chief Financial Officer, Vice President,
Finance and Administration and Secretary of the Company since June 1995. From
October 1994 to June 1995, Mr. Staples served as Chief Financial Officer of
MIS, a software development company. From October 1993 to October 1994, Mr.
Staples served as Chief Financial Officer of Simtec Corporation, a
semiconductor company. From April 1988 to October 1993, Mr. Staples served as
Chief Financial Officer and Vice President, Finance and Administration of
Codar Technology, a defense contracting company.

Clifford J. Walker has served as Vice President, Corporate Development of
the Company since June 1995. From September 1994 to June 1995, Mr. Walker
served as Vice President of Reach Software, a software company. From December
1993 to September 1994, Mr. Walker served as President of Morgan Walker, a
consulting company. From July 1992 to December 1993, Mr. Walker served as Vice
President of Extended Length Flex, a PCB company. From October 1986 to July
1992, Mr. Walker served as Vice President of Springer Technologies, a thin
film disk head company.

Dr. Edward C. Ross has served as a Director of the Company since January
1989 and has served as the Chairman of the Board of Directors since January
1995. From January 1989 to January 1995, Dr. Ross served as President and
Chief Executive Officer of the Company. Dr. Ross has served as President,
Technology and Manufacturing Group of Cirrus Logic, Inc., a semiconductor
company, since September 1995.

Dr. William Davidow has served as a Director of the Company since its
inception. Dr. Davidow has been a general partner of Mohr, Davidow Ventures, a
venture capital company since 1985. Dr. Davidow also serves as a director of
two public companies, Rambus Inc. and The Vantive Corporation.

E. Floyd Kvamme has served as a Director of the Company since September
1989. Mr. Kvamme has been a general partner of Kleiner Perkins Caufield &
Byers, a venture capital company, since 1984. Mr. Kvamme also serves as a
director of four public companies, TriQuint Semiconductor ("TriQuint"),
Harmonic Lightwaves, Photon Dynamics and Prism Solutions.

Steven J. Sharp is a founder of the Company and has served as a Director of
the Company since its inception. Mr. Sharp has served as President, Chief
Executive Officer and Chairman of the Board of TriQuint since September 1991.

ITEM 2. PROPERTIES.

The Company's main executive, administrative, manufacturing and technical
offices are located in a 30,000 square foot facility in Sunnyvale, California
under a lease which expires in October 1998 with a conditional five-year
option at fair market value to the year 2003. The Company's manufacturing
operations at this facility consist of testing wafers and ICs. While the
Company believes that its existing facilities are adequate for its current
needs and expects to exercise the lease option, it is exploring the
possibility of leasing additional space to accommodate future needs.

ITEM 3. LEGAL PROCEEDINGS.

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

In connection with the Company's initial public offering of common stock on
December 12, 1997 ("IPO"), the Company's predecessor-in-interest, Power
Integrations, Inc., a California corporation, solicited, by written

13
<PAGE>

consent, its shareholders with respect to approving (i) the Company's
reincorporation in the State of Delaware, including authorizing a 6.8-to-1
reverse stock split and a reduction in the Company's authorized capital stock,
(ii) the form of the Company's Indemnity Agreement, (iii) amendments to the
Company's 1997 Stock Option Plan (the "Option Plan") to provide that the
number of shares issuable under the Option Plan be increased on the first day
of each fiscal year of the Company beginning on or after January 1, 1999 by a
number of shares equal to 5% of the number of shares of the Company's common
stock issued and outstanding on the last day of the preceding fiscal year and
to make additional clarifying changes to the Option Plan, (iv) the adoption of
the Company's 1997 Employee Stock Purchase Plan with a share reserve of
250,000 shares of the Company's common stock and (v) the adoption of the
Company's 1997 Outside Directors Stock Option Plan with a share reserve of
200,000 shares of the Company's common stock. Each of the above-referenced
matters were approved by the Company's shareholders, effective as of September
30, 1997, as provided below:

The proposal to approve the Company's reincorporation in the state of
Delaware, a 6.8-to-1 reverse stock split and a reduction in the Company's
authorized capital stock received the following votes:

<TABLE>
<S> <C>
For: 8,703,297
Against: 0
Abstain: 663,839
</TABLE>

The proposal to approve the form of the Company's Indemnity Agreement
received the following votes:

<TABLE>
<S> <C>
For: 8,703,297
Against: 0
Abstain: 663,839
</TABLE>

The proposal to amend the Company's 1997 Stock Option Plan received the
following votes:

<TABLE>
<S> <C>
For: 8,703,297
Against: 0
Abstain: 663,839
</TABLE>

The proposal to approve the Company's 1997 Employee Stock Purchase Plan with
a share reserve of 250,000 shares of the Company's common stock received the
following votes:

<TABLE>
<S> <C>
For: 8,703,297
Against: 0
Abstain: 663,839
</TABLE>

The proposal to approve the Company's 1997 Outside Directors Stock Option
Plan with a share reserve of 200,000 shares of the Company's common stock
received the following votes:

<TABLE>
<S> <C>
For: 8,703,297
Against: 0
Abstain: 663,839
</TABLE>

14
<PAGE>

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.

The Company effected its IPO on December 12, 1997 with its common stock
traded on the Nasdaq National Market under the symbol "POWI." As of December
31, 1997, there were approximately 305 stockholders of record of the Company's
common stock. Because many of such shares are held by brokers and other
institutions on behalf of stockholders, the Company is unable to estimate the
total number of stockholders represented by these record holders. The
following table sets forth, for the quarter indicated, the high and low sales
price per share of the Company's common stock as reported on the Nasdaq
National Market:

<TABLE>
<CAPTION>
PRICE RANGE
-------------
HIGH LOW
------- -----
<S> <C> <C>
YEAR ENDED DECEMBER 31, 1997
Fourth Quarter (since December 12, 1997).................... $ 9 3/8 $ 8
</TABLE>

The Company has not paid any cash dividends on its capital stock. The
Company currently intends to retain its earnings for use in the operation and
expansion of its business and, therefore, does not anticipate paying any cash
dividends in the foreseeable future.

15
<PAGE>

ITEM 6. SELECTED FINANCIAL DATA.

The following selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and the
Notes thereto included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------
1993 1994 1995 1996 1997
------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Net revenues:
Product sales................... $ 1,578 $ 5,027 $17,406 $23,324 $44,827
License fees and royalties...... 4,185 2,099 1,009 619 1,162
------- ------- ------- ------- -------
Total net revenues............ 5,763 7,126 18,415 23,943 45,989
------- ------- ------- ------- -------
Cost of revenues.................. 3,764 4,324 12,371 15,546 26,291
------- ------- ------- ------- -------
Gross profit...................... 1,999 2,802 6,044 8,397 19,698
------- ------- ------- ------- -------
Operating expenses:
Research and development........ 2,050 2,366 2,044 3,519 5,253
Sales and marketing............. 2,158 2,098 2,744 3,905 6,417
General and administrative...... 958 1,061 1,619 1,558 2,053
------- ------- ------- ------- -------
Total operating expenses...... 5,166 5,525 6,407 8,982 13,723
------- ------- ------- ------- -------
Income (loss) from operations..... (3,167) (2,723) (363) (585) 5,975
Interest and other expense, net... (42) (23) (406) (726) (683)
------- ------- ------- ------- -------
Income (loss) before provision for
income taxes..................... (3,209) (2,746) (769) (1,311) 5,292
------- ------- ------- ------- -------
Provision for income taxes........ 323 6 34 30 530
------- ------- ------- ------- -------
Net income (loss)................. $(3,532) $(2,752) $ (803) $(1,341) $ 4,762
======= ======= ======= ======= =======
Earnings (loss) per share:
Basic........................... $(10.80) $ (7.67) $ (1.37) $ (1.57) $ 3.22
------- ------- ------- ------- -------
Diluted......................... $(10.80) $ (7.67) $ (1.37) $ (1.57) $ 0.49
======= ======= ======= ======= =======
Shares used in per share
calculation:
Basic........................... 327 359 585 856 1,480
------- ------- ------- ------- -------
Diluted......................... 327 359 585 856 9,781
======= ======= ======= ======= =======
<CAPTION>
DECEMBER 31,
-------------------------------------------
1993 1994 1995 1996 1997
------- ------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-
term investments................. $ 898 $ 1,551 $ 3,800 $ 7,692 $29,008
Working capital................... 683 2,580 7,435 9,769 30,131
Total assets...................... 2,798 5,371 15,729 19,535 48,559
Long-term debt and capitalized
lease obligations, net of current
portion.......................... 202 508 2,219 5,499 2,435
Stockholders' equity.............. 1,102 3,306 9,512 9,098 33,327
</TABLE>

16
<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.

This Management's Discussion and Analysis of Financial Condition and Results
of Operations includes a number of forward-looking statements which reflect
the Company's current views with respect to future events and financial
performance. These forward-looking statements are subject to certain risks and
uncertainties, including those discussed in the "Risk Factors" and elsewhere
in this Form 10-K that could cause actual results to differ materially from
historical results or those anticipated. In this report, the words
"anticipates," "believes," "expects," "future," "intends," and similar
expressions identify forward-looking statements. Readers are cautioned not to
place undue reliance on these forward-looking statements, which speak only as
of the date hereof.

OVERVIEW

The Company designs, develops, manufactures and markets proprietary, high-
voltage, analog ICs for use in AC to DC power conversion primarily for the
cellular telephone, personal computer, cable and direct broadcast satellite
and various consumer electronics markets. From its inception in March 1988
through 1993, the Company developed numerous standard and custom products
incorporating high levels of features and functionality, each intended to
address the needs of various markets. Although the Company was successful in
developing the core of its patented technology during this period, market
penetration of its products was low because these products were not as cost-
effective as alternative discrete products. The limited product revenue,
combined with the high costs of developing and marketing numerous solutions to
numerous target markets, prevented the Company from achieving profitability.

In 1993, the Company changed its strategy to focus on bringing cost-
effective, integrated products to the high-voltage AC to DC power supply
markets. As a result, in 1994, the Company completed development of the first
of its TOPSwitch family of products. The TOPSwitch family of products, with a
proprietary integrated architecture, is designed to address with relatively
few products broad applications in a number of high-volume, high-voltage AC to
DC power supply markets. The initial target markets addressed by TOPSwitch are
particularly sensitive to size, portability, energy efficiency and time-to-
market. The TOPSwitch products and the solutions enabled by them are
significantly lower in costs than the Company's previous products and the
solutions enabled by those products. Commercial shipments of TOPSwitch began
in May 1994. Primarily as a result of the increasing sales of TOPSwitch
products, the Company's net revenues from product sales more than tripled
between 1994 and 1995, increasing from $5.0 million to $17.4 million. Net
revenues from product sales increased 34% from 1995 to 1996 and 92% from 1996
to 1997.

By focusing on the TOPSwitch family of products, the Company was able to
more effectively utilize its resources and limit the growth of operating
expenses in 1994 and 1995. Because of this and the growth in net revenues,
operating expenses were reduced from 77.5% of net revenues in 1994 to 34.8% of
net revenues in 1995. In response to increasing market acceptance of its
TOPSwitch products and faster revenue growth, in 1996 the Company accelerated
its investment in research and development and sales and marketing, including
technical customer support, and, as a result, operating expenses increased
from $6.4 million in 1995 to $9.0 million in 1996 and to $13.7 million in
1997. The Company expects that operating expenses will continue to increase in
absolute dollars, but will fluctuate as a percentage of net revenues, as it
continues to add resources to research and development, sales and marketing
and general and administrative activities.

The Company has experienced increased net revenues in each of the last six
quarters, achieved a positive income from operations in each of the last five
quarters, and achieved positive net income in each of the quarters ended June
30, 1997, September 30, 1997, and December 31, 1997. However, the prediction
of future operating results is difficult. The Company's future operating
results will depend on many factors, including the volume and timing of orders
received by the Company from its customers; competitive pressures on selling
prices; the volume and timing of orders placed by the Company with its
foundries; the availability of raw materials; fluctuations in manufacturing
yields, whether resulting from the transition to new foundries or from other
factors; changes in product mix; the Company's ability to introduce new
products and technologies on a timely basis;

17
<PAGE>

the introduction of products and technologies by the Company's competitors;
market acceptance of the Company's and its customers' products; the timing of
investments in research and development and sales and marketing; cyclical
semiconductor industry conditions; fluctuations in exchange rates,
particularly the exchange rates between the U.S. dollar and the Japanese yen;
changes in the international business climate and economic conditions
generally. There can be no assurance that the Company will be able to sustain
profitability on a quarterly or annual basis. See "Risk Factors--Unpredictable
and Fluctuating Operating Results."

The Company licenses certain technologies and grants limited product
manufacturing and marketing rights to strategic partners in return for foundry
relationships, license fees and product royalty arrangements. Prior to the
introduction of TOPSwitch in 1994, the Company's analog ICs generated limited
product sales while license fees and prepaid royalties accounted for a
significant percentage of the Company's total revenues. In future periods, the
Company expects license fees and royalties to consist primarily of royalties
on products shipped by licensees incorporating licensed technology, and
anticipates that license fees and royalties will account for a small
percentage of net revenues. The Company does not expect significant prepaid
license fees from future license agreements.

A significant portion of the Company's cost of revenues consists of the cost
of wafers. The Company's contracts for its foundries' services are denominated
in Japanese yen. Changes in the exchange rate between the U.S. dollar and the
Japanese yen subject the Company's gross profit and operating results to the
potential for material fluctuations. From time to time, as the Company's
strategic partners close old production lines and move to new fabrication
facilities, the Company must absorb a portion of the costs of physically
moving the manufacturing of the Company's products to new production lines,
including the costs of installation of new process technologies. See "Risk
Factors--Dependence on Wafer Suppliers," "Risk Factors--Risks of Foreign
Manufacturers and Assemblers," "Business--Sales, Distribution and Marketing"
and "Business--Manufacturing."

Product revenues consist of sales to OEMs and merchant power supply
manufacturers and to distributors. Revenues from product sales to OEMs and
merchant power supply manufacturers are recognized upon shipment. At that
time, the Company provides for estimated sales returns and other allowances
related to those sales. Approximately half of the Company's sales are made to
distributors under terms allowing certain rights of return and price
protection for the Company's products held in the distributors' inventories.
Therefore, the Company defers recognition of revenue and the proportionate
cost of revenues derived from sales to distributors until such distributors
resell the Company's products to their customers. The gross profit deferred as
a result of this policy is reflected as "deferred income on sales to
distributors" on the Company's consolidated balance sheet. See Note 2 of Notes
to Consolidated Financial Statements.

18
<PAGE>

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
PERCENTAGE OF
TOTAL NET REVENUES
YEAR ENDED DECEMBER 31,
---------------------------
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Net revenues:
Product sales.................................... 94.5% 97.4% 97.5%
License fees and royalties....................... 5.5 2.6 2.5
------- ------- -------
Total net revenues............................. 100.0 100.0 100.0
------- ------- -------
Cost of revenues................................... 67.2 64.9 57.2
------- ------- -------
Gross profit....................................... 32.8 35.1 42.8
------- ------- -------
Operating expenses:
Research and development......................... 11.1 14.7 11.4
Sales and marketing.............................. 14.9 16.3 14.0
General and administrative....................... 8.8 6.5 4.4
------- ------- -------
Total operating expenses....................... 34.8 37.5 29.8
------- ------- -------
Income (loss) from operations...................... (2.0) (2.4) 13.0
Interest and other expense, net.................... (2.2) (3.1) (1.5)
------- ------- -------
Income (loss) before provision for income taxes.... (4.2) (5.5) 11.5
------- ------- -------
Provision for income taxes......................... .2 .1 1.1
------- ------- -------
Net income (loss).................................. (4.4)% (5.6)% 10.4%
======= ======= =======
</TABLE>

COMPARISON OF YEARS ENDED DECEMBER 31, 1996 AND 1997

Net revenues. Net revenues consist of revenues from product sales, which are
calculated net of returns and allowances, plus license fees and royalties paid
by licensees of the Company's technology. Net revenues increased 92.1% from
$23.9 million in 1996 to $46.0 million in 1997. Net revenues from product
sales represented $23.3 million and $44.8 million of net revenues in 1996 and
1997, respectively. The increase in net revenues from product sales was due
primarily to increased sales of the Company's TOPSwitch family of products
and, to a lesser extent, initial sales of the TOPSwitch-II family of products,
which began commercial shipment in April 1997. Net revenues also grew because
of an increase in royalty revenues, from $619,000 to $1.2 million in the two
periods, respectively.

International sales increased by $19.4 million in 1997 compared to 1996,
growing from approximately 72% of net revenues in 1996 to approximately 81% of
net revenues in 1997. Although the power supplies using the Company's products
are designed and distributed worldwide, most of such power supplies are
manufactured in Asia. As a result, the largest portion of the Company's
revenues is derived from sales to this region. The Company expects
international revenue to continue to account for a large portion of the
Company's net revenues. See "Risk Factors--Risks of International Sales."

For the year ended December 31, 1997, net revenues from two different
customers accounted for approximately 15% and 21% of net revenues. For the
year ended December 31, 1996, no individual customers accounted for more than
10% of net revenues. See "Risk Factors--Customer Concentration and Competing
Products from Customers" and Note 2 of Notes to Consolidated Financial
Statements.

Gross profit. Gross profit is equal to net revenues less cost of revenues.
The Company's cost of revenues consists primarily of costs associated with the
purchase of wafers from MEC and OKI, the assembly and

19
<PAGE>

packaging of its products, and internal labor and overhead associated with the
testing of both wafers and packaged components. These costs include expenses
incurred in connection with the physical move of the manufacturing of the
Company's products between wafer production lines at both of its foundry
suppliers and with the installation of new process technologies at these
foundries, which may recur from time to time and adversely effect the
Company's cost of revenues.

Gross profit increased from $8.4 million, or 35.1% of net revenues, to $19.7
million, or 42.8% of net revenues, in 1996 and 1997, respectively, due to the
combined effects of the absorption of certain fixed costs over the increased
sales volume, lower prices for wafers, partially as a result of favorable
foreign exchange rates, and improved packaging costs. During this period the
Company experienced an improved foreign exchange rate between the U.S. dollar
and the Japanese yen, contributing approximately $895,000, or approximately
4.6 percentage points, of the gross profit. Gross profit in future periods may
be influenced by fluctuations in the exchange rate between the U.S. dollar and
the Japanese yen.

Research and development expenses. Research and development expenses consist
primarily of employee-related expenses, expensed material and facility costs
associated with the development of new processes and new products. The Company
also expenses prototype wafers and mask sets related to new products as
research and development costs until new products are released to production.
Research and development expenses increased by 49.3%, from $3.5 million in
1996 to $5.3 million in 1997. The increase was primarily the result of
increased salaries and other costs related to the hiring of additional
engineering personnel, outside consulting fees and expensed prototype
materials resulting from the transition of foundry manufacturing processes
with MEC and OKI. These expenses decreased as a percentage of net revenues
from 14.7% in 1996 to 11.4% in 1997 due to increased sales. The Company
expects that research and development expenses will continue to increase in
absolute dollars but will fluctuate as a percentage of net revenues.

Sales and marketing expenses. Sales and marketing expenses consist primarily
of employee-related expenses, commissions to sales representatives and
facilities expenses, including expenses associated with the Company's regional
sales and support offices. Sales and marketing expenses increased 64.3%, from
$3.9 million in 1996 to $6.4 million in 1997, which represented 16.3% and
14.0% of net revenues, respectively. This increase represents the addition of
personnel to support international sales and field application engineers. The
Company expects that sales and marketing expenses will continue to increase in
absolute dollars but will fluctuate as a percentage of net revenues.

General and administrative expenses. General and administrative expenses
consist primarily of employee-related expenses for administration, finance,
human resources and general management, and legal and auditing expenses. In
1996 and 1997, general and administrative expenses were $1.6 million and $2.1
million, respectively, which represented 6.5% and 4.4% of net revenues,
respectively. This increase in absolute dollars is attributable to additional
headcount to support the growth in the volume of sales. The Company expects
that general and administrative expenses will continue to increase in absolute
dollars but will fluctuate as a percentage of net revenues.

Interest and other expense, net. Interest and other expense, net, of
$726,000 and $683,000 in 1996 and 1997, respectively, reflects interest
incurred by the Company on its capital equipment lease obligations and on the
$3.0 million of subordinated debt originated in the second quarter of 1996,
partially offset by interest income earned on its cash and short-term
investments. The Company repaid the subordinated debt with proceeds from its
initial public offering and expects to continue to utilize term debt to
finance its capital equipment needs.

Provision for income taxes. Provision for taxes for 1996 and 1997 represents
Federal, state and foreign taxes. The increase in the effective rate from 2.3%
for 1996 to 10.0% for 1997 reflects the profitable results for the 1997
period. The difference between the statutory rate and the Company's effective
tax rate for 1997 is due to the impact of benefiting net operating loss
carryforwards offset partially by a change in the deferred tax valuation
allowance. As of December 31, 1997, the Company had net operating loss
carryforwards for Federal and state income tax reporting purposes of
approximately $14.3 million and $2.5 million, respectively, which expire at
various dates through 2011. Utilization of the net operating loss
carryforwards will be subject to an

20
<PAGE>

annual limitation due to the ownership change limitations provided by the
Internal Revenue Code of 1986, as amended, and similar state provisions. See
Note 7 of Notes to Consolidated Financial Statements.

COMPARISON OF YEARS ENDED DECEMBER 31, 1995 AND 1996

Net Revenues. Net revenues were $18.4 million and $23.9 million in 1995 and
1996, respectively. Net revenues from product sales were $17.4 million and
$23.3 million in the same two years, respectively, reflecting the growth in
the Company's TOPSwitch family of products, which comprised 68% and 79% of net
revenues from product sales in 1995 and 1996, respectively. For 1995, three
customers accounted for approximately 12%, 20% and 21% of net revenues. For
1996, no individual customer accounted for more than 10% of net revenues. See
Note 2 of Notes to Consolidated Financial Statements. License fees consisted
of payments from foundry and technology licensing agreements with MEC and OKI
and a prior foundry. License fees have declined as fees payable pursuant to
license agreements executed in June 1990 and June 1993 sequentially declined
in accordance with the terms of those agreements. In future periods, the
Company expects license fees and royalties to consist primarily of royalties
paid on shipments by MEC and OKI of products that incorporate the Company's
licensed technologies.

Gross profit. Gross profit was $6.0 million and $8.4 million, representing
32.8% and 35.1% of net revenues, in 1995 and 1996, respectively. The increase
in gross profit in absolute dollars and as a percent of net revenues in 1996
over 1995 continued to reflect the absorption of fixed costs over a larger
sales volume and reductions in prices for wafers, partially as a result of
favorable exchange rates, and packaged assemblies.

Research and development expenses. Research and development expenses were
$2.0 million and $3.5 million, which represented 11.1% and 14.7% of net
revenues, in 1995 and 1996, respectively. Research and development expenses
increased 72.2% in 1996 compared to 1995 due to decisions to invest more
heavily in the development of the Company's technology to expand the cost
effective power range of the Company's TOPSwitch products. However, there can
be no assurance that the Company's increased research and development
activities will be successful or will lead to increased sales of the Company's
current or future products.

Sales and marketing expenses. Sales and marketing expenses were $2.7 million
and $3.9 million, which represented 14.9% and 16.3% of net revenues, in 1995
and 1996, respectively. This increase in absolute dollars reflected the
addition of staff in both sales and application engineering to improve the
Company's ability to facilitate customers' use of the Company's products in
the design of new power supplies for specific applications. The increased
spending also reflects higher commissions resulting from the increase in sales
volume. The fluctuation in sales and marketing expense as a percentage of net
revenues reflects primarily the increase in sales.

General and administrative expenses. General and administrative expenses
were $1.6 million in both 1995 and 1996, which represented 8.8% and 6.5% of
net revenues, in 1995 and 1996, respectively. As a percentage of net revenues,
general and administrative expenses decreased, reflecting primarily the
increase in sales.

Interest and other expense, net. Interest and other expense, net, was
$406,000 and $726,000, representing 2.2% and 3.1% of net revenues, in 1995 and
1996, respectively. The increase reflects increases in borrowings under the
Company's capital lease lines, primarily to finance the addition of test
equipment to expand capacity to meet the increased volume of sales and, in
1996, the addition of $3.0 million in subordinated debt to provide additional
cash to support operations.

Provision for income taxes. Provision for income taxes during 1995 and 1996
represented Federal and state minimum taxes and foreign taxes. As of December
31, 1996, the Company had net operating loss carryforwards for Federal and
state income tax reporting purposes of approximately $23.0 million and $6.5
million, respectively, which expire at various dates through 2011. Utilization
of the net operating loss carryforwards will be subject to an annual
limitation due to the ownership change limitations provided by the Internal
Revenue Code of 1986, as amended, and similar state provisions. See Note 7 of
Notes to Consolidated Financial Statements.

21
<PAGE>

SELECTED QUARTERLY RESULTS OF OPERATIONS

The following tables set forth certain consolidated statement of operations
data for each of the quarters in the years ended December 31, 1996 and 1997,
as well as the percentage of the Company's net revenues represented by each
item. This information has been derived from the Company's unaudited
consolidated financial statements. The unaudited consolidated financial
statements have been prepared on the same basis as the audited consolidated
financial statements contained herein and include all adjustments, consisting
only of normal recurring adjustments, that the Company considers necessary for
a fair presentation of such information when read in conjunction with the
Company's annual audited Consolidated Financial Statements and Notes thereto
appearing elsewhere in this report. The results of operations for any quarter
are not necessarily indicative of the results for any subsequent period or for
the entire fiscal year.

<TABLE>
<CAPTION>
QUARTER ENDED
-------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net revenues:
Product sales.......... $6,045 $5,247 $5,354 $6,678 $6,831 $9,878 $12,959 $15,159
License fees and
royalties............. 78 127 204 210 235 171 384 372
------ ------ ------ ------ ------ ------ ------- -------
Total net revenues.... 6,123 5,374 5,558 6,888 7,066 10,049 13,343 15,531
------ ------ ------ ------ ------ ------ ------- -------
Cost of revenues........ 4,040 3,544 3,740 4,222 4,321 5,789 7,492 8,689
------ ------ ------ ------ ------ ------ ------- -------
Gross profit............ 2,083 1,830 1,818 2,666 2,745 4,260 5,851 6,842
------ ------ ------ ------ ------ ------ ------- -------
Operating expenses:
Research and
development........... 705 886 968 960 1,077 1,215 1,404 1,557
Sales and marketing.... 805 926 1,015 1,159 1,105 1,464 1,839 2,009
General and
administrative........ 398 355 439 366 410 430 620 593
------ ------ ------ ------ ------ ------ ------- -------
Total operating
expenses............. 1,908 2,167 2,422 2,485 2,592 3,109 3,863 4,159
------ ------ ------ ------ ------ ------ ------- -------
Income (loss) from
operations............. 175 (337) (604) 181 153 1,151 1,988 2,683
Interest and other
expense, net........... (138) (189) (178) (221) (214) (139) (196) (134)
------ ------ ------ ------ ------ ------ ------- -------
Income (loss) before
provision for
income taxes........... 37 (526) (782) (40) (61) 1,012 1,792 2,549
Provision for income
taxes.................. 2 8 6 14 10 57 306 157
------ ------ ------ ------ ------ ------ ------- -------
Net income (loss)....... $ 35 $ (534) $ (788) $ (54) $ (71) $ 955 $ 1,486 $ 2,392
====== ====== ====== ====== ====== ====== ======= =======
Earnings (loss) per
share
Basic.................. $ 0.04 $(0.63) $(0.91) $(0.06) $(0.08) $ 1.08 $ 0.91 $ 0.95
Diluted................ $ -- $(0.63) $(0.91) $(0.06) $(0.08) $ 0.09 $ 0.14 $ 0.22
Shares used in per share
calculation
Basic.................. 835 848 866 873 876 886 1,632 2,507
Diluted................ 9,563 848 866 873 876 10,307 10,761 10,852
</TABLE>

<TABLE>
<CAPTION>
PERCENTAGE OF TOTAL NET REVENUES
----------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net revenues:
Product sales.......... 98.7% 97.6% 96.3% 97.0% 96.7% 98.3% 97.1% 97.6%
License fees and
royalties............. 1.3 2.4 3.7 3.0 3.3 1.7 2.9 2.4
----- ----- ----- ----- ----- ----- ----- -----
Total net revenues.... 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
----- ----- ----- ----- ----- ----- ----- -----
Cost of revenues........ 66.0 65.9 67.3 61.3 61.2 57.6 56.1 56.0
----- ----- ----- ----- ----- ----- ----- -----
Gross profit............ 34.0 34.1 32.7 38.7 38.8 42.4 43.9 44.0
----- ----- ----- ----- ----- ----- ----- -----
Operating expenses:
Research and
development........... 11.5 16.5 17.4 13.9 15.2 12.1 10.5 10.0
Sales and marketing.... 13.1 17.2 18.3 16.8 15.6 14.6 13.8 12.9
General and
administrative........ 6.5 6.7 7.9 5.4 5.9 4.2 4.7 3.8
----- ----- ----- ----- ----- ----- ----- -----
Total operating
expenses............. 31.1 40.4 43.6 36.1 36.7 30.9 29.0 26.7
----- ----- ----- ----- ----- ----- ----- -----
Income (loss) from
operations............. 2.9 (6.3) (10.9) 2.6 2.1 11.5 14.9 17.3
Interest and other
expense, net........... (2.3) (3.5) (3.2) (3.2) (3.0) (1.4) (1.5) (0.9)
----- ----- ----- ----- ----- ----- ----- -----
Income (loss) before
provision for income
taxes.................. 0.6 (9.8) (14.1) (0.6) (0.9) 10.1 13.4 16.4
Provision for income
taxes.................. -- 0.1 0.1 0.2 0.1 0.6 2.3 1.0
----- ----- ----- ----- ----- ----- ----- -----
Net income (loss)....... 0.6% (9.9)% (14.2)% (0.8)% (1.0)% 9.5% 11.1% 15.4%
===== ===== ===== ===== ===== ===== ===== =====
</TABLE>

22
<PAGE>

Net revenues in the second and third quarters of 1996 decreased from net
revenues in the first quarter of 1996 due primarily to the termination of a
significant PC desktop program by one of the Company's end-users. The
Company's net revenues increased in each of the six consecutive quarters
through the quarter ended December 31, 1997, primarily due to increased
shipments of the Company's TOPSwitch family of products. These increased
shipments were due to growth in the volume of sales from existing customers,
the addition of new customers and, in the second quarter of 1997, the
introduction of the TOPSwitch II product family. See "Risk Factors--
Unpredictable and Fluctuating Operating Results."

The Company's gross profit generally increased as a percentage of net
revenues during each of the eight quarters ended December 31, 1997. Gross
profit as a percentage of net revenues in the third quarter of 1996 declined
due to the lower absorption of manufacturing costs resulting from a reduced
level of production as the Company worked off excess inventories.

Research and development expenses generally increased in absolute terms
during the eight quarters presented, primarily due to increased staffing in
the areas of new product design and technology development. As a percentage of
net revenues, research and development expenses increased in the second and
third quarters of 1996 over the first quarter due to an increase in expenses
resulting from additional staffing and a lower net revenue base. During the
five quarters ended December 31, 1997, research and development expenses
fluctuated as a percentage of net revenues. The decline as a percentage of net
revenues in each of the quarters ended June 30, 1997, September 30, 1997 and
December 31, 1997 was due to an increase in net revenues.

Sales and marketing expenses generally increased in absolute dollars over
the eight quarters presented, primarily due to the additional staffing in
sales and application engineering and increased sales commissions due to the
increased revenues from product sales.

General and administrative expenses increased only slightly during the eight
quarters and fluctuated overall as a percentage of net revenues as net
revenues increased.

Interest and other expense, net, increased in the third and fourth quarters
of 1996 due to the increase in interest expense resulting from increased
borrowings under the Company's capital lease lines, and interest expense
resulting from the $3.0 million subordinated debt incurred in May of 1996. The
fluctuation of interest and other expenses, net, in each of the four quarters
of 1997, is due to increased interest income from higher cash balances created
by a net positive cash flow and cash proceeds from the Company's initial
public offering.

LIQUIDITY AND CAPITAL RESOURCES

In December 1997, the Company completed the initial public offering of its
common stock. The Company sold 2,700,000 shares of common stock raising
approximately $20.1 million in gross proceeds. Prior to its public offering,
the Company financed its operations from revenues from product sales and
proceeds from the private sales of preferred and common stock. The Company has
also funded operations through the sales of technology licenses and
engineering design services, and various capital equipment lease lines with
terms extending from thirty-six to forty-eight months, and an $8.0 million
revolving line of credit with Imperial Bank. A portion of the credit line is
used to back up letters of credit which the Company provides to MEC and OKI
prior to the shipment of wafers by the foundries to the Company. The balance
of this line is unused and available. The line of credit is secured by
substantially all of the Company's assets. The line of credit agreement
contains financial covenants and requires that the Company maintain
profitability on a quarterly basis and not pay or declare dividends without
the bank's consent.

The Company has financed a significant portion of its machinery and
equipment through capital equipment leases. In May 1997, the Company entered
into a new capital equipment lease line of credit with Finova Capital
Corporation which allows for combined borrowings up to $3.0 million to finance
the acquisition of property and equipment. Approximately $1.4 million was
available at December 31, 1997 under this line of credit. At

23
<PAGE>

December 31, 1997, the Company owed approximately $4.2 million on its various
capital equipment leases. See Note 5 of Notes to Consolidated Financial
Statements.

As of December 31, 1997, the Company had working capital, defined as current
assets less current liabilities, of $30.1 million, which was an increase of
approximately $20.4 million over December 31, 1996. The increase was primarily
due to the cash generated from the Company's initial public offering in
December 1997.

At December 31, 1997, the Company had cash, cash equivalents and short-term
investments of $29.0 million and no borrowings outstanding on its bank line of
credit. The Company's operating activities generated cash of $1.1 million and
$8.1 million in 1996 and 1997, respectively. Cash generated in 1996 reflects
an increase in depreciation and amortization and a decrease in accounts
receivable and inventories. Cash generated in 1997 was principally the result
of net income, depreciation and amortization, and an increase in accounts
payable and accrued liabilities, partially offset by increases in accounts
receivable and inventories.

The Company's investing activities used cash of $4.2 million and $484,000 in
1996 and 1997, respectively. In 1996, cash used for investing activities was
primarily for purchases of short-term investments and the balance was for
purchases of equipment and leasehold improvements. Financing activities
provided $3.3 million and $14.7 million of net cash during 1996 and 1997,
respectively, primarily due to the issuance of common stock.

At December 31, 1997, the Company had net operating loss carryforwards for
Federal and state tax reporting purposes of approximately $14.3 million and
$2.5 million, respectively, expiring at various dates through 2011. The public
offering on December 12, 1997 will cause an annual limitation on the Company's
use of its net operating loss carryforwards pursuant to the "change in
ownership" provisions of Section 382 of the Internal Revenue Code of 1986, as
amended. See Note 7 of Notes to Consolidated Financial Statements.

The Company believes that cash generated from operations, together with its
existing sources of liquidity and the net proceeds to the Company from the
public offering, will satisfy the Company's projected working capital and
other cash requirements for at least the next 12 months.

NEW ACCOUNTING STANDARDS

In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive
Income," which establishes standards for reporting and presentation of
comprehensive income. SFAS No. 130, which will be adopted by the Company in
the first quarter of 1998, requires companies to report a new measure of
income. "Comprehensive Income" is to include foreign currency translation
gains and losses and other unrealized gains and losses that have historically
been excluded from net income and reflected instead in equity. The Company
anticipates that SFAS No. 130 will not have a material impact on its financial
statements.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures About Segments of an Enterprise and Related Information," which
establishes standards for disclosure of segment information. SFAS No. 131 will
be adopted by the Company in the first quarter of 1998. The Company
anticipates that SFAS No. 131 will not have a material impact on its financial
statement.

RISK FACTORS

In addition to the other information in this Form 10-K, the following
factors should be considered carefully in evaluating the Company and its
business before purchasing shares of the Company's stock.

Unpredictable and Fluctuating Operating Results. The Company's quarterly and
annual revenues and operating results have varied significantly in the past,
are difficult to forecast, are subject to numerous factors both within and
outside of the Company's control, and may fluctuate significantly in the
future. Although the

24
<PAGE>

Company was profitable in each of the last three quarters in 1997, there can
be no assurance that the Company will continue to be profitable in future
periods. The Company believes that period-to-period comparisons are not
necessarily meaningful and should not be relied upon as indicative of future
operating results. The Company believes that the growth in revenues and
operating income in 1997 compared to 1996 resulted in large part from a
combination of factors relating to transitions in the Company's strategy,
increasing market acceptance of the Company's TOPSwitch products and customer
ordering patterns. Similar growth rates are not expected in future periods.

The Company's revenues and operating results are substantially dependent
upon the volume and timing of orders received by the Company from its
customers. The Company's lengthy sales cycle limits its visibility regarding
future financial performance. The Company is also subject to the risks to
which the markets for its customers' or end users' products are subject and to
technological or other changes in those markets, which may affect customer
buying patterns. In addition, the ordering patterns of some of the Company's
existing large customers have been unpredictable in the past, and the Company
expects that customer ordering patterns will continue to be unpredictable in
the future. Not only does the volume of units ordered by particular customers
vary substantially from period to period, but purchase orders received from
particular customers often vary substantially from early oral estimates
provided by those customers to the Company for planning purposes. The
Company's business is characterized by short-term customer orders and shipment
schedules, and customer orders typically can be canceled or rescheduled
without significant penalty to the customer. The Company has in the past
experienced customer cancellations of substantial orders for reasons beyond
the Company's control, and significant cancellations could occur again at any
time in the future.

The Company's revenues and operating results are also subject to competitive
pressures on selling prices. Historically, average selling prices of products
in the semiconductor and the high-voltage AC to DC power supply industries
have decreased over the lives of the products. If the Company is unable to
successfully introduce new products with higher average selling prices or is
unable to reduce manufacturing costs to offset expected decreases in the
prices of its existing products, the Company's operating margins will be
adversely affected.

The Company's operating results are also substantially dependent upon the
volume and timing of orders placed by the Company with its foundries. Due to
the absence of substantial noncancellable backlog, the Company must plan its
production and inventory levels based on internal forecasts of customer
demand, which is unpredictable and may fluctuate substantially. Because of
recent increases in demand for its products, the Company is currently seeking
to increase the level of its inventories. If the Company underestimates the
number of units required to meet customer demand and fails to maintain
adequate inventory levels, the Company may lose significant revenue
opportunities and may lose market share to competitors. On the other hand, if
the Company overestimates the number of units required to meet customer
demand, the Company's operating results may be materially and adversely
affected as a result of costs associated with carrying excess inventory and
with obsolescence. Excess inventory and obsolescence costs could be further
increased by any unestimated returns from the Company's distributors or
customers.

Other factors which may affect the Company's revenues and operating results
include the availability of raw materials; fluctuations in manufacturing
yields, whether resulting from the transition to new foundries or from other
factors; changes in product mix including the impact of new product
introduction on existing products; the Company's ability to develop and bring
to market new products and technologies on a timely basis; introduction of
products and technologies by the Company's competitors; market acceptance of
the Company's and its customers' products; the timing of investments in
research and development and sales and marketing; cyclical semiconductor
industry conditions; fluctuations in exchange rates, particularly exchange
rates between the U.S. dollar and the Japanese yen; changes in the
international business climate; and economic conditions generally.

The Company's operating results in a future quarter or quarters are likely
to fall below the expectations of public market analysts or investors. In such
an event, the price of the Company's common stock will likely be

25
<PAGE>

materially and adversely affected. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations."

Limited History of Profitability; Accumulated Deficit. Since inception the
Company has incurred significant losses and negative cash flow. At December
31, 1997, the Company had cumulative net losses of $22.0 million, with net
losses of $803,000 and $1.3 million for 1995 and 1996 respectively, and a net
profit of $4.8 million for 1997. Although the Company achieved a positive net
income for the year ended December 31, 1997, there can be no assurance that
the Company will achieve profitability in any future quarterly or annual
periods, and recent operating results should not be considered indicative of
future financial performance. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Concentration of Applications. A limited number of applications of the
Company's products, primarily in the cellular phone battery chargers and
desktop PC stand-by markets, currently account for the majority of the
Company's revenues. Although the exact dollar amounts and percentages of sales
for use in particular markets are difficult to ascertain because such sales
occur through distributors or indirectly through sales to power supply
manufacturers, during 1997, approximately 28% of the Company's revenues were
attributable to use of the Company's products in power supplies for cellular
phone battery chargers and approximately 21% of the Company's revenues were
attributable to the use of the Company's products in desktop PC stand-by power
supplies. The Company expects that its revenues and operating results will
continue to be substantially dependent upon these markets for the foreseeable
future. The cellular phone and desktop PC markets can be highly cyclical and
have been subject to significant economic downturns at various times,
characterized by diminished product demand, accelerated erosion of average
selling prices and production over capacity. The Company may experience
substantial period-to-period fluctuations in future operating results due to
general conditions of these markets. The Company's revenues and operating
results are subject to many of the risks to which the markets for these
applications are subject, and may also be impacted by technological or other
developments in these markets. In particular, recent advances in battery
technology which offer competitive advantages to the OEMs of cellular
telephones permit such OEMs, including Motorola, to lower, or consider
lowering, the wattage level of the power supplies used to recharge batteries.
As the output power drops below approximately 5 watts, older technological
alternatives to switchers can be more cost effective than any of the Company's
current products. While the Company continues its efforts to enhance the cost
effectiveness of TOPSwitch-based switchers, there can be no assurance that the
Company will be successful in its efforts, and, in the absence of a successful
competitive response by the Company, demand for the Company's products would
be materially adversely affected. Similarly, if a competitor of the Company
successfully and cost effectively combines desktop PC stand-by power supplies
with the main PC desktop power supplies prior to such combination by the
Company, demand for the Company's products could be materially adversely
affected. The Company believes that its future success will depend in part
upon its ability to penetrate additional markets for its products, and there
can be no assurance that the Company will be able to overcome the marketing or
technological challenges necessary to do so. To the extent that a competitor
penetrates additional markets before the Company is able to do so, or takes
market share from the Company in its existing markets, the Company's strategy
to be the leading provider of high-voltage power conversion ICs, and the
Company's revenues, financial condition and operating results would be
materially adversely affected. See "Business--Markets & Customers."

Customer Concentration and Competing Products from Customers. The Company's
end user base is highly concentrated and a relatively small number of OEMs,
directly or indirectly through merchant power supply manufacturers, accounted
for a significant portion of the Company's revenue in 1996 and 1997. Motorola
is presently the Company's largest end user. Although the exact dollar amounts
and percentages of sales to Motorola are difficult to ascertain because most
of such sales occur through distributors or indirectly through sales to
merchant power supply manufacturers which, in turn, sell power supplies to
Motorola, the Company estimates that direct and indirect sales to Motorola
accounted for approximately 20% of the Company's net revenues for the year
ended December 31, 1997.

The Company estimates that its top ten customers, including distributors
which resell to Motorola and other large OEMs and merchant power supply
manufacturers, accounted for 64% and 67% of the Company's net

26
<PAGE>

revenues for 1996 and 1997, respectively. The Company expects that it will
continue to be dependent upon a relatively limited number of customers for a
significant portion of its net revenues in future periods, although no
customer is presently obligated either to purchase a specified amount of
products or to provide the Company with binding forecasts of product purchases
for any period. The Company's products are typically one of many components
used in a larger product produced by the Company's customers. Demand for the
Company's products is therefore subject to many risks beyond the Company's
control, including, among others, competition faced by the Company's customers
in their particular end markets, market acceptance of the products of the
Company's customers, technical challenges which may or may not be related to
the components supplied by the Company, the technical, sales and marketing and
management capabilities of the Company's customers and the financial and other
resources of the Company's customers. Certain divisions within Motorola have
developed products intended to compete with TOPSwitch, as has Samsung, another
customer of the Company's products. The Company believes that it has been
successful in competing against such internally developed products to date,
but there can be no assurance that it will not in the future lose sales as a
result of such competing products. The reduction, delay or cancellation of
orders from Motorola or one of the Company's other significant customers, or
the discontinuance of the Company's products by the Company's end users, could
materially and adversely affect the Company's business, financial conditions
and results of operations. The Company has experienced such effects in the
past and there can be no assurance that any of the Company's customers will
not reduce, cancel or delay orders in the future. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations."

Slower Growth Rates in Orders from Significant Customers. As Motorola
continues to shift to cellular phone chargers with power ranges below 5 watts
and, in certain lower end products, trades form factor and functionality for
additional cost savings, Motorola may increase its usage of solutions based on
older technologies rather than switchers. As a result of these or other
factors, there is no assurance that direct or indirect orders from Motorola
will not decline from levels experienced in prior quarters. If the Company's
current efforts to enhance the cost-effectiveness of solutions utilizing
TOPSwitch and other attempts to offset any reduction in orders from other
customers are not successful, the Company's business, financial condition and
operating results will be materially and adversely affected.

Dependence on Wafer Suppliers. The Company outsources all of its
semiconductor manufacturing and product assembly except for testing and
finishing. The Company has supply arrangements for the production of wafers
with MEC and OKI. Although certain aspects of the Company's relationships with
MEC and OKI are contractual, many important aspects of these relationships
depend on the continued cooperation of these strategic partners and, in many
instances, the parties' course of conduct deviates from the literal provisions
of the contracts. There can be no assurance that the Company and its strategic
partners will continue to work together successfully in the future or that
either MEC or OKI will not seek an early termination of its wafer supply
agreement with the Company. See "Business--Manufacturing."

The Company's wafer supply contracts with OKI and MEC terminate in June 1998
and June 2000, respectively. There can be no assurance that the Company will
be able to reach an agreement with either company to extend the term of its
respective wafer supply agreements. The Company's failure to reach, in a
timely fashion, an extension of either agreement or to enter into an
arrangement with another manufacturer, could result in material disruptions in
supply. Certain contractual provisions limit the conditions under which the
Company can enter into such arrangements with other Japanese manufacturers or
their subsidiaries during the term of the agreement with MEC. In addition, the
Company's products do not require leading edge device process geometries. As
device process geometries become increasingly smaller and as demand for such
smaller geometries increases, MEC and OKI may decide at some point to convert
all of their manufacturing processes to smaller geometries in response to
these industry trends. In the event of a supply disruption with OKI or MEC, if
the Company were unable to qualify alternative manufacturing sources for
existing or new products in a timely manner or if such sources were unable to
produce wafers with acceptable manufacturing yields, the Company's business,
financial condition and operating results would be materially and adversely
affected. The Company estimates that it would take between 9 to 12 months from
the time an alternate manufacturing source is identified

27
<PAGE>

for such source to produce wafers with acceptable manufacturing yields in
sufficient quantities to meet the Company's needs. See "Business--
Manufacturing."

The Company typically receives shipments from MEC or OKI in approximately 12
to 14 weeks after placing orders, and lead times for new products can be
substantially longer. To provide sufficient time for assembly, testing and
finishing, the Company typically needs to receive wafers from MEC or OKI 4 to
6 weeks before the desired ship date to the Company's customers. As a result
of these factors and the fact that customers' orders can be made with little
advance notice, the Company has only a limited ability to react to
fluctuations in demand for its products, which could cause the Company to have
an excess or a shortage of inventory of a particular product. From time to
time in the past, the Company has been unable to fully satisfy customer
requests as a result of these factors. Any significant disruptions in
deliveries would materially and adversely affect the Company's business and
operating results. Although the Company provides OKI and MEC with rolling
forecasts of its production requirements, the ability of MEC or OKI to provide
wafers to the Company is limited by the available capacity of the foundry in
which it manufactures wafers for the Company. An increased need for capacity
to meet internal demands or demands of other customers could cause MEC and OKI
to reduce capacity available to the Company. MEC and OKI may also require the
Company to pay amounts in excess of contracted or anticipated amounts for
wafer deliveries or require that the Company make other concessions in order
to acquire the wafer supply necessary to meet the Company's customers'
requirements. Any such concessions could materially adversely affect the
Company's business, financial condition or operating results. See "Business--
Manufacturing."

Risks of Outside Manufacturing and Assembly; Sole Source Risks. The Company
depends on MEC and OKI to produce wafers, and independent subcontractors to
assemble finished products, at acceptable yields and to deliver them to the
Company in a timely manner. The manufacture of the Company's TOPSwitch
products utilizes a CMOS process with a proprietary, highly sensitive implant
process step. To the extent the wafer foundries do not achieve acceptable
manufacturing yields or they experience product shipment delays, the Company's
financial condition or results of operations would be materially and adversely
affected. The Company's IC assembly process requires a sole source high-
voltage molding compound that is difficult to process. This compound and its
required processes, together with the other non-standard materials and
processes needed to assemble the Company's products, require a more exacting
level of process control than normally required for standard packages.
Unavailability of the sole source compound or problems with the assembly
process can materially and adversely affect yields and cost to manufacture.
Good production yields are particularly important to the Company's business
and financial results, including its ability to meet customers' demand for
products and to maintain profitability. As the Company continues to increase
its product output, there can be no assurance that the Company's foundries and
assemblers will not experience a decrease in yields. Moreover, there can be no
assurance that acceptable yields will be maintainable in the future.

Risks of Licensing Technology to Third Parties. MEC currently manufactures
and sells its versions of the Company's TOPSwitch families of products under
the right (exclusive during the term of the contract as to other Japanese
companies, except OKI, and their subsidiaries) granted by the Company to
manufacture and sell products using the Company's technology to Japanese
companies worldwide and to subsidiaries of Japanese companies located in Asia.
In certain circumstances, these products are redistributed by the Japanese
customers to their manufacturing operations in other regions. Beginning in
April 1997, the Company agreed not to sell its products in Japan to new
customers. The Company receives royalties on sales by MEC, although such
royalties are substantially lower than the gross profit the Company would
receive on direct sales. In addition, the royalties paid by MEC are
denominated in Japanese yen and are subject to risks inherent in exchange rate
fluctuations. Although the Company engages in sales, marketing and support
activities to encourage sales by MEC, should MEC fail to adequately promote
and deliver the Company's products, the Company's ability to take advantage of
the potentially large Japanese market for its products could be severely
limited. OKI has a similar, non-exclusive license arrangement with the Company
but it does not currently manufacture and sell products to third parties. See
"Business--Intellectual Property and Other Proprietary Rights." Should the
Company fail to negotiate acceptable royalty-bearing extensions to its
contracts with MEC or OKI (if OKI begins to actively

28
<PAGE>

exercise its license rights), substantial effort and expense would be required
for the Company to establish itself in this market directly or though a
different partner, and there can be no assurance that customers for MEC's or
OKI's products would not be lost to the Company during such a transition. In
addition, the licenses to MEC and OKI for many important aspects of the
Company's technology are perpetual, and there can be no assurance that MEC or
OKI will not use such technology rights, together with the information and
expertise it gains in its relationship with the Company, to develop or market
competing products following any termination of its relationships with the
Company or after termination of its royalty obligations to the Company. See
"Business--Sales, Distribution and Marketing."

Risks of International Sales. Sales to customers outside of the United
States were $11.3 million, $16.8 million and $36 million in 1995, 1996 and
1997, respectively, which represented 65%, 72% and 81% of net revenues for
such periods. These sales involve a number of inherent risks, including
imposition of government controls, currency exchange fluctuations, potential
insolvency of international distributors and representatives, reduced
protection for intellectual property rights in some countries, the impact of
recessionary environments in economies outside the United States, political
instability, generally longer receivables collection periods, tariffs and
other trade barriers and restrictions, and the burdens of complying with a
variety of foreign laws. Furthermore, because substantially all of the
Company's foreign sales are denominated in U.S. dollars, increase in the value
of the dollar would increase the price in local currencies of the Company's
products in foreign markets and make the Company's products relatively more
expensive and less price competitive than competitors' products that are
priced in local currencies. The Company is exposed to additional risks to the
extent that the products of its customers are subject to foreign currency or
other international risks. There can be no assurance that these factors will
not have an adverse effect on the Company's future international sales and,
consequently, on the Company's business, financial condition or operating
results.

Dependence on Foreign Manufacturers and Assemblers. Because the Company
depends on MEC and OKI, both located in Japan, for the manufacture of all of
its finished silicon wafers and on foreign assembly subcontractors of its
products, the Company is directly affected by the political and economic
conditions of the countries in which its wafers are or are expected to be
manufactured. To the extent that these conditions result in any prolonged work
stoppages or other inability of the Company to manufacture and assemble its
products, the Company's business, financial condition or results of operations
could be materially adversely affected. The Company's contracts with MEC and
OKI are denominated in Japanese yen, exposing the Company to the risk of
increase in the value of the yen against the U.S. dollar resulting in
increased costs for finished wafers which could not be readily passed through
to the Company's customers.

New Products and Technological Change. The Company's future success depends
in significant part upon its ability to develop new ICs for high-voltage power
conversion for existing and new markets, to introduce such products in a
timely manner and to have such products selected for design into products of
leading manufacturers. The development of these new devices is highly complex,
and from time to time the Company has experienced delays in completing the
development of new products. Successful product development and introduction
depends on a number of factors, including accurate new product definition,
timely completion and introduction of new product designs, availability of
foundry capacity, achievement of manufacturing yields and market acceptance of
the Company's and its customers' products. There can be no assurance that the
Company will be able to adjust to changing market demands as quickly and cost-
effectively as necessary to compete successfully. Furthermore, there can be no
assurance that the Company will be able to introduce new products in a timely
and cost-effective manner or in sufficient quantities to meet customer demand
or that such products will achieve market acceptance. The Company's or its
customers' failure to develop and introduce new products successfully and in a
timely manner would materially adversely affect the Company's business,
financial condition or operating results. Certain customers may defer or
return orders for existing products in response to the introduction of new
products. Although the Company maintains reserves against any such returns,
there can be no assurance that such resources will be adequate.

Lengthy Sales Cycle. The Company's products are generally incorporated into
a customer's products at the design stage. However, customer decisions to use
the Company's products (design wins), which can often

29
<PAGE>

require significant expenditures by the Company without any assurance of
success, often precede volume sales, if any, by a year or more. If a customer
decides at the design stage not to incorporate the Company's products into its
product, the Company will not have another opportunity for a design win with
respect to that product for many months or years. Because of such a lengthy
sales cycle, the Company may experience a delay between increasing expenses
for research and development and its sales and marketing efforts and the
generation of volume production revenues, if any, from such expenditures.
Moreover, the value of any design win will largely depend upon the commercial
success of the customer's product. There can be no assurance that the Company
will continue to achieve design wins or that any design win will result in
future revenues. Failure by the Company to timely develop and introduce
products that are incorporated into its customers' products could have a
material adverse effect on the Company's business, financial condition or
results of operations.

Product Quality, Performance and Reliability. The fabrication and assembly
of ICs is a highly complex and precise process. The Company expects that its
customers will continue to establish demanding specifications for quality,
performance and reliability that must be met by the Company's products. ICs as
complex as those offered by the Company often encounter development delays and
may contain undetected defects or failures when first introduced or after
commencement of commercial shipments. The Company has from time to time in the
past experienced product quality, performance or reliability problems. There
can be no assurance that defects or failures will not occur in the future
relating to the Company's product quality, performance and reliability that
may have a material adverse effect on the Company's operating results. If such
defects and failures occur, the Company could experience lost revenue,
increased costs (including warranty expense and costs associated with customer
support), delays in or cancellations or reschedulings of orders or shipments
and product returns or discounts, any of which would have a material adverse
effect on the Company's business, financial condition or operating results.

Competition. The high-voltage power supply industry is intensely competitive
and characterized by extreme price sensitivity. Accordingly, the most
significant competitive factor in the target markets for the Company's
products is cost effectiveness. The Company's products face competition from
alternative technologies, primarily discrete switchers. The Company believes
that at current pricing, the TOPSwitch families of products offer favorable
cost performance benefits compared to discrete switchers in many high-volume
applications over the power range of approximately 0.5 watts to 150 watts.
However, any significant erosion in the price of discrete components, such as
high voltage Bipolar and MOSFET transistors and PWM controller ICs, could
adversely affect the cost effectiveness of the TOPSwitch products. Also, older
alternative technologies to switchers are more cost-effective than switchers
that use the Company's TOPSwitch products in certain power ranges for certain
applications. If power requirements for certain applications in which the
Company's products are currently utilized, such as battery chargers for
cellular telephones, drop below certain power levels, these older alternative
technologies can be used more cost effectively than TOPSwitch-based switchers.
The Company is continuing its efforts to enhance the cost effectiveness of
TOPSwitch-based switchers in the lower power ranges. There can be no assurance
that the Company will be successful in these efforts.

Recently, the Company's TOPSwitch product families have begun to meet
additional competition from hybrid and single high-voltage ICs similar to
TOPSwitch. These competing products are being developed or have been developed
and are being produced by companies such as Motorola, SGS, Samsung and Sanken.
The Company expects competition to increase as Motorola, SGS, Samsung, Sanken
and possibly other companies develop and introduce new products. To the extent
these competitors' products are more cost-effective than the Company's
products, the Company's business, financial condition and results of
operations could be materially and adversely affected. Many of the Company's
emerging competitors, including Motorola, SGS, Samsung and Sanken, have
significantly greater financial, technical, manufacturing and marketing
resources than the Company. In the context of a market where a high-voltage IC
is designed into a customer's product and the provider of such ICs is
therefore the sole source of the IC for that product, greater resources and,
in particular, greater manufacturing resources, may be a significant factor in
the customer's choice of the IC because of the customer's perception of
greater certainty in its source of supply. See "Risk Factors--Customer
Concentration and Competing Products from Customers."

30
<PAGE>

The Company's ability to compete in its target markets also depends on such
factors as the timing and success of new product introductions by the Company
and its competitors, the pace at which the Company's customers incorporate the
Company's products into their end user products, availability of wafer
fabrication and finished good manufacturing capability, availability of
adequate sources of raw materials, protection of Company products by effective
utilization of intellectual property laws and general economic conditions.
There can be no assurance that the Company's products will continue to compete
favorably or that the Company will be successful in the face of increasing
competition from new products and enhancements introduced by existing
competitors or new companies entering this market. Failure of the Company to
compete successfully in the high-voltage power supply business would
materially and adversely affect the Company's business, financial condition
and results of operations. See "Business--Competition."

Dependence on Proprietary Technology. The Company's future success depends
in part upon its ability to protect its intellectual property, including
patents, trade secrets, and know-how, and to continue its technological
innovation. There can be no assurance that the steps taken by the Company to
protect its intellectual property will be adequate to prevent misappropriation
or that others will not develop competitive technologies or products.

The semiconductor industry is characterized by frequent litigation regarding
patent and other intellectual property rights. While the Company has not
received formal notice of any infringement of the right of any third party,
questions of infringement in the semiconductor field involve highly technical
and subjective analyses. Litigation may be necessary in the future to enforce
the Company's patents and other intellectual property rights, to protect the
Company's trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity, and there can be no assurance that the Company would prevail in
any future litigation. Any such litigation, whether or not determined in the
Company's favor or settled by the Company, would be costly and would divert
the efforts and attention of the Company's management and technical personnel
from normal business operations, which would have material adverse effect on
the Company's business, financial condition and results of operations. Adverse
determinations in litigation could result in the loss of the Company's
proprietary rights, subject the Company to significant liabilities, require
the Company to seek licenses from third parties or prevent the Company from
licensing its technology, any of which could have a material adverse effect on
the Company's business, financial condition and results of operations.
Moreover, the laws of certain foreign countries in which the Company's
technology is or may in the future be licensed may not protect the Company's
intellectual property rights to the same extent as the laws of the United
States, thus increasing the possibility of infringement of the Company's
intellectual property.

Dependence on Key Personnel. The Company's success depends to a significant
extent upon the continued service of its executive officers and other key
management and technical personnel, and on its ability to continue to attract,
retain and motivate qualified personnel, such as experienced systems
applications engineers. The competition for such employees is intense. The
loss of the services of one or more of the Company's engineers, executive
officers or other key personnel or the Company's inability to recruit
replacements for such personnel or to otherwise attract, retain and motivate
qualified personnel could have a material adverse effect on the Company's
business, financial condition or operating results. The Company does not have
long-term employment contracts with any of its employees. The Company does not
have in place "key person" life insurance policies on any of its employees.
See "Business--Employees" and "Executive Officers of the Registrant."

Management of Growth. The Company has experienced a period of rapid growth
and expansion which has placed, and continues to place, a significant strain
on its resources. To accommodate this growth, the Company will be required to
implement a variety of new and upgraded operational and financial systems,
procedures and controls, including the improvement of its accounting and other
internal management systems, all of which may require substantial management
efforts. There can be no assurance that such efforts can be accomplished
successfully. In addition, any future periods of rapid growth or expansion
could be expected to place a significant strain on the Company's limited
managerial, financial, engineering and other resources. Relationships with new
customers generally require significant engineering support. As a result, any
increases in the number of customers using the Company's technology will
increase the strain on the Company's resources, particularly the Company's
engineers. Any delays or difficulties in the Company's research and
development

31
<PAGE>

process caused by these factors or others could make it difficult for the
Company to develop future generations of its products and to remain
competitive. In addition, the rapid rate of hiring new employees could be
disruptive and adversely affect the efficiency of the Company's research and
development process. Any failure to improve the Company's operational,
financial and management systems, or to hire, train, motivate or manage its
employees could have a material adverse effect on the Company's business,
financial condition and operating results.

Year 2000 Compliance. The Company is in the process of defining costs,
issues and uncertainties associated with making the Company's internal-use
software applications compliant with the Year 2000. In general, the Company
expects to resolve the Year 2000 issues through planned replacement upgrades
of its software applications. Although management does not expect the Year
2000 issues to have a material impact on the Company's business or future
results of operations, there can be no assurance that there will not be
interruptions of operations or other limitations of system functionality or
that the Company will not incur significant costs to avoid such interruptions
or limitations.

Concentration of Share Ownership and Voting Power; Anti-Takeover
Provisions. Officers, directors and affiliates of the Company beneficially own
approximately 27.6% of the Company's outstanding common stock. As a result,
these stockholders as a group are able to substantially influence the
management and affairs of the Company and, if acting together, would be able
to influence most matters requiring the approval by the stockholders of the
Company, including election of directors, any merger, consolidation or sale of
all or substantially all of the Company's assets and any other significant
corporate transactions. The concentration of ownership could have the effect
of delaying or preventing a change in control of the Company, reducing the
likelihood of any acquisition of the Company at a premium price.

The Company's Board of Directors ("Board of Directors" or "Board") has the
authority to issue up to 3,000,000 shares of preferred stock and to determine
the price, rights, preferences and privileges of those shares without any
further vote or action by the stockholders. The rights of the holders of
common stock will be subject to, and may be adversely affected by, the rights
of the holders of any preferred stock that may be issued in the future. The
issuance of shares of preferred stock, while potentially providing desirable
flexibility in connection with possible acquisitions and for other corporate
purposes, could have the effect of making it more difficult for a third party
to acquire a majority of the outstanding voting stock of the Company. The
Company has no present intention to issue shares of preferred stock. In
addition, certain provisions of the Company's Amended Certificate of
Incorporation may have the effect of delaying or preventing a change of
control of the Company, which could adversely affect the market price of the
Company's common stock. These provisions provide, among other things, that
stockholders may not take action by written consent, that the ability of
stockholders to call special meetings of stockholders and to raise matters at
meetings of stockholders is restricted and that certain amendments of the
Company's Certificate of Incorporation, and all amendments of the Company's
Bylaws, require the approval of holders of at least two-thirds of the voting
power of all outstanding shares. In addition, the Company is subject to the
anti-takeover provisions of Section 203 of the Delaware General Corporation
Law, which will prohibit the Company from engaging in a "business combination"
with an "interested stockholder" for a period of three years after the date of
the transaction in which the person became an interested stockholder, unless
the business combination is approved in a prescribed manner. The application
of Section 203 also could have the effect of delaying or preventing a change
of control of the Company.

Risks of Additional Shares Sold in the Public Market. Sales of substantial
amounts of common stock in the public market could adversely affect the
prevailing market price of the common stock. Currently, 4,600,000 shares are
freely tradable. Commencing June 12, 1998, 7,102,056 additional shares will
become freely tradable upon the expiration of agreements not to sell such
shares, subject to compliance with Rule 144 promulgated under the Securities
Act of 1933, as amended. An additional 364,980 shares will become freely
tradable at various times after June 12, 1998. Hambrecht & Quist LLC may in
its sole discretion and at any time without notice, release all or any portion
of the securities subject to such agreements. The Company intends to register
approximately 1,551,787 shares of the Company's common stock reserved for
issuance under its stock option and purchase plans.

32
<PAGE>

The holders of 6,258,948 shares of the Company's common stock (including
466,055 shares issuable upon exercise of outstanding warrants) will be
entitled to certain registration rights with respect to such shares. If such
holders, by exercising their registration rights, cause a large number of
shares to be registered and sold in the public market, such sales could have
an adverse effect on the market price for the Company's common stock. If the
Company were required to include in a Company initiated registration shares
held by such holders pursuant to the exercise of their piggyback registration
rights, such sale might have an adverse effect on the Company's ability to
raise needed capital.

Expected Volatility of Stock Price. The price of the Company's common stock
has been, and is likely to be, volatile. Factors such as future announcements
concerning the Company or its competitors, quarterly variations in operating
results, announcements of technological innovations, the introduction of new
products or changes in product pricing policies by the Company or its
competitors, proprietary rights or other litigation, changes in earnings
estimates by analysts or other factors could cause the market price of the
Company's common stock to fluctuate substantially. In addition, stock prices
for many technology companies fluctuate widely for reasons which may be
unrelated to operating results. These fluctuations, as well as general
economic, market and political conditions such as recessions or military
conflicts, may materially adversely affect the market price of the Company's
common stock. Moreover, the trading prices of many high technology stocks are
at or near their historical highs and reflect price/earning ratios
substantially above historical norms. There can be no assurance that the
trading price of the Company's common stock will remain at or near its initial
offering price to the public.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The Financial Statements and Supplementary Data of the Company required by
this item are set forth at the pages indicated at Item 14(a).

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

None.

33
<PAGE>

PART III

Certain information required by Part III is omitted from this report in that
the Company intends to file its definitive proxy statement pursuant to
Regulation 14A (the "definitive Proxy Statement") not later than 120 days
after the end of the fiscal year covered by this report, and certain
information therein is incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information required by this Item is incorporated by reference to
information set forth in the definitive Proxy Statement under the heading
"Proposal No. 1--Election of Directors" and in Part I of this Report under the
heading "Executive Officers of the Registrant."

The information required by this Item with respect to compliance with
Section 16(a) of the Securities Exchange Act of 1934 is incorporated by
reference to information set forth in the definitive Proxy Statement under the
heading "Executive Compensation and Other Matters."

ITEM 11. EXECUTIVE COMPENSATION.

The information required by this Item is incorporated by reference to
information set forth in the definitive Proxy Statement under the heading
"Executive Compensation and Other Matters."

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The information required by this Item is incorporated by reference to
information set forth in the definitive Proxy Statement under the heading
"Stock Ownership of Certain Beneficial Owners and Management."

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information required by this Item is incorporated by reference to
information set forth in the definitive Proxy Statement under the heading
"Certain Relationships and Related Transactions."

34
<PAGE>

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

(a) The following documents are filed as part of this Form:

1.Financial Statements

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Public Accountants............................. 36
Consolidated Balance Sheets.......................................... 37
Consolidated Statements of Operations................................ 38
Consolidated Statements of Stockholders' Equity...................... 39
Consolidated Statements of Cash Flows................................ 40
Notes to Consolidated Financial Statements........................... 41
</TABLE>

2.Financial Statement Schedules

All schedules have been omitted because the required information is
not present or not present in amounts sufficient to require submission
of the schedules or because the information required is included in the
Consolidated Financial Statements or Notes thereto.

3.Exhibits

See Index to Exhibits. The Exhibits listed in the accompanying Index
to Exhibits are filed as part of this report.

(b) Reports on Form 8-K

None.

35
<PAGE>

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Power Integrations, Inc.:

We have audited the accompanying consolidated balance sheets of Power
Integrations, Inc. (a Delaware corporation--see Note 6) and subsidiaries as of
December 31, 1996 and 1997, and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Power Integrations, Inc.
and subsidiaries as of December 31, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.

ARTHUR ANDERSEN LLP

San Jose, California
January 21, 1998

36
<PAGE>

POWER INTEGRATIONS, INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1996 1997
-------- --------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................ $ 3,282 $ 25,553
Short-term investments................................... 4,410 3,455
Accounts receivable, net of allowances of $285 and
$1,269, respectively.................................... 2,777 6,243
Inventories.............................................. 3,938 7,328
Prepaid expenses and other current assets................ 300 349
-------- --------
Total current assets................................... 14,707 42,928
-------- --------
PROPERTY AND EQUIPMENT, AT COST:
Machinery and equipment.................................. 8,920 11,914
Leasehold improvements................................... 636 711
-------- --------
9,556 12,625
Less: Accumulated depreciation and amortization.......... (4,728) (6,994)
-------- --------
4,828 5,631
-------- --------
$ 19,535 $ 48,559
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of capitalized lease obligations......... $ 1,566 $ 1,787
Current portion of note payable to a stockholder......... 251 --
Accounts payable......................................... 1,476 6,903
Accrued payroll and related expenses..................... 829 1,685
Taxes payable and other accrued liabilities.............. 82 1,042
Deferred income on sales to distributors................. 734 1,380
-------- --------
Total current liabilities.............................. 4,938 12,797
-------- --------
LONG-TERM DEBT, net of current portion:
Capitalized lease obligations............................ 2,750 2,435
Note payable to a stockholder............................ 2,749 --
-------- --------
5,499 2,435
-------- --------
COMMITMENTS (NOTE 5)
STOCKHOLDERS' EQUITY:
Convertible Preferred Stock, no par value in 1996; $0.001
par value in 1997
Authorized--54,000,000 shares at December 31, 1996;
3,000,000 shares at December 31, 1997
Outstanding--45,863,796 shares in 1996 and none in 1997
(Note 6) 35,271 --
Common Stock, no par value in 1996; $0.001 par value in
1997
Authorized--100,000,000 shares at December 31, 1996;
40,000,000 shares at December 31, 1997
Outstanding--875,822 shares in 1996 and 12,073,904
shares in 1997........................................ 565 12
Additional paid-in capital............................... -- 56,220
Common stock warrants.................................... 12 12
Stockholder notes receivable............................. -- (405)
Deferred compensation.................................... -- (461)
Cumulative translation adjustment........................ (13) (76)
Accumulated deficit...................................... (26,737) (21,975)
-------- --------
Total stockholders' equity............................. 9,098 33,327
-------- --------
$ 19,535 $ 48,559
======== ========
</TABLE>

The accompanying notes are an integral part of these consolidated balance
sheets.

37
<PAGE>

POWER INTEGRATIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------
1995 1996 1997
---------- ---------- ----------
<S> <C> <C> <C>
NET REVENUES:
Product sales............................. $ 17,406 $ 23,324 $ 44,827
License fees and royalties................ 1,009 619 1,162
---------- ---------- ----------
Total net revenues...................... 18,415 23,943 45,989
---------- ---------- ----------
COST OF REVENUES............................ 12,371 15,546 26,291
---------- ---------- ----------
GROSS PROFIT................................ 6,044 8,397 19,698
---------- ---------- ----------
OPERATING EXPENSES:
Research and development.................. 2,044 3,519 5,253
Sales and marketing....................... 2,744 3,905 6,417
General and administrative................ 1,619 1,558 2,053
---------- ---------- ----------
Total operating expenses................ 6,407 8,982 13,723
---------- ---------- ----------
INCOME (LOSS) FROM OPERATIONS............... (363) (585) 5,975
---------- ---------- ----------
OTHER INCOME (EXPENSE):
Interest income........................... 93 204 359
Interest expense.......................... (183) (780) (832)
Other, net................................ (316) (150) (210)
---------- ---------- ----------
Total other income (expense)............ (406) (726) (683)
---------- ---------- ----------
INCOME (LOSS) BEFORE PROVISION FOR
INCOME TAXES............................... (769) (1,311) 5,292
PROVISION FOR INCOME TAXES.................. 34 30 530
---------- ---------- ----------
NET INCOME (LOSS)........................... $ (803) $ (1,341) $ 4,762
========== ========== ==========
EARNINGS (LOSS) PER SHARE:
Basic..................................... $ (1.37) $ (1.57) $ 3.22
========== ========== ==========
Diluted................................... $ (1.37) $ (1.57) $ 0.49
========== ========== ==========
SHARES USED IN PER SHARE CALCULATION:
Basic..................................... 585 856 1,480
========== ========== ==========
Diluted................................... 585 856 9,781
========== ========== ==========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

38
<PAGE>

POWER INTEGRATIONS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(IN THOUSANDS)

<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK ADDITIONAL STOCKHOLDER CUMULATIVE
---------------- -------------- PAID-IN NOTES DEFERRED TRANSLATION ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL WARRANTS RECEIVABLE COMPENSATION ADJUSTMENT DEFICIT
------- ------- ------ ------- ---------- -------- ----------- ------------ ----------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT
DECEMBER 31,
1994............ 34,214 $27,773 382 $ 97 $ -- $ 38 $ -- $ -- $ (9) $(24,593)
Issuance of
Series F
Preferred
Stock.......... 9,091 4,947 -- -- -- -- -- -- -- --
Issuance of
Common Stock
under employee
stock option
plan........... -- -- 427 233 -- -- -- -- -- --
Issuance of
Common Stock
upon exercise
of warrant..... -- -- 22 108 -- (33) -- -- -- --
Issuance of
Series C
Preferred Stock
upon exercise
of warrants.... 1,754 1,756 -- -- -- (3) -- -- -- --
Expiration of
unexercised
warrants to
purchase Series
A, C and D
Preferred
Stock.......... -- 2 -- -- -- (2) -- -- -- --
Translation
adjustment..... -- -- -- -- -- -- -- -- 1 --
Net loss........ -- -- -- -- -- -- -- -- -- (803)
------- ------- ------ ------- ------- ---- ----- ----- ---- --------
BALANCE AT
DECEMBER 31,
1995............ 45,059 34,478 831 438 -- -- -- -- (8) (25,396)
Issuance of
Series C
Preferred Stock
upon exercise
of warrants.... 805 793 -- -- -- -- -- -- -- --
Issuance of
Common Stock
under employee
stock option
plan, net of
repurchases.... -- -- 28 27 -- -- -- -- -- --
Issuance of
Common Stock
upon exercise
of warrants.... -- -- 17 100 -- -- -- -- -- --
Issuance of
warrants to
purchase Common
Stock.......... -- -- -- -- -- 12 -- -- -- --
Translation
adjustment..... -- -- -- -- -- -- -- -- (5) --
Net loss........ -- -- -- -- -- -- -- -- -- (1,341)
------- ------- ------ ------- ------- ---- ----- ----- ---- --------
BALANCE AT
DECEMBER 31,
1996............ 45,864 35,271 876 565 -- 12 -- -- (13) (26,737)
Issuance of
Common Stock
under employee
stock option
plan........... -- -- 1,050 982 3 -- (405) -- -- --
Issuance of
Common Stock in
connection with
Public
Offering....... -- -- 2,700 3 18,842 -- -- -- -- --
Conversion of
Preferred Stock
to
Common Stock... (45,864) (35,271) 7,448 7 35,264 -- -- -- -- --
Change in par
value.......... -- -- -- (2,111) 2,111 -- -- -- -- --
Deferred
compensation... -- -- -- 566 -- -- -- (566) -- --
Amortization of
deferred
compensation... -- -- -- -- -- -- -- 105 -- --
Translation
adjustment..... -- -- -- -- -- -- -- -- (63) --
Net income...... -- -- -- -- -- -- -- -- -- 4,762
------- ------- ------ ------- ------- ---- ----- ----- ---- --------
BALANCE AT
DECEMBER 31,
1997............ -- $ -- 12,074 $ 12 $56,220 $12 $(405) $(461) $(76) $(21,975)
======= ======= ====== ======= ======= ==== ===== ===== ==== ========
<CAPTION>
TOTAL
STOCKHOLDERS'
EQUITY
-------------
<S> <C>
BALANCE AT
DECEMBER 31,
1994............ $ 3,306
Issuance of
Series F
Preferred
Stock.......... 4,947
Issuance of
Common Stock
under employee
stock option
plan........... 233
Issuance of
Common Stock
upon exercise
of warrant..... 75
Issuance of
Series C
Preferred Stock
upon exercise
of warrants.... 1,753
Expiration of
unexercised
warrants to
purchase Series
A, C and D
Preferred
Stock.......... --
Translation
adjustment..... 1
Net loss........ (803)
-------------
BALANCE AT
DECEMBER 31,
1995............ 9,512
Issuance of
Series C
Preferred Stock
upon exercise
of warrants.... 793
Issuance of
Common Stock
under employee
stock option
plan, net of
repurchases.... 27
Issuance of
Common Stock
upon exercise
of warrants.... 100
Issuance of
warrants to
purchase Common
Stock.......... 12
Translation
adjustment..... (5)
Net loss........ (1,341)
-------------
BALANCE AT
DECEMBER 31,
1996............ 9,098
Issuance of
Common Stock
under employee
stock option
plan........... 580
Issuance of
Common Stock in
connection with
Public
Offering....... 18,845
Conversion of
Preferred Stock
to
Common Stock... --
Change in par
value.......... --
Deferred
compensation... --
Amortization of
deferred
compensation... 105
Translation
adjustment..... (63)
Net income...... 4,762
-------------
BALANCE AT
DECEMBER 31,
1997............ $33,327
=============
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

39
<PAGE>

POWER INTEGRATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------
1995 1996 1997
---------- ---------- ----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)......................... $ (803) $ (1,341) $ 4,762
Adjustments to reconcile net income (loss)
to net cash provided by (used in)
operating activities:
Depreciation and amortization........... 1,036 1,887 2,265
Deferred compensation expense........... -- -- 105
Provision for accounts receivable and
other allowances....................... 95 143 984
Change in operating assets and
liabilities:
Accounts receivable................... (1,883) 166 (4,450)
Inventories........................... (3,239) 443 (3,390)
Prepaid expenses and other current
assets............................... (80) (134) (49)
Accounts payable...................... 1,321 (504) 5,427
Accrued liabilities................... 23 285 1,754
Deferred income on sales to
distributors......................... 592 142 646
---------- ---------- ----------
Net cash provided by (used in)
operating activities............... (2,938) 1,087 8,054
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment..... (1,316) (537) (1,439)
Purchases of short-term investments..... (797) (9,406) (13,402)
Proceeds from sales and maturities of
short-term investments................. 391 5,793 14,357
---------- ---------- ----------
Net cash used in investing
activities......................... (1,722) (4,150) (484)
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of preferred
stock.................................. 6,700 793 --
Net proceeds from issuance of common
stock.................................. 308 127 19,425
Net proceeds from issuance of warrants
to purchase common stock............... -- 12 --
Principal payments under capitalized
lease obligations...................... (505) (590) (1,724)
Proceeds (repayment) related to note
payable to a stockholder............... -- 3,000 (3,000)
---------- ---------- ----------
Net cash provided by financing
activities......................... 6,503 3,342 14,701
---------- ---------- ----------
NET INCREASE IN CASH AND CASH EQUIVALENTS. 1,843 279 22,271
CASH AND CASH EQUIVALENTS AT BEGINNING OF
PERIOD................................... 1,160 3,003 3,282
---------- ---------- ----------
CASH AND CASH EQUIVALENTS AT END OF
PERIOD................................... $ 3,003 $ 3,282 $ 25,553
========== ========== ==========
SUPPLEMENTAL DISCLOSURE OF NON-CASH
INVESTING AND FINANCING ACTIVITIES:
Capitalized lease obligations incurred
for property and equipment............. $ 2,838 $ 1,883 $ 1,630
========== ========== ==========
Conversion of preferred stock to common
stock.................................. $ -- $ -- $ 35,271
========== ========== ==========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid for interest.................. $ 183 $ 780 $ 832
========== ========== ==========
Cash paid for income taxes.............. $ 6 $ 45 $ 164
========== ========== ==========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

40
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 1997

1. THE COMPANY:

Power Integrations, Inc. (the "Company"), which was incorporated in
California on March 25, 1988 and reincorporated in Delaware in December 1997
(see Note 6), designs, develops, manufactures and markets proprietary, high-
voltage, analog integrated circuits for use in AC to DC power conversion
primarily for the cellular telephone, personal computer, cable and direct
broadcast satellite and various consumer electronics markets.

The Company is subject to a number of risks including, among others, the
volume and timing of orders received by the Company from its customers;
competitive pressures on selling prices; the volume and timing of orders
placed by the Company with its foundries; the availability of raw materials;
fluctuations in manufacturing yields, whether resulting from the transition to
new foundries or from other factors; changes in product mix including the
impact of new product introductions on existing products; the Company's
ability to develop and bring to market new products and technologies on a
timely basis; the introduction of products and technologies by the Company's
competitors; market acceptance of the Company's and its customers' products;
the timing of investments in research and development and sales and marketing;
cyclical semiconductor conditions; fluctuations in exchange rates,
particularly exchange rates between the U.S. dollar and the Japanese yen;
changes in the international business climate and economic conditions;
reliance on a limited number of key customers; dependence on key individuals;
the ability to secure adequate financing to support future growth, if and when
required; and the successful development and marketing of its products in an
emerging and rapidly changing market.

All of the wafers are manufactured by two offshore independent foundries.
Although there are a number of other suppliers that could provide similar
services, a change in suppliers could cause a delay in manufacturing and
possible loss of sales, which could adversely affect operating results.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation and Foreign Currency Translation

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries after elimination of intercompany
transactions and balances. The functional currencies of the Company's
subsidiaries are the local currencies. Accordingly, all assets and liabilities
are translated into U.S. dollars at the current exchange rates as of the
applicable balance sheet date. Revenues and expenses are translated at the
average exchange rate prevailing during the period. Cumulative gains and
losses from the translation of the foreign subsidiaries' financial statements
have been included in stockholders' equity.

Cash and Cash Equivalents and Short-Term Investments

The Company considers cash invested in highly liquid financial instruments
with an original maturity of three months or less to be cash equivalents. Cash
investments in highly liquid financial instruments with original maturities
greater than three months but less than one year are classified as short-term
investments. As of December 31, 1996 and 1997, the Company's short-term
investments consist of U.S. Government backed securities, which are classified
as held to maturity and are valued using the amortized cost method which
approximates market.

Inventories

Inventories (which consist of costs associated with the purchases of wafers
from offshore foundries and of packaged components from several offshore
assembly manufacturers, as well as internal labor and overhead

41
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

associated with the testing of both wafers and packaged components) are stated
at the lower of cost (first-in, first-out) or market. Provisions, when
required, are made to reduce excess and obsolete inventories to their
estimated net realizable values. Inventories consist of the following (in
thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
-------------
1996 1997
------ ------
<S> <C> <C>
Raw materials................................................ $ 264 $3,323
Work-in-process.............................................. 2,451 2,977
Finished goods............................................... 1,223 1,028
------ ------
$3,938 $7,328
====== ======
</TABLE>

Property and Equipment

Depreciation and amortization of property and equipment are provided using
the straight-line method over the shorter of the estimated useful lives of the
assets over a period of one to four years or over the applicable lease term.

Included in property and equipment are assets acquired under capital lease
obligations with an original cost of approximately $6.2 million and $7.8
million, as of December 31, 1996 and 1997, respectively. Related accumulated
amortization on these leased assets was approximately $2.1 million and $4.0
million, as of December 31, 1996 and 1997, respectively.

Earnings (Loss) Per Share

In December 1997, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 128 "Earnings per Share." SFAS No. 128 requires companies
to compute earnings per share under two different methods (basic and diluted).
Basic earnings per share is calculated by dividing net income (loss) by the
weighted average shares of common stock outstanding during the period. Diluted
earnings per share is calculated by dividing net income (loss) by the weighted
average shares of outstanding common stock and common stock equivalents during
the period. Common stock equivalents included in the diluted calculation
consist of dilutive shares issuable upon the exercise of outstanding common
stock options and warrants computed using the treasury stock method. As a
result, the 1996 net loss per share amounts have been restated and historical
per share information has been presented. The effect of this accounting change
on previously reported loss per share data was as follows:

<TABLE>
<CAPTION>
1996
------
<S> <C>
Pro forma net loss per share as previously reported............... $(0.14)
Effect of adopting SFAS No. 128................................... (1.43)
------
Basic and diluted loss per share................................ $(1.57)
======
</TABLE>

42
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

A summary of the earnings per share calculation for each of the three years
ended December 31, 1995, 1996 and 1997 is as follows (in thousands, except per
share amounts):

<TABLE>
<CAPTION>
1995 1996 1997
------ ------- ------
<S> <C> <C> <C>
Basic earnings (loss) per share:
Net income (loss).................................... $ (803) $(1,341) $4,762
------ ------- ------
Weighted average common shares....................... 585 856 1,480
------ ------- ------
Basic earnings (loss) per share.................... $(1.37) $ (1.57) $ 3.22
====== ======= ======
Diluted earnings (loss) per share:
Net income (loss).................................... $ (803) $(1,341) $4,762
------ ------- ------
Weighted average common shares....................... 585 856 1,480
Weighted average common share equivalents:
Preferred stock.................................... -- -- 7,448
Options............................................ -- -- 704
Warrants........................................... -- -- 149
------ ------- ------
Diluted weighted average common shares............... 585 856 9,781
------ ------- ------
Diluted earnings (loss) per share................ $(1.37) $ (1.57) $ 0.49
====== ======= ======
</TABLE>

New Accounting Standards

In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income," which establishes standards for reporting
and presentation of comprehensive income. SFAS No. 130, which will be adopted
by the Company in the first quarter of 1998, requires companies to report a
new measure of income. "Comprehensive Income" is to include foreign currency
translation gains and losses and other unrealized gains and losses that have
historically been excluded from net income and reflected instead in equity.
The Company anticipates that SFAS No. 130 will not have a material impact on
its financial statements.

Revenue Recognition, Significant Customers

Product revenues consist of sales to OEMs and merchant power supply
manufacturers and to distributors. Revenues from product sales to OEM and
merchant power supply manufacturers are recognized upon shipment. The Company
provides for estimated sales returns and allowances related to such sales at
the time of shipment. During 1995, 1996 and 1997, sales to distributors of the
Company's products accounted for approximately 54%, 52%, and 45% of net
revenues, respectively. Sales to distributors are made under terms allowing
certain rights of return and protection against subsequent price declines of
the Company's products held by the distributors. Pursuant to the Company's
distributor agreements, the Company protects its distributors' exposures
related to the impact of price reductions as well as products at distributors
that are slow moving or have been discontinued. These agreements, which may be
canceled by either party on a specified notice, generally contain a provision
for the return of the Company's product in the event the agreement with the
distributor is terminated. Accordingly, the Company defers recognition of
revenue and the proportionate costs of revenues derived from sales to
distributors until such distributors resell the Company's products to their
customers. The margin deferred as a

43
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

result of this policy is reflected as "deferred income on sales to
distributors" in the accompanying consolidated balance sheets.

The Company has entered into separate wafer supply and technology license
agreements with three separate unaffiliated companies (the "Foundries"). As of
December 31, 1997, all wafers are supplied by two foundries. The wafer supply
agreements, which expire in June 1998 and June 2000 are renewable. In
connection with the technology license agreements, the Company is entitled to
receive a royalty on sales of products by the Foundries which incorporate the
Company's technology into their own products. Initial license fees received
under the agreements were non-refundable. As of December 31, 1997, only one
foundry has sold products to third parties under its license rights. For the
years ended December 31, 1995, 1996 and 1997, revenue recognized under these
agreements was approximately $1.0 million, $619,000, and $1.2 million,
respectively.

The Company's end user base is highly concentrated and a relatively small
number of OEMs, directly or indirectly through merchant power supply
manufacturers, accounted for a significant portion of the Company's revenue.
For the years ended December 31, 1995, 1996, and 1997, ten customers accounted
for approximately 77%, 64%, and 67% of net revenues, respectively.

The following customers accounted for more than 10% of total net revenues:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
CUSTOMER 1995 1996 1997
-------- ------- ------- -------
<S> <C> <C> <C>
A.............................. 21% * *
B.............................. 20% * *
C.............................. 12% * *
D.............................. * * 15%
E.............................. * * 21%
</TABLE>
- --------
* less than 10% or no sales

Export Sales

The Company markets its products in North America and in foreign countries
through its sales personnel and a worldwide network of independent sales
representatives and distributors. Export sales, which consist of domestic
sales to customers in foreign countries are comprised of the following:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Japan.......................... 28% 16% 5%
Taiwan......................... 14% 13% 28%
Hong Kong...................... 4% 12% 25%
Western Europe................. 9% 19% 12%
Other.......................... 10% 12% 11%
------- ------- -------
Total foreign................ 65% 72% 81%
======= ======= =======
</TABLE>

Foreign Currency Risk

During 1995, the Company opened a Japanese yen bank account with a U.S. bank
for payments to suppliers and for cash receipts from Japanese suppliers and
customers denominated in yen. For the years ended December 31, 1995, 1996, and
1997, the Company realized foreign exchange transaction losses of
approximately $164,000,

44
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

$77,000, and $86,000, respectively, which are included in "other income
(expense)," in the accompanying consolidated statements of operations.

Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles 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. Actual results could differ from those estimates.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash investments and trade receivables.
The Company has cash investment policies that limit cash investments to short-
term, low risk investments. With respect to trade receivables, the Company
performs ongoing credit evaluations of its customers' financial condition and
requires letters of credit whenever deemed necessary. Additionally, the
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific customers, historical trends related
to past losses and other relevant information. As of December 31, 1996 and
1997, approximately 85% and 71% of accounts receivable, respectively, were
concentrated with ten customers.

3. BANK LINE OF CREDIT:

The Company has an $8.0 million revolving line of credit agreement (the
"Agreement") with a bank. Advances under the Agreement bear interest at the
bank's prime lending rate (8.5% at December 31, 1997). All advances under the
Agreement are limited to 75% of eligible accounts receivable and the lesser of
40% or $4.0 million of eligible domestic finished goods inventory.
Additionally, the Agreement contains certain limitations, including an $8.0
million limit on advances for commercial letters of credit and a $3.0 million
limit on advances for foreign currency contracts, if any, provided that at no
time will the aggregate sum of the limits exceed $8.0 million. As of December
31, 1997, there were outstanding letters of credit totaling 457,895,541
Japanese yen (approximately $3.5 million). The Agreement, which expires August
11, 1998, restricts the Company from entering into certain transactions and
contains certain financial covenants. As of December 31, 1997, there were no
borrowings outstanding under the Agreement.

4. NOTE PAYABLE TO A STOCKHOLDER:

In May 1996, the Company issued a $3.0 million note payable to a holder of
Series C Preferred Stock, with an original maturity date of October 1999 and
an interest rate of 12%. The note, which was subordinated in rights of payment
to all existing and future indebtedness of the Company, was repaid to the
holder in December 1997.

5. COMMITMENTS:

The Company leases its facilities under noncancellable operating leases
which expire at various dates through August 1999. The lease for the Company's
main corporate facilities expires in October 1998 and contains a conditional
five-year option at fair market value to the year 2003. While the Company
believes that its existing facilities are adequate for its current needs and
expects to exercise the lease option, it is exploring the possibility of
leasing additional space to accommodate future needs. Rent expense under all
operating leases was approximately $159,000, $223,000 and $291,000 in 1995,
1996 and 1997, respectively.

45
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

A significant portion of the Company's machinery and equipment is leased
under agreements accounted for as capital leases. The Company leased
approximately $1.9 million and $1.6 million of equipment during 1996 and 1997,
respectively, under various capital leasing arrangements. In May 1997, the
Company entered into a new capital lease line of credit agreement (the
"Capital Leasing Agreement"), which allows for combined borrowings of up to
$3.0 million to finance the acquisition of property and equipment. The capital
leasing agreement, which expires on March 31, 1998, bears interest at a fixed
rate established at the time of borrowing which was approximately 12.0% as of
December 31, 1997. Approximately $1.4 million was available under the Capital
Leasing Agreement as of December 31, 1997.

Future minimum lease payments under all noncancellable operating and capital
lease agreements as of December 31, 1997 are as follows (dollars in
thousands):

<TABLE>
<CAPTION>
FISCAL YEAR OPERATING CAPITAL
----------- --------- -------
<S> <C> <C>
1998 $264 $ 2,265
1999 11 1,771
2000 -- 692
2001 -- 95
---- -------
Total minimum lease payments............................. $275 $ 4,823
====
Less: Amounts representing interest on capital leases
(10.5% to 14.9%)........................................ (601)
-------
4,222
Less: Current portion.................................... (1,787)
-------
Long-term portion........................................ $ 2,435
=======
</TABLE>

6. STOCKHOLDERS' EQUITY:

Reincorporation and Reverse Stock Split

In September 1997, the Board of Directors approved the reincorporation of
the Company in Delaware which became effective in connection with the
Company's initial public offering ("IPO"). Upon completion of the IPO in
December 1997, the Company was authorized to issue 40,000,000 shares of $0.001
par value common stock.

In September 1997, the Company's Board of Directors approved a one-for-6.8
reverse split of its common stock. All common and per share amounts in the
accompanying consolidated financial statements have been adjusted
retroactively to give effect to this reverse stock split.

Preferred Stock

With the closing of the Company's IPO in December 1997, all of the
outstanding convertible preferred stock automatically converted into 7,447,558
shares of common stock. Upon conversion of the outstanding preferred stock to
common stock, such preferred stock was retired. As of December 31, 1997, the
Company was authorized to issue 3,000,000 shares of new $0.001 par value
preferred stock, of which none was outstanding as of December 31, 1997.

1988 Stock Option Plan

In June 1988, the Board of Directors approved the 1988 Stock Option Plan
(the "1988 Plan"), whereby the Board of Directors may grant options to key
employees, directors and consultants to purchase the Company's common stock at
exercise prices of not less than 85% of the fair value of the shares at the
date of grant. Options

46
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

expire ten years after the date of grant (five years if the option is granted
to a ten percent owner optionee) and generally vest over 50 months. Options
granted under the 1988 Plan will remain outstanding in accordance with their
terms, but, effective July 1997, the Board of Directors had determined that no
further options will be granted under the 1988 Plan.

1997 Stock Option Plan

In June 1997, the Board of Directors approved the 1997 Stock Option Plan
(the "1997 Plan"), whereby the Board of Directors may grant options to key
employees, directors and consultants to purchase the Company's common stock at
exercise prices of not less than 85% of the fair value of the shares at the
date of grant. As of December 31, 1997, the 1997 Plan's maximum share reserve
is 2,132,227 shares, which is comprised of the sum of (i) 660,745 shares (new
shares allocated to the 1997 Plan) and (ii) 1,471,482 (the number of shares
subject to outstanding options on December 31, 1997 granted pursuant to the
1988 Plan (the "1988 Plan Options")). The number of shares available for
issuance under the 1997 Plan, at any time, is reduced by the number of shares
remaining subject to the 1988 Plan Options. Options expire ten years after the
date of grant (five years if the option is granted to a ten percent owner
optionee) and generally vest over 48 months.

1997 Outside Directors Stock Option Plan

In September 1997, the Board of Directors approved an Outside Directors
Stock Option Plan (the "Directors Plan"). A total of 200,000 shares of common
stock have been reserved for issuance under the Directors Plan. The Directors
Plan provides for the grant of nonstatutory stock options to nonemployee
directors of the Company. The Directors Plan is designed to work automatically
without administration; however, to the extent administration is necessary, it
will be performed by the Board of Directors. The Directors Plan provides that
each current and future nonemployee director of the Company will be granted an
option to purchase 15,000 shares of common stock on the effective date or the
date on which the optionee first becomes a nonemployee director of the Company
after the effective date as the case may be (the "Initial Grant"). Thereafter,
each nonemployee director who has served on the Board of Directors
continuously for 6 months will be granted an additional option to purchase
5,000 shares of common stock (an "Annual Grant"). Subject to an optionee's
continuous service with the Company, approximately 1/3rd of an Initial Grant
will become exercisable one year after the date of grant and 1/36th of the
Initial Grant will become exercisable monthly thereafter. Each Annual Grant
will become exercisable in twelve monthly installments beginning in the 25th
month after the date of grant, subject to the optionee's continuous service.
The exercise price per share of all options granted under the Directors Plan
will equal the fair market value of a share of common stock on the date of
grant. Options granted under the Directors Plan have a term of ten years and
are non-transferable. In the event of certain changes in control of the
Company, options outstanding under the Directors Plan will become immediately
exercisable and vested in full.

47
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The following table summarizes option activity under the 1988, 1997 and
Directors Plans:

<TABLE>
<CAPTION>
OPTIONS OPTIONS EXERCISE WEIGHTED AVERAGE
AVAILABLE OUTSTANDING PRICES EXERCISE PRICES
--------- ----------- ---------- ----------------
<S> <C> <C> <C> <C>
Outstanding at December 31,
1994........................ 86,615 676,941 $ .34-.85 $ .75
Authorized................. 882,353 -- -- --
Granted.................... (951,346) 951,346 .51-1.36 .59
Exercised.................. -- (426,506) .34-.85 .54
Canceled................... 69,524 (69,524) .51-.85 .68
-------- ---------- ---------- -----
Outstanding at December 31,
1995........................ 87,146 1,132,257 .34-1.36 .70
Authorized................. 294,118 -- -- --
Granted.................... (323,970) 323,970 1.36 1.36
Exercised.................. -- (27,847) .51-1.36 .94
Cancelled.................. 131,954 (131,954) .51-1.36 1.16
-------- ---------- ---------- -----
Outstanding at December 31,
1996........................ 189,248 1,296,426 .34-1.36 .80
Authorized................. 859,775 -- -- --
Granted.................... (662,432) 662,432 1.36-8.84 2.69
Exercised.................. -- (1,049,602) .34-1.70 .55
Cancelled.................. 34,500 (34,500) .51-1.70 1.42
-------- ---------- ---------- -----
Outstanding at December 31,
1997........................ 421,091 874,756 $.51-$8.84 $2.76
======== ========== ========== =====
Exercisable at December 31,
1997........................ 237,629 $.51-$5.10 $ .97
========== ========== =====
</TABLE>

Options issued under the 1988 and 1997 Plans may be exercised at any time
prior to their expiration. Options issued under the Directors Plan are
exercisable upon vesting. In addition, the Company has the right, upon
termination of an optionholder's employment or service with the Company, at
its discretion, to repurchase any unvested shares issued under the 1988 and
1997 Plans at the original purchase price. Under the terms of the Plans, an
option holder may not sell shares obtained upon the exercise of an option
until the option has vested as to those shares. As of December 31, 1997, an
aggregate of 436,798 shares of common stock issued under the 1988 and 1997
Plans are subject to repurchase by the Company at $.51 to $1.70 per share and
a weighted average repurchase price of $1.25 per share.

The Company accounts for its Plans under APB Opinion No. 25, "Accounting for
Stock Issued to Employees." Had compensation expense for the Plans been
determined under a fair value method consistent with SFAS No. 123, "Accounting
for Stock Based Compensation," the Company's net income (loss) would have been
decreased (increased) to the following pro forma amounts (in thousands, except
per share information):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1995 1996 1997
------- -------- -------
<S> <C> <C> <C>
Net income (loss):
As reported....................................... $ (803) $ (1,341) $ 4,762
Pro forma......................................... $ (841) $ (1,401) $ 4,427
Basic earnings (loss) per share:
As reported....................................... $ (1.37) $ (1.57) $ 3.22
Pro forma......................................... $ (1.44) $ (1.64) $ 2.99
Diluted earnings (loss) per share:
As reported....................................... $ (1.37) $ (1.57) $ 0.49
Pro forma......................................... $ (1.44) $ (1.64) $ 0.45
</TABLE>

48
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The weighted-average grant date fair value of options granted during fiscal
years 1995, 1996 and 1997 was $.14, $.27 and $1.68, respectively. The fair
value of each option grant is estimated on the date of grant using the Black-
Scholes option pricing model with the following weighted average assumptions
used for grants in 1995, 1996 and 1997: risk-free interest rates of 6.3, 6.2
and 6.2 percent, respectively; expected dividend yields of zero percent;
expected lives of 4 years; expected volatility of zero percent for 1995 and
1996 and 70% for 1997.

The following table summarizes the stock options outstanding at December 31,
1997:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-----------------------------------------------------------------------
NUMBER WEIGHTED WEIGHTED NUMBER WEIGHTED
OUTSTANDING AT AVERAGE AVERAGE EXERCISABLE AT AVERAGE
EXERCISE DECEMBER 31, REMAINING EXERCISE DECEMBER 31, EXERCISE
PRICE 1997 LIFE PRICE 1997 PRICE
-------- -------------- --------- -------- -------------- --------
<S> <C> <C> <C> <C> <C>
$.51 166,283 7.36 $0.51 30,033 $0.51
$.68--$1.36 344,120 7.61 $1.11 182,785 $0.91
$1.70 164,148 9.35 $1.70 22,935 $1.70
$5.10--$8.84 200,205 9.66 $8.33 1,876 $5.10
------- ---- ----- ------- -----
$.51--$8.84 874,756 8.50 $2.76 237,629 $0.97
======= ==== ===== ======= =====
</TABLE>

1997 Employee Stock Purchase Plan

In September 1997, the Board of Directors adopted the 1997 Employee Stock
Purchase Plan (the "Purchase Plan"). The Company has reserved 250,000 shares
of common stock for issuance under the Purchase Plan. The Purchase Plan will
enable eligible employees to purchase common stock at 85% of the lower of the
fair market value of the Company's common stock on the first or the last day
of each offering period.

Stockholder Notes Receivable

In July 1997, in connection with the purchase of common stock upon exercise
of stock options granted to certain officers and employees of the Company, the
Company loaned to these officers and employees an aggregate of $405,000, at an
interest rate of 6.65% pursuant to Promissory Note and Pledge Agreements (the
"Loans"). The Loans, which are secured by 238,231 shares of common stock, are
full recourse notes, and are due in full without regard to the value of the
Company's common stock in July 2002, or at the Company's option upon (i)
termination of employment with the Company, (ii) a default in the payment of
any installment or principal and/or interest when due, (iii) a sale of the
Pledged Stock or (iv) acceleration being reasonably necessary for the Company
to comply with any regulations promulgated by the Board of Governors of the
Federal Reserve System affecting the extension of credit in connection with
the Company's securities.

Deferred Compensation

In connection with the issuance of stock options to employees and
consultants, the Company has recorded deferred compensation in the aggregate
amount of approximately $566,000, representing the difference between the fair
market value of the Company's common stock and the exercise price of the stock
options at the date of grant. The Company is amortizing the deferred
compensation expense over the shorter of the period in which the employee,
director or consultant provides services or the applicable vesting period,
which is typically over 48 months. For the year ended December 31, 1997,
amortization expense was approximately $105,000. Compensation expense is
decreased in the period of forfeiture for any accrued, but unvested
compensation arising from the early termination of an option holder's
services. No compensation expense related to any other periods presented has
been recorded.

49
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Warrants

In connection with an equipment lease agreement entered into during 1988
with a leasing company, the Company issued a warrant for the purchase of up to
22,058 shares of the Company's common stock at an exercise price of $3.40 per
share. This warrant was exercised in June 1995. The Company leased additional
equipment during 1989 from the same company and, as part of this lease, a
warrant for the purchase of up to an additional 16,883 shares of the Company's
common stock at an exercise price of $6.80 per share was issued. This warrant
was exercised in July 1996.

In connection with the issuance of Series C Preferred Stock during 1991, the
Company issued warrants for the purchase of up to 2,780,968 shares of the
Company's Series C Preferred Stock at an exercise price of $1.00 per share. In
1995, warrants to purchase 1,753,188 shares of Series C Preferred Stock were
exercised, 222,500 warrants expired during 1995, and the remaining 805,280
warrants were exercised during May 1996.

In connection with the issuance of Series E Preferred Stock in 1994, the
Company issued warrants for the purchase of Series E Preferred Stock, which
upon the completion of the IPO and the reincorporation in Delaware, were
automatically converted to purchase 20,728 shares of common stock at $5.74 per
share. The warrants are currently exercisable and expire the earlier of five
years from the date of issuance or 6 months after the closing of the initial
public offering.

In connection with an equipment lease agreement entered into during 1993
with a leasing company, the Company issued a warrant for the purchase of
preferred stock, which upon the completion of the IPO and the reincorporation
in Delaware, was automatically converted to purchase 16,303 shares of common
stock at $3.68 per share. This same warrant provides for the purchase of
additional preferred stock, which, upon the completion of the IPO and the
reincorporation in Delaware, was automatically converted to purchase 12,551
shares of common stock at $4.78 per share. This warrant is currently
exercisable and expires on December 29, 2003. The Company leased additional
equipment during 1994 from the same company and, as part of this lease, the
Company issued a warrant for the purchase of preferred stock, which upon the
completion of the IPO and the reincorporation in Delaware, was automatically
converted to purchase 12,551 shares of common stock at $4.78 per share. This
warrant is currently exercisable and expires on December 27, 2004. In 1995,
the Company leased additional equipment from the same company and issued a
warrant to purchase preferred stock, which upon the completion of the IPO and
the reincorporation in Delaware, was automatically converted to purchase
24,509 shares of common stock at $3.67 per share. The warrant is currently
exercisable and expires on December 27, 2005.

In connection with an equipment leasing agreement entered into during 1995
with a leasing company, the Company issued a warrant to purchase 41,165 shares
of the Company's common stock at $6.34 per share. The warrant is exercisable
upon issuance and expires on November 20, 2002.

In connection with obtaining the revolving line of credit agreement with a
bank in 1995 (see Note 3), the Company issued the bank warrants to purchase
preferred stock, which upon the completion of the IPO and the reincorporation
in Delaware, were automatically converted to purchase 29,956 and 116,830
shares of common stock at $3.67 and $5.01 per share, respectively. The
warrants are exercisable upon issuance and expire on February 26, 2002 and
August 6, 2002, respectively. In connection with the renewal of the line of
credit agreement in 1996, the Company issued the bank a warrant to purchase
23,149 shares of common stock at $6.34 per share. This warrant is exercisable
upon issuance and expires on April 14, 2003.

In connection with the issuance of a note payable to a stockholder in 1996
(see Note 4), the Company issued a warrant to purchase 176,470 shares of the
Company's common stock at $1.36 per share. The warrant is exercisable upon
issuance and expires on May 22, 2002. This warrant was deemed to have an
immaterial value

50
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

at the issuance date, and accordingly, is carried at the amount paid for the
warrant in the accompanying consolidated financial statements of $12,000.

Shares Reserved

As of December 31, 1997, the Company has shares of common stock reserved for
future issuance as follows:

<TABLE>
<S> <C>
Stock Option and Stock Purchase Plans............................ 1,545,847
Warrants to Purchase Common Stock................................ 474,212
---------
2,020,059
=========
</TABLE>

7. INCOME TAXES:

The Company accounts for income taxes under SFAS No. 109 "Accounting for
Income Taxes." SFAS No. 109 provides for a liability approach to accounting
for income taxes under which deferred income taxes are provided based upon
enacted tax laws and rates applicable to the periods in which taxes become
payable.

The components of the provision for income taxes are as follows (in
thousands):

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1995 1996 1997
------- ------- ---------
<S> <C> <C> <C>
Current provision:
Federal.................................... $ 14 $ 5 $ 262
State...................................... 13 3 55
Foreign.................................... 7 22 16
------- ------- ---------
34 30 333
------- ------- ---------
Deferred provision (benefit):
Federal.................................... (372) (422) 1,946
State...................................... 403 (68) (404)
Foreign.................................... -- -- --
------- ------- ---------
31 (490) 1,542
------- ------- ---------
Net increase (decrease) in valuation
allowance................................... (31) 490 (1,345)
------- ------- ---------
$ 34 $ 30 $ 530
======= ======= =========
</TABLE>

The provision for income taxes differs from the amount which would result by
applying the applicable Federal income tax rate to income (loss) before
provision for income taxes as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Provision (benefit) computed at Federal
statutory rate............................. (34.0)% (34.0)% 34.0%
Change in valuation allowance............... 34.0 34.0 (25.4)
Alternative minimum tax..................... 3.2 0.6 1.1
Non deductible expenses and other........... 0.2 -- --
Foreign tax................................. 1.0 1.7 0.3
------- ------- -------
4.4% 2.3% 10.0%
======= ======= =======
</TABLE>

51
<PAGE>

POWER INTEGRATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The components of the net deferred income tax asset were as follows (in
thousands):

<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1996 1997
-------- -------
<S> <C> <C>
Net operating loss carryforwards............................. $ 8,215 $ 5,013
Tax credit carryforwards..................................... 1,164 1,651
Inventory reserves........................................... 750 1,543
Accounts receivable allowances............................... 114 509
Accrued vacation............................................. 87 112
Other cumulative temporary differences....................... 190 347
-------- -------
10,520 9,175
Valuation allowance.......................................... (10,520) (9,175)
-------- -------
$ -- $ --
======== =======
</TABLE>

A valuation allowance has been recorded for the entire deferred tax asset as
a result of uncertainties regarding the realization of the asset balance, the
variability of operating results and taxable income.

As of December 31, 1997, the Company has net cumulative operating loss
carryforwards for Federal and state income tax reporting purposes of
approximately $14.3 million and $2.5 million, respectively. In addition, as of
December 31, 1997, the Company has research and development tax credit
carryforwards of approximately $1.7 million. These carryforwards expire in
various periods from 2004 to 2011. The United States Tax Reform Act of 1986
contains provisions that limit the net operating loss carryforwards and
research and development credits available to be used in any given year upon
the occurrence of certain events, including the change in ownership resulting
from the IPO completed in December 1997.

52
<PAGE>

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

POWER INTEGRATIONS, INC.

Dated: March 24, 1998 /s/ Howard F. Earhart
By: _________________________________
Howard F. Earhart
President, Chief Executive Officer
and Director
(Principal Executive Financial
Officer)

53
<PAGE>

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
above constitutes and appoints Howard F. Earhart and Robert G. Staples his
true and lawful attorney-in-fact and agent, with full power of substitution
and, for him and in his name, place and stead, in any and all capacities to
sign any and all amendments to this Report on Form 10-K, and to file the same,
with all exhibits thereto and other documents in connection therewith, with
the Securities and Exchange Commission, granting unto said attorney-in-fact
and agent full power and authority to do and perform each and every act and
thing requisite and necessary to be done in connection therewith, as fully to
all intents and purposes as he might or could do in person, hereby ratifying
and confirming all that said attorney-in-fact and agent, or his substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT
AND IN THE CAPACITIES AND ON THE DATES INDICATED.

Dated: March 24, 1998 /s/ Howard F. Earhart
By: _________________________________
Howard F. Earhart
President, Chief Executive Officer
and Director
(Principal Executive Financial
Officer)

Dated: March 24, 1998 /s/ Robert G. Staples
By: _________________________________
Robert G. Staples
Chief Financial Officer (Principal
Financial
and Principal Accounting Officer)

Dated: March 24, 1998 /s/ Dr. Edward C. Ross
By: _________________________________
Dr. Edward C. Ross
Director

Dated: March 24, 1998 /s/ Dr. William Davidow
By: _________________________________
Dr. William Davidow
Director

Dated: March 24, 1998 /s/ E. Floyd Kvamme
By: _________________________________
E. Floyd Kvamme
Director

Dated: March 24, 1998 /s/ Steven J. Sharp
By: _________________________________
Steven J. Sharp
Director

54
<PAGE>

POWER INTEGRATIONS

EXHIBITS
TO
FORM 10-K ANNUAL REPORT

FOR THE YEAR ENDED
DECEMBER 31, 1997

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
24.1 Power of Attorney (See signature page)
27.1 Financial Data Schedule
</TABLE>

<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 25,553
<SECURITIES> 0
<RECEIVABLES> 7,512
<ALLOWANCES> 1,269
<INVENTORY> 7,328
<CURRENT-ASSETS> 42,928
<PP&E> 12,625
<DEPRECIATION> 6,994
<TOTAL-ASSETS> 48,559
<CURRENT-LIABILITIES> 12,797
<BONDS> 0
0
0
<COMMON> 12
<OTHER-SE> 33,315
<TOTAL-LIABILITY-AND-EQUITY> 48,559
<SALES> 44,827
<TOTAL-REVENUES> 45,989
<CGS> 26,291
<TOTAL-COSTS> 26,291
<OTHER-EXPENSES> 13,723
<LOSS-PROVISION> 128
<INTEREST-EXPENSE> 832
<INCOME-PRETAX> 5,292
<INCOME-TAX> 530
<INCOME-CONTINUING> 4,762
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,762
<EPS-PRIMARY> 3.22
<EPS-DILUTED> 0.49

</TABLE>