Good afternoon. My name is Gabriel, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2018 results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you'd like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, simply press the pound key. Thank you. Mr. David Pasquale, you may begin your conference.
Thank you, operator. Welcome everyone to Lattice Semiconductor's third quarter 2018 results conference call. Joining us from the company today are Mr. Jim Anderson, Lattice's President and CEO, and Mr. Max Downing, Lattice's Chief Financial Officer. Both executives will be available for Q&A after the prepared comments. If you have not yet received a copy of today's results release, please email 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 website. Before we begin the formal remarks, I will review the safe harbor statement. It is our intention that this call will comply with the requirements of SEC Regulation FD. This call includes and constitutes the company's official guidance for the fiscal fourth 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 the 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 this 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 President and CEO, Mr. Jim Anderson. 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 results for the third quarter of 2018 met or exceeded Lattice's guidance. We continue to execute well with our near-term business focus on driving profitable revenue growth, carefully managing our OPEX, and paying down corporate debt. We again checked all of those boxes in Q3 with our highest non-GAAP EPS since the third quarter of 2014. We further reduced OPEX to $38.4 million, and we made an additional $15 million discretionary debt payment. Max will provide further detailed commentary on the results in just a few minutes. Before I hand it over to Max, I thought it would be helpful to provide some background on why I joined Lattice and what near-term actions we are taking.
As you get to know me over the coming quarters, you will see that I am focused on unlocking the full potential of Lattice. For over 20 years, I have worked in the technology industry across many markets, including consumer, enterprise, data center, and telecom. I was most recently in charge of AMD's computing and graphics business since Q2 of 2015. That was an exciting time as we were able to drive a strategic and operational transformation that brought disruptive new products to the market and delivered market-leading revenue growth and significant profitability expansion for AMD. When the opportunity to lead Lattice was brought to my attention, I did my own extensive due diligence on the company. It quickly became clear to me that Lattice has a strong position with much greater potential.
Lattice has a solid product portfolio with sought-after technology and market solutions, a tier 1 global customer base, and a deeply talented team. Our secure, low-power programmable technology is in high demand and highly relevant to many growing end market and applications worldwide. Importantly, we are in a position to capitalize on inflection points in the market, such as intelligence at the edge, increased industrial automation, continued growth in the electronic content in the automotive market, and the coming 5G wireless infrastructure rollout, to name just a few examples. These inflection points create increased demand for programmability in small, secure, low-power applications where Lattice leads. From a customer standpoint, Lattice has an impressive tier 1 customer relationships already in place, including an existing solid footprint across many large global customers across multiple geographies.
We have the opportunity to do much more with these customers. To extend and expand these relationships, we have to be more closely aligned to our customers' long-term application needs. A key focus for our team will be increasing the alignment between our customers' needs and our product roadmap, and ensuring that our customers can count on us for a steady cadence of new innovations over multiple product generations. This will allow us to build deeper multi-generational partnerships with our customers and is central to our ability to drive steady revenue growth and sustained profitability. To help with these efforts, we recently hired two new key executives, Steve Douglass, our new Corporate Vice President of R&D, and Esam Elashmawi, our new Chief Marketing and Strategy Officer. Steve was most recently at Xilinx and joined Lattice to lead our global engineering team.
He will help ensure that we have a world-class R&D execution machine, and Esam, who was most recently on Microsemi, will help ensure we are focused on the right markets and applications, and we are bringing the right products to our customers. Together, Steve and Esam have nearly 70 years combined FPGA, business, and engineering experience. I'm confident their experience and in-depth understanding of the FPGA market will help us make Lattice a de facto standard in small, secure, low-power FPGAs. As I've spent time with the global Lattice team over the past couple of months, I've been impressed with Lattice's highly talented team. The company has a scrappy, fast-moving culture that gives us a real competitive advantage. The team has built a strong product portfolio with more new products on the way.
For example, during Q3, our team expanded the Lattice sensAI software stack with features to help speed time to market for developers of low-power artificial intelligence applications across all our segments. We also engaged top server manufacturers with our new security solution for platform firmware resilience. As the industry moves to more secure systems, we are well-positioned to provide more value to our customers. Overall, we are committed to driving profitable revenue growth and bottom-line results that build greater value for the company and our shareholders. Let me now turn the call over to Max for additional details on our financial results. Max?
Thank you, Jim. The key takeaway that you will have today is that we continue delivering profitability and leverage improvements as we focus on our core business, market expansion, and fundamentally improving our cost structure. Our revenue for the third quarter was within our expectations at $101.5 million, compared to our expected range of $100 million-$103 million, and down by 1% from the second quarter revenue of $102.7 million. On an end market basis, communications and computing was up 11% sequentially and 19% year-over-year, primarily on continued growth in the server business. Mobile and consumer was up 11% sequentially and 4% year-over-year, with the third quarter incline driven by strength in consumer. Following five consecutive quarters of growth, industrial and auto was down 14% sequentially and up 12% year-over-year.
The quarter-over-quarter decline is driven largely by late third-quarter softness, primarily localized in Asia, due to conservatism related to the macroeconomic conditions and tariffs. Licensing and services was down 19% sequentially and down 22% year-over-year, primarily due to fewer royalty audit settlements. Gross margin on a GAAP basis was 57.5%, compared to 48.9% in the second quarter. The prior quarter GAAP gross margin included approximately $8.3 million, or roughly 800 basis points of inventory write-off directly related to the shutdown of our millimeter wave business. Our non-GAAP gross margin improved to 57.4%, just above the middle of our expected range of 55%-59%. This is up from 57.2% in the prior quarter as improved product mix and other efficiencies more than offset the effects of slightly lower licensing and services revenue. Third quarter GAAP operating expenses were $45.4 million compared to $63.8 million in the second quarter.
The prior quarter included $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 $38.4 million, down about 4% from the $39.9 million in the second quarter, and better than our third quarter guidance range of $39 million-$41 million. Our GAAP net income for the third quarter was approximately $7 million, or $0.05 per basic and diluted share. This represents the first quarterly GAAP-basis net income since the fourth quarter of 2014 and compares to a net loss of $20.2 million or a loss of $0.16 per basic and diluted share in the prior quarter. The second quarter included $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, third quarter net income was $13.8 million or $0.11 per basic and diluted share as compared to $12.4 million or $0.10 per basic and diluted share in the second quarter. In alignment with our goals to delever our balance sheet, we made debt principal payments of approximately $16 million during the quarter, including a $15 million discretionary principal payment. This is in addition to the $10 million discretionary principal payment we made last quarter.
We ended the quarter with healthy cash and short-term investments of approximately $117.5 million, allowing us flexibility for future discretionary debt payments and the ability to support our customers' long-term roadmaps. This concludes my portion of the call, and I'll turn it back to Jim for our outlook.
Thank you, Max. Revenue for the fourth quarter of 2018 is expected to be between approximately $93 million and $97 million. This reflects an expected inventory reduction at some distributors. In addition, we are seeing softness in the industrial and consumer markets, particularly in Asia. We expect this to be partially offset by strength in the communications and computing markets. For gross margin in Q4, we expect approximately 57% ±2%, on both a GAAP and non-GAAP basis. Total operating expenses for the fourth quarter are expected to be between $52 million and $55 million on a GAAP basis and between $37 million and $39 million on a non-GAAP basis. Operator, we can now open the call for questions.
Absolutely. At this time, I would like to remind everyone, in order to ask a question, simply press star then the number one on your telephone keypad. Your first question comes from the line of Charlie Anderson from Dougherty & Company. Your line is open.
Yeah, thanks for taking my questions. I wonder maybe if you could just drill down a little bit more on some of the weakness that you're seeing. Are there any particular use cases and, is it something that we should think about as a longer term associated with trade war, or is it short-term in nature? Any elaboration there would be helpful. I've got a couple follow-ups.
Yeah. Thanks, Charlie. Thanks for the question. Maybe I'll start, then maybe Max will add a little bit of commentary as well. If you look at the Q3 to Q4 sequential guidance that we're giving, what I would say is the downward guidance is really kind of two parts. The first part is we're expecting an inventory adjustment at our distributors, so about half the downward adjustment or downward guidance from Q3 to Q4 is due to anticipated inventory reductions at the distributors. The other half is due to some softness that we're seeing in industrial and consumer. We've really started to see that at the very end of Q3, sort of in the last month of Q3, and we're expecting that to roll into Q4. That's partially offset by some strength that we're seeing in the communications and computing segments.
That's a little additional color on the Q3 to Q4. Max, do you want to add anything to that?
No, I think that was pretty comprehensive, Charlie, unless you have any follow-up questions to that.
No, that all makes sense.
Okay.
On the comms and computing upside, that's certainly interesting. I think we've heard some of your peers talk about 5G starting to get pulled forward. I wonder if you're seeing any of that yourself, and maybe if you could just elaborate on Lattice's position in 5G as it rolls out over the next few years, that would be helpful.
I'll comment on the near term.
Yeah, go ahead, Max.
I'll comment on the near-term piece. In the near term, what we're seeing with respect to the comms and compute is, for us, it's really driven by the compute and the server ramps at multiple customers there. We see the comms component of that really being more of a 2019 aspect. Jim probably has something to add with respect to our position there as well.
Yeah, just to add a little bit of additional color. On the compute segment, that's really servers going into data center and cloud applications, and functionality that we're providing to those servers is manageability and security functionality. We've got a nice footprint across a number of different server vendors today, so we're seeing good growth there. We expect that to kind of continue moving forward. Then on the comms segment, like Max said, when we look to the 4G to 5G wireless infrastructure transition, we have a bit more content on the 5G infrastructure than on 4G, we'll see an expansion in content. As 5G ramps, expect that to be a growth factor for us. That's more of a 2019 and beyond impact for our revenue.
Great. Just last one from me. I wonder if you could just reconcile what you're seeing in gross margin. We see industrial down, but then consumer up, but stable margin. It sounds like there's some cost initiatives that are hitting, and just wonder how much headroom you see to improve gross margin even beyond what you're doing right now. Thanks.
Thanks, Charlie. You're exactly right. In the third quarter, we saw industrial down, which typically and historically would suggest a margin degradation in the quarter. As you know, we've been focused pretty strongly on margin expansion initiatives, and we're seeing those things provide a little bit more stability. We go forward, we're going to continue to focus on margin as an area of opportunity, through both better pricing as well as better cost structure, and targeting our market focus to those higher ASP markets as we move forward. I'm not going to necessarily comment on the long-term future, but we feel like we've got a good, solid foundation providing stability to the margin.
Great. Thanks so much.
Thanks, Charlie.
Your next question comes from the line of Tristan Gerra from Baird. Your line is open.
Hi, this is Maggie Sims on for Tristan. Thank you for taking my question. You mentioned some debt payments for Q3. Could you please update us on your debt de-leveraging in terms of a debt ratio target and the timing expectations?
Yeah, sure.
Why don't you go ahead with that?
Yeah. As you know, our stated goal for a while now has been to pay down about 20% of our outstanding debt by the second quarter of 2019. When we established that 20% line, our debt balance was right around $300 million. Along with that goal was to get our leverage ratio down to right around 3x, and that's our gross debt leverage ratio. We've been making discretionary payments the last two quarters and in fact increased it here in the third quarter. With those payments in our current $275 million debt balance using our Q3 EBITDA run rate, we're under that 3x ratio. We still have a little ways to go to get to that 20% target. Our financial priority is to continue to de-lever and pay down the debt as we go forward.
Thanks, Maggie.
Okay, great. Thanks so much. One more, if I could. Could you please give us an update on the 28 nanometer ramp?
Yeah. I'll cover that one. Our next major platform update is on the 28 nanometer node. Our next tape out is coming very shortly with the engineering team very focused on that. We're making good progress on that. We're really excited about that new platform generation. That'll bring a lot of new key capabilities to our product line. It's a brand new platform for us and we're just really excited to get it to market and pleased with the progress that it's making. The tape out is soon, and then the product launch. We'll talk more about the product launch once we get closer to the actual launch date.
Okay. Thanks so much.
Thanks, Maggie.
Again, if you'd like to ask questions, simply press star, then the number 1 on your telephone keypad. Your next question comes from Christopher Rolland from Susquehanna International. Your line's open.
Hi, this is David Haverly on behalf of Christopher Rolland. Thank you for taking our questions. I guess to start out, Jim, as you look over the business your first couple of months there, what do you think are the biggest opportunities where you can add value based on your past relationships and customers? Then I'd be curious to get kind of your take on the bigger picture opportunities like AI at the edge as well.
Yeah, sure. Thanks, David. On the first part on where I can add value, one of the nice things is, just over the couple of months that I've been on board, is I've had a chance to meet a number of our key customers. One of the nice things is, with many of those customers, I have existing relationships. One of the pleasant surprises as I joined Lattice was as I got to know the footprint that Lattice has at our customers, really is a pretty extensive footprint across what I would call global tier 1, really marquee customers. Lattice has a really nice footprint today. I do see a lot of opportunity for expanding that footprint, both in terms of breadth and depth. As I mentioned, one of the nice things is I have a lot of existing relationships there already.
Hopefully able to help us expand our footprint quickly. In terms of some of the new growth areas that I see, certainly artificial intelligence is a good potential growth opportunity for us. Our sensAI software stack is something that we're really excited about. We actually expanded that software offering in Q3. We're really excited about the, when we look at the edge of the network, especially new applications for artificial intelligence processing at the edge of the network across a variety of markets. Industrial, automotive, consumer markets. Now, I do think that artificial intelligence, how the processing is happening, is still evolving, we do see that as a longer-term growth vector, a good, important growth vector for us moving forward.
Maybe one other place that I'm excited about is on the compute side on, we mentioned this a little bit already, but the manageability and security processing that we're providing and the servers that go into our data center and cloud, really some nice features. We've got a new product coming out soon that brings some new capabilities in terms of firmware protection. I think that'll be a nice growth vector for the company as well.
Great. Thank you for the color there. I guess, just in general on the macro picture and maybe inventory levels at your distributors, you guys are certainly not alone in seeing kind of softness in the marketplace right now. What kind of visibility do you guys have to inventory levels through your distribution channel? I guess, can you see how bookings were for the quarter? When did kind of some of the softness kind of start to appear? How big might an inventory issue be? How long could it last?
Maybe I'll start and see if Max wants to add. We do have very good visibility of the levels of inventory that are held at our distributors, and as I mentioned, we are anticipating that there's some inventory draw down this quarter at our distributors. We would attribute that to more sort of end of year tightening up of inventory levels, sort of normal end of year tightening. Then see a little bit of that attributed to some of the conservatism that we're seeing in the market right now around the macroeconomic climate, especially in the Asia geography. Then in terms of just when did we first start to see a little bit of softness in terms of the softness in demand that we saw in industrial and consumer.
As I mentioned, that kind of started to happen at the very end of Q3, say the last month of Q3, and we're anticipating that rolling into Q4. Max, did you want to add any additional comments?
David, I think the only additional thing that I would add to what Jim had there was that we do some fairly granular analysis of our distributor inventory, including terms and expected sell-through and those types of things. While it is up a bit, we are within the historical range of distributor inventory levels, so we're not alarmed at all in that regard.
Got it. Thank you, guys.
Yep.
Thanks, David.
As a reminder, if you would like to ask a question, simply press star, then the number 1 on your telephone keypad. Your next question comes from the line of Richard Shannon from Craig-Hallum. Your line is open.
Well, hi guys. Thanks for taking my questions as well. I guess maybe I'll ask you a question on the industrial weakness here. Jim, you talked about it being in Asia. Is there any specific geographies within Asia you're seeing it more so than others, or is it broad based?
No, I would describe it as more broad based. It's across the number of different product lines as well. It's not localized to any particular product line. In general, the Asia geography.
Okay. No, that's fair. A financial question for Max. Max, I asked this question last quarter about OPEX, and I think you talked about a goal of getting down towards $37 million per quarter on a pro forma basis. Your guide here is $37 million-$39 million, so we're getting fairly close. Certainly, you did better than my estimates. Curious as to whether your $37 million goal is something you'd like to update, or do you think you can beat that? Any thoughts about where you're going there?
I think, going forward on OPEX, we're not guiding beyond the fourth quarter at this point, not different than the past. We're going to continue to focus on improving the operating leverage in the company, right? We're going to continue to focus on operating expenses in our overall cost structure. With respect to R&D, I think what you'll see our focus there really is on increasing the efficiency and the effectiveness of the R&D machine that Jim was talking about a little bit earlier, a little bit ago, within the existing R&D investment envelope. With SG&A, I think you'll see us focus on that with respect to trying to identify any cost structure improvements so that we can make there.
Okay, that's fair enough. Last question from me, Jim. Obviously, you've been on board here for a couple of months. Curious, when should we expect to hear about your kind of full strategic plan with financial goals? Is that something we should expect next quarter or how do you anticipate communicating that fully?
Thanks, Richard. We're expecting to do a financial analyst day next year. We haven't nailed down a specific date, certainly next year. Looking forward to sharing the long-term strategy, our long-term business model, and some of our product plans and market plans as well. It's something we're looking forward to.
Okay. Well, I look forward to that as well. That's all my questions, and look forward to working with you, Jim. Thanks.
Thanks, Richard.
Once again, if you'd like to ask a question, press star, then the number one on your telephone keypad. The next question comes from the line of David Duley from Steelhead. Your line is open.
Yeah, thanks for taking my question. I was wondering, you mentioned a couple of these opportunities and inflection points on the 5G, I think in auto and industrial is what you mentioned in your prepared comments. I was wondering if you might be able to frame how big of an increase in TAM opportunity that is for Lattice or any sort of revenue objectives that you might be able to get from those markets.
Yeah, thanks, David. Probably, at this point, we're really only talking about Q4 guidance, so I won't provide any specifics beyond that. Yeah, the couple things I talked about was in the 4G to 5G transition, we do see an increase in our content, and with that 5G ramp, we're expecting that to be a growth vector. We talked about compute. The only other thing I would mention is in the industrial and auto segment, we are seeing increased demand for automation in the industrial segment. In a number of cases and a number of applications, that the requirements are really to have a small, low power, very flexible device that Lattice's solutions are just sort of a perfect fit for. We're seeing a lot of activity and traction in the industrial automation space.
That's something that we see as a long-term potential growth vector for the company over time as well.
Okay, thanks. My other questions have already been answered.
Okay. Thanks, David.
There are no further questions at this time. I will now turn the call back over to CEO, Jim Anderson, for closing remarks.
All right. Thank you, operator, and thank you everyone for joining us on the call today. In summary, the key takeaways from our call today are that we have a solid product portfolio. We've got an extensive footprint with tier 1 customers and a deep talent base that puts us in a strong position moving forward. We've added new marketing and engineering leadership with really broad industry experience, and we are very focused on growing Lattice's core FPGA business. That's by delivering profitable revenue growth, expanding our gross margins, carefully managing our operating expenses, and paying down our corporate debt. All of these will increase value for our shareholders. We appreciate your continued support and encourage you to reach out with any follow-up questions. Operator, that concludes today's call.
Thank you very much. A recording of today's conference will be available in approximately two hours at toll-free 1-800-585-8367, or internationally at 404-537-3406. Thank you very much.