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 July 4, 2009 (Q2 Fiscal 2009), and the six months ended July 4, 2009. The company operates in a single industry segment with significant exposure to the communications equipment end market, particularly the China 3G telecommunications network build-out.

Key Financial Metrics

Liquidity and Debt: As of July 4, 2009, Lattice held $102.3 million in cash and cash equivalents and $1.98 million in short-term marketable securities. The company has no long-term debt outstanding, having retired all Convertible Notes in July 2008. Total liabilities were $31.96 million.

Material Changes vs. Prior Period

• Revenue Decline: Revenue decreased 19.3% year-over-year in Q2 2009 and 21.3% for the six-month period. This was driven by a 50% decline in Mature product revenue and a 39% decline in Mainstream product revenue, partially offset by a 70% increase in New product revenue.
• Improved Profitability: While the company reported a net loss, the loss narrowed significantly compared to the prior year (from $13.6M to $2.7M in Q2). This improvement was largely due to a reduction in "Other income (expense), net" charges related to marketable securities impairments, which dropped from $10.5M in Q2 2008 to a net gain of $0.2M in Q2 2009.
• Gross Margin Compression: Gross margin percentage declined from 56.0% to 52.4% due to a shift in product mix toward lower-margin New products and higher-margin Mature products, as well as underabsorbed overhead costs.
• Expense Reduction: Operating expenses decreased due to headcount reductions from prior restructuring plans. R&D expenses fell 23% and SG&A expenses fell 11% year-over-year.

Guidance, Outlook, and Risks

Restructuring Plan: On July 20, 2009, the Board approved a new restructuring plan to reduce headcount by approximately 64 employees (8% of workforce) and move warehouse operations from Oregon to Singapore. The company expects to record a charge of approximately $1.2 million in Q3 2009, with expected quarterly cost savings of $1.5 million starting in Q4 2009.

Market Outlook: Management notes that forecasting for the remainder of 2009 is challenging due to limited market visibility. Revenue from the communications end market (57% of Q2 revenue) remains critical, specifically tied to the China 3G build-out. A restructuring of the distribution network in Greater China is expected to have a negative revenue impact of approximately $2.0 million in Q3 2009.

Key Risks and Contingencies:

• Auction Rate Securities (ARS): The company holds $18.4 million in long-term marketable securities (ARS) with a face value of $38.2 million. These securities are illiquid due to failed auctions. Recent events include AMBAC discontinuing dividends and downgrading its preferred shares from B to CC, which may reduce the liquidation value of these holdings below the recorded fair value.
• Customer Concentration: Two large telecommunications equipment providers accounted for approximately 23% of revenue in the first six months of 2009.
• Supply Chain: The company relies on Fujitsu as a sole source for wafers for its newest products. A $54.0 million receivable from Fujitsu (including $30M cash and $24M credits) is unsecured.
• Legal: A patent infringement lawsuit filed by Lizy K. John is stayed pending re-examination by the PTO.

Investor Verification Checklist

• ARS Liquidity: Verify the current fair value and potential further impairment of the $18.4 million auction rate securities portfolio, especially given the AMBAC downgrade.
• China 3G Demand: Assess the sustainability of revenue from the China 3G telecommunications build-out and the impact of the distribution network restructuring in Greater China.
• Fujitsu Receivables: Monitor the collection of the $30 million cash receivable due from Fujitsu by October 15, 2009, and the realization of the $24 million in wafer credits.
• Restructuring Execution: Track the timing and magnitude of the $1.2 million restructuring charge in Q3 and the realization of the projected $1.5 million quarterly cost savings.
• Product Mix Transition: Evaluate whether revenue growth from New products can sufficiently offset the continued decline in Mature and Mainstream product lines to stabilize gross margins.