Lattice Semi with Margin Issues

Still battling hard, but we worry on margin growth

Lattice Semiconductor (LSCC - Snapshot Report) is starting to see the ramp of some new products, and new product revenue is expected to be the primary growth driver in 2009. However, the company has low gross and operating margins, and margin pressure from new product development costs is expected to continue.

The growth story surrounding the stock is centered on the FPGA market, and leading market research is positive about growth in this market despite macro softness. We were somewhat optimistic about both revenue growth and profitability in 2008 and 2009. However, the recession has had a significant impact on results, and the outlook for 2009 is cloudy at best.

The TTM ROE was -1.0%. The Du Pont analysis (based on pro forma profit numbers) indicates that the TTM [trailing 12 month] profit margin has been declining. Fiscal 2006 was a good year in terms of profits. We believe that the decline in TTM profit margins in 2007 was mainly due to the success of new products. So we do not necessarily view this as a negative.

However, execution remains something to watch. The TTM profit margin was positive in the last three quarters of 2008, although it turned negative again in the last quarter. The decline in the TTM asset turnover was related to two straight quarters of revenue decline. It is evident that management has been efficient in the use of assets. The equity multiplier also declined.

High initial costs related to new products likely to remain a drag on margins

Although the revenue opportunity is encouraging, we see limited scope for gross margin expansion in the near term. New product development and start-up costs are relatively high, which will negatively impact the gross margin until there is sufficient sales volume. New products continue to grow in the mix, so the margin pressure continues.

Gross margins have stayed in the 56-57% range in 14 of the last 21 quarters, and have fallen below that level in seven of these quarters. The recession has also lowered sales volumes, making cost absorption difficult, and leading to a consistent decline in the gross margin in the last four quarters. Management expects gross margins of 50-52% in the next quarter, a further decline from Q1.

The company has instituted restructuring measures to reduce operating expenses. Both R&D and SG&A expenses declined in the last three quarters (although they continue to increase as a percentage of sales).

Typical hitches to revenue growth

A percentage of the products that are currently in the prototyping phase will be cancelled per normal procedure. The remaining products, that actually reach the production phase, will be dependent on the demand experienced by the company’s customers and their individual product cycles. Management stated that engineering design cycles tend to push out, thus volume production could set in at a time when end demand starts to drop off.

As expected, results took a beating in the last quarter. Management also did not provide order information, which makes it harder to forecast future results. However, management did say that the backlog exiting the quarter was higher than the backlog entering it. This seems to indicate lower turns requirements to meet the guidance numbers. Therefore, order rates are likely to have picked up in the last quarter, in-line with others in the industry.

Sejuti Banerjea contributed to this post.