LSCC

Business Context and Reporting Period

Lattice Semiconductor Corporation (Lattice) designs, develops, and markets high-performance programmable logic devices. This Form 10-Q covers the quarterly period ended April 2, 2005 (referred to as the quarter ended March 31, 2005). The company operates in a single industry segment serving communications, computing, industrial, automotive, medical, consumer, and military end markets.

Key Financial Metrics

Expense Breakdown (Q1 2005): Cost of products sold was $22.2 million. Research and development (R&D) expenses were $24.6 million (48% of revenue). Selling, general, and administrative (SG&A) expenses were $14.3 million (28% of revenue). Amortization of intangible assets was $4.4 million.

Material Changes vs. Prior Period

• Revenue Decline: Revenue decreased 13% year-over-year to $51.3 million. This was driven by declines in Mainstream (-25%) and Mature (-31%) product lines, partially offset by an 86% increase in New product revenue.
• Improved Profitability: Net loss narrowed to $10.9 million from $16.5 million in the prior year, primarily due to a significant reduction in amortization of intangible assets ($4.4 million vs. $18.7 million) as assets from the 1999 Vantis acquisition were fully amortized.
• Expense Increases: R&D expenses rose to $24.6 million due to mask and engineering wafer costs for new products. SG&A increased to $14.3 million, largely due to professional fees related to pending litigation.
• Cash Flow: Operating cash flow turned negative at $(28.1) million, compared to positive $13.0 million in Q1 2004. This was driven by a $25.0 million payment to Fujitsu for wafer supply and an increase in accounts receivable.
• Debt Reduction: The company extinguished $15.5 million of Zero Coupon Convertible Subordinated Notes for $13.3 million in cash, recognizing a $2.0 million gain.

Guidance, Outlook, and Risks

Outlook: Management expects to continue significant investments in R&D to maintain product leadership. Future revenue growth is dependent on market acceptance of new FPGA products and general economic conditions in the communications and computing markets. The company does not expect to pay federal or state income taxes in 2005.

Accounting Changes: Lattice will adopt new FASB standards regarding share-based payment (SFAS 123R) in January 2006, which will require expensing the fair value of stock options, significantly impacting future operating results.

Risks and Contingencies:

• Litigation: The company faces consolidated class action and shareholder derivative lawsuits alleging securities law violations and breach of fiduciary duty related to a 2003 financial restatement. Potential liability is unquantifiable but could be material.
• Supply Chain: Lattice relies on third-party foundries (Seiko Epson, UMC, Chartered, Fujitsu) for wafer manufacturing. Disruptions in Asia or yield issues could impact supply.
• Market Conditions: The semiconductor industry is cyclical. A continued downturn in the communications end market could further reduce demand.
• Internal Controls: While management concluded disclosure controls were effective, the company is implementing changes to address previously identified material weaknesses regarding separation of duties and inventory allowances.

Investor Verification Checklist

• Verify the status and potential financial impact of the pending class action and derivative lawsuits regarding the 2003 restatement.
• Monitor the adoption timeline and estimated financial impact of the new share-based payment accounting standard (SFAS 123R) effective Jan 2006.
• Assess the progress of new FPGA product introductions and their market acceptance, as these are critical for future revenue growth.
• Review the company's liquidity position given the negative operating cash flow and reliance on cash reserves to fund operations and wafer supply payments.
• Confirm the stability of wafer supply commitments with foundry partners, particularly Fujitsu for next-generation products.