LSCC

Business Context and Reporting Period

Lattice Semiconductor Corporation (Lattice) designs, develops, and markets high-performance programmable logic devices (PLDs) and field-programmable gate arrays (FPGAs). This Form 10-Q covers the quarterly period ended October 2, 2010 (Fiscal Q3 2010) and the nine months ended October 2, 2010. The company operates in a single industry segment with significant revenue concentration in the communications end market and the Asia Pacific region.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Revenue increased 57% year-over-year in Q3 and 61% for the nine-month period, driven by broad-based growth across product lines and end markets. FPGA unit sales increased 80% in Q3.
• Profitability Turnaround: The company returned to profitability, reporting net income of $15.4 million in Q3 compared to a net loss of $4.1 million in the prior year quarter. Operating income improved from a loss of $3.5 million to $14.9 million.
• Margin Expansion: Gross margins improved to 59.1% in Q3 from 54.2% in Q3 2009, attributed to higher production volumes absorbing fixed overhead and a favorable product mix shift toward higher-margin mature and mainstream products.
• Restructuring Costs: Restructuring charges decreased significantly to $0.1 million in Q3 2010 from $2.5 million in Q3 2009 as the 2009 restructuring plan neared completion.
• Geographic Shift: While export revenue remains dominant (88%), the Asia Pacific region's share of total revenue remained steady at 55%, while Japan revenue grew significantly (14% of total).

Outlook, Risks, and Unusual Items

• Management Commentary: Management expects continued dependence on the communications end market, which accounted for 50% of revenue in the first nine months of 2010. They anticipate continued investment in R&D for advanced process technologies (65nm) and increased capital expenditures for test equipment.
• Liquidity and Auction Rate Securities: The company holds $19.9 million par value of illiquid auction rate securities, currently valued at $9.7 million. These are classified as long-term marketable securities due to failed auctions. Management intends to sell these as markets resume but notes that liquidation could result in amounts materially different from the estimated fair value.
• Executive Transition: Darin G. Billerbeck was appointed President and CEO, effective November 8, 2010. The company notes potential business disruption risks associated with this transition.
• Legal Proceedings: Three patent infringement lawsuits are pending (John, Stragent/SeeSaw, and Intellitech). The company states that the likelihood and amount of potential exposure cannot be estimated at this time.
• Supply Chain Risks: Lattice relies on Fujitsu as the sole source supplier for wafers for its newest FPGA and PLD products. Disruptions in wafer supply or yield issues could materially harm operations.

Investor Verification Checklist

• Auction Rate Securities Valuation: Verify the current fair value and liquidity status of the $19.9 million par value auction rate securities portfolio, as liquidation values may differ significantly from book value.
• Customer Concentration: Confirm the stability of revenue from the two large telecommunications equipment providers, which accounted for 12% of revenue in the first nine months of 2010 (down from 20% in 2009).
• Foundry Dependency: Assess the risk associated with reliance on Fujitsu as the sole wafer supplier for new products and the status of supply commitments.
• Revenue Recognition Model: Review the impact of the sell-through distribution model, where 55% of revenue is recognized upon resale by distributors, on future revenue predictability.
• Patent Litigation Exposure: Monitor the status of pending patent infringement lawsuits for potential injunctions or damages.