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Executives

Raiford Garrabrant – Director of IR

Chuck Swoboda – Chairman, President and CEO

John Kurtzweil – EVP of Finance, CFO and Treasurer

Analysts

Yair Reiner – Oppenheimer

Chris Lancet – JPMorgan

Jesse Pichel – Piper Jaffray

Dale Pfau – Cantor Fitzgerald

Andrew Wong [ph] – JC Research [ph]

Vijay Rakesh – ThinkEquity

Steve Milunovich – Merrill Lynch

Lauren Stoller – Lazard Capital

Carter Shoop – Deutsche Bank

Hans Mosesmann – Raymond James

Jed Dorsheimer – Canaccord Adams

Ramesh Misra – Brigantine Advisors

Cree, Inc. (CREE) F1Q10 (Qtr End 09/27/09) Earnings Call Transcript October 20, 2009 5:00 PM ET

Operator

At this time, I would like to welcome everyone to the Cree Inc. first quarter FY 2010 financial results conference call. (Operator instructions)

As a reminder, ladies and gentlemen, this conference is being recorded today, Tuesday, October 20. Thank you.

I would now like to introduce Raiford Garrabrant, Director of Investor Relations of Cree Incorporated. Mr. Garrabrant, you may begin your conference.

Raiford Garrabrant

Thank you, and good afternoon. Welcome to Cree’s first quarter fiscal 2010 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 first quarter of fiscal year 2010. 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 and financial metrics posted in the Investor Relations section of our Web site at www.cree.com under FY 2010 financial metrics.

Today’s presentation includes 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. Our press release today and 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 first quarter of fiscal year 2010 to a discussion of the information included in our earnings release and the metrics posted on our Web site. 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 welcome you to contact us after the call by email or phone at 919-287-7895. We are also web casting our conference call and a replay will be available on our Web site through November 3, 2009.

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

Chuck Swoboda

We got off to a very good start in fiscal Q1, as revenue increased 14% from Q4 to a record $169.1 million and non-GAAP net income increased 64% sequentially to a record $27.4 million, or $0.30 per diluted share.

Revenue and profits exceeded our targets for the quarter due to solid factory execution and strong demand. The revenue growth in Q1 was driven by higher XLamp LED sales for lighting application, higher LED chip sales due to increased demand in notebook backlighting and lighting, and solid growth in LED lighting products and power and RF devices.

Non-GAAP gross margin increased to 44.1% in Q1, which was 380 basis points better than Q4 and higher than our target for the quarter of 40% plus or minus. The better than expected results were due to a combination of factors including additional cost leverage from very high factory utilization across the entire quarter and increase production scale, better than plan yield across our factories, a more stable prizing environment for LED chips and LED components, and continued progress in our power and RF product line.

Working capital was in line with our targets and we further strengthened our balance sheet with a follow-on equity offering, which raised $434 million in net proceeds. So, why did we raise money now? Because we believe we have an opportunity to accelerate our growth in LED lighting.

These funds are primarily intended to support higher capital spending and additional working capital needed to fund the targeted growth over the next several years. With cash and investments now at $888 million, we are also in a good position to consider potential strategic investments that could strengthen our leadership position and help us accelerate the adoption of LED lighting.

Our Q2 backlog is higher than at this point last quarter due to increased demand across our LED product lines and solid demand for our power and RF products. We have started to build Q3 backlog in several of our product lines, while we continue to work on Q2 orders for the shorter lead time project business in LED lighting and components. Our near-term focus is on execution and capacity expansion at our U.S. and Asia manufacturing facilities.

I will now turn the call over to John Kurtzweil to review our first quarter financial results in more detail as well as our targets for the second quarter of fiscal 2010.

John Kurtzweil

I will be providing commentary on our financial statements on both the GAAP and non-GAAP basis, which is consistent with how management measures Cree's results internally. However, 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 our quarter is mentioned on this call is posted on our Web site as well as historical summaries of our other key metrics.

For the first quarter of fiscal 2010, revenue was $169.1 million and above our targeted range for the quarter of $160 million to $166 million. This represents a 14% increase sequentially. GAAP net income increased 255% year-over-year to $21 million, or $0.23 per diluted share and exceeded our targeted range of $0.14 to $0.16 per diluted share.

On a non-GAAP basis, net income for the first quarter increased 107% year-over-year to $27.4 million or $0.30 per diluted share. This is above our targeted range of $0.21 to $0.23 per diluted share and excludes $6.4 million of expense net of tax or $0.07 per diluted share from the amortization of acquired intangibles and stock-based compensation expense. The impact of the equity offering to EPS was $0.005 per share during the quarter. I will go into more detail on the future impact in a few minutes.

Cash provided by operations was $62 million. Free cash flow was $41 million and we ended the quarter with $888 million in cash and investments. The gross proceeds from our equity offering were $449 million or $432 million net of expenses.

We issued 12.7 million shares at a public offering price of $35.50 in September with the proceeds primarily intended for capital expenditures to support accelerated growth with the remainder being used for general corporate purposes including working capital and potential strategic investments.

LED product revenue for the first quarter increased 14% sequentially to $156 million, while Power and RF revenues increased 15% sequentially to $13.1 million. Please note that the Power and RF revenue includes $3.6 million of government contract revenue and LED products revenue includes $0.5 million of government contract revenue.

Q1 GAAP gross margin was 43.6% while non-GAAP gross margin was 44.1%, which excludes stock-based compensation of $0.8 million. This was above our targeted non-GAAP range of 40% plus or minus. The increase in gross margin versus our target was a result of a combination of factors, which include additional cost leverage from high factory utilization across the entire quarter; and increased production scale; better than planned yields across our LED factory; more stable pricing environment for LED chips and LED components; and continued progress in our Power and RF product line.

Operating expenses for Q1 were $47.1 million on a GAAP basis and $39.3 million on a non-GAAP basis which were in line with our targets. Non-GAAP operating expenses exclude approximately $4.8 million of stock-based compensation expense and $3 million of charges for amortization of acquired intangibles.

We achieved significant operating leverage during the quarter as our Q1 GAAP operating margin increased 810 basis points to 15.8%, while non-GAAP operating margins increased 680 basis points to 21.9%. This was a result of a combination of factors. Revenue increased quarter-over-quarter by 14% and provided significant factory leverage.

Gross margin increased 380 basis points and we achieved increased leverage out of our operating expenses, which did not scale with the increase in revenue. Net interest income and other for Q1 was $1.8 million which was above our target. The GAAP tax rate for the quarter was 26%, which was in line with our estimate.

The balance sheet improved again with accounts receivable down to $93 million while day sales outstanding declined to 50 days from 63 days at the end of June. This is a result of fairly linear shipments during the quarter.

Inventory increased $7.1 million and days on hand increased to 81 days from 79 days at the end of June. The majority of the inventory increase came in the form of raw and work-in-progress, which is intended to support our sales growth targeted for the second fiscal quarter.

During the first fiscal quarter, we added $32 million of capital (inaudible) we targeted capital additions to be between $150 million and $165 million. At this time, we target Q2 revenue to be in the range of $180 million to $190 million.

GAAP gross margin is targeted to be 43% and our non-GAAP target is 44% plus or minus. Our GAAP targets include stock-based compensation expense of approximately $1 million, or 60 basis points, and our non-GAAP targets do not. Chuck will give additional insight into our targets in a few minutes.

For operating expenses, we are targeting non-GAAP R&D expense to be up slightly, while non-GAAP SG&A expenses are targeted to increase by approximately $2.5 million for increased sales, staffing cost for our new application centers and increased IP litigation expense.

We target asset impairments to be approximately $500,000 for this quarter. Our GAAP targets include approximately $7.1 million of non-cash stock-based compensation and $3 million of charges for amortization of acquired intangibles. Interest income and other is targeted to increase to approximately $2 million based on higher cash investment balances. We target our tax rate to be 26%.

GAAP net income is targeted at $21 million to $23 million and based on an estimated 105 million diluted shares outstanding, which includes the full 12.7 million shares issued in our recent equity offering, our GAAP EPS target is $0.20 to $0.22 per diluted share.

Non-GAAP net income is targeted to increase quarter-over-quarter to $29 million to $32 million. For a non-GAAP EPS target of $0.28 to $0.30 per diluted share. The diluted EPS impact of the equity offerings is approximately $0.35 per share on both the GAAP and non-GAAP basis.

Our non-GAAP EPS targets exclude amortization of acquired intangibles in the amount of $0.02 and non-cash stock-based compensation in the amount of $0.06.

Thank you and I will now turn the discussion back to Chuck.

Chuck Swoboda

We remain focused on four key areas to continue to drive our business in fiscal 2010. Our first priority is to build on our leadership in LED lighting and further disrupt existing lighting market.

Our strategy is to be a catalyst for LED lighting adoption by developing innovative new LED lighting products to lead the market and open up new lighting applications for LED technology. The growth in sales of LED components and our own LED lighting products suggest that we are on the right track and our challenge now is, how do we go faster?

In terms of market leadership, Cree was once again named the American Lighting Associations’ Lighting for Tomorrow grand prize winner for our new Deep Recessed 1000 lumen downlight or PAR 38 LED bulb and high efficiency LR6 downlight each one special focus awards.

We also continue to work on raising the awareness for LED lighting by supporting new installation such as the recent McDonald's store North Carolina that opened with 97% of all the lighting based on LEDs. Looking ahead, we are working to further develop our channels and products to make LED lighting products more accessible to a broader base of customers and application.

Our second priority is to further enable our lighting customers to accelerate growth in LED component sales. This starts with expanding our LED product offering for the lighting market.

We recently announced commercial availability of our new XPG, XLamp LED, which is the industry's brightest and more efficient lighting class LED. While this LED is brighter, more importantly it changes the game for a number of lighting applications by delivering up to 367 lumens from a single LED at 111 lumens per watts. If the old benchmark for lighting class LED was 100 lumens per LED, we believe the new benchmark is 360 lumens.

We also now have the most lighting class LEDs for designing Energy Star compliant LED fixtures. We've also started to staff our new customer design centers in Europe, California and Asia with a goal of having these centers online in the second half of our fiscal year.

Our third priority is to maintain the product margin levels we have achieved and to start to build operating leverage in the business. We saw the benefit of very strong execution and high factory utilization across the entire quarter in Q1 as well the more favorable pricing environment for LEDs due to increased demand and limited supply. As a result, gross profit grew faster than operating expenses and our increased investment in sales and marketing, which resulted in some incremental progress in operating margins.

We look to maintain these gains in Q2 as we add capacity and introduce several new products with the primary risk being factory execution in the near-term. We need to keep in mind that the overall LED market continues to be highly competitive as we invest in expanding our marketing and technical support capabilities and remain focused on both cost reduction and increasing the value of our products by providing new capabilities to the customers.

Our fourth priority is to build on the recent progress in our Power and RF product line and further refine our product offering and market focus. We got off to a good start in Q1 as we built on the momentum from Q4 and delivered results that incrementally contributed to increase bottom line.

This product line is still subject to variability as demand fluctuations change the factory loading, but we seem to have achieved a new base level of business over the last several quarters.

The focus now is to build on this success and expand our customer penetration into new, higher value applications for both Power and RF as we look to grow the product line over the next several years.

As we look ahead to Q2, we are expanding our LED factories to support increased demand. We are targeting to add $150 to $165 million in capital additions this fiscal year to expand our LED chip factory and more than double our LED component packaging capacity by the end of the year.

Although we are currently capacity limited in most product lines, we target overall revenue to increase to a range of $180 to $190 million led by higher LED component sales for lighting applications, higher LED lighting product sales, followed by some growth in LED chips to support notebook and TV backlighting and incremental growth in Power and RF sales.

We target Q2 non-GAAP margins in a similar range as Q1 at 44% plus or minus as we look to maintain our recent gains in margins. We target continued investment at R&D to support new product development in LEDs as well as increase spending in sales and marketing to support our new global customer service and application centers.

As a result we target non-GAAP earnings in Q2 of $0.28 to $0.30 per diluted share based on share count of 105 million shares, which reflects the dilution from our recent offering. Please note that our non-GAAP targets exclude amortization of intangibles, stock-based compensation expense and related tax effects. We got off to a strong start in fiscal Q1 and we are well positioned for a solid Q2. As a result of the recent equity offering, we have the balance sheet to invest in the growth of our business as we look to continue to lead the LED lighting revolution.

The macroeconomic environment remains a risk factor that we will need to continue to monitor, but in the near-term our focus is on managing growth and execution. We are still in the early stages of LED lighting adoption and we must aggressively attack the traditional lighting markets and find ways to expand awareness, breakdown barriers and increase the value proposition for LED lighting.

We will now take analysts questions. Operator, we are ready for questions.

Questions-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Yair Reiner with Oppenheimer.

Yair Reiner – Oppenheimer

Congrats, first of all, on the nice quarter.

Chuck Swoboda

Thanks.

Yair Reiner – Oppenheimer

So, my first question, can you give us a sense directionally of how the mix was in the quarter in terms of components, chips, daily uses and so forth?

Chuck Swoboda

Yes. So, in the quarter what we saw the two big growth drivers were components and chips and the applications that drove that were a combination of lighting and back lighting. We definitely saw some benefit from back lighting, but actually overall I think lighting actually grew slightly as a percentage of the business. So, if you look at the application mix, lighting still the biggest a little over 50%, the video screen business is still hanging in there in second and then the next two big applications would be mobile and back lighting and they are similar size, but back lighting obviously has come up to rival to mobile in terms of size, but again net-net lighting is still the biggest driver.

Yair Reiner – Oppenheimer

Great and then in terms of your design centers you are building out, how should we measure the success of those moving forward and how do this going to impact your geographical mix in the quarters and years ahead?

Chuck Swoboda

In the short-term it is going to be difficult because obviously it take us mostly to get these online. The way we are going to measure them is design win rates, but we don't typically break that out. I think the easiest way for you is going to be sales growth momentum and components and that will be something that it will become more obvious in the year ahead in terms of fiscal 11, right. We are going to have rely on the sales team we have in place right now to drive the current business, but it's really going to be in sales growth and then internally we'll also look at design win momentum.

Yair Reiner – Oppenheimer

Okay. One more quick question and then I cede the floor. In terms of your capital investments moving ahead, clearly there is a quite a bit of bottleneck in terms of the major tool makers. How do you intend to deal with that and how much your capital investments must be patch different than a lot of the other players in the field?

Chuck Swoboda

Reiner, we probably started investing earlier than most. So, we started placing the first POS actually in our Q4, when we saw the business start to book up. So, we are a little bit ahead of the curve, and we have a little bit control over some of the key operations. So, well we obviously rely on outside vendors. We've become pretty good at adapting existing equipment for our processes. So, it gives us some flexibility because in many cases we are able to use equipment that exists versus necessarily having to go in the marketplace. That doesn't mean we don't buy new equipment, but I think it gives us a little bit more flexibility. That being said, we were pretty much capacity limited in Q1 and we are likely to be that way in Q2. That’s why execution is going to be such a big deal. It’s going to be the key to driving our revenue range for this quarter.

Operator

Our next question comes from the line of Chris Lancet from JPMorgan.

Chris Lancet – JPMorgan

Chuck, based on your comments about the mix of the CapEx, is it fair to say that a lot more of your own chips will go into your own packages and that’s a planned progression over the next 12 months?

Chuck Swoboda

What you'll see is a lot of the incremental investment in capacity for chips will go into our packages. We actually see the chip business keep staying in kind of a similar range. It was up last quarter but if you look at it on a year-over-year basis it's only up slightly from a year ago. So it is in the right range. We are not looking to shrink that business but I think most of the growth from the new capacity the majority of that will end up in components. So we will probably take some incremental growth in chips as well. I wouldn't look at it as much as taking existing capacity as much as the new capacity. It would probably be more for more internal than external but actually there will be a benefit to both.

Chris Lancet – JPMorgan

Then on your latest XLamp product, how do you describe the response from your customers and in general, I guess demand trends for components versus maybe chips of that same generation?

Chuck Swoboda

Yes. I would say that chips have been benefiting a lot on the whole backlighting phenomena. I think everyone is pretty well aware of that and lighting is a little broader than that. We have the new XPG, but the XPE product that came out only a couple of quarters ago. That’s probably has the most momentum as this had time to be designed in. With that being said, we have got products like our MC which is our multichip. It's been out there long enough percent to keep the momentum.

So I would say it's pretty broad-based across several of the new product lines. XPG is probably the most exciting from the customer, just because it's the newest and because you are starting to let customers do some different things with LEDs. This idea being we get 350 lumens plus from a single LED is really good and we think change some of the design constraints. So it probably more excitement than orders right now with the revenue being driven by the products that have been out six months.

Chris Lancet – JPMorgan

All right, one last one from me is, when do we see the XPG LEDs in your own lighting systems products?

Chuck Swoboda

Boy, you know what, I don't have a specific date for you. I think right now we are focused on using, we use both the XR and the XPG generation. A lot of that has to do with once you get a design approved there is quite a cycle to getting a new system approved, DRUL [ph] and all the other things, but I would imagine sometime in the next quarter or two you'll start to see some of the first Cree lighting systems that have XPGs. With that being said, we'll continue to use a lot of XP products in many of the applications.

Operator

Your next question comes from the line of Jesse Pichel with Piper Jaffray.

Jesse Pichel – Piper Jaffray

Yes good afternoon, Chuck, John, Ray. Congratulations on the stronger results on the guidance.

Chuck Swoboda

Thanks a lot.

Jesse Pichel – Piper Jaffray

Your utilization now, where is it and what type of quarterly revenue would a CapEx target of $150 million to $160 million support?

Chuck Swoboda

Yes. So let me answer the first question. We are probably for Q4, we ran as close to 100% utilization as you can run. I mean there’s a little bit of, obviously, there is always some gaps of underutilized capacity , but we were running pretty much full out, based on bottlenecks across the company. So with that being we have got a fairly good investment strategy, that’s what’s giving us the growth through our last quarter and we are targeting for this quarter and we would target into the second half of next year. So in terms of how much revenue do we get from that? We don't have a revenue target out there for beyond Q2. I don't necessarily have an exact number for you at this time. I think it's a great question but I'm not sure I'm in a good position to answer that.

Jesse Pichel – Piper Jaffray

It certainly up more than 100% year-on-year, thus could you think of it is somewhat doubling your quarterly revenue over the next couple of years?

Chuck Swoboda

Clearly it's going to give us a lot of leverage. It’s going to depend on exactly, where we end up spending that. Right now it's a combination of chip and components and so what we are having to do keep in mind is, we are investing in chip capacity that we then have to use in the component business, which we also have to buy capacity for. So I think there is a little bit of doubling up there, but it clearly gives us some pretty significant growth. Jesse I'm just not comfortable giving you specific target.

Jesse Pichel – Piper Jaffray

Understood and regarding the growth of the lighting business, the sequential growth you are seeing enough to offset potential seasonality in your third quarter?

Chuck Swoboda

Yes. We are already seeing solid bookings in the Q3. So, that’s an encouraging sign. The tone you should read is cautiously optimistic. I think it's clear that seasonality, what it hits is typically a Q3 phenomenon for Cree and that typically driven first by the consumer electronics applications. If we are going to see seasonality in LED chips we will see it in Q3. It’s too early to call that one. The other thing we have to deal with is that, our third quarter, the March quarter also has Chinese New Year, which typically limit production in China. Those are the two negatives. On the other side LED lighting adoption is ramped last quarter; we are targeting more in Q2. If that continues to grow, there's an opportunity to potentially grow through that seasonality. I wish I had the answer. We don't yet, but those are the variables and we'll see once we get closer to Q3, what’s going to happen.

Jesse Pichel – Piper Jaffray

In your answer to a previous question you said that component sales would be an indicator there of design success.

Chuck Swoboda

Yes.

Jesse Pichel – Piper Jaffray

I wonder and that would probably be in the distri channel, and I'm wondering how do you characterize the growth from the distributor channel because I noticed that Arrow was quite big for you over the last quarter. Are you seeing growth in that channel? Is that a good indicator of design success?

Chuck Swoboda

Yes, I’d actually tell you that we are seeing success both direct and distri, one of the nice things about putting in these design centers is that we are able to also drive some of the major accounts ourselves. With that being said, distribution is absolutely an important part of the strategy and we saw good growth both at Arrow and at World Peace last quarter. Both of them are having success and if anything right now our challenge is that, I think they are having success a little bit ahead of what they were expecting and so we have some challenges having enough inventory in the channel right now.

Jesse Pichel – Piper Jaffray

Did you think there is much legs lest in the LED backlighting story? I mean I know you never hinged your growth or marketing efforts towards the backlighting story and we've all seen that Samsung is ramping its own LED lines internally. I’m just wondering how you see the sector playing out.

Chuck Swoboda

I still think it's going to have a significant impact on the LED industry. Obviously Cree participates as a chip company. It's obviously it's not our primary focus. So, we really get incremental benefit. We will get that in two ways a little bit of chip revenue. We definitely get a factory loading benefit. You put that aside, I'll put my industry hat on. I think that if Samsung has put out some pretty aggressive numbers on estimates for the number of LED TVs they are planning to build next year. I think it’s almost a third of their demand.

Jesse Pichel – Piper Jaffray

That’s right.

Chuck Swoboda

Then Sharp came out with a similar type of numbers, if those guys are able to really convert that much of their production to LED backlight, I think the expectation in the industry is that there will continue to be supply constraints into 2010. So I think, I want to say calendar 2010. So I think, if those guys go, I think the TV backlighting will continue to have a pretty significant impact on that side of the LED supply chain.

Operator

Your next question comes from the line of Dale Pfau from Cantor Fitzgerald.

Dale Pfau – Cantor Fitzgerald

Good afternoon, gentlemen. My congratulations also. Great quarter, great outlook.

Chuck Swoboda

Thanks, Dale.

Dale Pfau – Cantor Fitzgerald

Chuck, my question is about your transition to the 4-inch wafers. Clearly, you’re saying yields are a little bit better. How far along are, we on the transition to 4 and how much better were your yields than you were expecting in the quarter there?

Chuck Swoboda

I don't have a specific number but I can tell you it's a couple of points of yield better, probably the right range. I don't have the exact number in front of me. In terms of how fare are we along, we should have essentially all the products we intend to convert in the near-term converted, which will that almost all of our production by the end of December is the current plan. So I don't know what the exact percentage is right now there, but we are well on our way to have in the factory essentially converted by the end of December.

Dale Pfau – Cantor Fitzgerald

All right, would you say you are 70% through right now?

Chuck Swoboda

Yes, probably at least that much at this point, probably maybe a little more.

Dale Pfau – Cantor Fitzgerald

Great. Could you maybe give me a little of indication here how much ASPs are being held by the demand for the backlighting. I mean we typically have seen ASPs dropping about 20% per year for the same lumen output and you always do shift higher lumen devices into the top end, but are we seeing some mitigation of those ASP pressures?

Chuck Swoboda

Two phenomenons is going on. I think you have chips and components. I think in LED chips, we are definitely seeing the supply vis-à-vis the increased demand that pushed out lead times definitely stabilize pricing a little more last quarter. So I think we have seen less price erosion than normal in Q3 and that’s likely to continue a little bit here into Q4, although I think as we get near to our Q3, which is the seasonal slower quarter, I think it may be a little more normal. In terms of components, we also saw that at least that, we were forecasting, it's been a little, I mean I think we were probably a little conservative on our outlook there, with that being said, I think that we are continuing to model but market will stay competitive in terms of pricing, just because as you know Dale, there is a number of other competitors out there. Although the market is very big, we all focus on making sure we drive those new designs. That frankly is benefic, because at the end of the day, as we drive down the price per lumen, we are going to expand the market.

Dale Pfau – Cantor Fitzgerald

Okay and one other question. Can you give me a little bit of indications of your kind of mix? How much are you shipping of your XPE products relative to some of your older style products?

Chuck Swoboda

I would say that right now the older designs probably are still in the process of converting to XP. So we still have a significant amount of XR business but I would say most of the new designs are on XP and they are probably, I don’t know if they are 50:50 but they are a similar order of magnitude at this point is what is driving the business there and then a few of the other products mixed in there.

Dale Pfau – Cantor Fitzgerald

Then my favorite topic here, Power and RF, Chuck. What is driving the demand there? Is it just socket wins, the market moving in some of the servers, can you give us indication where you are picking up share and what do you see?

Chuck Swoboda

Yes, boy Dale, you have been following the story long enough. We have been talking about this a lot. It's great to see some success there. What we are seeing is on RF I think, we started talking about some success there a couple of quarters ago. That is really driven on the military side of that. The new kind of the positive we are seeing right now is that the Power side is also getting some traction and it's a combination of things. It's more of the server-power supply business and the other thing is we are seeing growth in the solar market, solar inverters. So we are starting to see that pick up and that is really where our focus has been kind of on the higher value type applications. It's really a combination of those things that is kind of giving us some of the growth in the business.

Dale Pfau – Cantor Fitzgerald

How much revenue do you get out of the solar inverters?

Chuck Swoboda

Its small, I don't know what the exact numbers, we don't break that out but I know it's smaller than the Power-Supply but it probably grew faster than the Power-Supply segment. So, it growing fast, but its coming from a small base.

Dale Pfau – Cantor Fitzgerald

Great, congratulations. Keep up the good work Chuck.

Operator

Your next question comes from the line of Andrew Wong [ph] with JC Research [ph].

Andrew Wong – JC Research

Hi. I was hoping you could give us a little more color on three things. First, can you say which performed better on a sequential basis, LED components or LED chips?

Chuck Swoboda

Andrew, they were pretty similar. So each had a similar benefit in terms of the growth last quarter and then obviously we had some incremental benefit beyond those two in the lighting products and in the Power and RF but those two are similar impacts.

Andrew Wong – JC Research

Okay. Second, on general lighting, between the U.S. and China, which is the bigger opportunity and where do you expect to see faster growth over the next 12 months?

Chuck Swoboda

Boy, I think the opportunity is large in both. I'm not sure I can classify one or the other as better. I think what we are seeing is the outdoor market in China has definitely got some momentum. In the U.S., I think we are seeing a combination of both outdoor and indoor. So, maybe the scale of either one – maybe outdoors is not quite as large but I would say its similar scale and similar opportunity in both markets right now.

Andrew Wong – JC Research

Got it. Lastly it seems like your new high efficiency fixture has highest efficacy up there, by about two and half times. So I was wondering have you looked at any ways to kind of get that up to market more quickly.

Chuck Swoboda

I think you are talking about the high efficiency LR6. We actually had a couple of announcements there, when we won the Lighting for Tomorrow award, right. We had the DR1000, which is our Deep Recessed 1000 lumen product. That was actually the grand prize winner. That one we are targeting to get out here early in calendar 2010, so sometime next quarter. The high efficiency product is behind it and it's behind it primarily because although it's a very exciting technical achievement, right now what we see is more demand of the 1,000 human because of existing sockets working for that specific product novelty version. So it is a function of where we think there's more near-term market demand. It's clearly a great technical achievement. You will eventually see that in our product line but really just given the constraints of how much we can do so fast, that's how we picked the order of those.

Operator

Your next question comes from the line of Vijay Rakesh with ThinkEquity.

Vijay Rakesh –ThinkEquity

Yes I had just a couple of questions here. I was wondering what your fab utilizations are running at now? You probably have already answered, but just wanted to confirm what I have?

Chuck Swoboda

We are running pretty close to 100%. I am sure there is a few low pockets of underutilized capacity, but we are running pretty flat out right now and we did almost all last quarter.

Vijay Rakesh –ThinkEquity

So, on that, how do you – as your revenues pick up here how do you cater to that?

Chuck Swoboda

We started purchasing additional capacity in our Q4. So that was the June quarter. We continued to buy additional capital last quarter. We’ll continue here. So that capital starts to come online. We had some online last quarter, additional capital online in this quarter. That will drive part of the growth and the other thing is as we are continuing, as we finish converting the 4-inches well as yield improvement. We are getting a combination of those three things that’s really creating the additional capacities for the revenue.

Vijay Rakesh –ThinkEquity

By this capacity, is that beneficial to you versus your in-house capacity?

Chuck Swoboda

When I say buy, we are buying equipment and putting it in-house. So, it’s about the same benefit is the existing capital.

Vijay Rakesh –ThinkEquity

Okay, got it. Just wondering on the customer concentration side, as you see the TV side pickup, the panel side pickup and the lighting side, do you have any customer concentration as you go out and do first half next year?

Chuck Swoboda

Although we are getting some incremental TV business, I will be honest lighting is actually growing as a percentage of the overall company's revenue. So, it’s anything that not driving customer concentration. What we are seeing it’s really in the component business that driving, probably the bigger revenue driver, especially if you look into Q2. What that actually doing, that actually decreasing our customer concentration. Lighting is lots of customers and lots of different applications. So, what you are actually seeing is as we grow the business, we are relying less on any one key customer.

Vijay Rakesh –ThinkEquity

Got it and then last question on your gross margin now look longer term, wondering what you are looking at and how that could change as this mix most between lighting and consumer?

Chuck Swoboda

Obviously the near-term target is that in Q2 we are targeting 44% plus or minus again. So, I think it's pretty similar to what we did last quarter. As we look longer term, we laid out a couple of years ago a goal of getting our gross margin in the low 40% range and our operating margins in the below 20s and I’d classify, where we are at today is where in that range. I'm sure that there would be some variation quarter to quarter. I think we know that. As different things change in the market, utilization change, on the other side I think there is also things we can do as we scale the business where we are targeting to still drive some operating leverage. So, I think this is still the right range going forward that we are targeting. Obviously some variability, but this is the model we were shooting for at least for now from what we can see, we are going to maintain that target range.

Vijay Rakesh –ThinkEquity

Okay, great, thanks a lot, guys.

Operator

Your next question comes from the line of Steve Milunovich with Merrill Lynch.

Steve Milunovich – Merrill Lynch

Chuck, just to clarify that for me, so you said in the past 40% was probably as good as get on gross margin. You are now higher. You are expecting it’s going to be higher in the near-term. Is this the new baseline or do you think over time maybe supply comes on a bit more and competition hits up a bit we head back to 40?

Chuck Swoboda

Yes, so near-term, I think Q2 similar to Q1. Going forward the way I have classified it and just to clarify, what we did lay out in the past was trying we used the term low 40s low 20s. In my mind whether that’s 40 or 44, we are in the right range. So, right now I think that if the factory continues to operate the way it is and frankly as we get more components business I think that gives us the opportunity to maintain it in this level. Longer term obviously as the market changes and capacity comes online and utilization might vary, people always look in to that put some pressure on gross margin and it might put some on it. The counter balance to that is that our operating margins as we grow the business, we targeted some leverage especially in SG&A longer term as revenue grows and I think that still to come. So, I still think this is the right range going forward low 40s, low 20s plus or minus each quarter, but for now this is what makes sense for us.

Steve Milunovich – Merrill Lynch

What kind of decline are you seeing in your cost on annualized basis?

John Kurtzweil

I don't have if I have a specific number for you right now, Steve. I haven't seen that, frankly that specific analysis. Typically what we target is about 25% a year and that’s about 25% year ASP erosion. Obviously the cost are probably coming down as good as that much or more right now just because we are getting a combination of all the normal things and good utilization and ASP is probably a little of that slighter margin you’re seeing some of the benefit, but I don't have a specific number for you.

Steve Milunovich – Merrill Lynch

Okay. What's the headcount of the company and where do you see that going over the next six months to 12 months?

Chuck Swoboda

I want to say right now, we are in the range of about 3300 employees. We just announced a couple of weeks ago that we are going to be expanding in Durham over the next few years at 275 this year and then 575 I think in total over the next three years period in North Carolina and then we'll likely have to be expand in Asia as well for the backend type operation. I don't have a specific target for you there, but we should expect there will be growth there as well, but no number for you at this point.

Steve Milunovich – Merrill Lynch

Okay and then finally any update in terms of stimulus spending and you get that indirectly, but are you seeing any change in the flow there?

John Kurtzweil

Steve, I think we are seeing it in some incremental business. I think it's definitely helps on some of the municipal lighting project. It got people interested. What’s interesting is that, I think it got a lot of people working on the LED lighting, whether or not to ended up getting this stimulus or not. So, we are seeing some of that benefit, but it's very much incremental. I’d describe it as a similar way in China. I was just there last week and I don't think there is direct dollars driving in these program, but there is clearly an awareness and a real focus on energy efficiency projects, whether they are directly funded or not. So, I think we are getting, the stimulus program probably had their biggest effect in just getting people to think differently about some of the stuff.

Operator

Your next question comes from the line of Lauren Stoller with Lazard Capital.

Lauren Stoller – Lazard Capital

Sorry, my question actually might have just been answered, but I was going to ask about the government stimulus and whether or not you've seen an effect from the stimulus plan and how that affected your revenue in the quarter.

Chuck Swoboda

Yes. I think it's indirect. I think there's probably some incremental sales in there. I don't think it's a major driver of the revenue but we have seen some incremental benefit. Really at the end of the day, I think stimulus, the biggest effect it had is it's changed the market awareness for energy efficiency generally, and LED lighting specifically. So I'm sure there is some incremental benefit in our numbers, but I don't believe it's a significant piece. We see LED lighting adoption happening, independent at this point of stimulus dollars although they clearly help get the momentum started.

Lauren Stoller – Lazard Capital

Okay, interesting. So that's a little bit of a change from what you guys were saying before, I believe.

Chuck Swoboda

No. Actually what we said is the biggest impact in the past I think we said is, we thought we might see a future benefit, maybe some incremental positive to the company but that it has the biggest impact to move the market, when I say a benefit, not to Cree but to our customers who then buy LEDs from Cree.

Lauren Stoller – Lazard Capital

Right and then if you had to put a number on it, what would you say, like what would the percentage growth be for the industry in terms of supply over the next year? How about we'll go for calendar year 2009 and calendar year 2010?

Chuck Swoboda

I don't think I have a great estimate for you. I just spent last week with a bunch of people in the industry in China and I think it's kind of hard to put a number on what capacity growth is. It's clearly growing. It grew in 2009, specifically in the second half, but I don't think anyone has a good number on it. I think as far as 2010 goes, there are some people talking that have some capital purchases on the book but again I think there is so many speculation and rumor, I'm not sure anyone has a good handle on the real number even when I talked to my colleagues in the industry.

Lauren Stoller – Lazard Capital

Interesting. Okay, thank you very much.

Operator

Your next question comes from the line of Carter Shoop with Deutsche Bank.

Carter Shoop – Deutsche Bank

Good afternoon. First question on the lighting market. Can you discuss where you see the largest opportunity for Cree over the next six months? Is it more on the architectural lighting market, streetlights, or somewhere else?

Chuck Swoboda

Yes, I think Carter, also there's three things. I think the outdoor municipal lighting market, streetlights, parking garages, that's probably one of the large drivers. We are also starting to see some of the indoor lighting markets, whether we service those as with our own lighting products, but even with the LEDs we sell to other companies we are seeing that growth and then the third I would call is kind of the more indoor, but it would be a bulb market. So, we are starting to see some traction, whether they be linear to LED replacement lamps which are quite popular in Asia right now, to even some of the A lamp type products that are starting to appear in some of the stores here in North America. So, I think if I had to put three things out there it's those. That doesn't mean there's still things going on in architectural, kind of colored lighting. There is still the vehicle lighting. There's still the specialty lighting, like refrigeration. All those things are still happening, portable lighting, but in the end if I was looking at general elimination, it would be those kind of three buckets would be the drivers.

Carter Shoop – Deutsche Bank

That's helpful. Shifting gears to gross margins, can you help us understand which LED segments in the quarter were above or below the corporate average gross margin?

Chuck Swoboda

Yes. LED components is above the corporate average; LED chips is below. Both of them improved last quarter but they both kind of relatively speaking it rolled [ph] about the same. The LED lighting business is lower than the corporate average, but if you think about that business it's about driving the market right now and it's still kind of in a small scale stage. Then power and RF is below the corporate average, but some incremental improvements there as well. So, I think the components is the driver and the other three are in different positions below the average.

Carter Shoop – Deutsche Bank

That's helpful. Thanks. In regards to LED chips, I think in the last earnings call we were talking about then being about three months for chips. Have those come in a little bit or are they still holding out there about three months or so?

Chuck Swoboda

Yes, they are still pretty far out there. I think Q3, it's a little harder to get a handle on. We definitely have backlog into Q3, but I think part of what happens there is, I think even our customers are all trying to figure out what might happen in Q3. So I think, while last quarter, there was no concern with booking out pretty far in advance, I think everyone's wondering a little bit what we might see in Q3. So I guess the backlog's still good, but I would tell you that I think the chip business has probably come in a little bit from last quarter at this point. I don't have the specific number.

Carter Shoop – Deutsche Bank

Okay. That's helpful. In regards to the distribution channel, I know these are World Peace and Arrow right now. I think in the past as you've suggested that that's enough of a distribution partnership both in Asia and North America. Is that still the case and then can you remind us what is the strategy is in Europe? Do you plan on continuing to use manufacturing reps or is there opportunity for a more involved relationship with a partner?

Chuck Swoboda

So, Arrow is our global distributor, and we work with World Peace primarily in Asia, although we have some efforts with them in other markets but their real strength is in Asia at least when it comes to our product line right now. What we are doing in other markets is, is we've also have then, kind of the other side, which is we have both Digi-Key and Farnell as the catalog/online distribution. So we cover the small customer from that side and those guys have access to the markets around the world. Then in addition, in specific regions we often times when it comes to LED components we'll have a local distributor. So in Europe, I don't know what the exact number is, but we probably have eight or nine local distributors at this point. In the North America we have in some cases some specialty value added resellers that we work with. So I think each market can be different, and some applications require specific relationships. So, we are pretty open to finding relationships that help the customer solve their problem and be successful with the design. With that being said, clearly Arrow and WPR are the two biggest players, but especially in some of the local markets the local distributors do a great job for us.

Carter Shoop – Deutsche Bank

Okay. Are the Digi-Key and Farnell, were those established in the past year or have they been around for a while?

Chuck Swoboda

Well, I want to say is probably a year ago, maybe a year and a half ago, something like that.

Carter Shoop – Deutsche Bank

Okay. Last question for you, guys. Obviously the cash balance on the balance sheet is pretty attractive at this point. Can you talk a little bit about what type of acquisitions the company might be looking for without showing your hand too much?

Chuck Swoboda

Yes, I think obviously the primary purpose is to fund the growth that we can see from the product lines we already have. So I think that's the primary purpose of why we have that money, because obviously if the business is going to grow significantly, it's going to take more capital to fund that growth. With that being said, when we look out and think about strategic opportunities, there's nothing specific, but the way to think about it is, we have a pretty laid out strategy of driving the market with our lighting products and filling the demand with LED components and that continues to be the strategy. So, if there was a way for us to accelerate LED lighting adoption or improve our leadership position, related to the same strategy we have today, we would consider it. With that being said, really nothing specific right now. We are pretty focused on driving the growth that's in front of us with our current product lines.

Carter Shoop – Deutsche Bank

Do you think there is an opportunity for possibly integrating into more the fixture side, tends to bring similar to what you did with LOS [ph] or do you feel that right now the fixture opportunity as a company is sufficient?

Chuck Swoboda

I think our lighting business is doing a great job of getting the market going, and I think there's a big gap. We didn't think we had a customer that was addressing. We would consider it, but with that being said, I think that's a lower probability idea at least in the near term. I think it's more about how do we enable those types of customers; what can we do to make our components business more successful and make them more successful in the marketplace. So that's how I think about that.

Carter Shoop – Deutsche Bank

Great, that's very helpful.

Operator

Your next question comes from the line of Hans Mosesmann with Raymond James.

Hans Mosesmann – Raymond James

Congrats on the quarter guys. A few questions. You mentioned Chuck or John that the litigation expense is going to come up a little bit. What is driving that? Are those existing cases or is there enough case there? Thanks.

John Kurtzweil

No, Hans, that's the Newmark case. Right now, it is scheduled to go to trial in our Q3. So that's just a ramp up for that trial. Obviously, those schedules are subject to being changed but it's really a function of the timing of that trial, and that's been on the calendar for a couple of years now. So, that's all it is.

Hans Mosesmann – Raymond James

Okay. And then the greater issue here in terms of how (inaudible) trying to understand demand and tightness, is this issue called double ordering, it's something that everybody is talking about. What is your opinion, just if you can put your industry hat on for the degree of the tightness or shortages of certain types of components or chips, what's going on and how are you guys dealing with it if at all? Thanks.

Chuck Swoboda

Yeah so I think obviously we are always wary when lead times move out and that's affected the LED chip business more than anything. So we've done a number of different things. I'm not going to get into specifics to test whether the market demand was real or not. Obviously last quarter was real, and we think it's pretty solid for this quarter as well. I think the question in everyone's mind is what type of seasonal effect could there be in Q3 and the opposite side of that is if the TV back lighting guys really try to start converting, what's the offsetting in fact and I don't think we know yet. But in terms of Cree's backlog, I feel pretty good about at least what we can see. I think we've done a lot of things as you know from your industry days, there are some things you can do to see if you take the backlogs real or not. At this point we feel pretty good about it through Q2 and at least what's on the books for Q3 at this point. When it comes to LED components, we've done some things to try to ensure that we maintain some shorter lead times there. So, our lead times are not as long when it comes to especially some of the key lighting applications. We know it's a project-based business. So, though we get designed in when that order comes into the design, the demand is not there until someone gives a contract to do, for example, a street light project. So, we've been doing something to try to maintain some pretty relatively short lead times there. So I think we're a little less susceptible to that right now. If I look at distributor inventories, they are pretty lean right now. So, I think we're not there yet but I think your concern is correct. I think whenever demand is high you got to look for that at least in the short-term we don't think it's there, but we are watching for it.

Hans Mosesmann – Raymond James

Okay, and then a follow-up on the gross margin question. So the top line is going to grow, let's say, high single digit. Why wouldn't gross margin pick up just a little bit? What's keeping that from going up a little higher?

Chuck Swoboda

The way that target was developed, if you think about the fact that we ran all of Q1 pretty much fully loaded, the whole quarter, we're not going to get a loading benefit this quarter. And so, essentially if you're loaded for all 13 weeks you can't get any more loaded than that. That's really where, I'm sure there will be some improvements on one side of it and there is going to be some normal market activity on the other. So kind of the idea is there is no additional utilization benefit in at least in our targets for Q2.

Hans Mosesmann – Raymond James

Fair enough. Thanks a lot.

Chuck Swoboda

Sure.

Operator

Your next question comes from the line of Jed Dorsheimer with Canaccord Adams.

Jed Dorsheimer – Canaccord Adams

Thanks and congratulations on a solid quarter.

Chuck Swoboda

Hi, thanks, Jed.

Jed Dorsheimer – Canaccord Adams

Couple of quick questions for you. The 350 lumen, how many amps is that?

Chuck Swoboda

350, that's a one amp device.

Jed Dorsheimer – Canaccord Adams

How many watts?

Chuck Swoboda

It's 111, the device is 367, 111 lumens per watt. So at 350 you scale that down.

Jed Dorsheimer – Canaccord Adams

All right. Do you have that product now and I doubt you are going to comment on any pricing but do you have the product now?

Chuck Swoboda

No. I'm not going to give you pricing on that but it is priced on dollars per lumen basis, I will tell you that. In terms of availability, we do, we don't have as much availability as we would like right now and that's just the nature of introducing a new product and having a pretty good initial acceptance for us. So, we're in the process of ramping that up and hopefully as we get through this quarter we'll be able to get that to a higher level, but right now it's in relatively short supply.

Jed Dorsheimer – Canaccord Adams

All right. Scott and Richard have done a great job with the COTCO integration. I'm curious. Two questions actually. One, what are your thoughts, since COTCO has been so successful for you, do you sort of look for another COTCO out there in terms of that level of the supply chain in terms of strategic investments and then secondly, I was wondering if you could comment on what your exposure is geographically speaking to China?

Chuck Swoboda

I'll answer the second question first. I think, China, in the June was 38% of revenue and I think it's probably maintaining in a similar range at this point. I don't think it got any smaller as a percentage overall. So it's a big market for us. Back to your COTCO integration, obviously we didn't choose that business lightly. We really thought that not only was it a good business and had some strategic benefits but we thought we could integrate the two teams and just to give us a perspective that COTCO name we don't use anywhere in the company because it doesn't feel like that anymore. We've gotten it to where it's just part of the components business now. In terms of doing that again, I think it's going to depend on how fast we can grow the business on our own and what other opportunities might come up. If there was something that would accelerate our existing strategy, improve our leadership position and help us make a lighting adoption happen faster, we might consider it. If not, I think we're in a pretty good position to drive the growth with our own product lines today. So, I think it's different than when we did that because at that time we had a gap in terms of both manufacturing, we didn't have great access to China and we needed a broader product line to kind of fill up the portfolio. So, we got to handle three things in one, I think going forward it's going to have to meet those strategic criteria that I laid out, but if something comes up we'll obviously consider it.

Jed Dorsheimer – Canaccord Adams

Then lastly video screens, you noted that still hanging in there. Curious is that mostly in Asia?

Chuck Swoboda

Yes. Our biggest market in video screens is the Asia video screen business. I think our biggest market is China and then other parts of Asia and then we have some business in the U.S. and Europe as well, but not at the same level. So, that's our best market for that and it's doing pretty well. It's interesting, it's not growing as fast as the lighting so it's probably getting slightly smaller as a percentage of revenue, but it's definitely hanging in there. It continues to be a solid business for us.

Jed Dorsheimer – Canaccord Adams

Great. Thanks.

Operator

Your next question comes from Ramesh Misra with Brigantine Advisors.

Ramesh Misra – Brigantine Advisors

First question was where were lead times at the end of last quarter?

Chuck Swoboda

So lead times, in all of the chips are still out there about three months maybe slightly less than that in components. Don't have a specific number for you. It's going to depend on the customer and application and since a lot of that is in distribution we try to use them to handle kind of the buffer and the project business. So, components would be less but that's partially because we're managing it that way. That's not a demand phenomenon, and that's how we're trying to manage the business.

Ramesh Misra – Brigantine Advisors

Got it, Chuck. In regards to asking the question of your expected capacity expansion, I wanted to ask it in another way, how did you arrive at your revised CapEx target?

Chuck Swoboda

Well we looked at basically the rate of growth we had in Q1 and Q2. Obviously, we've spent last quarter I think it was capital additions were 32 million. We're looking at 50 to 60. If you look at that rate over the next couple of quarters, you get a sense for how much additional capital it would take to support that kind of growth going forward. So I guess that probably answers your question.

Ramesh Misra – Brigantine Advisors

So, basically with the 150 to 165 you expect to maintain the kind of low double digit kind of growth rate sequentially through the year?

Chuck Swoboda

I think the idea is to give us the capacity to be able to support a growth that will allow us to grow in the second half similar to what we grew in the first half.

Ramesh Misra – Brigantine Advisors

Okay. Thanks.

Operator

At this time there are no further questions. Mr. Kurtzweil, do you have any closing remarks?

John Kurtzweil

Thank you for your time today and we appreciate your interest and support and look forward to reporting our second quarter of fiscal year 2010 results on January 19, 2010. Good night.

Chuck Swoboda

Good night. Thanks.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Cree, Inc. F1Q10 (Qtr End 09/27/09) Earnings Call Transcript
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