Up another 55% or so from my last update and 250% from my first Seeking Alpha article on the company, Lattice Semiconductor (NASDAQ:LSCC) is a great go-to example of my investment philosophy that successful turnarounds can produce returns significantly ahead of what might seem fair or reasonable at the start of the process. Over the last two years, Lattice has not only turned over management and embraced a significantly different operating philosophy, it has delivered meaningful improvements in margins - one of the key drivers for semiconductor valuation.
I don't really think of Lattice as a turnaround anymore, as I believe the company is firmly in the midst of a transition to a growth story. In addition to opportunities in the data center and 5G base stations and auto driver assistance, I'm eager to see what the company will accomplish with its new FD-SOI platform and its AI-focused SensAI software stack.
As a growth story, I'm not quite as worried about valuation, but it is nevertheless hard to call Lattice "cheap". The shares already anticipate significant margin improvement and future revenue growth, and it's tough to make the numbers work.
Although Lattice has some attractive long-term drivers, the near-term performance has been impacted by many of the same broad industry trends that have hurt other chip companies - specifically slowdowns in auto, industrial, and consumer semiconductor demand. To that end, third quarter revenue was up just 2% yoy (and up 1% qoq) after a slight year-over-year decline in the prior quarter, roughly similar to the performance of the much larger STMicroelectronics (STM), a company with similar market exposures.
That said, there have been some areas of relative strength for Lattice. Communications and computing sales were quite strong in the third quarter, rising 27% on healthy demand from 5G base station customers and data center customers. On the base station side, the story is about improving attach rates and dollar value growth per attachment. Lattice has been seeing a better than 30% increase in per-station content in the move to 5G.
Although data center trends have been decidedly mixed for chip companies (including high-end FGPA chip producer Xilinx (XLNX)), Lattice is benefiting from significant growth in attach rates, particularly in security and pre-boot authentication applications, with the company seeing a roughly 3x increase in attach rates and a 2x increase in ASPs relative to the prior server generation. With the new MachXO 3D chip still relatively early in its lifecycle, further growth seems possible.
Lattice is still also generating its own tailwind from the changes new management has made to its pricing philosophy. The prior management at Lattice typically priced on a cost-plus model and was not particularly discriminating about the business it targeted ("volume is volume"). Now, though, Lattice has shifted to an approach that sets prices on the basis of the value delivered (less power consumption, smaller footprint, more programming flexibility, et al). Lattice has also been much more willing to walk away from low-margin business, and that has a lot to do with the steep declines seen in the consumer business.
It's far more typical for chip companies to miss their launch timelines than exceed them, but Lattice seems to be ahead of schedule with some significant new product platforms. The new CrossLink Plus chip was sampled and launched early, with chips going out to customers in the third quarter and initial revenue in this fourth quarter. Lattice is also ahead of schedule with its 28nm FD-SOI platform, with sampling in the fourth quarter instead of the previously-targeted first half of 2020.
Lattice's FD-SOI efforts remain a key future driver. At this point, Lattice is the only FPGA company investing in FD-SOI, and the advantages in chip performance (significantly improved power efficiency in particular) and profitability (a process cost similar to CMOS) should make this a major growth platform over the next three to five years and facilitate management's goal of approaching 30% operating margins. Although FD-SOI hasn't attracted widespread popularity, there are several credible chip companies pursuing this technology, including STM and NXP Semiconductors (NXPI). With a December 10 launch event scheduled, investors shouldn't have to wait too long to get an enhanced view of what management plans for this new platform.
Also relevant to the topic of early delivery, Lattice's efforts to improve its pricing algorithms, target more attractive markets, and generally be more attentive to the "blocking and tackling" of the business are paying off in faster-than-expected margin improvement. Lattice has been beating margin expectations at the gross and operating lines, and sell-side estimates for 2019 and 2020 operating margins have risen by roughly 200bp as a result (relative to May of this year).
Lattice has encountered many of the same top-line headwinds as other chip companies, and the company's guidance for the fourth quarter wasn't particularly robust as a result. This year (2019) is not going to be a banner year for revenue growth, but business should accelerate significantly next year and then again in 2021 as Lattice's new product platforms ramp up and as markets like auto and industrial recover (and 5G really gets going).
I continue to believe Lattice can achieve long-term annualized revenue growth in the high single digits, with a few years of double-digit growth on the way. I've boosted my margin expectations as well; while I don't yet have enough confidence to raise my long-term ceiling for operating margin, I do expect Lattice to reach that ceiling at a quicker pace, boosting my five-year FCF growth rate while keeping the long-term rate more or less steady.
Investors frequently pay up for growth and for stocks with differentiated stories, and I believe Lattice definitely offers the latter, while the former is a work in progress. That makes valuation difficult, as the shares already exceed typical valuation norms. I don't have any particular objection to the idea that better stories deserve a premium, but I think the premium here is already pretty robust. I'm not rooting against Lattice nor predicting a big pullback, but I'm not going to chase the stock here and would prefer a chance to buy on a bigger dip.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.