Lattice Semiconductor Continues With Strong Execution (NASDAQ:LSCC)

Given that the SOX is still down about 10% on a year-to-date basis, maybe it’s time to check in with Lattice Semiconductor (NASDAQ:LSCC) and see if investor nervousness about the semi cycle and peaking lead-times has led to a sustained sell-off in this great growth stock.

Yeah … no.

Although the shares are down about 25% from their November peak, Lattice shares are up another 30% or so since my last update. Fueled by incredibly strong momentum in its core lower-range FPGA business and very good ongoing execution, there’s really nothing to fault here other than the valuation, and even I’m willing to acknowledge that special growth stories fall into their own bucket where “fair value” is concerned.

Gaining Share And Leveraging Market Growth

The fundamental story continues to grow apace at Lattice, with the company executing well on content/attach growth, as well as leveraging underlying end-market growth.

In server compute, attach rates have climbed above 1.0 and the company continues to benefit from overall growth in data centers. Given that Lattice’s FPGAs provide very power-efficient and cost-effective control logic and power management, I expect further growth in attach rates. While about 80% of servers already have a Lattice FPGA on them, I expect security functionality to become even more important in driving attach growth, as security-oriented FPGAs can monitor whether the hardware and firmware has been corrupted and can repair the firmware.

Lattice is also in the early stages of what could prove to be a meaningful ramp in PCs. Lenovo (OTCPK:LNVGY) and Lattice are working together now, with Lattice’s CrossLink-NX chips and sensAI software going into ThinkPad X1 laptops to provide enhanced AI capabilities, including security.

Lattice has also been seeing good attach and growth elsewhere. In 5G, Lattice chips handle system management, power management, and (increasingly) security at the control plane level, and the company is benefiting from ongoing base station and radio head deployments. In autos, Lattice is seeing increased adoption in ADAS and infotainment, giving it better leverage to the higher-ASP models (with more advanced ADAS and infotainment) that are being prioritized today. In industrial, the company continues to leverage growth in robotics and automation.

Never Waste A Crisis

I believe the company is also benefiting from chip shortages. Lead-times are extended for microcontrollers (or MCUs) now, with companies like Microchip (MCHP), STMicro (STM) and Texas Instruments (TXN) struggling to keep up with demand. In such a pinch, the programmability of FPGAs allows them to be swapped in and programmed on the fly to fulfill the tasks of the MCU.

Management hasn’t quantified the impact of MCU substitution, but I believe it’s material, and management has noted an increasing number of engagements with customers for MCU substitution.

For its own part, Lattice has navigated this capacity crunch remarkably well for a small company. It certainly can’t hurt that the company was an early adopter of Samsung’s 28nm FD-SOI process, and with Lattice’s chips produced predominantly at older 28nm and 40nm nodes, there’s not quite as much of a capacity crunch.

Ongoing Growth Opportunities To Drive The Story

As impressed as I’ve been with management to this point, there are plenty of reasons to believe that there is a long runway for growth here.

For starters, Lattice has done what they’ve done almost solely on the low-end side of the FPGA market. Depending on the source, that’s a $2.2B to $3B market, suggesting Lattice has something in the neighborhood of 17% to 24% share, though probably a bit less considering the inclusion of software, licensing, and so on.

Avant, the company’s first mid-range product, will be launching in the second half of this year, roughly doubling the addressable market for the company. Better still, the conditions in the mid-range market aren’t really that much different than they’ve been in the low-end market – customers still increasingly prioritize power efficiency and security, and the large players (Intel (INTC) and AMD (AMD)) are more focused on the high end. Microchip is more active in mid-range, but I can see plenty of opportunities for Lattice just in transitioning customers to mid-range products and growing share of wallet.

Between ongoing design iterations and new mid-range capabilities, I see Lattice as leveraged to multiple growing end-market opportunities. I’ve discussed opportunities like servers, 5G, and autos already, but the added compute capabilities of mid-range FPGAs should allow for expanded addressable opportunities, particularly in edge applications (like monitoring).

I believe the acquisition of Mirametrix is also significant in the context of those growth opportunities. I’ve previously written that I expected Lattice to invest in expanding its software capabilities, and Mirametrix adds capabilities in AI, machine vision, and human/machine interface that should prove invaluable, particularly considering Lattice’s existing leverage to security (facial recognition) and robotics (machine vision) and opportunities in HMI (like auto infotainment).

The Outlook

I suppose it’s comparatively boring to some readers, but Lattice’s performance on the margin side is no less impressive, with the company posting 350bp of year-over-year gross margin growth in the fourth quarter. Management has been careful with guidance, but given the opportunities to secure more higher-value low-range and new mid-range business, with increased software attach, not to mention the advantages of the 28nm FD-SOI process, I don’t think 70% GPM / 40% operating margin is out of the bounds of reality as a goal for FY’25/26 margins.

If I have a concern in the outlook, it’s mostly whether or not Lattice’s exceptional margins attract renewed competition. As I said before, the largest players have generally focused on the high end of the market and shown less attention to Lattice’s core markets (and I’ve wondered whether Lattice could look to acquire the low/mid-range operations of either Intel or AMD at some point). Still, with Lattice showing what’s possible in this part of the market with the right technology/features, I wouldn’t rule out the risk of somebody taking a closer look at the opportunities here.

I believe that Lattice will continue to gain share in the low-range FPGA market on the back of its new product portfolio, including relatively new introductions like MachNX (security) and CertusProNX. I also think there’s a good chance of Lattice gaining meaningful share in the mid-range market fairly quickly. While gaining 20% of its newly-expanded addressable markets by 2026 may be too ambitious, it would mean over $1.2B in revenue versus the $0.52B reported in FY’21.

Long term, I still expect strong double-digit growth from Lattice, though I’ve pivoted to thinking that growth is going to be on the higher end of the mid-teens now (16%-plus). I mentioned just above that I think 70% GPM/ 40% operating margin is possible over the next five years, but that’s not an easy goal to hit. In any case, I think adjusted FCF margins could accelerate to 30% about two years faster than I previously expected, and I think FCF can grow more than 20% on an annualized basis.

The Bottom Line

Unfortunately, none of that helps where valuation is concerned. Were Lattice to get to $1.27B in FY’26 revenue with 40% margins, a 6.6x multiple (on the higher end of what the market typically pays for 40% operating margin) on $1.27B in revenue discounted back four years at 8% gets me a fair value of $43. Likewise, past multiples paid for growth stocks like Mellanox and Inphi don’t really drive an attractive fair value today.

Is this a case of “ignore the valuation worries and buy growth”? Maybe, but that’s really not my investing style, and it’s not something I’m usually comfortable recommending others do. I see Lattice still in the relatively early stages of a great growth story, but momentum investing is tricky in the best of times.