Lattice Not Immune To A Semiconductor Slowdown, But The Quality Is Still There

Having been bullish on Lattice Semiconductor (NASDAQ:LSCC) back when management launched a turnaround that has driven revenue acceleration and margin expansion beyond even what bulls believed possible, I’ve also spent a few articles lamenting how the shares ran away from me. While the stock has continued to outperform the SOX index (down 19% versus down 32% since my last update on Lattice), the pullback has at least made the valuation a little more reasonable.

When I say “reasonable”, I do mean reasonable in the context of a growth stock. These shares aren’t cheap on any reasonable multiples-based approach, unless you try to look at what the market has in the past been willing to pay for growth stories like Altera, Cavium, Inphi, Nvidia (NVDA), or Xilinx. I do believe Lattice can generate the sort of mid-to-high-teens growth that can support such hefty multiples, and I think these shares are worth a look from growth-oriented investors who can accept the risk that growth slows more sharply here and/or simply can’t match the level of investor expectations baked into the price today.

Another Strong Quarter

Lattice management has established a reliable beat-and-raise cadence where the company generally reports revenues that are a little better than expected and then raises guidance for the next quarter above the prior sell-side average. The company has been doing even better of late with gross margin, comfortably exceeding their projections and sell-side estimates (which are basically driven by guidance).

Revenue rose 31% year over year and 7% quarter over quarter in the third quarter to just under $173M, exceeding expectations by about 4%. Gross margin improved almost six points from the year-ago level and 40bp from the prior quarter to 69.5%; Microchip (MCHP) is at best an imperfect comparator, but this larger MCU and FPGA company saw gross margin improve 240bp yoy and 60bp qoq to 67.7%.

Operating income jumped 71% yoy and 11% qoq, with margin expanding more than nine points yoy and 160bp qoq to 39.7%. To provide some frame of reference, Microchip generates 36.9% operating margin on $3.4 billion in revenue and On Semiconductor (ON) generates 35.4% margin on $2.2 billion in revenue. Back in the day, Xilinx could generate low-30%’s margins on around $750M in revenue.

Lattice reported 45% yoy and 15% qoq growth from its Auto & Industrial segment, a strong performance compared to companies like NXP Semiconductors (NXPI) (up low-20%’s yoy) and onsemi (auto up 52% yoy and industrial up 28% yoy). I believe Lattice continues to benefit from supply shortages of MCUs, as customers can swap in their FPGAs in at least some use-cases. That said, I also see higher attach rates (share/socket gains) in areas like ADAS, in-cabin infotainment/controls, and security, as well as industrial automation/robotics, and machine vision.

Communications and Computing was up 26% yoy and flat sequentially. While Lattice is still seeing improving attach rates in data center servers, they don’t have the high-end data center exposure of companies like Marvell (MRVL) and are more vulnerable to slowing trends. On the computing side, I believe Lattice is also seeing a balancing out of weaker PC volumes with new attach/share gains with companies like Lenovo (OTCPK:LNVGY) for security.

Consumer revenue declined 13% yoy and 11% qoq, and this is a small business for Lattice (<10% of revenue), though there are some consumer-type exposures in C&C (PCs, mostly). With companies like Silicon Labs (SLAB), Synaptics (SYNA), and NXP all pointing to noticeably weaker trends in consumer IoT (smart devices, et al), this weakness isn’t out of line.

Can Lattice Keep Up This Pace?

While most semiconductor companies have guided to sequentially weaker sales as lead-times start contracting and demand cools, Lattice did at least guide to modest growth (about 1.5% at the midpoint), with stable gross margin.

The question in the semiconductor sector has shifted from “will 2023 be a weaker year?” to “how weak will it be?”, but I believe Lattice is relatively well-placed.

First, I do have some “medium-term” concerns about Lattice losing the revenue it gained from supply shortages in the MCU space, but that will take some time to unwind – lead-times for specialized trailing-edge chips are still close to a year in some cases, and not many fabs are adding significant trailing-edge capacity (leading Microchip to contemplate building a fab). So, while I do think the MCU supply pinch will unwind at some point, I don’t think it’s going to happen suddenly, and some MCU suppliers have talked about the possibility that MCU lead-times will simply just be higher going forward because of limited surplus production capacity.

Second, Lattice continues to expand its addressable market. Between product and software launches, the company has steadily expanded its addressable market across auto, industrial, server, PC, and wireless infrastructure markets. Lattice will be launching its new mid-range Avant FPGA in December, and this new product family should double the company’s addressable market (with attractive gross margins).

Third is ongoing growth in core Lattice use-cases. I don’t think 2023 will be a great year for industrial automation spending, but ABB (ABB), Faunc (OTCPK:FANUY), and Yaskawa (OTCPK:YASKY) have been reporting healthy order rates and Lattice continues to gain share in areas like machine vision. Likewise, I don’t think 2023 will be a great year for new car builds (I’m expecting low-to-mid single-digit growth), but Lattice continues to win slots in areas like ADAS.

The Outlook

I still believe Lattice can grow at a mid-to-high teens rate over the next decade. AMD (AMD) and Intel (INTC) have their FPGA businesses (Xilinx and Altera) more focused on the data center now, and there’s not that much competition in the low-power FPGA space (though Microchip has talked about expanding in this direction). With more and more edge applications demanding both intelligence and low power consumption, I believe Lattice as a very attractive market in hand. Likewise, I think expanding into more mid-range projects will unlock more opportunities to gain share with existing customers and add new use cases – there will be more competition with Microchip, but I think Lattice is up to the challenge.

Lattice is now close to multiyear goals of 70% gross margin and 40% operating margin. I do believe the company has benefited from MCU substitution, and I do see some risk that the next time management updates its guidance, the new targets may not meet the Street’s rising expectations, as I think that profitable substitution business will unwind at least in part. Even so, I’m expecting adjusted FCF margins to accelerate to 30%-plus over the next five years and continue growing after that, supporting a FCF growth rate in the 20%’s.

The Bottom Line

Based upon discounted cash flow, Lattice shares actually do seem to offer an attractive return now. Granted, that is with some exceptionally robust growth expectations, but I think management has done all that investors could reasonably ask of them in terms of repositioning this business for long-term growth (and profitable growth at that). The multiples are still very high, though, and I do not claim that this is a conventionally cheap stock. Still, I’ve watched growth semi stocks for quite a while and sometimes the best you can hope for is “kinda cheap” if you want to participate in these uncommon growth stories.