Lattice Semiconductor - 10-Q quarterly report FY

In May 2003, the FASB issued SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This pronouncement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in certain circumstances) because that financial instrument embodies an obligation of the issuer. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003.  On November 7, 2003, FASB issued FASB Staff Position No. FAS 150-3 ("FSP 150-3"), "Effective Date, Dis closures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity."  FSP 150-3 deferred certain aspects of SFAS 150.  The adoption of SFAS 150 and FSP 150-3 did not have a material impact on our consolidated financial position or results of operations.

In March 2004, the Emerging Issues Task Force finalized its consensus on EITF Issue 03-6, "Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share" (EITF 03-6). EITF 03-6 clarifies what constitutes a participating security and requires the use of the two-class method for computing basic earnings per share when participating convertible securities exist. EITF 03-6 is effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-6 did not have a material effect on our results of operations.

In March 2004, the Emerging Issues Task Force reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. In September 2004, the FASB issued a final FASB Staff Position that delays the effective date for the measurement and recognition guidance for all investments within the scope of EITF 03-01. The consensus re ached in March 2004 also provided for certain disclosure requirements associated with cost method investments that was effective for fiscal years ending after June 15, 2004. Management will evaluate the affect of adopting the recognition and measurement guidance when the matter is finalized.

In March 2004, the FASB issued a proposed Statement "Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95", that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic method currently used by us and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expense in our consolidated statement of operations. The currently recommended effective date of the proposed sta ndard is for interim or fiscal periods beginning after June 15, 2005. Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement of operations, as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan.

In April 2004, the Financial Accounting Standards Board issued FASB Staff Position (FSP)129-1, "Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities", further defining disclosure requirements for convertible notes, among other things.  As a result of adopting FSP 129-1 in April 2004, we further described circumstances under which our note holders may convert their notes into our common shares before note maturity.

In September 2004, the Emerging Issues Task Force issued EITF 04-08 "The Effect of Contingently Convertible Debt on Diluted Earnings Per Share" requiring us to include in diluted earnings per share, on the if-converted method, the aggregate of approximately 14 million shares of our common stock into which the Zero Coupon Convertible Subordinated Notes due in 2010 ("Convertible Notes") may be converted, regardless of whether the conversion threshold has been met. We adopted this standard as of September 2004. We have reported per share losses since June 2003 when our Convertible Notes were issued. Since inclusion of the additional shares would be anti-dilutive, no change to our historical results is appropriate required. However, to the extent inclusion of these shares is dilutive in the future, diluted earnings per share will include the effect of converting our outstanding Convertible Notes.

Note 8 - Legal Matters:

In September and October 2004, three putative class action complaints were filed in the United States District Court for the District of Oregon against Lattice Semiconductor Corporation, our Chief Executive Officer Cyrus Y. Tsui, and our President Stephen A. Skaggs. These complaints were filed on behalf of a putative class of investors who purchased our stock between April 22, 2003 and April 19, 2004. They generally allege violations of federal securities laws arising out of our previously announced restatement of financial results for the first, second, and third quarters of 2003. Consistent with the usual procedures for cases of this kind, we anticipate that these cases (and any other similar putative class action complaints that might be filed against us) may be consolidated into a single action. We believe that the co mplaints are without merit, and we intend to vigorously defend against the lawsuits.

In September and October 2004, two shareholder derivative complaints were filed, purportedly on behalf of Lattice Semiconductor Corporation, in the Circuit Court of the State of Oregon for the County of Washington, against all of our current directors, certain former directors, and certain executive officers. The derivative plaintiffs make allegations substantially similar to those in the putative class action complaints, as well as allegations of breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. Consistent with the usual procedures for cases of this kind, we anticipate that these cases (and any other similar complaints that may be filed in the same jurisdiction) may be consolidated into a single putative shareholder derivative complaint.

All of the complaints generally seek an unspecified amount of damages, as well as attorney fees and costs. The cases are still in the preliminary stages, and it is not possible for us to quantify the extent of our potential liability, if any. An unfavorable outcome in any of these matters could have a material adverse effect on our business and financial results. In addition, defending any litigation may be costly and divert management's attention from the day-to-day operations of our business.

We are exposed to certain asserted and unasserted potential claims. There can be no assurance that, with respect to potential claims made against us, we could resolve such claims under terms and conditions that would not have a material adverse effect on our business and financial results.

On September 6, 2004, we agreed with the U. S. Department of Commerce to settle charges that we did not comply with Export Administration Regulations between 2000 and 2002. The settlement resulted in a fine of $560,000. Provision for these costs has been made in prior year’s financial statements. The charges involved the exportation of controlled semiconductor devices to a Hong Kong distributor that subsequently re-exported those devices to the Peoples Republic of China (PRC), and the release of controlled semiconductor manufacturing technology to nationals of the PRC employed by us in the United States, as well as the exportation of such manufacturing technology to our design center in the PRC. We voluntarily disclosed these circumstances to the Department, cooperated fully with an investigation of our export practi ces and procedures, and have implemented enhancements to strengthen our export control procedures.

Note 9 - Foundry Investments:

In 1995, we entered into a series of agreements with United Microelectronics Corporation ("UMC"), a public Taiwanese company, pursuant to which we agreed to join UMC and several other companies to form a separate Taiwanese corporation, UICC, for the purpose of building and operating an advanced semiconductor manufacturing facility in Taiwan, Republic of China.  Under the terms of the agreements, we invested  $49.7 million for an approximate 10% equity interest in the corporation and the right to receive a percentage of the facility’s wafer production at market prices.

In 1996, we entered into an agreement with Utek Corporation ("Utek"), a public Taiwanese company in the wafer foundry business that became affiliated with the UMC group in 1998, pursuant to which we agreed to make a series of equity investments in Utek under specific terms. In exchange for these investments, we received the right to purchase a percentage of Utek’s wafer production. Under this agreement, we invested $17.5 million. On January 3, 2000, UICC and Utek merged into UMC.

As of September 30, 2004, we owned 60.8 million shares of UMC common stock of which approximately 23.3 million are restricted by the terms of our agreement with UMC.  Under the terms of the UMC agreement, if we sell any of these restricted shares, our rights to guaranteed wafer capacity at UMC may be reduced on a pro-rata basis based on the number of shares that we sell.  If we sell over 10.1 million of these restricted shares, we may lose all of our rights to guaranteed wafer capacity at UMC.

For financial reporting purposes, all of our UMC shares are accounted for as available for sale and marked to market in our Condensed Consolidated Balance Sheet until they are sold, at which time a gain or loss is recognized in our Condensed Consolidated Statement of Operations.  Unrealized gains and losses are included in Accumulated other comprehensive income (loss) within Stockholders’ equity.  An other than temporary impairment of UMC share value could result in a reduction of the Condensed Consolidated Balance Sheet carrying value and would result in a charge to our Condensed Consolidated Statement of Operations.

The carrying value of our investment in UMC was approximately $37.4 million and $81.1 million at September 30, 2004 and December 31, 2003, respectively, and this balance is classified as part of Other current assets ($24.6 million and $35.4 million at September 30, 2004 and December 31, 2003, respectively) and Foundry investments, advances and other assets. During the first nine months of 2004, we sold 36.6 million UMC shares for a gain of $6.1 million of which $5.6 million was already recorded as an unrealized gain in Accumulated other comprehensive income (loss). Also in the first nine months of 2004, we recorded a $15.0 million decrease in unrealized gain related primarily to the market value of our UMC shares. If we liquidate our UMC shares, it is likely that the amount of any future realized gain or loss wi ll be different from the accounting gain or loss reported in prior periods.

On September 10, 2004, we entered into an Advance Payment and Purchase Agreement (the "Fujitsu Agreement") with Fujitsu Limited ("Fujitsu"), pursuant to which we will advance $125 million to Fujitsu in support of the development and construction of a new 300mm wafer fabrication facility in Mie, Japan.  The initial payment of $25 million was made in October 2004, with the remaining payments to be made in three stages upon the achievement of certain milestones.  We currently anticipate that the advance payment will be paid in full by the second quarter of 2006.

Our $125 million advance will be credited against the purchase price of 300 mm wafers from the new wafer fabrication facility.  In addition, during the term of the Fujitsu Agreement, we will receive a specified number of free wafers from Fujitsu whenever the aggregate number of wafers shipped by Fujitsu reaches a specified volume. The Fujitsu Agreement will continue until the full amount of the advance payment has been returned to us in the form of wafers or other repayment, subject to the right of either party to terminate the agreement upon the occurrence of certain events. We may request a refund of the unused amount of the advance payment if we have not used all of our wafer credits by December 31, 2007. The repayment obligation of Fujitsu is unsecured.

The foregoing summary description of the Fujitsu Agreement is qualified in its entirety by reference to the Fujitsu Agreement, which is filed as an exhibit to this Form 10Q.

Note 10 - Segment and Geographic Information:

We operate in one industry segment comprising the design, development, manufacture and marketing of high performance programmable logic devices. Our revenues by major geographic area were as follows (in thousands):

Resale of product through two distributors accounted for approximately 13% and 10% of revenue in the first nine months of 2004, and 20% and 17%, respectively, for the first nine months of 2003. More than 90% of our property and equipment is located in the United States. Other long-lived assets located outside the United States consist primarily of foundry investments and advances.

Note 11 - Stock Option Exchange Program:

On March 14, 2003, we completed an exchange offer related to a stock option exchange program. Under the exchange offer, eligible employees had the opportunity to tender for cancellation certain stock options in exchange for new options to be granted at least six months and one day after the cancellation of the tendered options. Each eligible participant received new options to purchase four shares of common stock for every seven shares subject to options submitted for cancellation. We accepted options to purchase 11.2 million shares for exchange at various exercise prices between $6.30 and $32.25 and granted new options to purchase 6.4 million shares on September 18, 2003, the new grant date. The exercise price per share of the new options of $8.21 was equal to the fair market value of our common stock on the new grant date. In connection with the stock option exchange program, we accelerated the write-off of accrued deferred compensation recorded in conjunction with certain of our acquisitions, due to the cancellation of certain assumed in-the-money stock options. Such acceleration resulted in $2.2 million of additional intangible asset amortization expense in the first quarter of 2003. However, we do not expect to record any additional compensation expense as a result of the exchange program.

Note 12  - Yen Line of Credit Borrowing Agreement:

To minimize foreign exchange risk related to Yen-based net assets on our Condensed Consolidated Balance Sheet, on August 11, 2004, we entered into an agreement with a bank under the terms of which we can borrow up to $6 million in Japanese Yen in a revolving line of credit arrangement. Outstanding borrowing is collateralized by cash equivalents. Interest on outstanding borrowing is based on the Japanese LIBOR Fixed Rate, and averaged 1.04% during the three months ended September 30, 2004. The average principal balance outstanding was $3.9 million, and the maximum borrowing outstanding and outstanding principal balance at the end of the three month period ended September 30, 2004 was $4.2 million.

Lattice Semiconductor Corporation designs, develops and markets high performance programmable logic devices, or PLDs, and related software. Programmable logic devices are widely used semiconductor components that can be configured by the end customer as specific logic circuits, and enable the end customer to shorten design cycle times and reduce development costs.  Our end customers are primarily original equipment manufacturers in the communications, computing, industrial, automotive, medical, consumer and military end markets.

On September 10, 2004 we entered into an agreement with Fujitsu pursuant to which we will advance $125 million to Fujitsu in support of the development and construction of a new 300mm wafer fabrication facility in Mie, Japan. An initial payment of $25 million was made in October 2004, with the remaining payments to be made in three stages upon the achievement of certain milestones. We currently anticipate that the advance payment will be paid in full by the second quarter of 2006. Our $125 million advance will be credited against the purchase price of 300 mm wafers from the new wafer fabrication facility. Under the terms of the agreement, we will also have access to future process technologies to be developed for the manufacture of our wafers. We have the option of requesting repayment of the unused portion of the $125 mi llion wafer advance, if any, in January 2008. Fujitsu’s repayment obligation is unsecured.

As a percentage of total revenue, U.S. sales declined to 24% and 26% for the third quarter of 2004 and for the first nine months of 2004, respectively, compared to 25% and 30% for the third quarter and the first nine months of 2003, respectively. Export sales to Japan rose as a percentage of total revenue, to 15% and 13% in the third quarter and the first nine months of 2004, respectively, from 13% and 11% in the third quarter and in the first nine months of 2003, respectively. Export sales to Europe rose from 20% to 22% for the third quarter from 2003 to 2004, respectively, and declined from 26% to 23% for the first nine months of 2003 and the first nine months of 2004, respectively. Export sales to Asia (excluding Japan) declined from 34% to 32% for the third quarter from 2003 to 2004, respectively, and rose from 26% to 32% for the first nine months of 2003 and the first nine months of 2004, respectively. Export sales to the rest of world (predominantly the Americas excluding the United States) declined to 6% for the third quarter of 2004 and for the first nine months of 2004, respectively, compared to 8% and 7% for the third quarter and the first nine months of 2003, respectively.

During the third quarter and first nine months of 2004 compared to the same periods in 2003, units sold increased by 39% and 14%, respectively, while average selling prices decreased 4% and 1%, respectively. The increase in units sold is predominantly attributable to new products. The decrease in average selling prices is attributable to product mix. Our ability to achieve revenue growth is in large part dependent on the continued development, introduction and market acceptance of new products. See "Factors Affecting Future Results."

Gross Margin:

In absolute terms, gross margin grew by $8.8 million in the three months ended September 30, 2004 compared to the three months ended September 30, 2003, and by $10.0 million in the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003. As a percentage of revenue, gross margin declined from 58.3% for the first nine months of 2003 to 57.2% for the first nine months of 2004. These changes reflect revenue growth in new products, which currently carry a lower gross margin, and a decline in revenue from mature products, which have a higher gross margin. The gross margin percentage increased from 54.8% in the third quarter of 2003 to 56.6% in the third quarter of 2004. The improvement in gross margin for the three months ended September 30, 2004 compared to the three months ended September 30, 2003 is attributable to a provision for an allowance for price protection and sales returns from distributors in 2003.

Research and Development:

Research and development expenses increased by $2.0 million and $3.4 million in the third quarter and first nine months of 2004, respectively, when compared to the same periods in 2003, reflecting cost increases primarily attributable to masks for new products. Research and development expenses consist primarily of labor, masks, prototype wafers, third-party design automation software, assembly tooling and qualification expenses.  We believe that a continued commitment to research and development is essential in order to provide innovative new product offerings and to maintain product leadership of our existing product families, and therefore we expect to continue to make significant future investments in research and development.

Selling, General and Administrative Expense:

Selling, general and administrative expenses increased approximately $1.5 million and $3.6 million, respectively, in the third quarter and first nine months of 2004 when compared to the same periods of 2003. These increases were primarily due to increased sales commissions on higher revenue and marketing expenses to support the next generation FPGA launch.

Amortization of intangible assets is related to our 2002 acquisitions of the Agere FPGA business and Cerdelinx, our 1999 Vantis acquisition and our 2001 acquisition of Integrated Intellectual Property, Inc. ("I2P"). Amortization expense was $5.8 million and $41.5 million in the third quarter and first nine months of 2004, a decrease of $12.9 million and $17.0 million when compared to the same calendar periods of 2003. The most significant portion of the decrease ($12.7 million) resulted from completion during the second quarter of 2004 of the amortization of intangible assets related to our purchase of Vantis. An additional $2.2 million of the decrease in the first nine months of 2004 resulted from the accelerated write-off of accrued deferred compensation recorded in the first quarter of 2003 in conjunction with certain of our acquisitions, due to the cancellation of certain assumed in-the-money stock options as part of a stock option exchange program initiated during the first quarter of 2003 (refer to Note 11 to the Condensed Consolidated Financial Statements).

 Other Income (Expense), Net:

Other income (expense), net, was $4.0 million and $10.2 million, respectively, in the third quarter and first nine months of 2004, respectively, as compared to $(3.6) million and $(3.5) million, respectively, for the same periods of 2003. Gains on the sale of UMC shares (see Note 9 to the Condensed Consolidated Financial Statements) of $0.5 million and $6.1 million are included in the third quarter and first nine months of 2004, respectively. There were no similar sales in the comparable periods of 2003. During the third quarter of 2004 and 2003 we recorded a gain of approximately $2.8 million and $1.4 million, respectively, in connection with the extinguishment of a portion of our Convertible Notes. We recorded a gain of $2.9 million on extinguishment of our 4 ¾% Convertible Subordinated Notes due i n 2006 ("4 ¾% Convertible Notes") in the first quarter of 2003. During the third quarter of 2003, we redeemed for cash all of our outstanding 4¾% Convertible Notes plus accrued interest.  In conjunction with the call of these notes, we paid a call premium of 2.71% of the outstanding notes, or approximately $4.7 million. This call premium, plus unamortized issuance costs of approximately $1.0 million on the redemption date, was recorded as "Other expense" in the quarter ended September 30, 2003. We recorded interest expense related to our 4 ¾% Convertible Notes of $0.4 million in the third quarter of 2003 and $4.7 million in the nine months ended September 2003. Additional increases in Other income (expense) in the third quarter and first nine months of 2004 as compared to the same periods in 2003 resulted from an increase in interest income on invested balances caused by higher interest rates.

As of September 30, 2004, our principal source of liquidity was $319.4 million of cash and short-term investments, an increase of $41.6 million from the balance of $277.8 million at December 31, 2003. This increase was due primarily to the receipt of $29.6 million in the first nine months of 2004 from the sale of shares of our equity investment in UMC and from $26.0 million net cash flow from operations offset by $12.0 million expenditure to extinguish our Convertible Notes. Working capital decreased to $355.6 million at September 30, 2004 from $363.6 million at December 31, 2003. 

Accounts receivable days outstanding declined from approximately 46 to 43 days from December 31, 2003, to September 30, 2004 reflecting the timing of receipts within the period. Inventories decreased by $7.5 million, or 16%, as compared to December 31, 2003 primarily due to increased customer shipments. Accounts payable and accrued expenses increased $33.1 million or 116.1% at September 30, 2004 compared to December 31 2003 primarily due to the accrual of $25 million due and paid to Fujitsu Limited in October 2004 (see Note 9 to the Condensed Consolidated Financial Statements) and to a lesser extent due to the renewal and extension of vendor agreements related to the use of third party software. Deferred income increased by $5.5 million at September 30, 2004 as compared to December 31, 2003 reflectin g an increase in the amount of inventory held by distributors to accommodate higher levels of resale by distributors to their end customers.

  

Foundry investments, advances and other assets decreased by $12.7 million from December 31, 2003 to September 30, 2004. This decrease is attributable to a decline in the market value of our equity investment in UMC shares as well as sale of UMC shares partially offset by an increase represented by the accrual of our first payment due and paid in October 2004 under the Fujitsu agreement.

On September 10, 2004, we entered into an Advance Payment and Purchase Agreement (the "Fujitsu Agreement") with Fujitsu Limited ("Fujitsu"), pursuant to which we will advance $125 million to Fujitsu in support of the development and construction of a new 300mm wafer fabrication facility in Mie, Japan.  The initial payment of $25 million was made in October 2004, with the remaining payments to be made in three stages upon the achievement of certain milestones.  We currently anticipate that the advance payment will be paid in full by the second quarter of 2006.

Our $125 million advance will be credited against the purchase price of 300 mm wafers from the new wafer fabrication facility.  In addition, during the term of the Fujitsu Agreement, we will receive a specified number of free wafers from Fujitsu whenever the aggregate number of wafers shipped by Fujitsu reaches a specified volume. The Fujitsu Agreement will continue until the full amount of the advance payment has been returned to us in the form of wafers or other repayment, subject to the right of either party to terminate the agreement upon the occurrence of certain events. We may request a refund of the unused amount of the advance payment if we have not used all of our wafer credits by December 31, 2007. The repayment obligation of Fujitsu is unsecured.

Beginning in September 2004, three complaints on behalf of a purported class of investors who purchased our common stock between April 22, 2003 and April 19, 2004 were filed in the United States District Court for the District of Oregon. These complaints generally allege that we and some of our officers violated provisions of the Securities Exchange Act of 1934. Similar complaints purporting to be derivative actions have been filed on our behalf in Oregon state court alleging that some of our directors and officers breached their fiduciary duties. These complaints arise out of our restatement of financial results for the first three quarters of 2003 to correct inappropriate accounting entries and a failure to record a change in accounting estimate related to deferred income. The expense of defending such litigation may be costly and divert management's attention from the day-to-day operations of our business, which could adversely affect our business and financial results. In addition, an unfavorable outcome in any such litigation could have a material adverse effect on our business and financial results.

We are exposed to certain asserted and unasserted potential claims. There can be no assurance that, with respect to potential claims made against us, we could resolve such claims under terms and conditions that would not have a material adverse effect on our business and financial results.

On September 6, 2004, we agreed with the U. S. Department of Commerce to settle charges that we did not comply with Export Administration Regulations between 2000 and 2002. The settlement resulted in a fine of $560,000. Provision for these costs has been made in prior year’s financial statements. The charges involved the exportation of controlled semiconductor devices to a Hong Kong distributor that subsequently re-exported those devices to the Peoples Republic of China (PRC), and the release of controlled semiconductor manufacturing technology to nationals of the PRC employed by Lattice in the United States, as well as the exportation of such manufacturing technology to our design center in the PRC. We voluntarily disclosed these circumstances to the Department, cooperated fully with an investigation of our export p ractices and procedures, and have implemented enhancements to strengthen our export control procedures.