Lattice Semiconductor Corporation (LSCC) Earnings Call Transcript & Summary

Great. Good morning, everybody. My name is John Vinh. I cover semis here at KeyBanc Capital Markets, and we are pleased to have Jim Anderson, CEO; and Sherri Luther, CFO of Lattice. Welcome, guys.

Yes. Thank you. Thanks for having us.

Thank you.

Jim, last week, you reported strong Q2 results. I was wondering if you could just highlight what the growth drivers in the quarter were?

Yes, sure. We feel pretty good about, certainly, the growth in the first half, we saw about 20% growth in the first half this year versus prior year. You can break that down a couple of different ways. You can look at it from a sort of market, customer perspective or from a product perspective. If you start from kind of a market perspective, one of the things we feel really good about is how we've repositioned the company in what we believe are the right long-term end markets for the company. So over 90% of our revenue now comes from communications, computing, industrial and automotive. And when we look at those 4 markets, we believe they all have long-term secular growth trends underneath them that will drive semiconductor consumption in general, but FPGA consumption in particular. So we feel really good about where we're positioned from a market standpoint, which wasn't necessarily the case when we started 4 or 5 years ago. So great markets to be positioned in. And then from a product standpoint, that's the other way you can look at it. Look, the company is going through the biggest product portfolio expansion we've ever done in the company's history. And so we just -- John, we have so many different new product cycles now, and that's really helping drive the growth as well. We've got just in our small FPGA platform, we've got 5 new versions of Nexus that are ramping, that are in production and ramping. Another one that's -- that will start ramping next year. And then our newest midrange FPGA platform, that product ramp, that revenue ramp is still ahead of us. So we feel really well positioned both from a market and a product perspective as well.

Great. Thanks for the overview. Maybe talking on -- touching base on servers, you talked about seeing strength in the server market. Many of your peers have talked about seeing kind of a crowding out effect in the server market from the expansion of AI servers where there's obviously a much higher ASP and a lot of the cloud providers right now are kind of confined in terms of their CapEx budgets this year. What are you guys seeing from a server's perspective between traditional AI? And then maybe if you could also touch base on just how your content differs on AI server versus traditional?

Yes. So in general, servers has been a great growth area for us. Actually, if you look at the last 4 years, we've grown double digits in communications and computing segment for us for 4 years in a row. And a lot of that growth has been driven by servers. And we believe we continue to be really well positioned, whether it's a general purpose server or an AI optimized server, we think we're really well positioned to continue to grow. If you look at what's driven the growth over the last 3 to 4 years, actually, for us, it's primarily been about content expansion. So with each new generation of server or dollars of content per server has gone up with each new generation. And that's been the biggest driver of our revenue, not so much the underlying server units that would ship in totality for the industry, but the fact that our content with each generation continues to go up. And what's been driving that is higher attach rates, so more Lattice chips used per server, but also we've been continuing to bring devices that have higher capability, newer features, which has driven our ASP up over time. So that combination of attach rate and ASP has helped drive our dollars of content. And on the newest generation, of server that's starting to ramp this year, we see about a 50% increase in the dollars of content per server in that new generation versus prior generation. So we feel really good about the continued kind of growth opportunity for us in servers in general. And then you asked about AI in particular. So certainly, there is now a subset of servers that are more AI optimized have high GPU content. When we look at those systems, depending on the configuration of that system, we have anywhere from about the same level of content as a general purpose server or higher content. So for us, that's a -- it's a net positive, but it's either equal to or greater content in those GPU -- more GPU optimized servers.

Great. You mentioned the TAM expansion. So if you look at the TAM assumptions for the small FPGA market, it's roughly about $4.5 billion. And if you go off of your target model, it says potentially, you've got 1/3 of that market in a few years. What's your sense of who makes up the other 2/3 of that market today? Is this mostly Xilinx? And then how do we think about your ability to monetize the rest of that TAM going forward?

Yes. The most common competitors for us in our traditional market, and this would apply to mid-range as well. So either small FPGA, which -- I think you were referring to a small FPGA segment of FPGAs, but it would apply to mid-range as well. Most common competitors we would face are Altera and Xilinx, which are now obviously owned by Intel and AMD. But if you look at in the small FPGA space relative to those 2 competitors, and our customers would say the same thing. If you ask them, if you look at our product portfolio today, our customers would tell you we have the strongest -- Lattice has the strongest product portfolio that it's ever had in its entire history. And we've been around for about 40 years, right? And so why is that? It's because 4 or 5 years ago, we started really reinvesting in the competitiveness of our product line. And so if you look at our newest product, platform Nexus, we would have relative to competition anywhere from 2 to 3x better power efficiency, for example. So higher performance and not just 10% or 20% better power efficiency, but 2 to 3x. And that's the big deal to our customers because usually the primary design constraint of our customers is around total system power. So we're bringing on a product that's way more competitive than our competition. And so that's why you're seeing share gain. That's why you're seeing growth of Lattice in that small FPGA segment. And then the next step is what we announced back in December of last year is we're now bringing that expertise, our expertise around power efficiency, small physical device size to now the mid-range FPGA market, which doubles our addressable market and provides a whole new revenue stream for the company.

Yes. And then just how should we think about your ability to monetize the remaining 2/3 of that small FPGA market?

I think you should think about it as good. Yes.

Yes.

No, I mean, seriously, yes, I think with that big of a competitive advantage and the amount of software content that we provide, I think that we have a long runway of good growth opportunity in front of us. Actually, the best way to think about it is relative to our revenue base today, if you look at size of market relative to revenue base today, we could grow very strong for years without hitting any structural limit in terms of market share or size of the market. I think that's probably the right way to think.

Yes. When you think about your share gains, how much is this coming from taking sockets from your existing competitors versus maybe new use cases and applications?

Yes. That's a good question. And it's a combination, actually, 3. I'll throw in the third category, too. So there's kind of 3 sources of the revenue growth in that market. One is kind of what we were just talking about old fashioned share gain, where we're displacing in Alteras, Xilinx FPGA. And that's probably the biggest contributor in terms of revenue growth. The other one is the one that you just mentioned, where we're working with customers on new -- basically new capabilities, new features that they've never had in their system before, and they're using our FPGA with the software that we're providing to bring -- to design that into their system to bring new capability that didn't exist before. And to us, we call that TAM expansion because we're effectively expanding the TAM, creating new TAM for ourselves. And then the third category is what we call TAM conversion, which is a customer meeting in the past, they used a different type of silicon like a microcontroller. And we're showing them how if they switch to a Lattice FPGA, again, with our software content, they can see a big performance per watt benefit. And we view that as TAM conversion where we're converting other type of silicon TAM to our FPGA TAM. So I would say our revenue growth has been driven by all 3 of those categories, probably most of it from share.

Great. That makes a lot of sense. Maybe we can talk about kind of FPGAs versus MCUs. I think in your Investor Day presentation, you've kind of laid out kind of the performance and the metrics of FPGAs versus MCUs in industrial and auto applications. I think you said 35x faster in terms of AI infancy 2x actually in terms of motor control. What other hurdles are there for customers for fully adopting FPGAs over MCUs?

Yes. And I would love to tell you that all MCUs will convert to FPGA. That's not the case. I want to be clear about that, right? But you will see a subset of applications where yes, there -- the customer can switch to an FPGA and see a much better performance per watt, performance per dollar, whatever metric that you want to use, a really significant advantage by switching to an FPGA. And those are some of the use cases that we're focused on. I'll give you one example, which is a common example that we see in the industrial space, where, let's say, a customer has historically used within their system a microcontroller. And now let's say they're trying to add more decision-making capability, more intelligence to their system to allow that system to be more adaptable to its environment, et cetera. And what they're talking about then is adding some level of artificial intelligence processing -- this is inference processing, right, to allow that machine to make localized decisions without a direct connection back to the data center. . And when they're trying to make that transition, what they're finding is, hey, a microcontroller is a sequential processor, AI algorithms are inherently parallel algorithms, they don't map well onto a microcontroller. And what we're showing them is those AI algorithms do map really well into a Lattice FPGA. And we've given them a software stack that makes it really easy for them to take their unique AI algorithm and map that on to a Lattice FPGA and basically turn that Lattice FPGA into a customized AI processor for their unique inference algorithm. And they know that, that algorithm is going to evolve and change over time. And that's not a problem with Lattice FPGA, just reprogram the FPGA as you change your algorithm. And so it allows them to future-proof the system to some extent as well. And so that's one of the common use cases where we're seeing customers switch over to Lattice FPGA as that kind of inference more AI at the edge and industrial applications. We're seeing that in other markets as well. But that would be a common place where we're doing TAM, as I talked about earlier, TAM converging.

Speaking of inferencing, as you know, generative AI has been a huge topic of interest for investors. You've mentioned AI is a long-term growth driver there. Can you just expand upon that a little bit more and how you can benefit from increasing interest in AI?

AI in general. Yes, the 2 areas would be, number one, kind of the area we were just touching on, which call that Edge AI, AI in all sorts of industrial IoT or IoT applications in general. And that example that I just gave is a great example in the industrial would apply in an automotive context in other markets as well. So certainly, we see a good opportunity for continued growth in those edge AI processing applications. And we've already seen great growth in that. We expect good growth moving forward. And then the second category is kind of back to the server space. In generative AI or just call it AI machine learning workloads in general that are being done in the data center, that pushes a tremendous amount of compute cycles into the data center, right? And data center infrastructure will have to be built out and expanded to accommodate that. And that's certainly AI-optimized servers, heavy GPU content, but also even general purpose AI -- or general purpose servers and all of the networking equipment associated with that, right? So data center networking equipment has to feed all of that -- those processing elements. So I think AI in general, generative AI is one example, will continue to drive that data center growth. Now the way we benefit from that is Lattice chips are used for control management and security of the server platforms, right, both general purpose as well as those AI-optimized server platforms. And as I said before, in those AI-optimized server platforms, we have equal to or greater content in those versus general purpose. So we think it's a net benefit, certainly a benefit for the industry and net benefit for Lattice as well.

Great. Any questions? Sherri, maybe a question for you. Software attach rate right now is over 50%. Where can that go in a few years? And how critical is it for customers in terms of design engagements? And what types of premiums and ASPs and gross margins does it bring to your business?

Yes. So one of the elements of our gross margin expansion strategy that we talked about at our Investor Day earlier this year is pricing optimization and part of that is higher ASPs on software attached. New products also add value there. And so from a software attach perspective, we have seen that ASPs generally are higher when they include our software solution stacks with it. And so when we look at our new gross margin target that we put out of the low 70s, that is certainly an element of it. Software attach as well as pricing optimization, which is something that we've been looking at now for -- into our fifth year of gross margin expansion strategy. Product mix is also a contributor, and certainly, product cost efficiencies with respect to yields and cost efficiencies in that area. So all of those items together really help drive our gross margin expansion strategy.

Yes. Maybe a follow-up to that. You laid out kind of a gross margin target in your low 70s pretty much already there, right? Software attach rate sounds like it's going to continue to go up, you're going to ramp higher ASP products. Can we expect that gross margins will kind of continue to trend higher from here? And then potentially, what are the other offsetting factors to some of these tailwinds that you're seeing?

Yes. So the target that we just put out in May, just a few months back, the low 70s. We're certainly excited about that target because we believe our gross margin is durable. We've -- since over the past 5 years or into the fifth year of executing on that strategy, we've increased our gross margin by just under 1,400 basis points. So from that, you can see that there are a lot of elements to our strategy, and some of them kick in at various points in time, certainly new products, as I mentioned, certainly, software attach helps drive that. But we believe our gross margin is durable. And with the focus on greater capacity, greater capability that our customers want from our products, that's also a contributor to our gross margin expansion strategy. So we believe it's durable. We'll continue to execute on that strategy and love to raise the bar at the appropriate time, but we feel really, really good about our low 70s target at this point.

Have you guys seen any pricing dynamics change with Xilinx and Altera now being into big ugly companies that you...

I like your characterization. Yes. We believe we've seen very good stability in our pricing, right? And I would say that's not just a short-term comment, but I would say that's over a multiyear basis. So as Sherri mentioned, in the beginning of 2019, we put in place a gross margin expansion strategy. Part of that strategy was focused on pricing, what we call pricing optimization, our overall pricing strategy. And we, as a company, became, I think, much better about how we price our products. If I look back over the -- now we're in our fifth year, right?

Yes. Yes.

If I look back over the last 5 years, I see a lot of stability in our pricing, right? And we would expect that to continue.

Great. Maybe we can touch base on Avant. It sounds like you've had really great success ramping Avant. I think some of the metrics you've talked about is 100-plus customer engagements, 90% of them are from existing Nexus customers. I'm wondering if you could just talk about what progress you're making in terms of engaging kind of non-Nexus customers? How are things going on that front?

Well, I think you're probably not looking at it the right way, John, to be totally honest, is if you look at the target customers for Avant, right, 90% of those target customers are already Lattice customers today. So the other 10%, I'm not so worried about the other 10%, right? I want to sell those 90% of customers that are already customers of Lattice today, what I want to do is sell them now in Avant product, right? And to them, they know us, they trust us. They've known us for 40 years. We've done a good job of supporting them on small FPGAs. And now what we're offering them is, hey, we now have a mid-range FPGA so same great power efficiency, all the great performance, features capabilities that you've trusted Lattice to deliver for small FPGAs now in higher capacity, higher capability devices. So I think our focus is those 90% -- the 90% of the SAM or TAM, that's with existing customers where we don't have to go penetrate to new customers. These are customers that know us already, have known us for many years. There, we're just convincing them to use a new product line. And one of the things that helps us is not just our history with those customers, but the software, right? So when they look at, well, what's software would I need to use with Avant, they can leverage all the same software that they've been using on our Nexus devices after -- actually even our older devices our pre-Nexus devices. So that same software they're already using is leverageable upon. So they don't have to go figure out how to use a whole bunch of new software. So that's our biggest opportunity is, is selling now a Avant to our existing customer base, right? And that's most of the doubling of our addressable market rate there.

Great. How does the software attach rates on these Avant wins compared to Nexus? Are they comparable or they...

Very comparable. Yes, which is what we would expect. We would expect a similar level of attach rate because the attach rate has more to do with a particular customer and application example, right? But yes, so far, we've seen very comparable attach rates.

Okay. And then what are you seeing from a competitive perspective? I would imagine in low-end small FPGAs. There's not has many tough, competitors there -- about 70% gross margin. But obviously, the other 2 big incumbents have broader offerings in midrange.

Yes. I think we -- first of all, we take all competitors very seriously and our 2 traditional competitors. And we always build our road map and our product portfolio, assuming there will be robust competition. We've always done from day 1 of when we started, we always assume there would be robust competition. That way, if the competitors do show up in new devices, we're ready. And if they don't, then great, that's upside for us, right? So with that in mind, certainly, we believe we have a very competitive offering. I think our customers would tell you the exact same thing. When we launched the Avant devices back in December that platform and we showed the first Avant device, we showed measured silicon capability versus competition. And we showed up to 2.5x better power efficiency up twice as much performance and then a physical size of the product that's up to 6x better. So we showed significant competitive advantages. So we believe we're really well positioned. We certainly don't take anything for granted. We're always paranoid about the competition. But I think based on what our customers would tell us as well, we feel we have a really good competitive position in both small FPGA and the mid-range FPGA...

Great. I know there's been a lot of interest on Avant, but want also just touch base on Nexus. How is that progressing? Can you give us an update in terms of how design win traction is progressing on that front?

Yes. Very good. Nexus has continued to ramp really well. If you look at the growth last year or the growth in the first half of this year, Nexus has grown faster overall than our overall company growth, which is what you would expect from a new platform. So we're really pleased with the continued growth of Nexus. And the great thing about Nexus as a platform is we believe Nexus will continue to ramp for at least the next 3 years, right? We have 5 different device families that are already in production. The sixth has been launched, goes into production first half of next year. We've got more Nexus devices that we're going to be launching in future quarters. So there's a steady stream of new Nexus devices, each of which create a new revenue stream. And so we would expect that platform to, as I said, to continue to ramp for at least another 3 years.

Great. Going back to servers. I think recently, a BMC supplier in the service space has talked about plans to go after sever security and kind of I/O expander applications where I think you have incumbency there. I know you don't take competition lightly, but can you talk about the confidence that you have in terms of being able to hold share in these areas and why?

Yes. We feel really good about just our ability to continue to expand the dollars of content per server. And whether that's -- whether that's a traditional FPGA competitor or a competitor from a different type of silicon, right? And part of it is what's happening in the server space, right? If you think about what's happened over the past years and what's happening moving forward is, there's a lot more differentiation within the servers with heterogeneous computing, many different types of CPU architectures, now graphics being used for -- GPUs being used for machine learning, generative AI. So there's a lot more complexity in the server offerings from our customers. And they're also all of our customers, whether they're hyperscale data center customers or traditional enterprise customers. Look, they're trying to figure out how do I make sure I continue to differentiate in this complex world, right? And that's where we can help them because we can use a Lattice --a standard product Lattice FPGA combined with their particular algorithm or differentiation, and we can show them how, hey, you can customize. You can program that Lattice FPGA to implement custom features that are differentiated and unique to you using a standard product from Lattice. And I think that value proposition of being able to help them differentiate across all of their platforms while they leverage a standard product from Lattice, I think that's worked really well over the past years. And I think that's going to continue to work well as the complexity of offerings from them, continues to expand. And just as the number of different SKUs they have to manage and their sense of urgency around continuing to be able to differentiate themselves in the marketplace.

Last question for Sherri. I noticed at the end of 2Q, you're debt-free. Does that change the way you approach your capital structure going forward?

Well, we're certainly pleased that subsequent to the end of last quarter, we did pay off the remaining outstanding debt on our balance sheet. So this is the strongest balance sheet that the company has had in at least a decade. That's as far back as I went, but certainly a very strong balance sheet. And when we look at it from a capital allocation perspective, our top priority still remains the organic growth of the business and investing in our long-term product portfolio, investing in demand creation. You certainly see that in our R&D spend as we continue to invest in new products and launch new products. So that's our #1 priority. Health of the balance sheet, I mentioned already, I definitely want to make sure that we focus -- continue to focus on working capital, strong cash generation, which we had 35% in Q2, which I'm also very proud of. And then returning capital to shareholders through our share repurchase program is also something that we've been executing now on 11 consecutive quarters. On Q2, we bought back $10 million worth of stock. And to date, since we started that program, we've actually reduced dilution by about 3.8 million shares. So we're pleased with the progress there. We do have another $110 million outstanding on the Board authorization, $110 million, that expires at the end of this year. So we continue to look at all of those things on a quarterly basis to determine the best use of our cash.

Great. With that, it looks like we're out of time. Thank you, guys.

Yes. Thanks, John. Appreciate it.