LATTICE SEMICONDUCTOR CORP (LSCC) FY 2022 MD&A

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Lattice Semiconductor Corporation and its subsidiaries (“Lattice,” the “Company,” “we,” “us,” or “our”) develop technologies that we monetize through differentiated programmable logic semiconductor products, silicon-enabling products, system solutions, design services, and licenses. Lattice is the low power programmable leader. We solve customer problems across the network, from the Edge to the Cloud, in the growing communications, computing, industrial, automotive, and consumer markets. Our technology, long-standing relationships, and commitment to world-class support lets our customers quickly and easily unleash their innovation to create a smart, secure, and connected world.

Lattice has focused its strategy on delivering programmable logic products and related solutions based on low power, small size, and ease of use. We also serve our customers with IP licensing and various other services. Our product development activities include new proprietary products, advanced packaging, existing product enhancements, software development tools, soft IP, and system solutions for high-growth applications such as Edge AI, 5G infrastructure, platform security, and factory automation.

This discussion and analysis of financial condition and results of operations should be read in conjunction with our consolidated financial statements and accompanying notes included in Part II, Item 8. "Financial Statements and Supplementary Data" of this report. Discussions of results for prior periods (fiscal 2021 compared to fiscal 2020) are incorporated by reference from our Annual Report on Form 10-K for the year ended January 1, 2022.

Impact of COVID-19 and Global Economic Environment on our Business

The COVID-19 pandemic, increased financial market volatility, inflationary pressure, rising interest rates, recessionary concerns, and geopolitical tension continue to impact business globally and may impact our operations by causing disruption to our labor markets and supply chains. The ongoing COVID-19 pandemic, including the periodic resurgence of cases relating to the spread of new variants, has and continues to impact worldwide economic activity and poses the risk that our employees, contractors, suppliers and other partners may be prevented from conducting business activities. The extent to which the COVID-19 pandemic, increased financial market volatility, inflationary pressures and related uncertainty will impact our business activities will depend on future developments that are highly uncertain and cannot be predicted at this time. See the section entitled “Risk Factors” in Item 1A of Part I of this report for further information about related risks and uncertainties.

Critical Accounting Policies and Use of Estimates

Critical accounting policies are those that are both most important to the portrayal of a company's financial condition and results of operations, and that require management's most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments affecting the amounts reported in our consolidated financial statements and the accompanying notes. We base our estimates and judgments on historical experience, knowledge of current conditions, and our beliefs of what could occur in the future considering available information. While we believe that our estimates, assumptions, and judgments are reasonable, they are based on information available when made, and because of the uncertainty inherent in these matters, actual results may differ materially from these estimates under different assumptions or conditions. We evaluate our estimates and judgments on an ongoing basis.

We believe the following accounting policies and the related estimates are critical in the portrayal of our financial condition and results of operations, and require management's most difficult, subjective, or complex judgments. See Note 1 - Nature of Operations and Significant Accounting Policies to our Consolidated Financial Statements in Part II, Item 8 of this report for further information on the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Revenue from Contracts with Customers

We recognize revenue upon satisfaction of performance obligations when control of promised goods or services has been transferred to our customers. We measure revenue based on the amount of consideration we expect to be entitled to in exchange for products or services. For revenue recognized on both sales to distributors and related to HDMI and other royalties, the amount of consideration we expect to be entitled to receive is based on estimates that require assumptions and judgments relating to trends in recent and historical activity. See Note 1 - Basis of Presentation and Significant Accounting Policies to our Consolidated Financial Statements in Part II, Item 8 of this report for further information on our recognition of revenue. Sales to most distributors are made under terms allowing certain price adjustments upon sale to their end customers and limited rights of return of our products held in their inventory. The revenue recognized based on estimated price adjustments and stock rotation reserves may be materially different from the actual consideration received if the actual distributor price adjustments and stock rotation returns differ significantly from the historical trends used in the estimates.

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Inventories and Cost of Revenue

Inventories are stated at the lower of actual cost (determined using the first-in, first-out method) or net realizable value. We review and set standard costs quarterly to approximate current actual manufacturing costs. Our manufacturing overhead standards for product costs are calculated assuming full absorption of actual spending over actual costs. The valuation of inventory requires us to estimate excess or obsolete inventory. Material assumptions we use to estimate necessary inventory carrying value adjustments can be unique to each product and are based on specific facts and circumstances. In determining provisions for excess or obsolete products, we consider assumptions such as changes in business and economic conditions, projected customer demand for our products, and changes in technology or customer requirements. The creation of such provisions results in a write-down of inventory to net realizable value and a charge to Cost of revenue. If in any period we anticipate a change in assumptions such as future market or economic conditions to be less favorable than our previous estimates, additional inventory write-downs may be required and would be reflected in Cost of revenue, resulting in a negative impact to our gross margin in that period. If in any period we are able to sell inventories that had been written down to a level below the ultimate realized selling price in a previous period, related revenue would be recorded with a lower or no offsetting charge to Cost of revenue resulting in a net benefit to our gross margin in that period.

Business Combinations

Business combinations are accounted for using the acquisition method of accounting, under which we allocate the purchase price paid for a company to identifiable assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill is measured as the excess of purchase price over the fair value of identifiable assets acquired and liabilities assumed. Determining the fair value of assets acquired and liabilities assumed requires management to make assumptions, estimates, and judgments that are based on all available information, including comparable market data and information obtained from our management and the management of the acquired companies. These judgments affect the amount of consideration paid that is allocable to identified tangible and intangible assets acquired and liabilities assumed in the business combination. The estimation of the fair values of the intangible assets requires significant judgment and the use of valuation techniques including primarily the income approach. Consideration is given to all relevant factors that might affect the fair value such as estimates of future revenues and costs, present value factors, and the estimated useful lives of intangible assets.

Accounting for Income Taxes

We are required to estimate our provision for income taxes and amounts ultimately payable or recoverable in numerous tax jurisdictions around the world. These estimates involve significant judgment and interpretations of regulations and are inherently complex. Resolution of income tax treatments in individual jurisdictions may not be known for many years after completion of the applicable year. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements using enacted tax rates and laws that will be in effect when the difference is expected to reverse.

Valuation allowances are provided to reduce deferred tax assets to an amount that in management’s judgment is more-likely-than-not to be recoverable against future taxable income. The determination of a valuation allowance and when it should be released requires complex judgment. In assessing the ability to realize deferred tax assets, we regularly evaluate both positive and negative evidence that may exist and consider whether it is more-likely-than-not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.

As part of our regular financial review process, we also assess the likelihood that our tax reporting positions will ultimately be sustained on examination by the taxing authorities, based on the technical merits of the position. To the extent it is determined it is more likely than not (a likelihood of more than 50 percent) that some portion or all of a tax reporting position will ultimately not be recognized and sustained, a provision for unrecognized tax benefit is provided by either reducing the applicable deferred tax asset or accruing an income tax liability. Our judgment regarding the sustainability of our tax reporting positions may change in the future due to changes in U.S. or international tax laws and other factors. These changes, if any, may require material adjustments to the related deferred tax assets or accrued income tax liabilities and an accompanying reduction or increase in income tax expense which may result in a corresponding increase or decrease in net income in the period when such determinations are made. We recognize the tax impact of including certain foreign earnings in U.S. taxable income as a period cost.

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Results of Operations

Key elements of our Consolidated Statements of Operations, including as a percentage of revenue, are presented in the following table:

* The year ended January 2, 2021 was a 53-week year as compared to the other years presented, which were based on our standard 52-week year.

Revenue

Revenue increased $145.0 million, or 28.1%, in fiscal 2022 compared to fiscal 2021, primarily from our products used in data center servers, client computing solutions, 5G wireless infrastructure, industrial automation, and robotics applications.

Revenue by End Market

We sell our products globally to a broad base of customers in three primary end markets groups: Communications and Computing, Industrial and Automotive, and Consumer. We also provide IP licensing and services to these end markets.

Within these end markets, there are multiple segment drivers, including:

We also generate revenue from the licensing of our IP, the collection of certain royalties, patent sales, the revenue related to our participation in consortia and standard-setting activities, and services. While these activities may be associated with multiple markets, Licensing and services revenue is reported as a separate end market as it has characteristics that differ from other categories, most notably a higher gross margin.

The end market data below is derived from data provided to us by our customers. With a diverse base of customers who may manufacture end products spanning multiple end markets, the assignment of revenue to a specific end market requires the use of judgment. We also recognize certain revenue for which end customers and end markets are not yet known. We assign this revenue first to a specific end market using historical and anticipated usage of the specific products, if possible, and allocate the remainder to the end markets based on either historical usage for each product family or industry application data for certain product types.

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The following are examples of end market applications for the fiscal years presented:

The composition of our revenue by end market is presented in the following table:

Revenue from the Communications and Computing end market increased by 26% in fiscal 2022 compared to fiscal 2021 primarily due to content expansion in datacenter servers, new greenfield client computing opportunities, 5G infrastructure, and datacenter networking.

Revenue from the Industrial and Automotive end market increased by 41% in fiscal 2022 compared to fiscal 2021, primarily due to strong customer adoption in a broad range of applications, including industrial automation and robotics. Growth in Automotive was driven by the adoption of new designs in ADAS and infotainment applications.

Revenue from the Consumer end market decreased by 3% in fiscal 2022 compared to fiscal 2021 primarily due to macroeconomic weakness in Consumer in the current year.

Revenue from the Licensing and Services end market decreased by 16% in fiscal 2022 compared to fiscal 2021 primarily due to decreased licensing and IP royalties.

Revenue by Geography

We assign revenue to geographies based on ship-to location of the customer.

The composition of our revenue by geography is presented in the following table:

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Revenue from Customers

We sell our products to independent distributors and directly to customers. Distributors have historically accounted for a significant portion of our total revenue, and the two distributor groups noted below individually accounted for more than 10% of our total revenue in the periods covered by this report.

The composition of our revenue by customer is presented in the following table:

Gross margin

The composition of our gross margin, including as a percentage of revenue, is presented in the following table:

Gross margin percentage increased 610 basis points from fiscal 2021 to fiscal 2022. Improved margins were driven by benefits from our gross margin expansion strategy.

Because of its higher margin, the licensing and services portion of our overall revenue can have a disproportionate impact on Gross margin.

Operating Expenses

Research and Development Expense

The composition of our Research and development expense, including as a percentage of revenue, is presented in the following table:

Research and development expense includes costs for compensation and benefits, stock compensation, engineering wafers, depreciation, licenses, and outside engineering services. These expenditures are for the design of new products, IP cores, processes, packaging, and software solutions.

The increase in Research and development expense for fiscal 2022 compared to fiscal 2021 was due primarily to increased headcount-related costs as we continue to invest in our long-term product roadmap.

We believe that investing in research and development is important to delivering innovative products to our customers and, therefore, we expect to continue to increase our investment in research and development.

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Selling, General, and Administrative Expense

The composition of our Selling, general, and administrative expense, including as a percentage of revenue, is presented in the following table:

Selling, general, and administrative expense includes costs for compensation and benefits related to selling, general, and administrative employees, commissions, depreciation, professional and outside services, trade show, and travel expenses.

The increase in Selling, general, and administrative expense for fiscal 2022 compared to fiscal 2021 was due primarily to increased headcount-related costs to support the growth of our business, and to increased legal expenses primarily related to the defense of claims outside the ordinary course of business.

Amortization of Acquired Intangible Assets

The composition of our Amortization of acquired intangible assets, including as a percentage of revenue, is presented in the following table:

The increase in Amortization of acquired intangible assets for fiscal 2022 compared to fiscal 2021 was due to the amortization expense for new intangible assets added in the fourth quarter of fiscal 2021 through the acquisition of Mirametrix, Inc., partially offset by end of the amortization period during the first quarter of fiscal 2022 for acquired intangible assets from previous acquisitions.

Restructuring Charges

The composition of our Restructuring charges, including as a percentage of revenue, is presented in the following table:

Restructuring charges are comprised of expenses resulting from reductions in our worldwide workforce, consolidation of our facilities, removal of fixed assets from service, and cancellation of software contracts and engineering tools. Details of our restructuring plans and expenses incurred under them are discussed in Note 9 - Restructuring to our Consolidated Financial Statements in Part II, Item 8 of this report.

Restructuring charges increased in fiscal 2022 compared to fiscal 2021 due to additional lease right-of-use asset impairment charges for our partially vacated facility in San Jose, California and contract termination fees in the current year under the internal restructuring plan that our management approved and executed in April 2019, as compared to minimal activity in the prior year.

Acquisition Related Charges

The composition of our Acquisition related charges, including as a percentage of revenue, is presented in the following table:

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Acquisition related charges include legal and professional fees directly related to acquisitions. For fiscal 2022 and 2021, Acquisition related charges were entirely attributable to our acquisition of Mirametrix in November 2021 and were comprised primarily of professional services including legal and accounting fees, as well as closing costs.

Interest Expense

The composition of our Interest expense, including as a percentage of revenue, is presented in the following table:

Interest expense is primarily related to our long-term debt. This interest expense is comprised of contractual interest and amortization of original issue discount and debt issuance costs based on the effective interest method.

The increase in Interest expense for fiscal 2022 compared to fiscal 2021 was driven by the increase in the applicable base rate for our long-term debt, the adjusted Term Secured Overnight Financing Rate ("SOFR") from September 1, 2022, and the London Interbank Offered Rate ("LIBOR") prior to that date.

Other (Expense) Income, net

The composition of our Other (expense) income, net, including as a percentage of revenue, is presented in the following table:

For fiscal 2022 compared to fiscal 2021, the increase in Other (expense) income, net was primarily due to the $0.7 million loss on refinancing of our long-term debt during the current year.

Income Taxes

The composition of our Income tax expense is presented in the following table:

Our Income tax expense (benefit) is composed primarily of foreign income and withholding taxes, partially offset by benefits resulting from the release of uncertain tax positions ("UTP") due to statute of limitation expirations that occurred in the respective periods. The increase in expense in fiscal 2022 as compared to fiscal 2021 is primarily due to increased worldwide income and changes in uncertain tax positions.

We updated our evaluation of the valuation allowance position in the United States through December 31, 2022 and concluded that we should continue to maintain a full valuation allowance against the net federal and state deferred tax assets. In making this evaluation, we considered the uncertain stability of the current economic and operating environment and estimates about our ability to generate taxable income in future periods within the United States. We continue to evaluate future projected financial performance to determine whether such performance is sufficient evidence to support a reduction in or reversal of the valuation allowance. We will continue to evaluate both positive and negative evidence in future periods to determine if we will realize the deferred tax assets. The amount of the deferred tax asset considered realizable could be adjusted if sufficient positive evidence exists. Details of our deferred tax assets and valuation allowance are discussed in Note 13 - Income Taxes to our Consolidated Financial Statements in Part II, Item 8 of this report.

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Liquidity and Capital Resources

The following sections discuss material changes in our financial condition from the end of fiscal 2021, including the effects of changes in our Consolidated Balance Sheets, and the effects of our credit arrangements and contractual obligations on our liquidity and capital resources. There continues to be uncertainty around the extent and duration of the disruption to our business, including from the effects of the ongoing COVID-19 pandemic, market volatility, and inflationary pressures, which may impact our liquidity and working capital needs in future periods.

We have historically financed our operating and capital resource requirements through cash flows from operations, and from the issuance of long-term debt to fund acquisitions. Cash provided by or used in operating activities will fluctuate from period to period due to fluctuations in operating results, the timing and collection of accounts receivable, and required inventory levels, among other things. We believe that our financial resources, including current cash and cash equivalents, cash flow from operating activities, and our credit facilities, will be sufficient to meet our liquidity and working capital needs through at least the next 12 months. On September 1, 2022, we entered into our 2022 Credit Agreement, as described in Note 8 - Long-Term Debt to our Consolidated Financial Statements in Part II, Item 8 of this report. As of December 31, 2022, we did not have significant long-term commitments for capital expenditures. For further information on our cash commitments for operating lease liabilities, see Note 10 - Leases to our Consolidated Financial Statements in Part II, Item 8 of this report.

In the future, we may continue to consider acquisition opportunities to further extend our product or technology portfolios and further expand our product offerings. In connection with funding capital expenditures, acquisitions, securing additional wafer supply, increasing our working capital, or other operations, we may seek to obtain equity or additional debt financing. We may also seek to obtain equity or additional debt financing if we experience downturns or cyclical fluctuations in our business that are more severe or longer than we anticipated when determining our current working capital needs.

Liquidity

Cash and cash equivalents

As of December 31, 2022, we had Cash and cash equivalents of $145.7 million, of which approximately $30.9 million in Cash and cash equivalents was held by our foreign subsidiaries. We manage our global cash requirements considering, among other things, (i) available funds among our subsidiaries through which we conduct business, (ii) the geographic location of our liquidity needs, and (iii) the cost to access international cash balances. The repatriation of non-US earnings may require us to withhold and pay foreign income tax on dividends. This should not result in our recording significant additional tax expense as we have accrued expense based on current withholding rates. As of December 31, 2022, we could access all cash held by our foreign subsidiaries without incurring significant additional expense.

The net increase in Cash and cash equivalents of $14.2 million between January 1, 2022 and December 31, 2022 was primarily driven by cash flows from the following activities:

Operating activities — Cash provided by operating activities results from net income adjusted for certain non-cash items and changes in assets and liabilities. Cash provided by operating activities was $238.8 million in fiscal 2022 compared to $167.7 million in fiscal 2021. This increase of $71.1 million was primarily driven by an increase of $98.9 million provided by improved operating performance, partially offset by $27.8 million of changes in working capital, primarily from cash used by inventories.

Investing activities — Investing cash flows consist primarily of transactions related to capital expenditures and payments for software and intellectual property licenses, and a business acquisition in fiscal 2021. Net cash used by investing activities in fiscal 2022 was $34.9 million compared to $89.8 million in fiscal 2021. This $54.9 million decrease was primarily a result of the acquisition of Mirametrix in the prior year, which used cash, net of cash acquired, of $68.1 million. Total cash used for capital expenditures and payments for software and intellectual property licenses increased $13.2 million to $34.9 million in fiscal 2022 from $21.7 million in fiscal 2021.

Financing activities — Financing cash flows consist primarily of repurchases of common stock, tax payments related to the net share settlement of restricted stock units, proceeds from the exercise of options to acquire common stock, and activity on our long-term debt. Net cash used by financing activities in fiscal 2022 was $188.1 million compared to $128.6 million in fiscal 2021. This $59.5 million increase was due to the following mix of activities. During fiscal 2022, we repurchased approximately 2.0 million shares of common stock for $110.1 million compared to repurchases in fiscal 2021 of approximately 1.3 million shares of common stock for $70.1 million. Payments for tax withholdings on vesting of RSUs partially offset by employee exercises of stock options used net cash flows of $47.8 million in fiscal 2022, an increase of approximately $2.4 million from the net $45.4 million used in fiscal 2021. In September 2022, we entered into our 2022 Credit Agreement and drew down an initial $150.0 million revolving loan at closing, which we used to pay off the $150.0 million outstanding balance on our previous term and revolving loans. In connection with the 2022 Credit Agreement, we paid $1.4 million in debt issuance costs. During fiscal 2022, we made a discretionary payment of $20.0 million on our current revolving loans, and we paid required quarterly installments on our previous long-term debt totaling $8.8 million. During fiscal 2021, we paid required quarterly installments on our long-term debt totaling $13.1 million.

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Accounts receivable, net

Accounts receivable, net as of December 31, 2022 increased by approximately $14.2 million, or approximately 18%, compared to January 1, 2022. This resulted primarily from higher revenue shipments in the fourth quarter of fiscal 2022 compared to the fourth quarter of fiscal 2021. We calculate Days sales outstanding on the basis of a 365-day year as Accounts receivable, net at the end of the quarter divided by sales during the quarter annualized and then multiplied by 365.

Inventories

Inventories as of December 31, 2022 increased $42.8 million, or approximately 63%, compared to January 1, 2022 primarily to meet the increased demands of our customers and for new product ramps.

The Days of inventory on hand ratio compares the inventory balance at the end of a quarter to the cost of sales in that quarter. We calculate Days of inventory on hand on the basis of a 365-day year as Inventories at the end of the quarter divided by Cost of sales during the quarter annualized and then multiplied by 365.

Credit Arrangements

On September 1, 2022, we entered into our 2022 Credit Agreement. The details of this arrangement are described in Note 8 - Long-Term Debt to our Consolidated Financial Statements in Part II, Item 8 of this report. As of December 31, 2022, we had no used or unused credit arrangements beyond the secured revolving loan facility described in the 2022 Credit Agreement.

Share Repurchase Program

See "Issuer Purchases of Equity Securities" under Part II, Item 5 of this Annual Report on Form 10-K for more information about the share repurchase program.

New Accounting Pronouncements

The information contained under the heading "New Accounting Pronouncements" in Note 1 - Nature of Operations and Significant Accounting Policies to our Consolidated Financial Statements in Part II, Item 8 of this report is incorporated by reference into this Part II, Item 7.