1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared by Monolithic Power Systems, Inc. (the “Company” or “MPS”) in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted in accordance with these accounting principles, rules and regulations. The information in this report should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2015, filed with the SEC on February 29, 2016.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The financial statements contained in this Form 10-Q are not necessarily indicative of the results that may be expected for the year ending December 31, 2016 or for any other future periods.

Summary of Significant Accounting Policies

There have been no changes to the Company’s significant accounting policies during the three and six months ended June 30, 2016 as compared to the significant accounting policies described in the Company’s audited consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2015.

Recent Accounting Pronouncements

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments, which introduces a model based on expected losses to estimate credit losses for most financial assets and certain other instruments. In addition, for available-for-sale debt securities with unrealized losses, the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. The standard will be effective for annual reporting periods beginning after December 15, 2019, with early adoption permitted for annual reporting periods beginning after December 15, 2018. Entities will apply the standard’s provisions by recording a cumulative-effect adjustment to retained earnings. The Company is evaluating the impact of the adoption on its consolidated financial position, results of operations, cash flows and disclosures.

In March 2016, the FASB issued ASU No. 2016-09, Compensation—Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which changes how entities account for certain aspects of share-based payment awards, including the accounting for excess tax benefits and tax deficiencies, forfeitures, statutory tax withholding requirements, as well as classification of excess tax benefits in the statements of cash flows. The standard will be effective for annual reporting periods beginning after December 15, 2016, with early adoption permitted. The manner of application varies by the different provisions of the guidance, with certain provisions applied on a retrospective or modified retrospective approach, while others are applied prospectively. The Company is evaluating the impact of the adoption on its consolidated financial position, results of operations, cash flows and disclosures.

In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires entities to recognize a right-of-use asset and a lease liability on the balance sheets for substantially all leases with a lease term greater than 12 months, including leases currently accounted for as operating leases. The standard requires modified retrospective adoption and will be effective for annual reporting periods beginning after December 15, 2018, with early adoption permitted. The Company is evaluating the impact of the adoption on its consolidated financial position, results of operations, cash flows and disclosures.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The standard’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In July 2015, the FASB approved a one-year deferral of the effective date. The standard will be effective for annual reporting periods beginning after December 15, 2017. Early adoption is permitted for reporting periods beginning after December 15, 2016. The standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company is evaluating the impact of the adoption on its consolidated financial position, results of operations, cash flows and disclosures.

2. STOCK-BASED COMPENSATION

Stock Plan

The Board of Directors adopted the 2014 Equity Incentive Plan (the “2014 Plan”) in April 2013, and the stockholders approved it in June 2013. In October 2014, the Board of Directors approved certain amendments to the 2014 Plan. The 2014 Plan became effective on November 13, 2014 and provides for the issuance of up to 5.5 million shares. The 2014 Plan will expire on November 13, 2024. As of June 30, 2016, 3.9 million shares remained available for future issuance. 

Stock-Based Compensation Expense

The Company recognized stock-based compensation expenses as follows (in thousands):

In the first quarter of 2016, the Company’s then Chief Financial Officer retired. As the service or performance conditions for certain of her unvested restricted stock units (“RSUs”) had not been satisfied at the time of her departure, the Company reversed previously accrued stock-based compensation expenses of approximately $2.9 million associated with the unvested shares and recorded the one-time credit in selling, general and administrative expenses for the three months ended March 31, 2016.

RSUs

The Company’s RSUs include time-based RSUs, RSUs with performance conditions (“PSUs”), RSUs with market and performance conditions (“MPSUs”), and RSUs with market conditions (“MSUs”). Vesting of all awards requires continued service for the Company. In addition, vesting of awards with performance conditions or market conditions is subject to the achievement of pre-determined performance goals. A summary of RSU activity is presented in the table below (in thousands, except per-share amounts): 

The intrinsic value related to awards released for the three months ended June 30, 2016 and 2015 was $13.5 million and $8.4 million, respectively. The intrinsic value related to awards released for the six months ended June 30, 2016 and 2015 was $42.6 million and $33.9 million, respectively. As of June 30, 2016, the total intrinsic value of all outstanding awards was $296.1 million, based on the closing stock price of $68.32. As of June 30, 2016, unamortized compensation expense related to all outstanding awards was approximately $105.8 million with a weighted-average remaining recognition period of approximately four years. 

2016 Time-Based RSUs:

For the six months ended June 30, 2016, the Board of Directors granted 116,000 shares with service conditions to employees and non-employee directors. The RSUs vest over one year for non-employee directors and four years for employees, subject to continued employment with the Company.

2016 PSUs:

In February 2016, the Board of Directors granted 285,000 shares to the executive officers, which represent a target number of RSUs to be awarded based on the Company’s average two-year (2016 and 2017) revenue growth rate compared against the analog industry’s average two-year revenue growth rate as determined by the Semiconductor Industry Association (“2016 Executive PSUs”). The maximum number of 2016 Executive PSUs that an executive officer can earn is 300% of the target shares. 50% of the 2016 Executive PSUs will vest in the first quarter of 2018 if the pre-determined performance goals are met during the performance period and approved by the Compensation Committee. The remaining shares will vest over the following two years on a quarterly basis. Vesting is subject to the employees’ continued employment with the Company. In March 2016, the Company cancelled 32,000 shares granted in February 2016 as a result of the departure of its then Chief Financial Officer. Assuming the achievement of the highest level of performance goals, the total stock-based compensation cost for the 2016 Executive PSUs is approximately $30.0 million.

In February 2016, the Board of Directors granted 64,000 shares to certain non-executive employees, which represent a target number of RSUs to be awarded based on the Company’s 2017 revenue goals for certain regions or product line divisions, or the Company’s average two-year (2016 and 2017) revenue growth rate compared against the analog industry’s average two-year revenue growth rate as determined by the Semiconductor Industry Association (“2016 Non-Executive PSUs”). The maximum number of 2016 Non-Executive PSUs that an employee can earn is either 200% or 300% of the target shares, depending on the job classification of the employee. 50% of the 2016 Non-Executive PSUs will vest in the first quarter of 2018 if the pre-determined performance goals are met during the performance period and approved by the Compensation Committee. The remaining shares will vest over the following two years on an annual or quarterly basis. Vesting is subject to the employees’ continued employment with the Company. Assuming the achievement of the highest level of performance goals, the total stock-based compensation cost for the 2016 Non-Executive PSUs is approximately $6.2 million.

The 2016 Executive PSUs and the 2016 Non-Executive PSUs contain a purchase price feature, which requires the employees to pay the Company $20 per share upon vesting of the shares. Shares that do not vest will not be subject to the purchase price payment. The Company determined the grant date fair value of the 2016 Executive PSUs and the 2016 Non-Executive PSUs using the Black-Scholes model with the following assumptions: stock price of $58.98, expected term of 2.6 years, expected volatility of 31.1% and risk-free interest rate of 0.9%. 

2015 MPSUs:

On December 31, 2015, the Board of Directors granted 127,000 shares to the executive officers and certain key employees, which represent a target number of RSUs to be awarded upon achievement of both market conditions and performance conditions (“2015 MPSUs”). The maximum number of 2015 MPSUs that an employee can earn is 500% of the target shares. The 2015 MPSUs consist of four separate tranches with various performance periods ending on December 31, 2019. The first tranche contains market conditions only, which require the achievement of five MPS stock price targets ranging from $71.36 to $95.57 over a four-year period. The second, third and fourth tranches contain both market conditions and performance conditions. Each tranche requires the achievement of five MPS stock price targets to be measured against a base price equal to the greater of: (1) the average closing stock price during the 20 consecutive trading days immediately before the start of the measurement period for that tranche, or (2) the closing stock price immediately before the start of the measurement period for that tranche. In addition, each of the second, third and fourth tranches requires the achievement of one of following six operating metrics:

Subject to the employees’ continued employment with the Company, the 2015 MPSUs will fully vest on January 1, 2020 if the pre-determined individual market and performance goals in each tranche are met during the performance periods and approved by the Compensation Committee. In addition, the 2015 MPSUs contain post-vesting restrictions on sales of the vested shares by employees for up to two years.

The Company determined the grant date fair value of the 2015 MPSUs using a Monte Carlo simulation model with the following weighted-average assumptions: stock price of $61.35, expected volatility of 33.2%, risk-free interest rate of 1.3%, and an illiquidity discount of 7.8% to account for the post-vesting sales restrictions. In March 2016, the Company cancelled 13,000 shares of the 2015 MPSUs as a result of the departure of its then Chief Financial Officer. Assuming the achievement of all of the required performance goals, the total stock-based compensation cost for the 2015 MPSUs is approximately $24.6 million to be recognized as follows: $8.3 million for the first tranche, $4.5 million for the second tranche, $5.2 million for the third tranche, and $6.6 million for the fourth tranche.

For the first tranche, stock-based compensation expense is being recognized over four years even if the market conditions are not satisfied. For the second, third and fourth tranches, stock-based compensation expense for each tranche will be recognized depending upon the number of the operating metrics management deems probable of achievement in each reporting period. As of March 31, 2016 and June 30, 2016, based on management’s assessment, two of the six operating metrics were considered probable of being achieved during the performance period. Accordingly, stock-based compensation expense is being recognized for the second and third tranches over four years.

Stock Options

As of June 30, 2016, outstanding and vested options totaled 34,000 shares, with a weighted-average exercise price of $15.68, a weighted-average remaining contractual term of 1.5 years, and an aggregate intrinsic value of $1.8 million.

Total intrinsic value of options exercised was $1.4 million and $12.9 million for the three months ended June 30, 2016 and 2015, respectively. Total intrinsic value of options exercised was $2.5 million and $15.4 million for the six months ended June 30, 2016 and 2015, respectively. The net cash proceeds from the exercise of stock options were $1.0 million and $6.7 million for the six months ended June 30, 2016 and 2015, respectively. As of June 30, 2016, there was no unamortized compensation expense.

Employee Stock Purchase Plan (“ESPP”)

No shares were issued under the ESPP for the three months ended June 30, 2016 and 2015. For the six months ended June 30, 2016 and 2015, 29,000 and 30,000 shares, respectively, were issued under the ESPP. As of June 30, 2016, 4.7 million shares were available for future issuance.

The intrinsic value of shares issued was $0.4 million for both the six months ended June 30, 2016 and 2015. As of June 30, 2016, the unamortized expense was $0.1 million, which will be recognized through the third quarter of 2016. The Black-Scholes model was used to value the employee stock purchase rights with the following weighted-average assumptions: 

Cash proceeds from the shares issued under the ESPP were $1.3 million and $1.1 million for the six months ended June 30, 2016 and 2015, respectively. 

3. BALANCE SHEET COMPONENTS

Inventories 

Inventories consist of the following (in thousands):  

When the Company records a write-down on inventory, it establishes a new, lower cost basis for that inventory, and subsequent changes in facts and circumstances will not result in the restoration or increase in that newly established cost basis.

Other Long-Term Assets

Other long-term assets consist of the following (in thousands):

Accrued Liabilities

Accrued liabilities consist of the following (in thousands): 

A roll-forward of the warranty reserve is as follows (in thousands):

Other Long-Term Liabilities

Other long-term liabilities consist of the following (in thousands):

4. GOODWILL AND ACQUISITION-RELATED INTANGIBLE ASSETS, NET

There have been no changes in the balance of goodwill during the three and six months ended June 30, 2016.

Acquisition-related intangible assets subject to amortization consist of the following (in thousands):

Amortization expense is recorded in cost of revenue in the Condensed Consolidated Statements of Operations. For the three months ended June 30, 2016 and 2015, amortization expense totaled $0.5 million and $0.4 million, respectively. For the six months ended June 30, 2016 and 2015, amortization expense totaled $1.0 million and $0.7 million, respectively.

As of June 30, 2016, the estimated future amortization expense was as follows (in thousands):

5. NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that would occur if outstanding securities or other contracts to issue common stock were exercised or converted into common stock, and calculated using the treasury stock method. Contingently issuable shares, including equity awards with performance conditions or market conditions, are considered outstanding common shares and included in the basic net income per share as of the date that all necessary conditions to earn the awards have been satisfied. Prior to the end of the contingency period, the number of contingently issuable shares included in the diluted net income per share is based on the number of shares, if any, that would be issuable under the terms of the arrangement at the end of the reporting period.

The Company’s outstanding RSUs contain forfeitable rights to receive dividend equivalents, which are accumulated and payable to the employees when the underlying RSUs vest. Dividend equivalents accumulated on the underlying RSUs are forfeited if the employees do not fulfill their service requirement during the vesting periods. Accordingly, these awards are not treated as participating securities in the net income per share calculation. 

The following table sets forth the computation of basic and diluted net income per share (in thousands, except per-share amounts):

Anti-dilutive common stock equivalents were not material in any of the periods presented.

6. SEGMENT AND GEOGRAPHIC INFORMATION

The Company operates in one reportable segment that includes the design, development, marketing and sale of high-performance power solutions for the communications, storage and computing, consumer and industrial markets. The Company’s chief operating decision maker is its chief executive officer, who reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. The Company derives a majority of its revenue from sales to customers located outside North America, with geographic revenue based on the customers’ ship-to locations.

The Company sells its products primarily through third-party distributors and value-added resellers, and directly to original equipment manufacturers, original design manufacturers and electronic manufacturing service providers. The following table summarizes those customers with sales greater than 10% of the Company's total revenue: 

The following table summarizes those customers with accounts receivable balances greater than 10% of the Company’s total accounts receivable:

Both of the customers are third-party distributors. The Company’s agreements with these distributors were made in the ordinary course of business and may be terminated with or without cause by these distributors with advance notice. Although the Company may experience a short-term disruption in the distribution of its products and a short-term decline in revenue if its agreement with either of these distributors was terminated, the Company believes that such termination would not have a material adverse effect on its financial statements because it would be able to engage alternative distributors, resellers and other distribution channels to deliver its products to end customers within a few quarters following the termination of the agreement with the distributor.

The following is a summary of revenue by geographic regions (in thousands):

The following is a summary of revenue by product family (in thousands):

The following is a summary of long-lived assets by geographic regions (in thousands):

7. LITIGATION

The Company is a party to actions and proceedings in the ordinary course of business, including litigation regarding its shareholders and its intellectual property, challenges to the enforceability or validity of its intellectual property, claims that the Company’s products infringe on the intellectual property rights of others, and employment matters. These proceedings often involve complex questions of fact and law and may require the expenditure of significant funds and the diversion of other resources to prosecute and defend. The Company defends itself vigorously against any such claims.

As of June 30, 2016, there were no material pending legal proceedings to which the Company was a party.

8. CASH, CASH EQUIVALENTS AND INVESTMENTS

The following is a summary of the Company’s cash, cash equivalents and short-term and long-term investments (in thousands): 

The contractual maturities of the Company’s short-term and long-term available-for-sale investments are as follows (in thousands):

The following tables summarize the unrealized gain and loss positions related to the Company’s investments in marketable securities designated as available-for sale (in thousands): 

9. FAIR VALUE MEASUREMENTS  

The following table details the fair value measurement of the financial assets (in thousands):

The Company’s level 3 assets consist of government-backed student loan auction-rate securities, with interest rates that reset through a Dutch auction every 7 to 35 days and which became illiquid in 2008. The following table provides a rollforward of the fair value of the auction-rate securities (in thousands):

The Company determined the fair value of the auction-rate securities using a discounted cash flow model with the following assumptions: 

10. DEFERRED COMPENSATION PLAN

The Company has a non-qualified, unfunded deferred compensation plan, which provides certain key employees, including executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax deferred basis. The Company does not make contributions to the plan or guarantee returns on the investments. The Company is responsible for the plan’s administrative expenses. Participants’ deferrals and investment gains and losses remain as the Company’s liabilities and the underlying assets are subject to claims of general creditors. The following table summarizes the deferred compensation plan amounts in the Condensed Consolidated Balance Sheets (in thousands):

11. INCOME TAXES

The income tax provision for the three and six months ended June 30, 2016 was $0.9 million, or 7.6% of the pre-tax income, and $1.3 million, or 5.5% of the pre-tax income, respectively. The effective tax rate differed from the federal statutory rate primarily because foreign income was taxed at lower rates, and because of the benefit that the Company realized from the release of RSUs. In addition, the effective tax rate was impacted by changes in the valuation allowance.

The income tax provision for the three and six months ended June 30, 2015 was $2.4 million, or 23.7% of the pre-tax income, and $3.0 million, or 17.7% of the pre-tax income, respectively. The Company recorded a one-time net charge of $2.7 million to the income tax provision related to the resolution of the income tax audits for the tax years 2005 through 2007 in the second quarter of 2015. In addition to the impact of this charge, the effective tax rate differed from the federal statutory rate primarily because the foreign income was taxed at lower rates, and because of the benefit that the Company realized from stock option exercises and the release of RSUs, and from the release of an income tax reserve where the statute of limitations expired. In addition, the effective tax rate was impacted by changes in the valuation allowance.

On July 27, 2015, in Altera Corp. v. Commissioner, the U.S. Tax Court issued an opinion related to the treatment of stock-based compensation expense in an intercompany cost-sharing arrangement. A final decision was issued in December 2015, and the IRS appealed the decision in February 2016. At this time, the U.S. Department of the Treasury has not withdrawn the requirement from its regulations to include stock-based compensation. Due to the uncertainty surrounding the status of the current regulations, questions related to the scope of potential benefits, and the risk of the Tax Court’s decision being overturned upon appeal, the Company has not recorded any adjustments as of June 30, 2016. The Company will continue to monitor developments related to this opinion and the potential impact on its financial statements.

Unrecognized Tax Benefits

As of June 30, 2016, the Company had $14.0 million of unrecognized tax benefits, $3.8 million of which would affect its effective tax rate if recognized after considering the valuation allowance. At December 31, 2015, the Company had $12.1 million of unrecognized tax benefits, $2.7 million of which would affect its effective tax rate if recognized after considering the valuation allowance.

Uncertain tax positions relate to the allocation of income and deductions among the Company’s global entities and to the determination of the research and development tax credit. It is reasonably possible that over the next twelve-month period, the Company may experience increases or decreases in its unrecognized tax benefits. However, it is not possible to determine either the magnitude or the range of increases or decreases at this time.

The Company recognizes interest and penalties, if any, related to uncertain tax positions in its income tax provision. As of June 30, 2016 and December 31, 2015, the Company has approximately $0.3 million and $0.2 million of accrued interest related to uncertain tax positions, respectively, which were recorded in long-term income tax liabilities in the Condensed Consolidated Balance Sheets. 

Income Tax Examination

The Company is subject to examination of its income tax returns by the Internal Revenue Service (“IRS”) and other tax authorities. In May 2016, the IRS notified the Company that its federal income tax return for the year ended December 31, 2014 is under examination.  The opening conference with the IRS for the examination is scheduled in August 2016.

12. ACCUMULATED OTHER COMPREHENSIVE INCOME

The following table summarizes the changes in accumulated other comprehensive income (in thousands):

The amounts reclassified from accumulated other comprehensive income were recorded in interest and other income, net, in the Condensed Consolidated Statement of Operations.

13. STOCK REPURCHASE

In July 2013, the Board of Directors approved a stock repurchase program that authorized the Company to repurchase up to $100 million in the aggregate of its common stock through June 30, 2015. In April 2015, the Board of Directors approved an extension of the program through December 31, 2015. The stock repurchase program expired as of December 31, 2015 with a remaining unused balance of $5.9 million. Shares were retired upon repurchase under the program.

In February 2016, the Board of Directors approved a new stock repurchase program that authorized the Company to repurchase up to $50 million in the aggregate of its common stock through December 31, 2016. Shares are retired upon repurchase under the program.

The Company did not repurchase any shares for the three and six months ended June 30, 2016. For the three months ended June 30, 2015, the Company repurchased 0.1 million shares for $7.7 million at an average price of $52.19. For the six months ended June 30, 2015, the Company repurchased 0.4 million shares for $18.1 million at an average price of $51.70.

14. DIVIDENDS AND DIVIDEND EQUIVALENTS

Cash Dividend Program

In June 2014, the Board of Directors approved a dividend program pursuant to which the Company intends to pay quarterly cash dividends on its common stock. Stockholders of record as of the last day of the quarter are entitled to receive the quarterly cash dividends when and if declared by the Board of Directors, which are generally payable on the 15th of the following month. The Board of Directors declared the following cash dividends (in thousands, except per-share amounts): 

As of June 30, 2016 and December 31, 2015, accrued dividends totaled $8.1 million and $7.9 million, respectively.

The declaration of any future cash dividends is at the discretion of the Board of Directors and will depend on, among other things, the Company’s financial condition, results of operations, capital requirements, business conditions, statutory requirements of Delaware law, compliance with the terms of future indebtedness and credit facilities and other factors that the Board of Directors may deem relevant, as well as a determination that cash dividends are in the best interests of the stockholders. The Company anticipates that the cash used for future dividends will come from its current domestic cash and cash generated from ongoing U.S. operations. If cash held by the Company’s international subsidiaries is needed for the payment of dividends, the Company may be required to accrue and pay U.S. taxes to repatriate the funds.

Cash Dividend Equivalent Rights

Under the Company’s stock plans, outstanding RSUs contain rights to receive cash dividend equivalents, which entitle employees who hold RSUs to the same dividend value per share as holders of common stock. The dividend equivalents are accumulated and are payable to the employees when the underlying RSUs vest. Dividend equivalents accumulated on the underlying RSUs are forfeited if the employees do not fulfill their service requirement during the vesting periods. As of June 30, 2016 and December 31, 2015, accrued dividend equivalents totaled $3.3 million and $2.8 million, respectively, which will be payable to the employees when the underlying RSUs vest. 

15. SUBSEQUENT EVENT

2016 PSUs

In July 2016, the Company appointed Mr. Bernie Blegen as its new Chief Financial Officer. In connection with the appointment, the Board granted 12,000 shares to Mr. Blegen, subject to the terms and conditions of the 2016 Executive PSUs (see Note 2).