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Good afternoon, ladies and gentlemen. Today's conference call is being recorded and will be made available by dialing 404-537-3406, conference ID 6199158, and will also be made available on the Lattice Web-site, www.lscc.com. I would now like to turn the call over to Mr. David Pasquale.
Thank you, Operator. Welcome everyone to Lattice Semiconductor's Second Quarter 2018 Results Conference Call. Joining us from the Company today are Mr. Glen Hawk, Lattice's Interim CEO, and Mr. Max Downing, Lattice's Chief Financial Officer. Both executives will be available for Q&A after the prepared comments. We would also like to welcome Dougherty & Company analyst, Charlie Anderson, who recently initiated coverage on Lattice.
If you have not yet received a copy of today's results release, please e-mail Global IR Partners using lscc@globalirpartners.com or you can get a copy of the release off of the Investor Relations section of Lattice Semiconductor's Web-site.
Before we begin the formal remarks, I'll review the Safe Harbor statement. It is our intention that this call will comply with requirements of SEC Regulation FD. This call includes and constitutes the Company's official guidance for the fiscal third quarter of 2018. If at any time after this call we communicate any material changes to this guidance, we intend that such updates will be done using a public forum such as a press release or publicly announced conference call.
The matters that we discuss today, other than historical information, include forward-looking statements relating to our future financial performance and other performance expectations. Investors are cautioned that forward-looking statements are neither promises nor guarantees. They involve risks and uncertainties that may cause actual results to differ materially from those projected in the forward-looking statements.
Some of those risks and uncertainties are detailed in our filings with the Securities and Exchange Commission, including our Form 10-K for the fiscal year ended December 30, 2017 and our quarterly reports on Form 10-Q. The Company disclaims any obligation to publicly update or revise any such forward-looking statements to reflect events or circumstances that occur after this call.
Our prepared remarks also will be presented within the requirements of SEC Regulation G regarding Generally Accepted Accounting Principles or GAAP. Some financial information presented by us during this call will be provided on both a GAAP and on a non-GAAP basis. By disclosing certain non-GAAP information, management intends to provide investors with additional information to permit further analysis of the Company's performance for results and underlying trends.
Management uses non-GAAP measures to better assess operating performance and to establish operational goals. Non-GAAP information should not be viewed by investors as a substitute for data prepared in accordance with GAAP. If we use any non-GAAP financial measures during the call, you will find the required presentation of and reconciliation to the most directly comparable GAAP financial measure in the Company's earnings press release.
At this time, I would like to now turn the call over to Mr. Glen Hawk. Please go ahead, sir.
Thank you, David, and thank you to everyone for joining us on our call today. We are pleased to report that for the second quarter of 2018, results exceeded our expectations for revenue, for margins, and for operating expense reduction. As I stressed a few months ago, we continue to execute to our strategy, focusing on our core business, delivering revenue growth, expanding margins, driving down operating expenses, and being very clear and consistent with you, doing what we say.
Underlying the solid quarterly results were both strong fundamentals in our target markets and actions to reduce spending. We saw broad strength in industrial markets from end applications such as video displays and factory automation. Strength in our compute market continues to be driven by increased data center server demand. Communications was up despite limited revenue from ZTE due to the U.S. Commerce Department ban, which has recently been lifted. As expected, consumer was down on declining sales into mobile handsets.
From a product perspective, the MachXO family remains our workhorse and continues to deliver solid revenue. We are also seeing our first year of meaningful revenue contributions from new products such as CrossLink and ECP5 variant.
Also contributing to the quarterly results were benefits of our operational efficiency efforts, which Max will discuss momentarily. I would like to elaborate on one important action in this category whose benefits did not contribute to our solid Q2 results but will be realized in Q3 and going forward thereafter. Last week, on July 18, we announced the discontinuance of our millimeter wave business. We did not achieve or see a path to the revenue levels necessary to justify further investments of approximately $13 million per year. We pursued a number of strategic alternatives for this business but none proved viable. We took this action but will continue to support customers during the transition period.
We stated in our press release and I will reiterate here that we do not expect this to cause a significant impact to our 2018 revenue expectations, given strengths we have been reporting in multiple markets for our FPGA product. Max will run through the related one-time charges in a few minutes. The bottom line is that discontinuance is directionally aligned with our commitment to further improve our financial performance and sharpen our focus on the compelling opportunities in our core business.
For our future success, operational efficiencies will help us become more profitable but growth will come from delivering on innovations to capture these compelling opportunities. For example, we are pleased with the reception from the Q2 launch of our Lattice sensAI stack, which as the name implies enables our silicon products for artificial intelligence. We now offer a complete suite of software and IP that customers can use to implement low-powered machine inferencing.
In Q2 we also began limited sampling of a new product with advanced security features, important for data centers as well as IoT. Progress on 28 nanometers is on track and we expect to tape out a platform for multiple families later this year.
In terms of our specific expectations for the third quarter of 2018, revenue for the third quarter of 2018 is expected to be between approximately $100 million and $103 million. For gross margin we expect approximately 57%, plus or minus 2%, on both a GAAP and a non-GAAP basis. Total operating expenses for the third quarter are expected to be between $44 million and $47 million on a GAAP basis and between $39 million and $41 million on a non-GAAP basis.
In summary, we are fully focused on building shareholder value. Our improved financial performance underscores the shift at Lattice from a revenue-driven focus to one driven by increased profitability. We are delivering on our promise of improving operational efficiencies and a business mix that deemphasizes handsets and pivots to less volatile and higher-margin markets such as industrial, automotive, and the emerging trends associated with AI and IoT.
Let me now turn the call over to Max for details on our financial results. Max?
Thank you, Glen. Before I summarize the second quarter results, I'd like to walk through the financial impacts of our decision to discontinue the millimeter wave business. This action will result in a $13 million reduction to our annual operating expenses, primarily through reduced R&D headcount. This benefit will start in the third quarter and is factored into our outlook. Our second quarter operating expenses included a full quarter of these costs.
The action resulted in approximately $24 million of restructuring and impairment charges that were recorded in the second quarter of 2018. These charges include approximately $8 million in inventory write-down that is recorded in cost of sales, approximately $12 million in impairment of acquired intangible assets that is recorded as a component of GAAP operating expenses, and severance and other asset write-offs amounting to approximately $4 million that are recorded as restructuring charges as a component of GAAP operating expenses. We expect this action to have cash impact in the third quarter of approximately $4.2 million to $4.5 million.
Moving onto our second quarter financial results, our revenue for the second quarter was just above our expectations at $102.7 million, compared to an expected range of $98 million to $102 million. Compared to the first quarter, revenue was up $4.1 million or 4.1%, primarily on increases in industrial and computing, which are consistent with the growth drivers we have seen in previous quarters. We also experienced an increase of approximately $1 million on licensing and services revenue related to royalty audit settlements.
We saw approximately $4 million in increased revenue from distributor inventory growth in the second quarter. This is about $2 million more than we expected. This inventory growth is to serve increasing demand for our products performing control applications in servers as well as connectivity applications in our consumer market. We still expect the new revenue rules to positively impact our full-year revenue by approximately 1%.
Specifically, we expect the full-year benefit to product revenue resulting from distributor inventory growth to be in the $3 million to $6 million range. And for licensing and services, we expect the full-year benefit to be insignificant. During the second quarter, we did collect cash of $6.4 million for our 2017 HDMI royalties that we were unable to recognize as revenue because of the new revenue rules.
Our third quarter revenue guidance of $100 million to $103 million reflects sequential strength in both communications and computing. We see industrial and auto staying relatively flat and our consumer market down sequentially. We expect our distributor inventory to decline quarter over quarter as our sell-through continues to grow and outpaces our shipments in the third quarter. In addition, we do not expect the recurrence of the royalty audit settlements we benefited from in the second quarter.
Gross margin on a GAAP basis was 48.9% compared to 57.3% in the first quarter. Our second quarter GAAP gross margin includes approximately $8.3 million or roughly 800 basis points of inventory write-off directly related to the shutdown of the millimeter wave business. Our non-GAAP gross margin held strong at 57.2% as compared to an expected range of 54% to 58%, reflecting better-than-expected end market mix including higher-than-expected licensing and services revenue.
Our third quarter guidance of 57%, plus or minus 2%, which is a departure from our traditional 56%, plus or minus 2%, guidance reflects both the strength in our industrial and automotive end market and our confidence in margin expansion initiatives that we have underway.
Second quarter GAAP operating expenses were $63.8 million compared to $57.3 million in the first quarter. The quarter over quarter incline includes $4 million in restructuring charges and $11.9 million in impairment charges related to the shutdown of our millimeter wave business.
On a non-GAAP basis, operating expenses were $39.9 million, down 12% from the $45.4 million in the first quarter. This is under our second quarter guidance of $43 million to $45 million. The quarter over quarter decline in operating expenses reflects the non-recurrence of about $2 million of first quarter expense which were related to CEO and Board transitions. In addition, headcount and other spending controls contributed approximately $2 million in cost structure improvement. And finally, we saw a quarter over quarter decline of approximately $1.5 million related to cyclical declines in project-related timing.
Our third quarter non-GAAP operating expense guidance of $39 million to $41 million reflects the initial benefits of the millimeter wave discontinuance, offset primarily by $1.5 million in mask and associated project costs related to new product development.
Our GAAP net loss for the second quarter was approximately $20.2 million or $0.16 per basic and diluted share. This includes the $24 million or $0.19 per share in restructuring and impairment charges associated with the shutdown of our millimeter wave business. On a non-GAAP basis, second quarter net income was $12.4 million or $0.10 per basic and diluted share, an improvement of approximately $6.3 million or $0.05 per basic and diluted share from the first quarter.
In alignment with our goals to delever our balance sheet, we made debt principal payments of approximately $11.1 million during the quarter, including a $10 million discretionary principal payment. We ended the quarter with healthy cash and short-term investments of approximately $106 million, allowing us flexibility for future discretionary debt payments.
Sitting here today, I'm both excited and proud of the cost structure progress that we've made. Our key profitability and leverage metrics are consistently improving, but more importantly, we have established a solid foundation to leverage this momentum as we go forward.
This concludes my portion of the call. Operator, we can now open the call for questions.
[Operator Instructions] Your first question comes from the line of Charlie Anderson with Dougherty & Company.
Congrats on the solid performance guys. So, I wanted to start with a lot has changed since the year started obviously, ZTE in, ZTE out, et cetera, changes in operating expenses. So I wonder maybe if you wouldn't mind just sort of recalibrating us on the year to any degree that you can, and then I've got a few follow-ups.
This is Glen. As you know, we do not provide full year guidance. We provide quarterly guidance and Max has given that out. We are very, very pleased by the progress that we've made so far in the first half of the year and we're looking forward to a strong Q3 as well.
Okay, great. As it relates to ZTE, maybe you could add a little color on, I think you gave last quarter kind of roughly where they were as a customer, do they come back in a similar way, they come back in a different way, what are you seeing there, and just in terms of tariff type impacts in general, what are you guys seeing there?
I would separate out a little bit the ZTE issue versus the tariff impact. To address the latter first, from a tariff's perspective, our products are not affected to date and we are in a similar boat as other semiconductor companies with that regards for the most part.
With regards to ZTE, in a situation like this where they are re-engaging so to speak, a lot of times some of the initial signals that you get tend to be a little lumpy and you try to smooth those out with the supply-chain concerns and things like that. In this case, we are in pretty good shape because the products that they buy are products that we sell to other customers as well. And so, we are able to meet most of their needs, but certainly not all as they start to make decisions about the rate at which they would like to restock so to speak.
We mentioned last quarter that we didn't have any customers larger than 4%. I think larger than 5% is where we are at this quarter. We don't see that changing going forward. ZTE should fit within that box. It is noteworthy because ZTE had traditionally been in our top five customers. Rarely, I'll say never, the top for sure, but they are in that ballpark, so it is significant.
Great. And then Max, you gave guidance on a number of fronts on Q3. I was just curious maybe you could [indiscernible] for us on interest expense, share count, and tax rate directionally, anything changing there from Q2?
Our dilution is typically about 0.5 point per quarter, 2% a year, on the share count and that's kind of how I would think about it. With respect to tax rate, given the relatively small dollar amount involved with our tax expense, I tend to not focus as much on rate at this point as I do on overall tax expense. And I think of it this way, I think our full-year tax expense will be right around $3 million to $3.5 million for the year with cash tax being a little bit north of that but not much. And then on interest, I would expect it to be fairly consistent with where it was in the first half, maybe inclining a bit as LIBOR grows.
Okay, great. Thanks so much.
Your next question comes from the line of Christopher Rolland with Susquehanna IG.
This is David Haberle on behalf of Chris. I guess, to start out, after you guys announced your departure from millimeter wave, which just sounds like the economics just weren't justifiable at this point, as you think about the business, are there any other areas that you cut as a cost saving where the economics are just not good enough right now or are we kind of running with the core business at this point?
This is Glen. For the most part, you are correct, that was certainly one of the larger areas of spending that we took action on. Other than that, it's small project level pruning, if you will. But we're pretty comfortable with what we're investing in right now for the most part.
Got it. And I think earlier in the year you guys had kind of set a goal to get to $40 million a quarter in OpEx excluding mask costs in the second half of the year. So, how should we think about that goal now that millimeter wave is out, do we just kind of take $3 million off of that and say about $37 million, what should our kind of OpEx target look like going forward here excluding mask cost?
David, I think where we can go from here I think that there is more room over the sort of mid-term horizon, and I would expect us to drive at our normalized run rate to be 3% to 4% down from where it is today.
Got it, thanks. And then I guess one last one for me, once again nice progress on the industrial and automotive front, it continues to be a winner for you guys, can you guys talk about like what the revenue contribution is from automotive right now in that segment? Is there any design win traction happening now that's going to kind of ramp meaningfully in the next year or two or we wait and see, how is that part of that business?
You bet, David, and I think that this is an area that we'll provide more color on going forward. Historically, Lattice has combined those two segments, industrial and auto, and as we focus on them, clearly we're seeing that they behave a little bit differently. As you have noted in our result, industrial were showing meaningful improvements in revenue, especially year-over-year. Typically those design wins come online much sooner than some of those in auto. So, as things currently stand, to answer your question, virtually all the improvements that we're talking about today revenue-wise have come from the industrial side of that.
Automotive, and the reason we keep emphasizing that, it is a forward-looking type of a comment. The design wins, we are very pleased with the design win progress but it will take some time before that actually shows up in terms of real revenue.
All right, thanks for taking my questions.
Your next question comes from the line of Richard Shannon with Craig-Hallum.
Thanks for taking my questions as well. Maybe I'll ask a question on gross margins. A nice result in the second quarter and a nice guide here. Max, I think you mentioned something regarding having confidence in some of your – I'm trying to find my notes here – confidence in your expansion opportunities underway. Wonder if you can help us understand what exactly that means.
As you know, we've been looking at cost structure and margin expansion opportunities for a while. In part as a result of the investments that we've made in our systems and tools, we have much more intense visibility into the data at product level, customer level, et cetera, and that's helping us really zero-in on refinements in the sales channel, pricing, as well as some supply chain enhancements that will deliver margin expansion for us. And we expect to focus on that over the long-term horizon and leverage, as stated, continue to improve.
Given those activities as well as what I think most people assume are a healthy mix of gross margins that come from your automotive and industrial bucket, which seems to be probably the best growth where you have, any ideas on how you would have us thinking about where gross margins can go several quarters out?
Yes, we're only guiding the third quarter at this point. I do think that we feel obviously very comfortable with our guide and in stepping up and raising our guide from our traditional range of 56, plus or minus 2. We do in the near-term see some period cost that we will add as we pursue these initiatives. You know, saving money costs money sometimes. But we think that will fall within the guided range, and as we get closer to realizing upside benefits from that, we'll talk about those at that time.
Okay, fair enough. We'll look forward to that update. Last question for me, I know you have talked about this maybe two or three quarters ago, and including profile at the analyst event last fall, but maybe Glen, if you can update us on your thought process and breadth of the product lines you expect to have with 20 nanometers?
Richard, real quickly, clarification, 20 nanometers is what we are focused on, and what we're pursuing, and has been several years in the works quite correctly, is a new platform that we'll be deploying that will enable us to just very efficiently both continue our very important product line, successful product lines today from XO to ECP line and the iCE line, and that platform, it's not just about the silicon technology and the design but also the software. A big portion of our R&D effort goes into developing the software that customers need to use our products in the IP, and this is just a much more reusable platform for us.
You might have remembered from last fall that I clarified that after several acquisitions that Lattice had made, we really wound up with four very different technology platforms, the original Lattice one, one from SiliconBlue, and two from Silicon Image. So, this is really going to help us in terms of R&D efficiency going forward.
Excellent. I think that's all for me, guys. Thank you. I'll step out of line.
Your next question comes from Mietek Biskupski with Invesco.
Congratulations on the quarter. Can you give us any approximation of how much was sold into or out of the channel, as you did for last quarter?
So, in the third quarter, what do we expect with respect to channel inventory?
No, just for this quarter, how much – you did [indiscernible] underlying sales here, how much was – was it 5 million or 8 million or anything like that, how much more was sold into the channel or sold out?
In the second quarter?
Second quarter, yes.
Okay, yes. So, channel inventory inclined about 4.1 million in the second quarter. We did have sell-through growth, consumption growth of about 9% from first quarter to second quarter. And then we expect in the third quarter that kind of sell-through consumption growth to continue and then our channel inventory to decline in the third quarter about 3 million to 4 million. Does that answer your question?
Got you, that's perfect. Just taking a step back, if I understand, in the first quarter that sales are going to bump up as people are buying ahead of ZTE, and then second and third quarter come in actually strong from that, can you give us any more granular detail of where you are seeing the strength in markets and what type of products are [indiscernible]?
I'm sorry, was the question more for Q2 or for Q3 or just in general?
Really for Q2, and generally as you like.
Okay. I think certainly for Q2 relative to the prior quarter and certainly relative to the prior year, as we mentioned, industrial is clearly a bright spot. We're seeing a pretty broad-based increase. Some of the noteworthy end applications include things like factory automation and robotics in particular. Another area that's really in the industrial space is what you would call video walls. A lot of our products are ideal for mixing and matching video displays and sensors, and so that's going very well for us.
Believe it or not, in communications, despite some of the shortfalls from ZTE, communications was actually up, thanks to strength from some of our other communications customers. And another bright spot continues to be into what we call the computing segment, which is in particular data center servers. We're very pleased with the reception of our products onto servers that are using the Intel Purley platform and others.
Great. Thanks so much.
Your next question comes from the line of Charlie Anderson with Dougherty & Co.
So I just had a quick follow-up on millimeter wave. I wonder, Glen, if you could speak to is there any potential to monetize the patents there? I suppose IBM was pretty early innovator there. So, as we went through the process there, wonder if you have value with that and if that's a possibility here on out? Thanks.
Yes, Charlie, we've certainly looked at everything that we have and how we can get the best value for our shareholders. One thing I'd like to point out is we did actually monetize some of those patents the prior year, in Q1 and Q2 of 2017. I believe the total was around 18 million for the two quarters combined. So we had taken that action earlier. But you are right, we do still have patents in other assets that we will pursue monetizing.
Okay, great. Thanks so much.
And there are no further questions at this time. I would like to turn the call back to CEO, Glen Hawk, for closing remarks.
Thank you, operator, and thank you again to everyone for joining us on today's call. We appreciate you taking the time, especially during the busy reporting season, to hear an update on Lattice. We are excited about our results, our progress, and our outlook.
In summary, the key takeaways from our call is that we are continuing to execute to our business strategy, we're achieving the operating efficiency improvements that we had mentioned, we're delivering higher non-GAAP profitability, we're actively paying down corporate debt, we're further enhancing shareholder value, and as I mentioned, we're pursuing some innovations to take advantage of some of the key market trends that we see going forward.
Again, we appreciate your continued support and encourage you to reach out with any additional follow-up questions you may have. Operator, that concludes today's call.
This concludes today's conference call. You may now disconnect.