Description

Lattice Semiconductor

Investment Summary:

In current markets, where we may be in a late stage cycle, we view Lattice Semiconductor as a decent business available at a reasonable price.  We believe that the underlying value of the company is not evident to the casual observer but will get clearer in coming years as reflected in the company’s P/L.  We feel confident that the company’s turnaround under the watch of a new and motivated CEO will be successful, and that an investment in shares today can generate satisfactory returns over a three to five-year period.  The following reasons bolster our belief:

• The company has regained focus after a prolonged transition period while selling itself to Canyon Bridge.

• High margin business with sticky customer base.

• Secular tailwind in 5G infrastructure build and Edge AI.

• Limited competition. The industry’s major players, Xilinx and Intel (Altera), focused on the data path and large/hyper-scale computing leaving the control path for Lattice to dominate.

• New management. The company brought in an industry veteran who has revamped the entire executive team in just months after taking over, focused on its core markets and eliminating previous distractions.

• The transformation has already boosted the stock price, although we believe the transformation is in its early stages and will continue for several years into the future.  

Business:   

For over 35 years, the company has focused on programmable logic devices (PLDs).  Since the acquisition of SiliconBlue in 2011, Lattice has differentiated its offerings in the marketplace with its ultra-low power and ultra-small field programmable gate array (FPGA) solutions.  Under the new leadership of Jim Anderson, the company has re-focused the business entirely on FPGA solutions and has divested non-core assets from the company’s Silicon Image acquisition.

Below is a slide from Lattice’s recent analyst day presentation that illustrates how it differentiates itself from Xilinx and Intel’s FPGA portfolio.  While the competition focuses on data path with a much larger TAM, Lattice focuses on the control path where low power, small-size, and reliability are essential ingredients to succeed.  The company has solid customer relationships with over 9,000 customers developed over several decades. A smaller TAM and stickier customer base are the reasons why Lattice can maintain its lead over its competition.

Investment Case:

Over the past decade, the company could not capitalize on its strong technical know-how, great products and, large and sticky customer base due to lack of focus and sub-par capital allocation.  The large debt due to the 2015 Silicon Image acquisition strained the company’s balance sheet. The situation was aggravated further due to the prolonged process to sell itself to China-affiliated Canyon Bridge (which did not materialize due to Trump administration’s objection).  Thanks to its technology leadership, the company was able to attract industry veteran Jim Anderson as the CEO. The following developments under the Anderson's leadership are the reasons that we are confident about the prospects of the company:

1. The new CEO simplified the company’s complex organizational structure and installed new leaders with industry experience to head Marketing, Engineering, Operations, Sales, and Finance.  

2. As mentioned earlier, the new management team changed the direction of the company by focusing entirely on the FPGA franchise and eliminated the distractions from the Silicon Image acquisition.  The revenues from the acquisition are now less than 10% of the company’s annual revenue and is on a run-off mode.

3. Resources were shifted by shutting down low ROI projects (and products) and moving into those with likely higher return.

4. Although the company has a solid customer roster, its products are underpenetrated.  The focus of the new sales head is to increase the wallet share at the largest 20 - 30 key OEMs.

5. In order to deepen the relationship with customers, the marketing team is visiting the top 60 customers to understand customer needs and incorporate those findings in optimizing the product portfolio. This approach has been introduced to Lattice by the current management. The company has prioritized discussions on product development with OEM's interested in learning about new products and features. For example, Amazon is a customer of Lattice and is constantly innovating to improve the robots used in its fulfillment centers. If Amazon knows Lattice's roadmap of future products, then Amazon can plan out future generations of robots better. Since Lattice can meet Amazon's future requirements, the relationship will be a lot stickier.

6. To further differentiate its future products and widen the lead vs competition, Lattice has re-architected its platform, adopting FDSOI technology to cut power consumption by half.  The company is enhancing its product’s software stack with new tools like SensAI to allow customers to integrate their devices with inference AI processing at the edge.  

7. Improved COGS and adopted a pricing optimization strategy to extract the appropriate pricing for the company’s products for the value it provides to customers.

8. Within months of the new CFO's hire, the company improved its collections and increased cash generation.  Since her arrival in 2019, the company has repaid $90 million in discretionary debt, reduced interest rate expense by 250 bps, and reduced the leverage ratio from 4.2x to less than 2x. 

9. Sustained double-digit revenue growth and improved margins beginning 2021 due to macro industry tailwinds.

Valuation

Lattice has been operating under new management for about a year.  The company is expected to grow revenue in the single digits for 2019 and 2020.  Due to secular macro tailwinds like 5G base station upgrade and AI in industries where the company operates, revenue growth will accelerate to double digits till at least 2024.  We believe gross margins will improve to 62% gross margin and would not be surprised if gross margins rose to the high 60s like other large FPGA operators currently deliver. The company's targets for R&D and SG&A are 20% and 15% respectively.   

We believe Lattice will provide decent returns over the next three to five years period.  Although, the stock is not an absolute bargain at the current price, we would add to our position if it pulls back meaningfully.  As the macro tailwinds described earlier play out, the company’s operating margin will likely increase over 30% and our estimates could prove conservative.  We expect the investment to yield low double-digit IRR in three to five years.

Risks

Although an investment in Lattice may work well in the long-term, investors should be aware of a few risk factors listed below: 

• Industry observers believe that FPGA can potentially replace ASIC in high volume applications.  We believe this risk is likely where FPGA's utilized in data path and since Lattice does not play here, the risk is non-existent.

• The main risk we believe is global slowdown in economic activity.  We believe if were to happen, the value creation may be delayed by a couple of years.

• Cyclicality in semiconductor industry.

• Tariff risk.

• Execution risk.

• Due to the restructuring underway, quarter-to-quarter financial performance may fluctuate in the short term.  Since we invest for the long-term, we are not too concerned with this risk.

Catalyst

• Continued execution will further improve margins in the near term.

• Adoption of new FPGA platform by the customer base.

• Migration from 4G infrastructure to 5G at the base stations will increase Lattice’s share of wallet by about 30%.

• Further adoption of new generation server platforms boosts the attachment rates of Lattice products from the current 25% to 80%.

• As the semiconductor content in auto and industrial automation increases, Lattice will benefit with this trend.