In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Standards Accounting Board Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities," an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN 46 establishes accounting guidance for consolidation of a variable interest entity. In a variable interest entity the equity investors do not have a controlling interest or their equity interest is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. We do not currently have any business relationship with a variable interest entity, so the adoption of FIN 46 had no impact on our consolidated financial position or results of operations.
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):
New Accounting Pronouncements:
In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Standards Accounting Board Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities," an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN 46 establishes accounting guidance for consolidation of a variable interest entity. In a variable interest entity the equity investors do not have a controlling interest or their equity interest is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. We do not currently have any business relationship with a variable interest entity, so the adoption of FIN 46 had no impact on our consolidated financial position or results of operations.
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 Da
te, Disclosures, 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 results of operations, financial position or cash flows.
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 with the scope of EITF 03-01. The consens
us reached in March 2004 also provided for certain disclosure requirements associated with cost method investments which 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 the Company and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expense in the Company’s consolidated statement of operations. The currently recommended eff
ective date of the proposed standard 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 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 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 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 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.
Liquidity and Capital Resources
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.
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.
Convertible Notes with a face value of $15 million were extinguished during the three months ended September 30, 2004. A long term agreement with a third party to license and maintain software used to design the company’s new products primarily accounts for the increase in Other long term liabilities at September 30, 2004 compared to December 31, 2003.
Deferred stock compensation within Stockholders’ equity decreased by $2.9 million during the first nine months of 2004 due to amortization. The $20.5 million decrease in Accumulated other comprehensive income (loss) within the Stockholders’ Equity during the first nine months of 2004 is attributable to the unrealized loss in equity securities partially offset by the realized gain on sale of UMC securities (see Note 9 to the Condensed Consolidated Financial Statements).
At September 30, 2004, we had no senior indebtedness and our subsidiaries had approximately $1.9 million of Other liabilities. Issuance costs of $2.5 million, net of debt extinguishments, relative to our Convertible Notes are included in Other assets in our Condensed Consolidated Balance Sheet and are being amortized to expense over the life of the notes. Accumulated amortization amounted to $2.8 million at September 30, 2004. The estimated fair value of our Convertible Notes, based on quoted market prices, was approximately $140 million at September 30, 2004. At the conversion price of $12.06 per share (82.9105 shares of common stock per each $1,000 principal amount notes), 14.0 million common shares are issuable upon conversion of the Convertible Notes. In general, and as further described
in the related agreements and Note 11 to our consolidated financial statements in our annual report on Form 10-K for the fiscal year ended December 31, 2003, our Convertible Notes may be converted into common stock before maturity if we request a redemption, or make a distribution to common stock holders that is dilutive to note holders or if we become a party to a merger or consolidation or sale of substantially all of our assets.
Capital expenditures were $8.3 million for the first nine months of 2004. We expect to spend approximately $10 million to $13 million for the fiscal year ending December 31, 2004.
At September 30, 2004, we own 60.8 million shares of UMC common stock. Restrictions by UMC apply to approximately 23.3 million of these shares (see Note 9 to the Condensed Consolidated Financial Statements). During the first nine months of 2004, we sold 36.6 million of our UMC shares for $29.6 million in cash, resulting in a gain of $6.1 million. In the future, we may choose to liquidate additional UMC shares.
In March 1997 and as subsequently amended in January 2002 and March 2004, we entered into an advance payment production agreement with Seiko Epson and Epson Electronics America, Inc. ("EEA") under which we advanced $51.3 million to Seiko Epson to finance construction of an eight-inch sub-micron semiconductor wafer manufacturing facility. Under the terms of the agreement, the advance is to be repaid with semiconductor wafers over a multi-year period. No interest income is recorded. The agreement calls for wafers to be supplied by Seiko Epson through EEA pursuant to purchase agreements with E
EA. Cumulatively, $22.9 million of these payments have been repaid to us in the form of semiconductor wafers. We currently estimate that approximately $13.9 million of the outstanding advances are expected to be repaid with semiconductor wafers during the next twelve months and are thus reflected as part of Other current assets in our Condensed Consolidated Balance Sheet. We are not obligated to make additional payments under this agreement.
We believe that our existing liquid resources, expected cash generated from operations and existing credit facilities combined with our ability to borrow additional funds will be adequate to meet our operating and capital requirements and obligations for the next 12 months, including the continued possible extinguishment of a portion of our Convertible Notes as discussed above.
For a variety of business reasons, we may in the future seek new or additional sources of funding. In addition, in order to secure additional wafer supply, we may from time to time consider various financial arrangements including joint ventures, equity investments, advance purchase payments, loans, or similar arrangements with independent wafer manufacturers in exchange for committed wafer capacity. To the extent that we pursue any such additional financing arrangements, additional debt or equity financing may be required. There can be no assurance that such additional financing will be available when needed or, if available, will be on favorable terms. Any future equity financing will decrease existing stockholders’ equity percentage ownership and may, depending on the price at which the equity is sold, resu
lt in dilution.
Off-Balance Sheet Arrangements
We do not have any financial partnerships with unconsolidated entities, such as entities often referred to as structured finance or special purpose entities, which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had such relationships.
Factors Affecting Future Results
We may be unsuccessful in defining, developing or selling new products required to maintain or expand our business.
As a semiconductor company, we operate in a dynamic environment marked by rapid product obsolescence. Our future success depends on our ability to introduce new or improved silicon and software products that meet customer needs while achieving acceptable margins. We are presently in the process of releasing next generation FPGA product families that are critical to our ability to address the FPGA segment of the programmable logic market. If we fail to introduce these, or other, new products in a timely manner or such products fail to achieve market acceptance, our operating results would be harmed.
Fujitsu Limited has agreed to manufacture our next generation FPGA products on its 130 nanometer and 90 nanometer CMOS process technologies, as well as on a 130 nanometer technology with embedded Flash memory that we have jointly developed with Fujitsu. The success of our next generation FPGA products is dependent on our ability to successfully partner with Fujitsu, which has not previously manufactured any of our products. If for any reason we are unsuccessful in our efforts to partner with Fujitsu in connection with these next generation FPGA products, our future revenue growth would be materially adversely affected.
The introduction of new silicon and software products in a dynamic market environment presents significant business challenges. Product development commitments and expenditures must be made well in advance of product sales. The market reception of new products depends on accurate projections of long-term customer demand, which by their nature are uncertain.
Our future revenue growth is dependent on market acceptance of our new silicon and software product families and the continued market acceptance of our current products. The success of these products is dependent on a variety of specific technical factors including:
• successful product definition;
• timely and efficient completion of product design;
• timely and efficient implementation of wafer manufacturing and assembly processes;
• product performance;
• product cost; and
• the quality and reliability of the product.
If, due to these or other factors, our new silicon and software products do not achieve market acceptance, our operating results would be harmed.
Our products may not be competitive if we are unsuccessful in migrating our manufacturing processes to more advanced technologies or alternative fabrication facilities.
To develop new products and maintain the competitiveness of existing products, we need to migrate to more advanced wafer manufacturing processes that use larger wafer sizes and smaller device geometries. We also may need to use additional foundries. Because we depend upon foundries to provide their facilities and support for our process technology development, we may experience delays in the availability of advanced wafer manufacturing process technologies at existing or new wafer fabrication facilities. As a result, volume production of our advanced process technologies at the fabs of Seiko Epson, UMC, Chartered Semiconductor, Fujitsu or future foundries may not be achieved. This could harm our operating results, including gross margin.
The cyclical nature of the semiconductor industry may limit our ability to maintain or increase revenue levels and operating results during industry downturns.
The semiconductor industry is highly cyclical, to a greater extent than other less technology-driven industries. Our financial performance has periodically been negatively affected by downturns in the semiconductor industry. Factors that contribute to these industry downturns include:
• the cyclical nature of the demand for the products of semiconductor customers;
• general reductions in inventory levels by customers;
• excess production capacity;
• general decline in end-user demand; and
• accelerated declines in average selling prices.
Historically, the semiconductor industry has experienced periodic downturns of varying degrees of severity and duration. Typically, after such downturns, semiconductor industry conditions improve, although such improvement may not be significant or sustainable. Increased demand for semiconductor industry products may not proportionately increase demand for programmable logic devices in general, or our products in particular. Even if demand for our products increases, average sales prices for our products may not increase, and could decline. Whenever adverse semiconductor industry conditions or other similar conditions exist, there is likely to be an adverse effect on our operating results.
A downturn in the communications equipment and computing end markets could cause a reduction in demand for our products and limit our ability to maintain or increase revenue levels and operating results.
The majority of our revenue is derived from customers in the communications equipment and computing end markets. Any deterioration in these end markets or any reduction in technology capital spending could lead to a reduction in demand for our products. Whenever adverse economic or end market conditions exist, there is likely to be an adverse effect on our operating results.
We face risks related to implementation of new Sarbanes Oxley Section 404 Controls Audit requirements.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that our management assess our internal control over financial reporting annually and include a report on its assessment in our annual report. Our auditors are required to audit both the design and operating effectiveness of our internal controls and management's assessment of the design and the operating effectiveness of its internal controls. Through its assessment process, management believes there are no known material weaknesses at this time. This will be the first year that we have undergone an audit of our internal controls and procedures, and it is possible that material weaknesses could be found. If we are unable to remediate any such weaknesses, management may be unable to conclude our controls are operating effectively and our external auditors may i
ssue an adverse opinion on our internal controls. If this were to occur, particularly in light of our recent restatement, investor confidence regarding our internal controls could be harmed and our stock price could decline.
We face risks related to our recent accounting restatement.
On January 22, 2004, we announced that we had discovered possible accounting inaccuracies in previously reported quarterly financial statements. An internal investigation was conducted by the Audit Committee of our Board of Directors to determine the scope and magnitude of these inaccuracies. On March 24, 2004, we announced that the Audit Committee had completed its internal accounting investigation and, as a result, we restated our financial statements for the first, second and third quarters of 2003 to correct inappropriate accounting entries and a failure to record a change in accounting estimate related to deferred income. On April 19, 2004, we filed such restated financial statements with Form 10Q/A for the affected quarters.
The restatement of these financial statements has led to litigation claims and may lead to further litigation claims and/or regulatory proceedings against us. The defense of any such claims or proceedings may cause the diversion of management’s attention and resources, and we may be required to pay damages if any such claims or proceedings are not resolved in our favor. Any litigation or regulatory proceeding, even if resolved in our favor, could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on the financial statement inaccuracies and resulting restatement. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our common stock to decline.
If we are unable to effectively and efficiently implement our plan to improve our internal controls there could be a material adverse effect on our operations or financial results.
We received notice from our independent registered public accounting firm that, in connection with the 2003 year-end audit, the auditor identified a material weakness in our internal controls and procedures relating to separation of duties and establishment of standards for review of journal entries and related file documentation. We have implemented and are continuing to implement various initiatives intended to materially improve our internal controls and procedures to address this weakness. These initiatives address our control environment, organization and staffing, policies, procedures and documentation, and information systems. The implementation of these initiatives is one of our highest priorities. Our Board of Directors, in coordination with our Audit Committee, will continually asses
s the progress and sufficiency of these initiatives and make adjustments as necessary. However, no assurance can be given that we will be able to successfully implement our revised internal controls and procedures or that our revised controls and procedures will have the desired effect. In addition, we may be required to hire additional employees, and may experience higher than anticipated capital expenditures and operating expenses, during the implementation of these changes and thereafter. If we are unable to implement these changes effectively or efficiently, there could be a material adverse effect on our operations or financial results. Moreover, we could be subject to additional regulatory oversight and our business and reputation could be harmed.
In addition, we may in the future experience accounting estimate changes related to our deferred income account, inventory account, income tax liability, accounts receivable collectibility, or realization of goodwill and intangible assets, any of which could adversely affect our business and financial results.
We face risks related to pending litigation.
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.
Our future quarterly operating results may fluctuate and therefore may fail to meet expectations.
Our quarterly operating results including gross margin have fluctuated and may continue to fluctuate. Consequently, our operating results including gross margin may fail to meet the expectations of analysts and investors. As a result of industry conditions and the following specific factors, our quarterly operating results are more likely to fluctuate and are more difficult to predict than a typical non-technology company of our size and maturity:
• general economic conditions in the countries where we sell our products;
• conditions within the end markets into which we sell our products;
• the cyclical nature of demand for our customers’ products;
• excessive inventory accumulation by our end customers;
• the timing of our and our competitors’ new product introductions;
• product obsolescence;
• the scheduling, rescheduling and cancellation of large orders by our customers;
• our ability to develop new process technologies and achieve volume production at the fabs of Seiko Epson, UMC, Chartered Semiconductor, Fujitsu or at other foundries;
• changes in manufacturing yields including delays in achieving target yields on New products;
• adverse movements in exchange rates, interest rates or tax rates; and
• the availability of adequate supply commitments from our wafer foundries and assembly and test subcontractors.
As a result of these factors, our past financial results are not necessarily a good predictor of our future results.
Our stock price may continue to experience large fluctuations.
In recent years, the price of our common stock has fluctuated greatly. These price fluctuations have been rapid and severe and have left investors little time to react. The price of our common stock may continue to fluctuate greatly in the future due to a variety of company specific factors, including:
• quarter-to-quarter variations in our operating results;
• shortfalls in revenue or earnings from levels expected by securities analysts; and
• announcements of technological innovations or new products by other companies.
Presently, our stock price is trading near our consolidated book value. A sustained decline in our stock price may result in a write-off of goodwill (see Note 6 of our Condensed Consolidated Financial Statements).
Our wafer supply may be interrupted or reduced, which may result in a shortage of products available for sale.
We do not manufacture finished silicon wafers. Currently, substantially all of our silicon wafers are manufactured by Seiko Epson and Fujitsu in Japan, UMC in Taiwan, and Chartered Semiconductor in Singapore. If any of our current or future foundry partners significantly interrupts or reduces our wafer supply, our operating results could be harmed.
In the past, we have experienced delays in obtaining wafers and in securing supply commitments from our foundries. At present, we anticipate that our supply commitments are adequate. However, these existing supply commitments may not be sufficient for us to satisfy customer demand in future periods. Additionally, notwithstanding our supply commitments we may still have difficulty in obtaining wafer deliveries consistent with the supply commitments. We negotiate wafer prices and supply commitments from our suppliers on at least an annual basis. If any of our foundry partners were to reduce its supply commitment or increase its wafer prices, and we cannot find alternative sources of wafer supply, our operating results could be harmed.
Many other factors that could disrupt our wafer supply are beyond our control. Since worldwide manufacturing capacity for silicon wafers is limited and inelastic, we could be harmed by significant industry-wide increases in overall wafer demand or interruptions in wafer supply. Additionally, a future disruption of any of our foundry partners’ foundry operations as a result of a fire, earthquake, act of terrorism, or other natural disaster or catastrophic event could disrupt our wafer supply and could harm our operating results.
If our foundry partners experience quality or yield problems, we may face a shortage of products available for sale.
We depend on our foundries to deliver reliable silicon wafers with acceptable yields in a timely manner. As is common in our industry, we have experienced wafer yield problems and delivery delays. If our foundries are unable for a prolonged period to produce silicon wafers that meet our specifications, with acceptable yields, our operating results could be harmed.
The majority of our revenue is derived from products based on a specialized silicon wafer manufacturing process technology called E²CMOS®. The reliable manufacture of high performance E²CMOS semiconductor wafers is a complicated and technically demanding process requiring:
• a high degree of technical skill;
• state-of-the-art equipment;
• the absence of defects in the masks used to print circuits on a wafer;
• the elimination of minute impurities and errors in each step of the fabrication process; and
• effective cooperation between the wafer supplier and us.
As a result, our foundries may experience difficulties in achieving acceptable quality and yield levels when manufacturing our silicon wafers.
If our assembly and test contractors experience quality or yield problems, we may face a shortage of products available for sale.
We rely on contractors to assemble and test our devices with acceptable quality and yield levels. As is common in our industry, we have experienced quality and yield problems in the past. If we experience prolonged quality or yield problems in the future, our operating results could be harmed.
The majority of our revenue is derived from semiconductor devices assembled in advanced packages. The assembly of advanced packages is a complex process requiring:
• a high degree of technical skill;
• state-of-the-art equipment;
• the absence of defects in lead frames used to attach semiconductor devices to the package;
• the elimination of raw material impurities and errors in each step of the process; and
• effective cooperation between the assembly contractor and us.
As a result, our contractors may experience difficulties in achieving acceptable quality and yield levels when assembling and testing our semiconductor devices.
Deterioration of conditions in Asia may disrupt our existing supply arrangements and result in a shortage of finished products available for sale.
All of our major silicon wafer suppliers operate fabs located in Asia. Our finished silicon wafers are assembled and tested by independent contractors located in China, Malaysia, the Philippines, South Korea and Taiwan. Economic, financial, social and political conditions in Asia have historically been volatile. Financial difficulties, governmental actions or restrictions, prolonged work stoppages or any other difficulties experienced by our suppliers may disrupt our supply and could harm our operating results.
Export sales account for a substantial portion of our revenues and may decline in the future due to economic and governmental uncertainties.
Our export sales are affected by unique risks frequently associated with foreign economies including:
• changes in local economic conditions;
• exchange rate volatility;
• governmental controls and trade restrictions;
• export license requirements and restrictions on the export of technology;
• political instability or terrorism;
• changes in tax rates, tariffs or freight rates;
• interruptions in air transportation; and
• difficulties in staffing and managing foreign sales offices.
We may not be able to successfully compete in the highly competitive semiconductor industry.
The semiconductor industry is intensely competitive and many of our direct and indirect competitors have substantially greater financial, technological, manufacturing, marketing and sales resources. If we are unable to compete successfully in this environment, our future results will be adversely affected.
The current level of competition in the programmable logic market is high and may increase in the future. We currently compete directly with companies that have licensed our technology or have developed similar products. We also compete indirectly with numerous semiconductor companies that offer products and solutions based on alternative technologies. These direct and indirect competitors are established multinational semiconductor companies as well as emerging companies. We also may experience significant competition from foreign companies in the future.
We may fail to retain or attract the specialized technical and management personnel required to successfully operate our business.
To a greater degree than most non-technology companies or larger technology companies, our future success depends on our ability to attract and retain highly qualified technical and management personnel. As a mid-sized company, we are particularly dependent on a relatively small group of key employees. Competition for skilled technical and management employees is intense within our industry. As a result, we may not be able to retain our existing key technical and management personnel. In addition, we may not be able to attract additional qualified employees in the future. If we are unable to retain existing key employees or are unable to hire new qualified employees, our operating results could be adversely affected.
If we are unable to adequately protect our intellectual property rights, our financial results and competitive position may suffer.
Our success depends in part on our proprietary technology. However, we may fail to adequately protect this technology. As a result, we may lose our competitive position or face significant expense to protect or enforce our intellectual property rights.
We intend to continue to protect our proprietary technology through patents, copyrights and trade secrets. Despite this intention, we may not be successful in achieving adequate protection. Claims allowed on any of our patents may not be sufficiently broad to protect our technology. Patents issued to us also may be challenged, invalidated or circumvented. Finally, our competitors may develop similar technology independently.
Companies in the semiconductor industry vigorously pursue their intellectual property rights. If we become involved in protracted intellectual property disputes or litigation we may utilize substantial financial and management resources, which could have an adverse effect on our operating results.
Our industry is characterized by frequent claims regarding patents and other intellectual property rights of others. We have been, and from time-to-time expect to be, notified of claims that we are infringing the intellectual property rights of others. If any third party makes a valid claim against us, we could face significant liability and could be required to make material changes to our products and processes. In response to any claims of infringement, we may seek licenses under patents that we are alleged to be infringing. However, we may not be able to obtain a license on favorable terms or without our operating results being adversely affected.
Our marketable securities, which we hold for strategic reasons, are subject to equity price risk and their value may fluctuate.
Currently we hold substantial equity in UMC, which we acquired as part of a strategic investment to obtain certain manufacturing rights. The market price and valuation of these equity shares has fluctuated widely due to business, stock market or other conditions over which we have little control. During the year ended December 31, 2001, we recorded a $152.8 million pre-tax impairment loss related to this investment. In the future, UMC shares may continue to experience significant price volatility. In the second quarter of 2002 and the first nine months of 2004, we sold a portion of our UMC shares, but have otherwise not attempted to reduce or eliminate this equity price risk through hedging or similar techniques and hence substantial, sustained changes in the market price of UMC shares could impac
t our financial results. To the extent that the market value of our UMC shares experiences a significant decline for an extended period of time, our net income could be reduced.
Proposed changes in accounting for equity compensation could adversely affect earnings or could adversely affect our ability to attract and retain employees.
We have historically used stock options as a key component of employee compensation in order to align employees’ interests with the interests of our stockholders, encourage employee retention, and provide competitive compensation packages. The Financial Accounting Standards Board and other agencies have proposed changes to generally accepted accounting principles that would require us and other companies to record a charge to earnings for employee stock option grants and other equity incentives. To the extent that these or other new regulations make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain, and motivate employees. Any of these results could materially and adversely aff
ect our business.
There have been no material changes from what we reported in our Annual Report on Form 10K for the year ended December 31, 2003.
This portion of our quarterly report is our disclosure of the conclusions of our management, including our Chief Executive Officer and Chief Financial Officer, regarding the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report, based on management’s evaluation of those disclosure controls and procedures. You should read this disclosure in conjunction with the certifications attached as Exhibit 31.1 and 31.2 to this quarterly report for a more complete understanding of the topics presented.
In January 2004, the Audit Committee of our Board of Directors, with the assistance of outside legal counsel and our independent auditor, commenced an internal investigation of the facts and circumstances surrounding inappropriate journal entries affecting the deferred income and accrued expense accounts. As a result of the investigation, it was determined that the unaudited consolidated condensed financial statements for each of the three month periods ended September 30, 2003, June 30, 2003 and March 31, 2003 required restatement.
After reviewing the restatement adjustments and performing an evaluation of our controls and disclosure procedures, management concurred with the Audit Committee that improvements to internal controls are needed relating to: (1) separation of duties and (2) establishment of standards for review and approval of journal entries as well as related file documentation.
We received notice from our independent registered public accounting firm that, in connection with the 2003 year-end audit, the auditor had identified a material weakness relating to our internal controls and procedures. Management agreed with this finding. Certain of these internal control deficiencies may also constitute deficiencies in our disclosure controls. While we are in the process of implementing a more effective system of controls and procedures, we have instituted controls, procedures and other changes to ensure that information required to be disclosed in this quarterly report on Form 10-Q has been recorded, processed, summarized and reported accurately.
The incremental steps that we have taken as a result of the aforementioned control deficiencies to ensure that all material information is accurately disclosed in this report include:
1. Performed an analytical review of all journal entries processed for the 2003 year and the first nine months of 2004;
2. Applied additional methods and techniques to evaluate the accuracy of the deferred income account balance;
3. Instituted an additional level of approval for non-recurring journal entries;
4. Strengthened segregation of duties by adding an additional level of review for authorization and review of significant transactions;
5. Made appropriate personnel changes;
6. Separated responsibilities for preparing financial statements and maintaining accounts in our general ledger;
7. Performed more detailed quarterly reconciliations and analyses of our deferred revenue accounts related to its distributors;
8. Enhanced quarterly accounting review procedures by requiring an independent review of material general ledger accounts;
9. Required all non recurring journal entries to be approved by an independent reviewer; and
10. Selected and began the process of implementation of improvements to information systems for distribution accounting.
Based in part on the steps listed above, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported accurately within the time periods specified in Securities and Exchange Commission rules and forms.
In addition, in order to further address deficiencies described above and to further improve our internal disclosure and control procedures for future periods, we will:
1. Complete implementation of newly selected improvements to information systems for distribution accounting;
2. Perform a review of internal controls and procedures in connection with Section 404 of Sarbanes-Oxley legislative requirements; and
3. Enhance staffing to provide sufficient resources to accomplish the foregoing objectives.
These steps will constitute material changes in internal controls.
In conjunction with (1) our ongoing reporting obligations as a public company and (2) the requirements of Section 404 of the Sarbanes-Oxley Act that management report as of December 31, 2004 on the effectiveness of our internal control over financial reporting and identify any material weaknesses in our internal control over financial reporting, we are engaged in an ongoing process to document, evaluate and test our disclosure controls and procedures, which include internal control over financial reporting. In response to any material weaknesses in the design or operation of our internal controls identified by us as part of this ongoing process, we may be required to implement additional controls and procedures or hire additional personnel. If a material weakness exists at year end, our management may be unable to
report favorably as of year-end as to the effectiveness of our control over financial reporting.
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 complaints 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 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.
On May 11, 2004, we issued a warrant to purchase 294,579 shares of our common stock to Bain & Company, Inc., in connection with consulting services provided to us. The warrant has an exercise price of $7.45 per share, and vests at a rate of 24,548.25 shares on the first day of each month, beginning March 1, 2004, subject to Bain’s continued service as a consultant to us. The foregoing transaction was exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof.
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Exhibits |
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10.1 |
Advance Purchase and Payment Agreement dated September 10, 2004, between Lattice Semiconductor Corporation and Fujitsu Limited.1 |
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31.1 |
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |
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31.2 |
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. |
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32.1 |
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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(1) |
Pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, confidential treatment has been requested for portions of this exhibit, which portions have been deleted and filed separately with the Securities and Exchange Commission. |
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
LATTICE SEMICONDUCTOR CORPORATION (Registrant)
Date: November 9, 2004
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By: |
/s/ Jan Johannessen |
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Jan Johannessen |
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Corporate Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer and Authorized Signatory) |