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Cree, Inc. (NASDAQ:CREE)

F2Q09 Earnings Call

January 20, 2009 5:00 pm ET

Executives

Raiford Garrabrant - Director of Investor Relations

Charles Swoboda - President and Chief Executive Officer

John Kurtzweil – Chief Financial Officer

Analysts

Harsh Kumar - Morgan Keegan

Dale Farrell - Cantor Fitzgerald

Yair Reiner - Oppenheimer

Daniel Amir - Lazard Capital

Bennett Notman - Davenport & Company

Carter Shoop - Deutsche Bank Securities

Michael Burton - Thinkequity

Hans Mosesmann - Raymond James

Operator

At this time I would like to welcome everyone to the Cree, Inc., second quarter 2009 fiscal year financial results conference call. (Operator instructions) As a reminder, ladies and gentlemen, this conference is being recorded today, January 20, 2009.

I would now like to introduce Raiford Garrabrant, Director of Investor Relations of Cree, Inc.

Raiford Garrabrant

Welcome to Cree's second quarter fiscal 2009 earnings conference call. By now you should have all received a copy of the press release. If you did not receive a copy, please call our office at 919-287-7895 and we will be pleased to assist you.

Today Chuck Swoboda, our Chairman and CEO, and John Kurtzweil, Cree’s CFO, will report on our results for the second quarter of fiscal year 2009. Please note that we will be presenting both GAAP and non-GAAP financial results in our remarks during today’s call which are reconciled in our press release which is posted in the Investor Relations section of our website at www.cree.com under financial metrics, quarter ending September 28th, 2008.

Today's presentations include forward-looking statements about our business outlook, and we may make other forward-looking statements during the call. These may include comments concerning trends in revenue, gross margin and earnings, plans for new products and other forward-looking statements indicated by words like anticipate, expect, target, and estimate. Such forward-looking statements are subject to numerous risks and uncertainties. In our press release today and the SEC filings noted in the release mention important factors that could cause actual results to differ materially.

Also, we'd like to note that we will be limiting our comments regarding Cree's second quarter fiscal year 2009 to a discussion of the information included in our earnings release and the metrics posted on our website. We will not be able to answer any questions that would involve providing additional financial information about the quarter, beyond the comments made in the prepared remarks.

This call is being recorded on behalf of the company. The presentations and the recording of this call are copyrighted property of the company and no other recording, reproduction, or transcription is permitted unless authorized by the company in writing. Consistent with our previous conference calls, we are requesting that only sell-side analysts ask questions during the Q&A session.

Also, since we plan to complete the call in the allotted time of one hour, we recognize that other investors may have additional questions and we welcome to you contact us after the call by e-mail or phone at 919-287-7895. We are also webcasting our conference call to allow more flexibility for our conference call attendees. A replay of the webcast will be available on our website through February 3, 2009.

Now, I would like to turn the call over to Chuck.

Charles Swoboda

We delivered record revenue in the second quarter of $147.6 million and non-GAAP net income of $17.8 million, or $0.20 per diluted share. These results include approximately $5.6 million of revenue and $4.4 million of net income, or $0.05 per diluted share, related to the Mitsubishi chemical bulk GaN license, Bridgelux settlement, and a franchise tax benefit that were not included in our previously announced targets for the quarter.

Excluding revenue from the licenses, Q2 sales increased 1.3% sequentially to $142.0 million as higher LED sales for lightening applications more than offset a decline in Schottky diode and government contract revenue.

LED sales growth was driven by a double-digit increase in XLamp LED components and LED lighting product sales, while LED chip and high-bright LED component sales declined single digits due to lower demand in consumer, mobile, and automotive applications.

Excluding the margin benefit of the license field, gross margin increased to 36.8% in Q2. The increase was primarily driven by higher LED chip and wafer factory utilization, improved yields in both LED chips and XLamp LED components, and some benefit due to a more favorable LED product mix.

These improvements helped offset increased pricing pressure in both our LED chip and LED component product line.

Working capital was in line with our target and our debt-free balance sheet got stronger as cash and investments increased to $365.0 million.

As we start the third fiscal quarter we are facing reduced visibility from both our customers and distributors. Overall backlog is down from this point last quarter but in line with the seasonal booking pattern we saw in fiscal Q3 of last year. The recession has reduced near-term demand for some of our products in consumer, mobile, and automotive applications, but we continue to forecast growth in commercial LED lighting.

We continue to closely manage expenses and capital spending while still investing in R&D to develop new products and technology to support our strategy to win in LED lighting.

I will now turn the call over to John Kurtzweil to review our second quarter financial results in more detail and our targets for the second quarter.

John Kurtzweil

I will be providing commentary on our financial statements on both a GAAP and non-GAAP basis, which is consistent with how management internally measures Cree's results. However, our non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies. Non-GAAP information should be considered a supplement to, and not a substitute for, financial statements prepared in accordance with GAAP. A reconciliation of the non-GAAP information for all quarters mentioned on the call is posted on our website as well as a historical summary of other key metrics.

For the second quarter of fiscal 2009 revenue was $147.6 million and included $5.6 million from up-front patent licenses which were not included in our previously announced targets for the quarter. When these are excluded, revenue was $142.0 million and within our targeted range for the quarter of $142.0 million to $146.0 million. This represents a 19% increase over Q2 of fiscal 2008 and a 1% sequential increase over Q1.

GAAP net income was $10.7 million, or $0.12 per diluted share. On a non-GAAP basis net income for the first quarter was $17.8 million, or $0.20 per diluted share, which excludes $7.1 million of expenses net of tax, or $0.08 per diluted share, from the amortization of acquired intangibles and stock-based compensation expense.

Included in our non-GAAP earnings is approximately $0.05 of benefit due to the licensing revenue and a franchise tax benefit. When these items are excluded, non-GAAP earnings were consistent with the company’s previously announced target range of $0.15 to $0.16.

LED revenue increased 28% when compared to the same period last year and 3% sequentially to $126.7 million while non-LED product and contract revenues of $15.3 million were down 23% from the same period last year and 11% sequentially.

Our power and RF business had a decline of approximately 5% while materials and government contract revenue were in line with expectations.

Q2 GAAP gross margin was 38.3% while non-GAAP gross margin was 38.9%, which excludes stock-based compensation of $0.9 million. Included this quarter was $5.1 million, or approximately 200 basis points, of unforecasted licensing margin. When this benefit is excluded from the non-GAAP gross margin, we were at the high end of our targeted range of 35.5% million to 36.5%.

Operating expenses were $45.0 million on a GAAP basis on $36.7 million on a non-GAAP basis and included a $780,000 benefit due to a safe franchise tax credit that reduced SG&A for the quarter.

Non-GAAP operating expenses exclude approximately $4.2 million of stock-based compensation expense and $4.1 million of charges for amortization of acquisition intangibles. Excluding the franchise tax benefit, non-GAAP operating expenses were consistent with our target ranges.

We incurred higher than targeted R&D on the development of our next generation high brightness LED chips which was offset by lower litigation expense due to a favorable settlement of the Bridgelux case.

Net interest income and other decreased year-over-year to $2.6 million, which was close to our target.

Given the recent drop in the Fed Funds rate the average return on our cash is forecasted to decline again in the third fiscal quarter as we continue to emphasize cash preservation over yield.

The tax rate for the quarter was 23% which is slightly higher than the 22.5% targeted. This relates to the impact of the licensing agreement.

Our debt-free balance sheet got stronger during the quarter due to improvements in working capital and strong cash flow from operations.

Days sales outstanding remains flat at 66 days as accounts receivable increased by $5.1 million to $108.6 million on a $7.3 million increase in revenue.

Inventory days on hand also remained flat at 78 days as inventories declined by $0.4 million to $78.8 million. Inventories are expected to increase slightly in Q3 as we are planning to increase inventories in XLamp, LED components, and LED lighting products to be in a position to take advantage of quick-turn opportunities.

Cash flow from operations was $40.7 million and capital expenditures were $17.8 million for free cash flow of $22.9 million during the quarter. We are targeting capital expenditures for the third fiscal quarter to be in the range of $10.0 million to $15.0 million, primarily for new product introductions in China and the continuing transition of LED chip production to four-inch wafers.

We ended December with $365.0 million in cash and investments and continue to be debt free. Year-to-date cash provided by operations was $84.7 million and capital expenditures were $31.5 million, resulting in free cash flow of $53.2 million.

We continue to make capital investments to support new product introduction but we have reduced our overall capital spending for the year by over 25%.

The first earn-out milestone related to the LFF acquisition of $4.4 million was recorded during the second fiscal quarter and we have increased goodwill associated with the acquisition and accrued in associated liability in accordance with the statement of financial accounting standards No. 141. We anticipate that this will be paid out in our fiscal third quarter.

With the growing economic uncertainty, it has become more challenging to forecast the business and has increased the chance that our actual results could differ from our targets. Overall, backlog is down from this point last quarter but in line with the seasonal booking pattern we saw in fiscal Q3 of last year. We do not expect visibility into the quarter order trends to improve until mid-February, at the earliest, after the Chinese New Year holiday.

At this time, we target Q3 revenue to be in a range of $128.0 million to $135.0 million. Chuck will provide some additional insight to our revenue targets in a few minutes.

GAAP gross margin is targeted to be in a range of 34% to 36%, which includes approximately $1.0 million, or 70 basis points, of stock-based compensation expense. On a non-GAAP basis we target gross margin to be in a range of 35% to 37%, when you exclude the stock-based compensation expenses.

We are targeting lower factory utilization in Q3, in line with lower revenue, to limit the growth in inventory and we plan to use the opportunity to increase focus on yield improvement.

We have also accelerated the transition of our new XLamp LED products to our factory in China.

GAAP operating expenses are targeted to be down approximately $1.0 million, plus or minus, and includes approximately $4.0 million of non-cash stock-based compensation and $4.1 million of charges for amortization of acquired intangibles.

We target R&D to be down from reduced spending and materials and LED chips yet we are maintaining LED component R&D levels and increasing our LED lighting products R&D.

SG&A expenses are targeted to be flat. We continue to closely manage expenses and capital spending while still investing in new products and technology to support our strategy to win in LED lighting.

Interest income and other is targeted to be approximately $2.0 million, primarily due to the significant decline in short-term interest rates.

We are targeting our effective tax rate to be 24% for the balance of the year.

Based on an estimated 89.0 million dilute shares outstanding, our GAAP EPS target for the third fiscal quarter of 2009 is expected to be $0.02 to $0.05 per diluted share when amortization of acquired intangibles and stock-based compensation are included.

We target non-GAAP earnings per diluted share in a range of $0.10 to $0.13 for the third quarter of fiscal 2009. Our non-GAAP-basis EPS targets exclude amortization of acquired intangibles in the amount of $0.03 and non-cash stock-based compensation in the amount of $0.05.

I will now turn the discussion back to Chuck.

Charles Swoboda

We remain focused on four key areas to continue to drive our business and leadership in energy-efficient LED components and lighting products. Our first priority is to drive top line growth for Cree through higher sales of LED components. In Q2 LED components continue to increase as a percentage of revenue as XLamp sales once again grew double-digit sequentially, which more than offset slightly lower high brightness LED sales.

We target LED component revenue to be down single digits in Q3 as solid demand for indoor and outdoor commercial lighting and China video screens is offset by lower demand for portable lighting applications, like LED flashlights, a shorter sales quarter due to a longer Chinese New Year shutdown at our customers, and reduced inventory levels at both our customers and distributors.

Our second priority is to build upon our market leadership in LED lighting by driving LED adoption through higher sales of our LED lighting products, continuing to develop products that set new standards for lighting class performance, and expanding Cree's brand awareness through our market development activities.

LED lighting product sales increased double digits again in Q2 led by sales of the LR6 downlights and the first shipments of our new LR24 product as we made progress in the ramp-up of several new products during the quarter.

Our Q3 backlog for lighting products remains strong and is ahead of where we were at this point last quarter. We recently announced the production availability of the R2 brightness bin for our new XP XLamp LEDs, which raises the bar on lighting class performance up to 122 lumens from a single-power LED.

We also set a new benchmark for what is possible with LED light sources as we demonstrated an R&D result of 161 lumens per watts at 350 mA from a single white LED using a standard size 1x1 millimeter LED chip and a prototype package.

We made great progress extending Cree's market leadership with two high-profile installations of our new LR24 recessed LED luminaire at the Federal Reserve in Washington and the planned Pentagon renovation. The LR24 demonstrates that LED lighting can now compete directly with linear fluorescent lighting, which is the primary indoor light source for commercial buildings.

These projects are not only important for Cree but they also demonstrate to the industry that LED lighting is ready now, providing a legitimate, energy-saving, and mercury-free alternative to fluorescent and other traditional lighting technologies that can deliver real pay-back to the customers.

Our third priority is to increase new product margin and build operating leverage. Gross margins continue to be the key to driving operating leverage in our business and we made solid progress in Q2, despite a more challenging pricing environment for LED chips and components. Excluding the benefit of license deals, gross margin increased to 36.8%, due primarily to higher LED chip factory utilization and higher yields in both our LED chip and component product lines.

For Q3 we forecast increased pricing pressure and lower factory utilization may offset some of our recent margin gains in the near term but we remain focused on a number of activities to reduce costs over the next several quarters, including further yield improvements at the LED chip and component level, capacity additions in Asia, and the transition of LED chip production to four-inch wafers.

Our fourth priority is to continue to grow our commercial power and RF product revenue and transition this product line from the current level of a small quarterly loss to adding to the bottom line in fiscal 2010. As we had forecasted at the beginning of the quarter, combined power and RF revenue was in a similar range as Q1 as higher RF revenue mostly offset lower silicon carbide power device sales.

With the growth in RF, our priority over the next couple of quarters is to build sales momentum for Schottky diodes from a broader customer base beyond the server power supply market, which should increase the factory loading and improve operating margins for this product line.

Sales through distribution continue to increase as a percentage of our total revenue in the quarter. Despite the tough economic environment, distributors sell-through grew for LED components in Q2, which made Cree's LED components one of the few growth product lines in all of distribution last quarter.

Distributors sell-through for LED chips was similar to Q1.

Distributors days of inventory ended the quarter in line with our targets for both LED components and LED chips.

As we look ahead to Q3 the lack of visibility from our customers and distributors has made it more challenging to forecast the business and increase the chance that our actual results could differ from our targets.

We target overall Q3 revenue to be down 5% to 10% sequentially in a range of $128.0 million to $135.0 million based on the following factors. Growth in LED lighting product sales due to continued adoption, LED component revenue down single digits as solid demand for commercial LED lighting is offset by lower portable lighting demand, a longer Chinese New Year shut down, and reduced inventory levels at our customers and distributors.

LED chip sales down primarily due to lower automotive and mobile demand but less than the overall market due to incremental general lighting demand.

Power and RF revenue in a similar range as Q2 and material sales and contract revenue flat to down single digits.

We have implemented cost controls to reduce factory spending and manage operating expenses to better align with the target revenue range while continuing to invest in new product development to enable our LED lighting growth strategy.

We target Q3 non-GAAP margins in a range of 35% to 37% as lower factory utilization and increased pricing pressure offsets some of our recent margin improvements. As a result, we target non-GAAP earnings in Q2 of $0.10 to $0.13 per diluted share.

Please note that our non-GAAP margins exclude amortization of intangibles, stock-based compensation expense, and related tax effects.

As we look ahead to 2009 we are faced with many of the same challenges as other companies due to the recession. However, we are in a better position due to our focus on the LED lighting market. We target that the LED lighting adoption will continue to gain momentum as product availability increases and recognition of the benefits grows from new installations, like the Federal Reserve, the planned Pentagon renovation, and President Obama’s emphasis on energy efficiency.

We will now take analysts’ questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

First of all, congratulations. These are very good numbers in light of everything that is going on in the economy.

Royalties, is there any [beatability] to this metric and is it quarterly or yearly? Can you give some color on that?

Charles Swoboda

The numbers we gave you are really the upfront license payments associated with these recent deals we announced. There is some small ongoing royalties that will vary depending on various factors, sales and other things, but they are relatively small compared to the upfront amounts.

Harsh Kumar - Morgan Keegan

And could you give us an update on the move to China? Where are you as a percentage sales or your metrics that you laid out for the year? And same thing for the four-inch conversion.

Charles Swoboda

In terms of the move to China, our big focus this year was to, obviously we wanted to get our standard XLamps over there and then get the new products transitioned. And the original plan was we announced both the XP and the MC products went into production over the last quarter. And our normal thinking was we would transition those over our Q3 and Q4 and by the end of the fiscal year we would be pretty much having them fully transferred, probably running dual production.

Given kind of the change in the plan, we are actually going to accelerate that and we will have both the XP and the MC products fully transitioned to our China factory within this Q3 quarter. So we are going to move that up by about a quarter. And that’s really a function of the last transitions have gone well and we just think we have an opportunity to go ahead and go a little faster than we originally targeted. And obviously there are cost benefits to doing that.

As far as the four-inch transition goes, we have continued to work on it. We’re really rolling through the different product lines, getting them qualified. I think we’ve got most of the product lines that have been through that process. We may have one or two that are left. But as we go through this quarter we will start to increase the four-inch percentage this quarter and really the larger increase will happen actually in Q4 with the goal being that we will exit fiscal 2009, or the June quarter, with the majority of the high volume products fully on four-inch wafers. That’s the current thinking as of right now.

Harsh Kumar - Morgan Keegan

You’re a public company, very good balance sheet. Could you talk about how that affects the competitive nature, particularly in Asia. Does that matter at all to pricing in the near- to mid-term?

Charles Swoboda

I don’t really think so. Obviously we’re very financially strong, given the fact that we have $360.0-something million in cash, no debt, and obviously a fairly healthy operating line right now. So I think it gives us opportunity to do a lot of things we need to to win the market, both in the short term and in the longer term.

I think the biggest downside of being public is that obviously everyone else can see your results and so it does put more pressure on us. And that challenge will remain but it’s part of being in the business.

Operator

Your next question comes from Dale Farrell - Cantor Fitzgerald.

Dale Farrell - Cantor Fitzgerald

Could you talk a bit about your outlook in the general lighting, the competition you are seeing, where you think that you’re positioned and what kind of growth do you think you could see over the calendar year, over last calendar year, on the solid state lighting portion.

Charles Swoboda

When you say general lighting do you mean for all of our products or are you talking about one product line specifically?

Dale Farrell - Cantor Fitzgerald

I’m talking about your LR4s, LR6s, LR24s.

Charles Swoboda

That business started out essentially, as we exited last fiscal year, it’s a relatively small start up and it has been growing each quarter. Double digits last quarter, target that again this quarter. I think we originally put out targets for the year that said it would add incremental about $30.0 million for the fiscal year, and that included some amount of incremental XLamp sales.

If I look from those targets, I would say we’re tracking pretty well right now and it’s really the commercial markets that’s what’s driving that. So it’s a variety of things, whether it be retail, whether it be restaurant chains, things like that, that are driving that. So it’s where the momentum is.

As far as the outlook, where could that go? Obviously, as of right now the backlog this quarter is ahead of where it was last quarter, so we’re relatively optimistic in the near term. I think I would tell you that we remain cautiously optimistic though, because any time you are looking at overall spending patterns and other things, I think we continue to try to keep an eye out for something going to change there. As of right now we haven’t seen it, in terms of the growth is still there.

But at the same time we do know that we are seeing distributors holding less inventory. We’re seeing a lot of those types of factors that are out there, so we are monitoring it closely. It is probably a bigger benefit than just pure revenue increase, as it has really moved the market.

And one of the reasons we did that was to try make the other big companies start to move. And I think there’s no doubt that from a year ago to today, we have all the big players now serious about LED lighting and trying to push that. And so whether that benefits us directly as creating new customers for our components, or indirectly by just getting the industry moving.

As much as the revenue, I’m even more pleased with the fact that the goal to move the market has really worked.

I know I didn’t give you a specific number and we really don’t have better targets on that right now. Our goal is to keep it growing each quarter but in terms of what that might mean a few quarters out, it’s hard to put a number on it, especially given everything else that is going on.

Dale Farrell - Cantor Fitzgerald

Could you talk a bit in that market segment, talking about your LR4s through LR24s, how much of your revenues are coming from your distribution network of resellers out there versus your selling direct, like the Pentagon, which is a direct sale?

Charles Swoboda

I would say the vast majority of sales are through the channels. I would say the Pentagon is the exception to how we are winning business today. We do work on large projects like that but most of the revenue today has really been LR6 in North America through the distribution channel.

We have started to see a little bit of revenue last quarter from the Zoom [Tobal] agreement so we have started shipping the 230 volt product to Zoom [Tobal] and some other customers internationally. But really the majority of the business right now is coming from the LR6 through the distribution sales channel and I would say that projects like the Pentagon, at least in the near term, are more the exception than the rule.

Although I would tell you there is a lot of activity there and I think that’s kind of the wild card to the growth, especially as we get on to the summer time frame, is there are some large projects that we are working on that could add nicely to the bottom line. But most of the growth today is distribution.

Dale Farrell - Cantor Fitzgerald

I was intrigued by your comment that in a distribution market, which you have signed some new agreements there for LEDs, that it was actually a growth area for the distis. Did you grow in absolute terms in that distribution market for yourself?

Charles Swoboda

Yes. Our sell-through in distribution grew in raw dollars, quarter-to-quarter, and in fact the comment I heard from one distributor was this was maybe the only product line that grew last quarter. But that’s anecdotal.

Dale Farrell - Cantor Fitzgerald

What kind of pricing pressure are you seeing out there? Clearly we have all heard various things, maybe you could comment on what pricing pressure you’re seeing and how you are reacting to it.

Charles Swoboda

It is going to vary by product line. I would say obviously in the mid- to lower-performance products, as the market has slowed down in things like mobile, and consumer, and auto, it’s pretty tough.

I don’t have a specific number for you but there’s a lot of battle for share at those ends of the market place. I think in our components products, where they’re not distinguished in terms of where we’re dealing, on more the mid-level performance, it’s picked up last quarter and we’re targeting it to stay at a fairly aggressive rate this quarter.

I think where we’re seeing the benefit though is at the same time we’re seeing that we continue to be able to push up the performance. Getting new bins of XLamps released, getting new products released on the high brightness. Even opening up some new performance levels, even in the chip business, has helped us offset that some amount.

So I think what we are able to is, we’re having to meet more aggressive price requests from our customers. Through product mix, yield, and some volume we’ve been able to offset it in Q2 and although we’re targeted to have an effect this quarter we think maybe less of an effect on us than maybe some others.

Operator

Your next question comes from Yair Reiner – Oppenheimer.

Yair Reiner - Oppenheimer

Looking at China, that had been an important growth driver for the business in recent quarters. Can you talk about some of the trends you’re seeing there, particularly in the outdoor displays?

Charles Swoboda

What we’ve seen so far is that business has remained fairly solid. Last quarter demand was pretty similar than the previous quarter and we’re targeting it should be pretty stable, plus or minus 5% this quarter as well. So right now, for the large infrastructure in China, which is where I would put the large display screens, it remains relatively solid.

I would also add to that that if you go beyond that, the lighting-related stuff that we’re doing in China also has remained pretty solid. So I think there are some signs on the consumer side and definitely on the export business that there is obviously weakness there.

When it comes to China domestic infrastructure, so far it has remained pretty solid for us.

Yair Reiner - Oppenheimer

Can you give us the number for the LSS sales? I think you have done that in prior quarters.

Charles Swoboda

Actually, we haven’t been breaking it out specifically since at the end of the year, when we gave you a number. So we’re not breaking it out. I can tell you it is obviously the smallest percentage of the business. It’s in the single-digit millions but we’re not going to be able to break it out more specifically for you than that.

Yair Reiner - Oppenheimer

Going back to the question about direct versus indirect sales, it seems like looking out towards the back half of the year, there is going to be some money released in the U.S. towards infrastructure projects that are green and toward green retrofits. What can you do, as a company, to try to target some of that money and make sure that the folks in Washington and state and local governments are aware of the benefits of some of your products?

Charles Swoboda

The best thing we can do is try to get involved with some of the projects we’ve been using over the last few years. One of the things that we have been encouraging is that when we deal with whether it be LED Cities, the LED Universities, or things like this, they have an opportunity to bid specific projects through some of these programs, and so obviously we are trying to encourage them to stay active there.

And our goal is if we can get momentum from some of the applications that we have recently installed, hopefully that can spur the whole cycle. So it’s more of a combination of lots of little things is what we’re doing. Obviously we will continue to work on projects like the Pentagon when we’re able to do that directly, but I would say the ability for us to do a lot of specific projects like that is probably less the rule, more the exception. And that where we really can do this is through partnerships with other people and the other programs we’re doing, to really kind of build on some of that momentum.

And one of the keys is to be able to show them that it really works. And so I think the Pentagon raised a lot of eyebrows, not just because it was 4,200 fixtures and it was an entire wing, but that they were able to put together some payback numbers that I think have opened a lot of people’s eyes. And they’re talking about less than four-year payback. So that’s a pretty big deal and hopefully we can build on that momentum.

Yair Reiner - Oppenheimer

For the license revenue that you recognized, did that already hit the cash flow statement or will that be coming this quarter?

John Kurtzweil

That ended up in our receivables at the end of the quarter and we have actually received the cash already. It was actual cash flow this quarter.

Yair Reiner - Oppenheimer

The receivables would have been down sequentially if not for that?

John Kurtzweil

Yes.

Operator

Your next question comes from Daniel Amir - Lazard Capital.

Daniel Amir - Lazard Capital

Can you expand on the inventory? You were saying you are increasing inventory for some of your LED components and for the XLamp, to capture potential orders. Can you expand a bit on what you are seeing in terms of visibility or is this in terms of potential projects down the road that you are going to get here this quarter?

Charles Swoboda

The way I would describe that, both for the XLamp and also for the lighting products, so there is a kind of similar reason but two different areas. When it comes to XLamp we know that last quarter, for example, despite the fact that we were growing sales and people were talking about concerns, we actually had some expedite issues in terms of there wasn’t enough inventory in the channel to be able to serve some of the customer needs.

So one of the goals is while we have an opportunity, especially on the new products, is try to get a little ahead of the curve there so that if there are issues where people are trying to be more conservative on inventory, when demand comes back, and like I said earlier, we remain optimistic that especially in the commercial lighting markets that LED lighting as an option is not going to stop because of the recession. It may slow, the rates may change, but we’re obviously optimistic that it is going to continue as more of a macro trend.

So that is to get some of the more new products in our hands so that if, and when, demand starts to pick back up that if the channel is light we can service that. That’s the XLamp side of it.

On the lighting product side, we recognized about two quarters ago that we actually have a challenge in that that is a market that is used to having products held in inventory by the manufacturers and shipped at a fairly high rate. I think the number we heard from one lighting company is they ship 80% of their orders within 24 hours.

As a semiconductor company that’s not traditionally how we did it and in the past we were counting on the distributors to do that. Given the economic changes, what we want to do is add a little inventory on those product of our own so that even if the distributors there remain lean, when those projects come in, they are expecting very quick turn and we don’t want to lose those opportunities.

So there are similar reasons to try to use this chance to get ahead of the curve on both of those.

Daniel Amir - Lazard Capital

On the project side, can you give us a bit on visibility? You commented that projects are not being necessarily cancelled. Obviously there is a move to green technology but because of the economy are you seeing any stretch of projects now or projects that were supposed to come on line but municipalities are more cautious in bringing it on line right now?

Charles Swoboda

At this point I would tell you that, this is going to be a rough guess, there is some amount of projects that look like they’re delays but I would say it’s more of one or two out of ten are delayed and the vast majority that we have been working on are at least continuing forward at this point. From what we see.

And again, some of the projects we see are municipalities, but most of the municipal stuff we see is actually through our components business, so that would be our customers then bidding on those.

What we have a tendency to see more directly is the stuff we do with LR6 and the LR24 and what we’re seeing there is those tend to be more, there’s a few municipal projects but there are more corporate driven and what we see there is a continuing activity where it is coming down to can you get the payback down to in that two-year range or less. And if we’re able to do that, we continue to see people doing those purely as a cost payback.

So we’ll see. Again, we remain, I think just like everyone else, we’re cautious about what might happen there but so far the demand has remained relatively solid.

Operator

Your next question comes from Bennett Notman - Davenport & Company.

Bennett Notman - Davenport & Company

It looks like you may have started to place a little more emphasis on monetizing your intellectual property. Can you talk about if these were kind of one-off deals that we saw or if this really is a shift in strategy and we should look for more of this in the future?

Charles Swoboda

I think it’s more coincidental they both happened. Obviously the Bridgelux litigation has been going on for a while and it was a bit of, just the way the timing worked out, I think the fact that the trial was coming up in the not too distant future probably was the reason we were able to get a favorable resolution and get the licensing agreement in place, as well as the supply agreement.

So I think that one was more the nature of how that case was rolling along in its natural time line.

As far as the Mitsubishi one, that’s technology we’ve had around. We’ve been talking to people for a while. I think it’s more coincidental that they both happened around the same time.

I don’t know that there is a big shift in strategy. I think the way we look at that is if there is technology that we are not actively pursuing, I think we’ve always had an open mind. Maybe we just haven’t as much success in the past of getting people’s attention on it or being able to bring it to closure.

So I think you may see other projects like this in the future but they’ll be kind of spotty. They will come and go from time to time, as various circumstances change.

Operator

Your next question comes from Carter Shoop - Deutsche Bank Securities.

Carter Shoop - Deutsche Bank Securities

First, on litigation expenses, would you be willing to disclose what they were in the quarter and what you expect them to be next quarter?

Charles Swoboda

We didn’t break them up specifically so I don’t think we can break them on here. I can give you a kind of relative term. They were below budget last quarter because we were able to settle Bridgelux and I think this quarter they are going to be similar, maybe up a little bit just because of the timing of where the other two cases are in the cycle.

So they will probably be up incrementally a little bit this quarter, but last quarter they were below our target level.

Carter Shoop - Deutsche Bank Securities

And what percentage of your LED are sold through the distribution channel and can you comment on how that has changed over the past year?

Charles Swoboda

Over the last year I would say that distribution has increased as a percentage. If you look at it, obviously LED chips are primarily sold direct, with the exception of our Semi [tobal] arrangement. When you talk high bright components, those tend to be more direct, although the distribution piece is growing. But it’s still a relatively small piece, but growing.

And then on the XLamp product line, that’s where we have put the big push on distribution and that’s probably up to roughly two-thirds of that business is through distribution at this point. And I bet you a year ago it was probably less than half, just as a relative basis.

Carter Shoop - Deutsche Bank Securities

How can high can you get actually and is there a percentage in distribution? Will that become 90% or do you feel comfortable with where it is right now?

Charles Swoboda

I think at the current level, maybe a little higher. I think there will always be, especially as long as we are trying to drive new market adoption. In other words, when you are trying to convince people to try new technology we are going to need to maintain some amount of direct for the big accounts.

So whether it would be 80/20 or 60/40 or 70/30, somewhere in that range is probably where we will settle out. Keep enough of it just to continue to drive the market.

Carter Shoop - Deutsche Bank Securities

My understanding is that the fixtures at the Pentagon aren’t going to be installed for another two years. Is a four year paypack based on current technology or anticipated technological improvements?

Charles Swoboda

Those products will actually all be shipped over the next several quarters and I think they are starting to install them in the near term. And it’s my understanding, based on that analysis, that it was actually based on current prices and current electricity rates. And if you actually look at the forward-looking projections, the payback should actually get better because as electricity rates change, and they’re projected to go up, even at the Pentagon, that payback should actually come in, and it’s all using existing LR24 product, it’s the current product, at the current prices,

Operator

Your next question comes from Michael Burton – Thinkequity.

Michael Burton - Thinkequity

Regarding that four-year payback, was that test against a four-foot linear fluorescent or two-foot linears? And what color temperature were you running?

Charles Swoboda

It was the standard LR24 specs so I would have to look on our website to give you exactly what those specs are, but they’re out there. And it is basically a payback to retrofit what they had to go to the new LR24 was the calculation. So if they buy the new fixtures and retrofit them, how fast will they get a return on their investment, is how it was done.

Michael Burton - Thinkequity

And versus a four-foot linear fluorescent?

Charles Swoboda

Versus whatever product was currently installed. It’s a renovation, they already have a linear fluorescent product so what they had to figure out was what was the cost of buying new ones, pay for the cost to replace them, and how fast do they get their money back in terms of maintenance and electricity savings.

Michael Burton - Thinkequity

I’m curious about the gross margins on the former LF products. A couple of quarters ago it wasn’t really where you wanted it be. How has that progressed? Are we still below corporate average or have we gotten above now?

Charles Swoboda

It basically started out significantly below, as a start up. It’s definitely making progress. We had improvement last quarter. But I would tell you, it’s still got a ways to go. We now call those our lighting products business. Those lighting products are probably where XLamp was over a year ago.

So XLamp went through this curve where it was below, kind of got equivalent, and is now running actually a little ahead of the corporate average. At least for some of the products.

And I think they are probably where XLamp was a year or so ago. So they’re below.

Michael Burton - Thinkequity

On the litigation settlements, the $5.6 million for this last quarter, did that include all of the upfront payments, including for MCC, or are we going to see any second quarter?

John Kurtzweil

Those are combined.

Michael Burton - Thinkequity

You said that ongoing licensing fees, they’re not going to be large enough to break out going forward?

Charles Swoboda

Going forward we don’t expect them to significantly larger. It will obviously depend on the future success of some of the revenue streams in the products we’ve licensed but at this time we don’t anticipate them to be significant enough to be breaking out.

Michael Burton - Thinkequity

And if you could, also go through and break out the percentage of sales for the different segments. Lighting I think up is greater than 50% now, but consumer, mobile.

Charles Swoboda

By application?

Michael Burton - Thinkequity

Yes.

Charles Swoboda

If you look at the OED combined business, what you get is lighting is just a little bit below 50% of the total. It’s not quite 50%. Video screens, then I think you get into mobile, consumer, auto, notebooks, all that kind of starts to kind of wash together. It’s basically, once you get past lighting and then video screens, you get in, from a quarter-to-quarter basis, it varies between mobile and auto and what I would call consumer.

Michael Burton - Thinkequity

So roughly 50/50 then. The $780,000 benefit to SG&A, was that included in the pro forma reconciliation on the SG&A line?

John Kurtzweil

That’s in our GAAP numbers and it’s also in our non-GAAP numbers so I didn’t pull that out.

Michael Burton - Thinkequity

For our guidance for operating expenses for next quarter?

John Kurtzweil

For SG&A it’s basically flat. That assumes that that one-time benefit isn’t there, so they’re actually down.

Operator

Your next question comes from Hans Mosesmann - Raymond James.

Hans Mosesmann - Raymond James

Can you give some more flavor on your technology, the bulk GaN, that you are licensing to Mitsubishi? What are they using it for? What are you using it for? And what is the state of that technology globally in terms of [inaudible] going in that direction?

Charles Swoboda

The bulk GaN technology idea has been around a while. Most of our effort came from when we originally acquired the ATMI business years ago. We did some work on that and decided that, from our standpoint, we didn’t see it as a primary platform for how we wanted to run our business internally, so we have continued to do some development on it but it hasn’t been a major focus.

And Mitsubishi would really like to focus on that and try to build a substrate business out of that. They are obviously a significant supplier to the opti-electronics business and so they are looking to try to develop that technology and turn it into a substrate alternative for everything from potentially lasers to potentially LEDs or other things.

Operator

Your next question is a follow-up from Dale Farrell - Cantor Fitzgerald.

Dale Farrell - Cantor Fitzgerald

Back to the [tofers] installing at the Pentagon, did I hear you say correctly that you were actually recognizing some revenues here in the third quarter on those?

Charles Swoboda

A very small amount. I would say most of that, we had some LR24 installs at the Federal Reserve and then we also had a very small amount for the Pentagon. Most of that will ship here over the next several months.

Dale Farrell - Cantor Fitzgerald

Can we look for additional new product introductions, perhaps say a two-foot by four-foot fluorescent replacement in that group? What should we expect in the near future?

Charles Swoboda

Obviously it wouldn’t be a surprise if we told everyone. Maybe I’ll answer that in a generic sense but it will give you an idea directionally.

What we basically do in our lighting group is we look at places in the market that we think are underserved. So the basic premise when they started LFS is everyone said you couldn’t do an LED downlight, so they did an LED downlight and proved people wrong. Then they said you might could do a six-inch but you can’t do a four-inch. They did a four-inch. And then the LR24 came about because everyone said that’s great, you can go compete with an incandescent bulb downlight, but fluorescent, you’re never going to get there. And so the whole point was let’s go build an LED downlight to compete with fluorescent and try to prove them wrong, and it worked.

So I think we generally look for places that are underserved by the broader lighting industry. And we are obviously are working on some things, we have some ideas right now, but it’s really a function of what’s underserved. If we can get the lighting industry to go attack a market and go do it, we would rather have them go do it. It’s better for us to get the whole industry moving.

And so at this time we’re working on a couple of things and hopefully we’ll have something interesting to talk about over the next couple of quarters, but really looking for what is that unserved segment where people say LEDs aren’t ready to attach that yet.

Operator

Your last question is a follow-up from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

Could you talk about your laptop backlighting revenues, if you have seen any where you are, what your expectation is for that business.

Charles Swoboda

On the laptop backlighting what we have seen is we are getting some LED chip business there through our packaging customers. What we have seen is that trend, and CES made it pretty clear, notebooks are going to LEDs and what is interesting is that there is a lot of talk at CES about trying to take TVs there as well. There are obviously a couple of high-end ones in the market.

But the notebook one has happened and I think the real trick there is it’s a little hard to predict how much is going to happen in the near term, just because I think they’re all trying to figure out what their real demand is, at least in the near term.

But as I look out over calendar 2009 I would expect that that will be a net growth area for the chip business because almost everyone I see is talking about putting LEDs in their notebooks. So I think that will be a net benefit to us and other suppliers from a chip standpoint.

Harsh Kumar - Morgan Keegan

On the competitive front, going back to Asia a bit, you are obviously doing very well in anything related to overhead lighting or what you call general lighting. Are there any Asian players, in your opinion, that come to mind that even have the technology to compete with you, and if they do, how much lead do you think you have before we get back to the world where there is pricing pressure and things of that nature in this newer segment of yours?

Charles Swoboda

There is pricing pressure today. I think the reason that it doesn’t feel the same is there is so much innovation going on right now and there are so many new products and a lot of new customers trying these things, is that it’s really about growing the market and the customer base.

We have absolutely competitors we compete with every day and that we take very seriously. We take not only the Asian competitors, we take CalTrans seriously and Loomy [Livs]. They obviously have a big commitment to this market, long term. And I would say today, in terms of technology, we watch Nichia very closely. We know they are a formidable competitor and we have battled with them for a long time and I think for years to come we will be continuing to battle with them.

As far as that next tier, we really haven’t seen any serious guys at that next tier yet but we’re keeping our eye out. But right now I would say it’s Nichia and the other two more traditional players we see the most but we’re keeping an eye out for who might be next. And that’s why we’re pushing so hard to keep trying to drive up performance and do the product platforms and really extend the product line.

Operator

There are no further questions in the queue.

Raiford Garrabrant

Thank you for your time today and we appreciate your interest and support. We look forward to reporting our third quarter of fiscal year 2009 on April 21, 2009.

Operator

This concludes today’s conference call.

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Source: Cree, Inc. F2Q09 (Qtr End 12/28/08) Earnings Call Transcript
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