Lattice Semiconductor Corp: Form 10-Q for the period ended Oct 1, 2022

The following discussion should be read along with the unaudited consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, as well as the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2021 10-K.

Overview

Lattice Semiconductor Corporation and its subsidiaries (“Lattice,” the “Company,” “we,” “us,” or “our”) develop technologies that we monetize through differentiated programmable logic semiconductor products, silicon-enabling products, system solutions, design services, and licenses. Lattice is the low power programmable leader. We solve customer problems across the network, from the Edge to the Cloud, in the growing communications, computing, industrial, automotive, and consumer markets. Our technology, long-standing relationships, and commitment to world-class support helps our customers quickly and easily unleash their innovation to create a smart, secure, and connected world.

Lattice has focused its strategy on delivering programmable logic products and related solutions based on low power, small size, and ease of use. We also serve our customers with intellectual property ("IP") licensing and various other services. Our product development activities include new proprietary products, advanced packaging, existing product enhancements, software development tools, soft IP, and system solutions for high-growth applications such as Edge Artificial Intelligence, 5G infrastructure, platform security, and factory automation.

Critical Accounting Policies and Use of Estimates

Critical accounting policies are those that are both most important to the portrayal of a company's financial condition and results of operations, and that require management's most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. There have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2021 10-K.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments affecting the amounts reported in our consolidated condensed financial statements and the accompanying notes. We base our estimates and judgments on historical experience, knowledge of current conditions, and our beliefs of what could occur in the future considering available information. While we believe that our estimates, assumptions, and judgments are reasonable, they are based on information available when made, and because of the uncertainty inherent in these matters, actual results may differ materially from these estimates under different assumptions or conditions. We evaluate our estimates and judgments on an ongoing basis.

Impact of COVID-19 and Global Economic Activity on our Business

The ongoing COVID-19 pandemic, increasing market volatility, inflationary pressure, and geopolitical tension continue to impact business globally and may impact our operations on an ongoing basis by causing disruption to our labor markets and supply chains. The COVID-19 pandemic, including the resurgence of cases relating to the spread of new variants, has and continues to impact worldwide economic activity and poses the risk that our employees, contractors, suppliers and other partners may be prevented from conducting business activities. The extent to which the COVID-19 pandemic, increasing financial market volatility, inflationary pressure and related uncertainty will impact our business activities will depend on future developments that are highly uncertain and cannot be predicted at this time.

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Results of Operations

Key elements of our Consolidated Statements of Operations, including as a percentage of revenue, are presented in the following table:

(In thousands)

Revenue by End Market

We sell our products globally to a broad base of customers in three primary end market groups: Communications and Computing, Industrial and Automotive, and Consumer. We also provide IP licensing and services to these end markets.

Within these end markets, there are multiple segment drivers, including:

• Communications and computing: 5G infrastructure deployments, client computing platforms, and cloud and enterprise servers,
• Industrial and automotive: industrial Internet of Things ("IoT"), factory automation, robotics, and automotive electronics,
• Consumer: smart home, and prosumer.

We also generate revenue from the licensing of our IP, the collection of certain royalties, patent sales, the revenue related to our participation in consortia and standard-setting activities, and services. While these activities may be associated with multiple markets, Licensing and services revenue is reported as a separate end market as it has characteristics that differ from other categories, most notably a higher gross margin.

The end market data below is derived from data provided to us by our customers. With a diverse base of customers who may manufacture end products spanning multiple end markets, the assignment of revenue to a specific end market requires the use of judgment. We also recognize certain revenue for which end customers and end markets are not yet known. We assign this revenue first to a specific end market using historical and anticipated usage of the specific products, if possible, and allocate the remainder to the end markets based on either historical usage for each product family or industry application data for certain product types.

The following are examples of end market applications for the periods presented:

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The composition of our revenue by end market is presented in the following table:

(In thousands)

Revenue from the Communications and Computing end market increased by 26% for the third quarter of fiscal 2022 compared to the third quarter of fiscal 2021 and increased by 29% for the first nine months of fiscal 2022 compared to the first nine months of fiscal 2021 primarily due to our key growth drivers in data center servers, client computing and 5G infrastructure.

Revenue from the Industrial and Automotive end market increased by 45% for the third quarter of fiscal 2022 compared to the third quarter of fiscal 2021 and increased by 38% for the first nine months of fiscal 2022 compared to the first nine months of fiscal 2021 primarily due to strong customer adoption in a broad range of applications, including industrial automation and robotics. Growth in Automotive was driven by the adoption of new designs in advanced driver assistance ("ADAS") and infotainment applications.

Revenue from the Consumer end market decreased by 13% for the third quarter of fiscal 2022 compared to the third quarter of fiscal 2021 primarily due to macroeconomic weakness in Consumer, and increased by 2% for the first nine months of fiscal 2022 compared to the first nine months of fiscal 2021 primarily due to increased demand for our products in Consumer end market applications over the year-to-date periods.

Revenue from the Licensing and services end market increased by 18% for the third quarter of fiscal 2022 compared to the third quarter of fiscal 2021 and increased by 5% for the first nine months of fiscal 2022 compared to the first nine months of fiscal 2021 primarily due to increased royalties.

Revenue by Geography

We assign revenue to geographies based on ship-to location of the customer.

The composition of our revenue by geography is presented in the following table:

(In thousands)

Revenue from Customers

We sell our products to independent distributors and directly to customers. Distributors have historically accounted for a significant portion of our total revenue, and the two distributor groups noted below individually accounted for more than 10% of our total revenue in the periods covered by this report.

The composition of our revenue by customer is presented in the following table:

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Gross Margin

The composition of our Gross margin, including as a percentage of revenue, is presented in the following table:

(In thousands)

Gross margin, as a percentage of revenue, increased 600 basis points in the third quarter of fiscal 2022 compared to the third quarter of fiscal 2021 and increased by 640 basis points in the first nine months of fiscal 2022 compared to the first nine months of fiscal 2021. Improved margins were driven by benefits from our pricing optimization and gross margin expansion strategy.

Because of its higher margin, the licensing and services portion of our overall revenue can have a disproportionate impact on Gross margin.

Operating Expenses

Research and Development Expense

The composition of our Research and development expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Research and development expense includes costs for compensation and benefits, stock compensation, engineering wafers, depreciation, licenses, and outside engineering services. These expenditures are for the design of new products, IP cores, processes, packaging, and software solutions. The increase in Research and development expense for the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 was due primarily to increased headcount-related costs as we continue to invest in our long-term product roadmap. We believe that investing in research and development is important to delivering innovative products to our customers and, therefore, we expect to continue to increase our investment in research and development.

Selling, General, and Administrative Expense

The composition of our Selling, general, and administrative expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Selling, general, and administrative expense includes costs for compensation and benefits related to selling, general, and administrative employees, commissions, depreciation, professional and outside services, trade show, and travel expenses. The increase in Selling, general, and administrative expense for the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 was due primarily to increased headcount-related costs to support ongoing customer growth, and to increased legal expenses primarily related to the defense of claims outside the ordinary course of business.

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Amortization of Acquired Intangible Assets

The composition of our Amortization of acquired intangible assets, including as a percentage of revenue, is presented in the following table:

(In thousands)

The increase in Amortization of acquired intangible assets for the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 is due to the amortization expense for new intangible assets added in the fourth quarter of fiscal 2021 through the acquisition of Mirametrix, Inc., partially offset by end of the amortization period during the first quarter of fiscal 2022 for acquired intangible assets from previous acquisitions.

Restructuring Charges

The composition of our Restructuring charges, including as a percentage of revenue, is presented in the following table:

(In thousands)

Restructuring charges are comprised of expenses resulting from consolidation of our facilities, cancellation of contracts, and headcount reductions. Details of our restructuring plans and expenses incurred under them are discussed in "Note 6 - Restructuring" to our Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. Restructuring charges increased in the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 primarily due to lease right-of-use impairment and contract termination fees in the current year periods, as compared to minimal activity in the prior year.

Acquisition Related Charges

The composition of our Acquisition related charges, including as a percentage of revenue, is presented in the following table:

(In thousands)

For the first nine months of fiscal 2022, Acquisition related charges were attributable to our acquisition of Mirametrix in November 2021 and were comprised primarily of professional services including legal and accounting fees.

Interest Expense

The composition of our Interest expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Interest expense is primarily related to our long-term debt. This interest expense is comprised of contractual interest and amortization of original issue discount and debt issuance costs based on the effective interest method. The increase in Interest expense for the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 was driven by the increase in the effective interest rate on our long-term debt.

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Other (Expense) Income, net

The composition of our Other (expense) income, net, including as a percentage of revenue, is presented in the following table:

(In thousands)

The changes in Other (expense) income, net for the third quarter and first nine months of fiscal 2022 compared to the third quarter and first nine months of fiscal 2021 were primarily due to the $0.7 million loss on refinancing of our long-term debt during the period.

Income Taxes

The composition of our Income tax expense (benefit) is presented in the following table:

(In thousands)

Our Income tax expense (benefit) is composed primarily of foreign income and withholding taxes, partially offset by benefits resulting from the release of uncertain tax positions due to statute of limitation expirations that occurred in the respective periods. The increase in tax expense in the third quarter and first nine months of fiscal 2022 as compared to the third quarter and first nine months of fiscal 2021 is primarily due to increased worldwide income and changes in uncertain tax positions.

Liquidity and Capital Resources

The following sections discuss material changes in our financial condition from the end of fiscal 2021, including the effects of changes in our Consolidated Balance Sheets, and the effects of our credit arrangements and contractual obligations on our liquidity and capital resources. There continues to be uncertainty around the extent and duration of the disruption to our business, including from the effects of the ongoing COVID-19 pandemic, market volatility, and the rising rate of inflation, which may impact our liquidity and working capital needs in future periods.

We have historically financed our operating and capital resource requirements through cash flows from operations, and from the issuance of long-term debt to fund acquisitions. Cash provided by or used in operating activities will fluctuate from period to period due to fluctuations in operating results, the timing and collection of accounts receivable, and required inventory levels, among other things.

We believe that our financial resources, including current cash and cash equivalents, cash flow from operating activities, and our credit facilities, will be sufficient to meet our liquidity and working capital needs through at least the next 12 months. On September 1, 2022, we entered into our 2022 Credit Agreement, as described in "Note 5 - Long-Term Debt" under Part I, Item 1 of this report. As of October 1, 2022, we did not have significant long-term commitments for capital expenditures. For further information on our cash commitments for operating lease liabilities, see Note 7 - Leases under Part I, Item 1 of this report.

In the future, we may continue to consider acquisition opportunities to further extend our product or technology portfolios and further expand our product offerings. In connection with funding capital expenditures, acquisitions, securing additional wafer supply, increasing our working capital, or other operations, we may seek to obtain equity or additional debt financing. We may also seek to obtain equity or additional debt financing if we experience downturns or cyclical fluctuations in our business that are more severe or longer than we anticipated when determining our current working capital needs.

Cash and cash equivalents

(In thousands)

As of October 1, 2022, we had Cash and cash equivalents of $118.8 million, of which approximately $21.1 million was held by our foreign subsidiaries. We manage our global cash requirements considering, among other things, (i) available funds among our subsidiaries through which we conduct business, (ii) the geographic location of our liquidity needs, and (iii) the cost to access international cash balances. The repatriation of non-US earnings may require us to withhold and pay foreign income tax on dividends. This should not result in our recording significant additional tax expense as we have accrued expense based on current withholding rates. As of October 1, 2022, we could access all cash held by our foreign subsidiaries without incurring significant additional expense.

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The net decrease in Cash and cash equivalents of $12.8 million between January 1, 2022 and October 1, 2022 was primarily driven by cash flows from the following activities:

Operating activities — Cash provided by operating activities results from net income adjusted for certain non-cash items and changes in assets and liabilities. Cash provided by operating activities for the first nine months of fiscal 2022 was $156.8 million compared to $116.1 million for the first nine months of fiscal 2021. This increase of $40.8 million was primarily driven by an increase of $73.7 million provided by improved operating performance, partially offset by $32.9 million of net changes in working capital, primarily from cash used by inventories and accounts receivable. We are using cash provided by operating activities to fund our operations.

Investing activities — Investing cash flows consist primarily of transactions related to capital expenditures and payments for software and intellectual property licenses. Net cash used by investing activities in the first nine months of fiscal 2022 was $21.4 million compared to $16.7 million in the first nine months of fiscal 2021.

Financing activities — Financing cash flows consist primarily of activity on our long-term debt, proceeds from the exercise of options to acquire common stock, tax payments related to the net share settlement of restricted stock units, and repurchases of common stock. In September 2022, we entered into our 2022 Credit Agreement and drew down an initial $150.0 million revolving loan at closing, which we used to pay off the $150.0 million outstanding balance on our previous term and revolving loans. In connection with the 2022 Credit Agreement, we paid $1.4 million in debt issuance costs. During the first nine months of fiscal 2022, we paid required quarterly installments on our previous long-term debt totaling $8.8 million. Payments for tax withholdings on vesting of RSUs partially offset by employee exercises of stock options used net cash flows of $45.7 million in the first nine months of fiscal 2022, an increase of approximately $9.4 million from the net $36.3 million used in the first nine months of fiscal 2021. During the first nine months of fiscal 2022, we also repurchased approximately 1.7 million shares of common stock for $90.1 million, as further discussed below under "Share Repurchase Program."

Accounts receivable, net

(In thousands)

Accounts receivable, net as of October 1, 2022 increased by approximately $20.6 million, or 26%, compared to January 1, 2022. This increase resulted primarily from higher revenue shipments in the third quarter of fiscal 2022 compared to the year-end period. We calculate Days Sales Outstanding on the basis of a 365-day year as Accounts receivable, net at the end of the quarter divided by sales during the quarter annualized and then multiplied by 365.

Inventories

(In thousands)

Inventories as of October 1, 2022 increased $26.4 million, or approximately 39%, compared to January 1, 2022 primarily to meet the increased demands of our customers.

The Days of inventory on hand ratio compares the inventory balance at the end of a quarter to the cost of sales in that quarter. We calculate Days of inventory on hand on the basis of a 365-day year as Inventories at the end of the quarter divided by Cost of sales during the quarter annualized and then multiplied by 365.

Credit Arrangements

On September 1, 2022, we entered into our 2022 Credit Agreement. The details of this arrangement are described in "Note 5 - Long-Term Debt" in the Notes to Consolidated Financial Statements of this Quarterly Report on Form 10-Q.

As of October 1, 2022, we had no used or unused credit arrangements beyond the secured revolving loan facility described in the 2022 Credit Agreement.

Share Repurchase Program

See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds,” of this Quarterly Report on Form 10-Q for more information about the share repurchase program.

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Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates and interest rates. We assess these risks on a regular basis and have established policies that are designed to protect against the adverse effects of these and other potential exposures. There have been no material changes to either the foreign currency exchange rate risk or interest rate risk previously disclosed in Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," of our Annual Report on Form 10-K for the fiscal year ended January 1, 2022.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

In connection with the filing of this Quarterly Report on Form 10-Q, our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls were effective as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over financial reporting (as defined in Rules 13a-15(f) under the Exchange Act) that occurred during the third quarter of fiscal 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We do not believe there has been any material impact to our internal controls over financial reporting notwithstanding that most of our employees are working remotely due to the COVID-19 pandemic. We continue to monitor and assess any potential impact of the COVID-19 pandemic on the design and operating effectiveness of our internal controls.

Inherent Limitations on Effectiveness of Controls

We do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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In addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors associated with our business previously described in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the fiscal year ended January 1, 2022 ("2021 10-K"). There have been no material changes in the risk factors included in our 2021 10-K, and this report should be read in conjunction with the risk factors set forth in our 2021 10-K. The additional risks described below supplement the risk factors described in our 2021 10-K based on information currently known to us and recent developments since the filing date of that report. If any of these risks occur, our business, financial condition, operating results, and cash flows could be materially adversely affected, and the trading price of our common stock could decline. These risk factors are not the only risks facing our company. Additional risks and uncertainties not presently known to us or that we may currently deem to be immaterial, including those discussed below, could materially adversely affect our business, financial condition, or operating results.

Worldwide political and economic conditions may create uncertainties that could adversely affect our business. For example, the continuing military conflict between Ukraine and Russia, as well as the financial and trade-related restrictions associated with Russia and Belarus and economic sanctions on certain individuals and entities in Russia and Belarus, may further disrupt global supply chains and could result in shortages of key materials that our suppliers and foundry partners require to satisfy our needs. Furthermore, any deterioration in the relations between Taiwan and China, and other factors affecting military, political or economic conditions in Taiwan, could adversely impact our third-party manufacturing partners and suppliers located in Taiwan, which could disrupt our business operations. Geopolitical tensions or conflicts may also create a heightened risk of cyberattacks. The ongoing COVID-19 pandemic and adverse macroeconomic conditions, such as rising inflation and labor shortages, may affect demand for our products or increase our product or labor costs, negatively impacting our revenues, gross margins, and overall financial results. Additionally, the U.S. government recently announced new controls regarding semiconductor- and supercomputer-related products and new restrictions affecting U.S. persons’ ability to send certain chips and chip-related technology and software to China without an export license which may impact the global supply chain. We also may be impacted by changes in the tax laws of the United States and foreign jurisdictions. President Biden signed into law the Inflation Reduction act of 2022 (“IRA”) on August 16, 2022 and the CHIPS and Science Act of 2022 on August 9, 2022. These laws implement new tax provisions and provide for various incentives and tax credits, including a 1% excise tax on certain stock repurchases made by publicly traded US corporations after December 31, 2022. Although such events have not significantly affected our business or operations, the ultimate impact is unknown and future developments could adversely affect our operating results and financial condition.

These factors, together with all of the other information in this Quarterly Report on Form 10-Q, including our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, should be carefully considered before making an investment decision relating to our common stock.