Cree, Inc. F2Q10 (Qtr End 12/31/10) Earnings Call Transcript

Jan.19.10 | About: Cree, Inc. (CREE)

Cree, Inc. (NASDAQ:CREE)

F2Q10 Earnings Call

January 19, 2010 5:00 pm ET

Executives

Raiford Garrabrant – Director, Investor Relations

Charles Swododa – Chairman, Chief Executive Officer

John Kurtzweil – Chief Financial Officer

Analysts

Dale Pfau – Cantor Fitzgerald

Steven Milunovich – Bank of America

Yair Reiner – Oppenheimer

Jesse Pichel – Piper Jaffray

Daniel Amir – Lazard Capital

Harsh Kumar – Morgan, Keegan & Company

Christopher Blansett – J. P. Morgan

Mark Heller – CLSA

Carter Shoop – Deutsche Bank

Hans Mosesmann - Raymond James

Jonathan Dorsheimer – Cannacord Adams

Operator

Good afternoon. My name is Courtney, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Cree, Incorporated second quarter fiscal year 2010 conference call. (Operator Instructions) 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, Courtney, and good afternoon. Welcome to Cree’s second 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 CFO will report on our results for the second 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 website at www.cree.com under fiscal year 2010 financial metrics.

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. 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’ll be limiting our comments regarding Cree’s second quarter for fiscal year 2010 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 sellside 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 you to contact us after the call by email or phone at 919-287-7895. We are also webcasting our conference call and a replay will be available on our website through February 2, 2010.

Now I’d like to turn the call over the Chuck.

Charles Swoboda

Thank you, Raiford. Fiscal Q2 was another record quarter for Cree as revenue increased 18% from Q1 to $199.5 million and non-GAAP net income increased 47% sequentially to a record $40.2 million or $0.38 per diluted share.

Revenue and profits exceeded our targets for the quarter due to a combination of strong LED demand and solid factory execution. The revenue growth in Q2 was driven by a strong increase in XLamp LED sales for lighting applications and incremental growth in LED lighting products, LED chips and power and RF devices.

Non-GAAP gross margin increased to 47.5% in Q2 which is 340 basis points better than Q1 and higher than our target for the quarter of 44% plus or minus. The better than expected results were due to a combination of factors including better than forecast execution on the LED factory ramp, which enabled higher production volumes and better factory cost spreading, better than planned yield improvement across our LED product lines and more stable pricing environment for LED chips and LED components, and continued progress in our power and RF product line.

Our balance sheet got even stronger as cash and investments increased to $954 million. Working capital and CapEx spending have increased as expected with the growth in our business, but this was mostly offset with higher operating income due to higher revenues and increased profitability.

We remain in a strong position and continue to invest in our business to strengthen our leadership position and help us accelerate the adoption of LED lighting.

Fiscal Q3 would generally be considered a seasonally weaker quarter due to a slower consumer market and the Chinese New Year holiday. However, based on the strength of our bookings this is not the case this year as increased adoption of LED lighting is driving significant growth in our business.

Our backlog for Q3 is higher than at this point last quarter due to increased demand for our LED components, lighting products and power and RF devices. We have started to build Q4 backlog in most of our products lines while we continue to work on Q3 orders for the shorter lead time project business and LED lighting and components. Our near term focus is on factory execution and capacity expansion at both our U.S. and Asia manufacturing facilities to meet the higher demand.

Cree was also recently awarded $39 million in tax credits as part of the American Reinvestment and Recovery Act to support our investment in new manufacturing capacity and jobs in North Carolina to build energy efficient LED lighting.

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

John Kurtzweil

Thank you, Chuck. I will be providing commentary on our financial statements on both a 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 all quarters mentioned on this call is posted on our website as well as a historical summary of other key metrics.

For the second quarter fiscal 2010 revenue was $199.5 million, above our targeted range for the quarter of $180 million to $190 million. This represents an 18% increase sequentially and 35% increase year over year.

GAAP net income was $33.8 million, an increase of 61% sequentially and 216% year over year. GAAP diluted earnings per share were $0.32 and exceeded our targeted range of $0.20 to $0.22. On a non-GAAP basis, net income was $40.2 million, an increase of $12.8 million sequentially and $22.4 million year over year. Non-GAAP diluted earnings per share were $0.38 per diluted share and exceeded our targeted range of $0.28 to $0.30.

Non-GAAP net income excluded $6.4 million of expense net of tax or $0.06 per diluted share from the amortization of acquired intangibles and stock based compensation expense.

Cash provided by operations was $21.5 million which included $19 million of depreciation and amortization and we spent $41.4 million on capital expenditures in Q2 which resulted in a negative free cash flow of $19.9 million.

We ended the quarter with $954 million in cash and investments which increased by $66 million since the end of September.

LED product revenue for the first quarter increased 17% sequentially to $182 million while power and RF revenues increased 34% sequentially to $17.5 million. Please note that power and RF revenue includes $3.7 million of government contract revenue and LED products revenue includes $0.4 million.

Q2 GAAP gross margin was 47.2% while non-GAAP gross margin was 47.5% which excludes stock based compensation of $0.7 million. This was above our targeted non-GAAP range of 44% plus or minus.

The increase in gross margin versus our target was the result of a combination of factors including better than forecast execution on the LED factory ramp, better than planned yield improvements across our LED product lines, a more stable pricing environment for LED chips and LED components, and continued progress in our power and RF product lines.

Operating expenses for Q2 were $48 million on a GAAP basis and $39.7 million on a non-GAAP basis which were below our targets. R&D was below our target by approximately $1 million as we were able to transition some new products from R&D to production sooner than anticipated.

SG&A expenses were approximately $1 million below target as our head count additions were slower than anticipated. We continue to hire in both areas, but there is a lag in how quickly we are able to hire new people as compared to our expense targets.

Non-GAAP operating expenses exclude approximately $5.3 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 Q2 GAAP operating margin increased 730 basis points sequentially to 23.1% while non-GAAP operating margin increased 670 basis points sequentially to 27.6%.

This was the result of several factors. Revenue increased 18% sequentially. Non-GAAP gross profit increased 27% sequentially while operating expenses increased less than 2%.

Net interest income and other for Q2 was $2 million which was on target. The tax rate for the quarter was 29.6% which is above our target due to a larger percentage of income and higher tax jurisdiction as well as several discrete items that are not expected to occur next quarter.

As I mentioned earlier, cash investments increased to $954 million from $888 million last quarter. Day sales outstanding were 51 days as compared to 50 days at the end of September and 63 days at the end of June.

Accounts receivable balances increased by $20 million which matched our increase in revenue. Inventory days on hand were 80 days as compared to 81 days at the end of September and 79 days at the end of June.

Inventory increased by $7.3 million during the quarter with the increase in raw and WIP as finished goods inventory decreased from the previous quarter. This increase is intended to support our targeted sales growth for the third fiscal quarter.

For fiscal 2010, we are increasing our capital targets to be in a range of $240 million to $260 million. This increase is to help position us to meet our higher revenue growth targets for this fiscal year and the first half of next fiscal year.

This includes our new LED chip factory in China, manufacturing equipment to support the growth in our business and new product development. For those of you building cash flow models, please realize that there is a lag between when capital is ordered and when it is paid for.

The second earn out milestone related to the LLF acquisition of $8.8 million was recorded during the second fiscal quarter. We have increased good will associated with the acquisition and also accrued the associated liability. We anticipate that this will be paid out in our fiscal Q3.

At this time, we target Q3 revenue to be in a range of $215 million to $225 million. GAAP and non-GAAP gross margins are targeted to be 46.5% and 47% plus or minus respectively. Our GAAP gross margin targets include stock based compensation expense of approximately $1 million while our non-GAAP targets do not. Chuck will provide additional insight into our targets in just a few minutes.

For operating expenses, we are targeting GAAP and non-GAAP R&D expenses to increase by approximately $1 million while GAAP and non-GAAP SG&A expenses are targeted to increase by approximately $2.5 million to $3 million. The increase is primarily due to growth in marketing expenses and sales commissions along with staffing increases to support the growth in the company.

We target asset impairments to be approximately $500,000 for the quarter. Our GAAP targets include approximately $5.3 million of non cash stock based compensation and $3 million of charges for amortization of acquired intangibles.

Interest income and other is targeted to be approximately $1.8 million. We target our tax rate to be 26% next quarter. Included in this estimated tax rate is the expected benefit related to the $39 million tax credit we have been awarded as a part of the American Recovery and Reinvestment Act's Advanced Energy Manufacturing tax credit program which will support our investment to build energy efficient LED lighting.

We expect this benefit to be realized in the tax rate over a five to seven year horizon. Cree expects to receive approximately 40% of a cash benefit related to this credit in fiscal 2010 and the balance of the cash benefit is expected to be realized in fiscal 2011.

Please note there is a significant timing difference between when we receive the cash benefits and when the income statement reflects the benefits which is targeted to be about 1 percentage point going forward.

GAAP net income for Q3 is targeted at $37 million to $40 million and based on an estimated 107.5 million diluted shares outstanding, our GAAP EPS target is $0.35 to $0.37 per diluted share.

Non-GAAP net income is targeted to increase quarter over quarter to $44 million to $47 million for a non-GAAP EPS target of $0.41 to $0.44 per diluted share. 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 $0.04.

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

Charles Swoboda

Thanks, John. 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 markets. 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.

In terms of market leadership, we achieved one of the most important milestones to date for the adoption of LED lighting in commercial applications with the recent announcement that Walmart plans to install our LRP38 LED light bulbs in approximately 650 stores. We believe this announcement validates that LED lighting is ready for mainstream commercial applications.

We are now working on the next challenge which is to develop new products and channels to bring LED lighting products to the residential market. Today, we demonstrated our new CR6 down light at the Homebuilders Show in Las Vegas.

This product is a lower cost version of our award winning LR 6 down light that has been designed to bring our true light technology to the residential market and do it yourself customers. We target this product to be available to consumers in the summer at less than $50.00 after rebates or incentives.

We also continue to work to change industry perception about LED lighting and we recently released a white paper that outlines the significant life cycle energy benefits of LED lighting as compared to both incandescent and compact fluorescent light sources.

While this might seem to be an obvious conclusion to those that follow Cree and LED lighting, there is still a lot of confusion in the market that we need to clear up to make LED lighting a mainstream option.

Our second priority is to accelerate growth in LED component sales by further enabling our lighting customers. This starts with developing innovative new LED components that make it easier for our customers to develop energy efficient lighting products.

We recently announced commercial availability of our new Easy White LED components that simplify LED system design by improving color consistency. We also released new outdoor light Xlamp LED’s optimized for neutral-white color applications.

In October, we demonstrated 100 lumen per watt lamp using our new XPG XLamp LED’s and we continue to raise the bar for power LED efficiency with a prototype high power LED that produced 186 lumens per watt at 350 milliamps of drive current.

We continue to staff our new customer design centers in the U.S., Europe and Asia as we expand our global customer support capability.

Our third priority is to maintain the product at operating margin levels we have recently achieved as we continue to ramp up the business. Second quarter gross profit and operating profit both came in ahead of our targets as we saw the benefit of strong execution and high factory utilization combined with a favorable pricing environment for LEDs.

We look to maintain these gains in Q3 as we continue to ramp up the factory and increase our investment in sales and marketing. In the near term, factory execution is critical to achieve the targets as we add new capacity quickly to support increased demand. At the same time, the LED component market continues to be highly competitive as the industry looks to continue to reduce costs to open up new applications and further expand the market for LED lighting.

We remain focused on expanding our marketing and technical support capabilities to increase the value of our products and help our customers to succeed while we continue to work on a range of cost reduction activities across our factories.

Our fourth priority is to build on the progress on our power and RF product line and further refine our product offering and market focus. Q2 was another good quarter for this product line as we improved on Q1 and continued to deliver results that incrementally added to Cree’s bottom line.

The RF product line is being driven primarily by military applications while the power demand is coming from both high efficiency power supplies as well as growing demand for solar applications.

The demand for Q3 looks strong for both power and RF products and we are now working on some capacity expansion projects that should come on line in early fiscal 2011. We look to build on the recent success especially in the power market as we continue to focus on higher value products and markets for this exciting energy efficient power switching technology.

As we look ahead to Q3, and the second half of fiscal 2010, we are focused on expanding our LED factories to support increased demand. We are increasing our capital targets for fiscal 2010 to a range of $240 million to $260 million to support additional LED chip and component packaging capacity and development of our initial 150 millimeter production capability.

We target exiting this fiscal year with three times more power LED component production capacity than we had at the beginning of this fiscal year and we have started investing in additional capacity expansion for the first half of fiscal 2011 when our new China factory is scheduled to come online.

We target overall revenues to increase in Q3 to a range of $215 million to $225 million led by higher LED component sales for lighting application, higher LED lighting product sales and incremental growth in power and RF sales.

With the strength in our backlog for Q3 this revenue target is somewhat limited by the rate at which we can bring online new capacity. Factory execution will once again be an important factor to achieving these targets.

We target Q3 non-GAAP gross margins at 47% plus or minus as we look to maintain our recent gains. We target continued investment in R&D to support new product development in LEDs as well as increased spending in sales and marketing to support our new global customer service and design centers.

As a result, we target non-GAAP earnings in Q3 of $0.41 to $0.44 per diluted share. Please note that our non-GAAP targets exclude amortization of intangibles, stock based compensation expense and related tax effects.

Fiscal Q2 was another strong quarter and the LED lighting revolution continues to gain momentum. We are still in the early stages of adoption and we need to continue to aggressively attack the traditional lighting markets and find ways to expand awareness, break down barriers and increase the value proposition for LED lighting.

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

Question-and-Answer Session

Operator

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

Dale Pfau – Cantor Fitzgerald

Gentlemen, congratulations. Could we talk just a little bit about these gross margins? Clearly they’re above your targets. They were above what you said you targeted for the long term goals of the company as well as your operating margins. How much of this is coming from stability and ASPs and tell us can you maintain these kinds of margins going forward?

Charles Swoboda

If you go back to kind of what drove the increase quarter over quarter, Dale, it’s back to kind of the things I mentioned earlier. So obviously we were able to execute the ramp even better than we had anticipated, so that gave us additional volume which gives us cost benefits from a scale standpoint but also from a factory overhead spreading.

We definitely got some yield improvements ahead of plans so that helped. ASP was a part of it, and then power and RF. It really was if you look at the gain, it was really across those four areas that drove that and it wasn’t any one really that dominated the other four.

In terms of what we can do going forward, Q3 we’re targeting 47% plus or minus again. I think that if demand stays strong and based on what we can see Q4, it’s too early to give a firm target but I would tell you right now it looks pretty good. So given what we can see there I think we can be in a similar range there.

As far as longer term, it’s really going to come down to what is the rate of the market growth. So today we have the benefit generally of back lighting, but that’s not driving our business very much, but it helps the market, and really the growth in lighting. It’s going to depend a lot on how that growth continues over the next couple of years as to what that does from a margin standpoint.

Dale Pfau – Cantor Fitzgerald

You mentioned that revenue targets for Q3 is somewhat limited by how fast you can bring on capacity. How much demand out there is, how much could you conceivably be leaving on the table if you can’t bring the capacity on?

Charles Swoboda

I don’t have a specific number for you. I think we’re trying to ramp the capacity to meet the demand. We’re probably, lead times are getting a little bit longer so we’re probably trailing it a little bit, but I think that there is some upside in demand if we could execute a little bit better.

At the same time we’re at one of those points where we’re running so fast I think our targets are kind of built around what we think we can execute here over the next quarter.

Operator

Your next question comes from Steven Milunovich from Bank of America.

Steven Milunovich – Bank of America

Chuck, you just alluded to back lighting and said it wasn’t a big factor in your growth. Could you talk a bit more about back lighting because I think some investors have the perception that it is a key driver? Could you either talk about it as a percentage of revenue or a percentage of revenue growth sequentially and maybe talk about what’s going on in back lighting? And to the degree that it’s not a primary driver of growth could you maybe talk a bit more about the core general lighting business and where all the stuff is going? What are the applications? You don’t walk down the street for the most part and see lots of LEDs yet, so where is it taking off?

Charles Swoboda

Back lighting for Cree had a very little impact on the growth last quarter. I think actually our revenue related to back lighting was flat quarter to quarter, so I don’t think that in fact any of the growth came from that.

I think it is helping the overall industry so I think it is helping overall LED demand which is a good overall industry factor, but really our business in being driven by the lighting segment and I would say the vast majority or almost all the growth really came out of lighting. And if you break that down, and it came out of components was the biggest growth driver although we did get some incremental benefits in some of the other areas as I mentioned earlier.

Within lighting I think we would look at the outdoor lighting segment, the bulb retrofit segment and then some other indoor applications would be the big three that are driving that. And I recognize that it’s hard for people to see it, but I think one of the things you have to remember is you’re talking about a lighting market that depending on what numbers people use, you know I’ve seen estimates in the $100 billion range, we’re talking about LED lighting being a very small single digit percentage of that market today.

I think we can drive for Cree, fairly nice incremental growth right now based on that adoption rate even though it’s a relatively small percentage of the overall market.

Steven Milunovich – Bank of America

Could you talk a little bit about XLamp? That's obviously a part of this growth rate and the pricing. You talked about generally pricing being a bit firmer. My understanding is Xlamp probably comes down 20% to 25% annual rate. Is that not the case right now and do you see with increase in competition, GE is talking about it, obviously Phillips is highlighting the LED business, do you see it getting more competitive going forward?

Charles Swoboda

I would say that right now obviously with demand being robust, we’re probably not; we’re not seeing quite as much ASP erosion as those traditional rates. I would tell you it’s a little hard to track it specifically only because there’s so many new products coming online, I think it masks it a little bit.

So on addition to the growth in our XP product line and our XR, we’re also seeing a lot of the new products grow. With that being said, it’s interesting. I’d say it’s a little better than that traditional rate right now. At the same time, the new designs continue to be very competitive, and so we continue to work real hard on yield improvements and new lower cost designs because I think we all know that to drive large scale adoption in the lighting market, that the upfront cost of LED lighting is a barrier.

So we’re all interested in moving it down. So it’s kind of interesting. Demand is helping on one side, but we’re planning for a fairly traditional trend over the next year just because we think that it’s healthy for the industry to really drive market adoption.

Operator

Your next question comes from the line of Yair Reiner from Oppenheimer.

Yair Reiner – Oppenheimer

First a question on manufacturing; you’re opening a new plant in China for chip production. Traditionally you’ve liked to do all the chip production close to your headquarters there. What exactly are you going to be doing overseas and are you at all worried about intellectual property leakage?

Charles Swoboda

What we’re doing is our chip factory in China is really focused on the back end operations. This is similar to the work we do today in Malaysia. So we have done this before outside the U.S. and we actually had really good success in our China factory so far, so we’re pretty optimistic that we can make this an effective transition and manage the intellectual property issues that so many people talk about.

So we think we can manage it. We have experience doing some of these operations outside the U.S. and so we’re planning on taking that same approach with our China factory.

Yair Reiner – Oppenheimer

So the epi stays in North Carolina.

Charles Swoboda

Yes. Right now there is no plan to transfer epi outside of our headquarters.

Yair Reiner – Oppenheimer

You mentioned that you’re going to be beginning the transition to six inch. Do you have a timetable in place right now for when you expect that transition to start in earnest and maybe how long you expect to take to complete?

Charles Swoboda

We’re right on the 150 millimeter six inch, is that we’re really just now starting to spend the money to really get the development going at a higher level. We’ve obviously been doing the R&D for awhile, but we’re now stepping up the investment to put the capital in place to really start to develop the production processes for that

I think we’re really early in that. I would say sometime over the next two years you’ll start to see that come on line. Could it be a little sooner? Yes. Could it take a little longer? I think you never know for sure, but that’s the kind of way you should think about it.

I think it’s important though that’s a faster transition than we had three to four and I think it’s important that we think about how we’re going to do that in terms of moving the market going forward.

Yair Reiner – Oppenheimer

It seems like you’re executing extremely well in the manufacturing end of things, it looks like you under shot your targets in terms of infrastructure build, in terms of R&D and building out your marketing operations. What do you see as your main challenge on that front going forward and what do you think you can do better?

Charles Swoboda

I think the simple answer is timing on those. I think from an R&D standpoint we are actually at absolutely adding people capacity there and that’s going well. I think we’re getting new projects started up. I think where we missed there a little bit is we had some new products that transitioned from R&D into production a little sooner than we expected, and that really was more of a timing issue last quarter.

So it ended being a product instead of R&D. But we’ll see. It may take us a little longer to ramp up than we thought, but we’re making those investments. We haven’t slowed that down.

On sales and marketing, we are hiring. We’re building that infrastructure out, but frankly there’s a lag to how quickly we want to bring those people in. But at this point I’m not sure they’re limiting us. I think maybe we’re just a little too optimistic on how fast we might have been able to bring those people in before.

But at this point obviously with the growth numbers that we’re showing, it’s obviously not limiting at least the near term growth.

Operator

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

Jesse Pichel – Piper Jaffray

Congratulations on the execution as well. I appreciate the color you gave around the lighting market to a previous analyst. Now although back lights aren’t a driver for Cree it’s certainly taking a lot of industry capacity and keeping ASP degradation modest. By your estimations, how long can back lighting growth continue in the TV monitor and laptop market?

Charles Swoboda

If you look at the projections that the large TV manufacturers are putting out, they’re looking at some pretty aggressive growth numbers year over year. I think I saw one of the big guys talk about trying to build 30% or some number on that order of magnitude of their TVs next year.

I think at least over the next calendar year, that’s a pretty significant amount of growth and it’s going to take a lot of energy for the industry to put that capacity online. So I feel like as we go through this year, at least at this point, if they really build that many TVs that are LED back lit, I think you could continue to see that segment of the market stays fairly constrained.

We’re also seeing that while there is production capacity generally coming online, you’re really seeing two separate markets. You are looking at unique products being developed for both markets and really focusing on each one. So I think we’re seeing as well supply constraints on the lighting side and I think it has its own challenges and especially as that market continues to adapt.

So we are benefiting from that fact that both markets are growing at the same time right now and I think lighting has a long runway, and I think in terms of back lighting, if they go to 30% this year, then we should see pretty growth at least over the next twelve months in that segment.

Jesse Pichel – Piper Jaffray

Do you lump PCs and laptop monitors in there with TVs for back lighting or do you just separate those markets and is there any distinction there or conclusions you can give us?

Charles Swoboda

There actually is a difference. I would tell you that obviously the notebook market is the one that has really converted heavily. I think TV is the one that is the larger market and it’s the one that’s trying to grow pretty fast year over year.

The technologies are similar; slightly different chip requirements for both but they’re similar, and I would tell you that it’s TV that’s expected to be the driver here in the next calendar year.

Jesse Pichel – Piper Jaffray

Recently one of your German competitors said it doesn’t see a consumer LED market developing for some time. When do you think the consumer can actually benefit from the 100 and 60 watt light bulb? The second part of my question is, outside of price, when I talk to the commercial lighting integrators and some of the design engineers, they complain about light degradation of LEDs as kind of the dirty little secret. Can you talk about how Cree products benchmark to your competitors on light degradation?

Charles Swoboda

I’ll take the second one first. On the light degradation question, I would tell you that it’s interesting because when most people in the industry talk about that, what they don’t talk about is the fact that almost every other technology out there has a similar or worse issue.

When it comes to LEDs, there’s really two parts to that question. One is, there’s two different grades of quality. There are well designed LED lighting products that have well established life times. Typically these ones are designed around the Energy Star specifications, meet what’s called L70, and there’s a lot of criteria on that.

All the products that Cree is building are designed to meet those Energy Star specifications. There are products being made typically by what I call the second or third tier companies that are talking about LED lighting but frankly don’t meet almost any of those criteria.

So there are some issues with the low cost, lower performance products getting into the marketplace. But I also would tell you I think the industry is getting a lot smarter about the fact that there are good LED lighting products and there’s the other stuff which is pretty similar to any new technology.

So I think we’re working through that and really in North America that discussion is around Energy Star as kind of the benchmark specification to drive that conversation.

Switching gears, in terms of the large German company which you said doesn’t think there’s a consumer LED market, I would tell you that I think that’s their perspective. I didn’t hear them make that comment and I’m not sure that most people in the industry would actually believe that comment anymore.

We are seeing a bulb retrofit market starting to grow. And again, it’s not the majority of the market, but the point is, we’re staring at essentially zero adoption and so we are seeing good growth out of that. And what I would tell you is typically the traditional players are the last ones to see these trends because they’re thinking about their business the way it was not the way it’s going to be.

So I don’t worry too much about that. I think we’ve been hearing that for three or four years since we made the bet on LED lighting and if we keep driving the cost down and the performance up, I think we can keep driving the adoption.

Operator

Your next question comes from the line of Daniel Amir from Lazard Capital.

Daniel Amir – Lazard Capital

Congratulations on a good quarter. Related to the Walmart deal that you guys announced last quarter, from your perspective, how much has that been a potential game changer in the market in terms of have companies now come forward seeing the announcement and seeing the level of interest that is higher than what you saw before or have you been obviously working on this for a while and you’ve kind of seen the same level of interest and the Walmart deal is the first big deal to fall through.

Charles Swoboda

The way I would describe it is, there was lots of discussion before Walmart but clearly theirs was the most serious and they’re the ones that got it to the point where they could make the cost trade off and say, hey this works, let’s go do it.

Where we’ve seen change since then the most is that all those other more casual conversations became much more serious. So I can’t say it’s driven demand yet, but it has absolutely driven customer activity where many, many other large retailers and small retailers frankly, see that and I think it makes them re-evaluate LED lighting and ask a whole different set of questions than they were asking before.

I think that design cycle is never a quick one, but I do think it has changed the activity level and it makes me optimistic what we’ll see more LED lighting in that commercial retail space over the next year.

Daniel Amir – Lazard Capital

Related to the municipalities and government, I guess related to more government spending or infrastructure spending on LEDs, if it’s street lights or parking lots etc what are you seeing there right now? We have seen some municipalities clearly being public about adopting LED infrastructure here in the U.S. Are you continuing to see the same level or same pace of activity or are you seeing a slowdown as it relates to government spending in that area?

Charles Swoboda

If I think about the whole municipal or the infrastructure markets, I would tell you that those markets, the spending we see related to LED lighting, I can’t speak to the larger picture, but at least to that area, we see that to be as good or frankly probably has increased over the last quarter from where it was.

So that seems to be pretty solid right now and in fact gaining some momentum. I think it’s becoming more of an adoption thing. I think as you start to get more installations out there, the conversations are still somewhat infrastructure spending related, but we’re also starting to have conversations about are there payback discussions and I think that’s where we really want to push this over the next year.

Operator

Your next question comes from Harsh Kumar from Morgan, Keegan & Company.

Harsh Kumar – Morgan, Keegan & Company

Congratulations. Tremendous quarter, tremendous guidance. I think you talked a lot about specific product areas that worked. Can you talk about maybe geographies just broadly, Europe, Asia versus the U.S, anyone better or faster growing than the other ones?

Charles Swoboda

I would say that the two best markets last quarter from a growth standpoint were China and the U.S. I would say that everything else -- nothing else is nearly as significant. Those were the two markets that drove the business.

Harsh Kumar – Morgan, Keegan & Company

I think you also gave several kind of general reasons for why the margins went up. Was there any, can you think of any bigger one or two reasons that might have helped you more than the other such as maybe was it the China factory or anything like that that helped you with the margins?

Charles Swoboda

It was actually pretty broad based. I think I gave you four concepts earlier, and it really is a combinatoin of those things that worked together to drive the improvement. I think as Cree grows and we have more product lines ramping up, I think it really cuts across them to have that kind of performance.

Harsh Kumar – Morgan, Keegan & Company

You make lamps, you make LED components you make LED chips. If you had your way at the end of the day, which kind of business angle would you like to focus on longer term or is it too early for me to ask that question to you?

Charles Swoboda

No. We actually think it’s the combination of those three that makes the strategy work. So you’ve got to have the chip technology because it enables the application. But as we said, the growth driver for Cree is really going to be in the LED component segment.

It doesn’t mean we won’t grow the other areas, but it means the focus of the growth comes at the components level because that’s where we think we add the most value. At the lighting systems, lamps, fixtures, that is important as any part of our strategy and in some cases it’s more important because without those products out there showing the market what’s possible, and basically proving that LED lighting works and its ready, we wouldn’t have the business in components that we have today.

So it really is a combination of all three that it takes to drive the overall LED strategy and we’re looking to manage in a similar way going forward.

Operator

Your next question comes from the line of Christopher Blansett from J. P. Morgan.

Christopher Blansett – J. P. Morgan

I wanted to ask about the penetration or the shipment of your new generation XLamp products. How is that progressing versus overall shipments and then also how is that affecting your mix. Is it safe to say that it’s improving your mix and holding up your ASPs?

Charles Swoboda

What we have going on is, do we have -- I think you’re talking about the XP platform generally, and that has definitely become the primary growth driver for the XLamp product line. We do some incremental growth in the old XR products, but really XP has become the work horse and it’s more than one product. It’s a platform that has the traditional products that are out there that kind of replaced the XRs but also has the XPG version which we’ve seen some nice take up on which is kind of the premium version.

But I would tell you we’re also starting to see some gains even in the NC product line where as you start to look at specific lighting applications, what you start to find out is that depending on what exact problem you’re going to solve, different LEDs and different package combinations work.

So what we’re realizing is, it’s the breadth of our product line that’s really critical to enabling some of these applications because where one company, an XP might be perfect, another one, the XPG is really a lot better, and in the third case the MC solves the problem. So what we’re actually seeing is kind of a broad base. But it’s really products for specific applications.

Christopher Blansett – J. P. Morgan

The second question I had related to the general mix of LEDs for the industry and maybe you can comment. Obviously back lighting for large panels is driving a lot of demand as well as just general lighting. It’s pretty clear that general lighting is a high performance application in order to make that cost effective, and I wanted to get your thoughts on the impact the LED back lighting is having on overall mix. Do you think the overall requirements for the industry are moving up at a faster rate than normal because of these two drivers?

Charles Swoboda

I would tell you that if you look at both the high power segment for general lighting, I think it’s clearly a performance driven application. And in the back lighting, the notebook pushed it to one level. And I think today that level is not at the very highest end, but it’s a higher end product.

But now TV is pushing it to the next level. So it’s interesting that both the large drivers of the industry are also pushing performance and I think obviously that plays to Cree’s strength, but also some of the other technology leaders, and I think that’s helped push the whole market along.

Christopher Blansett – J. P. Morgan

What are you next areas of leverage to improve margins from current levels if you think you have some more upside from here? I think that’s a question many investors are going to start asking now that we’ve seen a significant improvement. What can bring you up to the next level?

Charles Swoboda

I think right now I’d say our focus is on building the scale of the company to address the growth in demand. We’re targeting gross margins in this range next quarter so I’m not really setting an expectation to raise, I’m not trying to raise expectations there.

I think on the operating line, if we can continue to grow the revenue, we’re going to continue to invest in R&D and sales and marketing. I think if you look out longer term, there are additional opportunities there.

We have to invest more but at the same time if we can grow revenue at these types of rates then we should be able to grow revenue faster than that at some point especially when you look out a few quarters.

Operator

Your next question comes from the line of Mark Heller at CLSA.

Mark Heller – CLSA

I’m not sure if you commented, but can you talk about visibility at this point? I know last quarter you were talking about booking orders into the March quarter. Are you now booking orders now into June as well?

Charles Swoboda

Yes we are. I would say that our backlog is as good or better at this point for Q3 than it was last quarter and we have started booking into Q4 as well.

Mark Heller – CLSA

On the CapEx front, can you give us some color on how much of that is going to chip making equipment and how quickly can you bring capacity online as you spend $1 of CapEx. Does it basically take one or two quarters to bring that capacity up?

Charles Swoboda

I would say that I don’t have an exact break out, but generally speaking when we add capacity it’s probably chip capacity is a higher percentage than the packaging capacity, but I don’t have an exact ratio for you.

In terms of the timing though, I would say it’s going to depend. Obviously if you’re some of the fab equipment or bringing up some of the more chip related capacity, that can take a couple of quarters. At the same time, there are some parts that can be done quickly and then on the back end in terms of components, sometimes we can make improvements as quickly as three months.

So to give you an idea, when we say we’re increasing our capital plan here, raising it up, some of it will benefit Q3 and Q4 and some of that will start to build for the next fiscal year. So we can actually increase now and get some benefit this fiscal year and some of that will start to bleed in the next.

So we in kind of that cross over time, but I don’t have a specific percentage for you.

Mark Heller – CLSA

I know you’ve been talking about some cost reduction activity. Is there any internal or cost target that Cree has to reduce, basically let's say 20% a year? Is that the way we should think about it?

Charles Swoboda

Generally speaking, and obviously right now we’re in kind of a different market time, but I would tell you from a general planning standpoint we typically look at a market that we’re going to see ASPs go down 20% to 25% a year, and we’re trying to reduce costs 25% plus to stay ahead of it. That’s generally how we plan the business. It doesn’t always work that way. Sometimes we’re ahead or behind, but that’s the idea.

Mark Heller – CLSA

One or two of your competitors have been talking about a technology called AC LED. I’m just wondering about what your thoughts are and the viability of that technology.

Charles Swoboda

I think it’s an interesting approach. The idea is to basically have an LED which is a DC device no matter how you design it, is to run it in an AC mode. There are some applications where you want to not have to provide that circuitry from a silicon standpoint, so you basically just have the LED operate in both modes.

I think for some applications there seems to be some interest but I think for the large mainstream things that we’re working on, I think you give up efficiency to do that and so it doesn’t drive the value proposition as much. It’s really a function of can you solve the power conversion efficiently enough in a different way.

So at this point I would say there are some applications where it’s interesting but for the mainstream stuff we’re working on, we really think that it’s not the most efficient way to solve the problem. So we don’t know that that’s going to be the winner there.

Operator

Your next question comes from Carter Shoop from Deutsche Bank.

Carter Shoop – Deutsche Bank

I wanted to ask a question on the operating model here and particularly with operating expenses. How should investors think about the incremental OpEx for the company going forward? Obviously this last quarter you did a phenomenal job of keeping that low while sales really drove above expectations there. How should investors think about that longer term as a percentage of sales going forward?

Charles Swoboda

We remain committed to investing in those two areas. I think as we proved over the last quarter or two, business has gone faster than we were targeting, so it’s hard to give you a specific percentage. We’re going to continue to invest in those areas.

I would, generally speaking, I think that the investment will be -- if the revenue continues to grow at these rates, it would be tough to spend at that rate. If revenue slows down a little bit we can probably get it into balance.

Our goal at this point is to really try to maintain the gross margins in the near term and then figure out how we continue that investment not to try to drive more operating leverage in the next couple of quarters, but we want to make that investment because we think that’s the key to driving further revenue growth in FY ‘11 and beyond.

So for us we are focused on making those investments. We’re trying to be smart about it and I don’t think we’re trying to constrain ourselves too much there because we don’t know that that incremental improvement in the short term gets us to the long term goal. But again I don’t have a specific number for you or a model to give you at this point.

Carter Shoop – Deutsche Bank

So for longer term planning, it doesn’t sound like any particular formula that you guys are holding to, just as opportunities arise, you’re going to spend as you see fit.

Charles Swoboda

I think it would be tough to give you a specific model. Obviously if you look at where we’re at today versus where we thought we’d be in June, we’re probably a year ahead of plans. So I think at this point, we’re just dealing with a fast growing market and we’re trying to be prudent in our investments but also make sure we put ourselves in place to grow the business, but again, no specific new model for you at this point.

Carter Shoop – Deutsche Bank

Within the lighting market without divulging too much information that your competitors can glean from this call, could you give us a little more color? You mentioned that within lighting you’re focusing on the outdoor bulb replacement and other indoor applications. I was hoping to get a little bit more granularity there if possible.

Charles Swoboda

I’m not sure there’s a lot to tell you more there. That’s kind of how we break it down. Outdoors is street lighting and it’s the municipal markets and the bulb replacement is exactly what it sounds like.

As far as other indoor, we’re talking about other generally speaking fixture light products, so other companies building typically indoor lighting fixtures for a variety of applications. Obviously that’s a very diverse marketplace. But I don’t have any more specific color to give you there.

Carter Shoop – Deutsche Bank

When you look forward a year, how do you see the overall revenue mix shifting between chips, components and fixtures. I know you don’t want to provide details about percentage of sales for those but where do you see the fastest growing segment over the next year?

Charles Swoboda

I don’t think chips is going to grow in terms of dollars so it may grow a little bit, but it’ll probably become a lower percentage over time. We want to maintain a good scale there but we’re also not looking to drive that from a percentage standpoint growth.

I think lighting systems will grow but unlikely it will grow as fast as components. So you should expect the components business will become a larger percentage of the overall.

Operator

Your next question comes from Ahmar Zaman from UBS.

Ahmar Zaman – UBS

Great quarter. Congratulations on the execution. I’m trying to figure out how conservative your March revenue guidance is. You grew inventory by 10% sequentially in December despite being capacity constrained as you said. Can you assume that you work down the inventory going forward to make sure you don’t leave any unmet demand?

Charles Swoboda

One of the things you probably can’t tell from the inventory, I don’t know if John broke it out in his comments earlier, but while we grew inventory that was actually in WIP and raw materials. We actually, finished goods declined quarter over quarter. So you can see that we actually are working very hard to meet demand there last quarter and I think as we go forward, it’s a factory execution challenge.

Keep in mind that this is a quarter where we have to run our factories and we have to try to deal with the Chinese New Year holiday so that will limit the number of production days in the quarter which does give us less opportunity to meet overall demand in the March quarter.

I think we’re trying to give you a range of targets that we think is reasonable given what we can see in terms of the execution out there and it’s going to come down to in the end, how well we run through these 13 weeks and manage the shut down through the holiday and ramp back up.

Ahmar Zaman – UBS

On your gross margin guidance of 47% plus or minus, assuming that you can execute your factory run going forward, is that the new base that we can expect going forward?

Charles Swoboda

I think it’s obviously our target for Q3 and we could be in a similar range in Q4 if demand continues to be strong. As far as longer term, I think it’s premature to update that model. I think we have to keep in mind that we do have other competitors in this space and it’s going to be a bit of a function of what does the adoption rate do to overall growth and then what happens on the competitive factors. It would be premature to change, to put that as a long term model at this point.

Ahmar Zaman – UBS

You mentioned about China and the U.S. being the strongest growth markets for you in the quarter. Can you tell us what percentage of sales China was in the quarter?

Charles Swoboda

We don’t break it out on a quarterly basis but I know it increased slightly from where we were at the end of the year. I don’t have the specific numbers in front of me but I think it’s in our K, so if you look at where it is at in our K, I think it’s up slightly from there.

Ahmar Zaman – UBS

Recently I’ve seen some articles about some issues with street lights in areas where there’s snow and ice where the street lights, because these don’t emit any heat the street lights could be at risk. Do you have any comments on that?

Charles Swoboda

It’s actually a traffic signal, is what they’re describing, at least the articles I saw. So you’re talking about the actual traffic signals which is a fairly small percentage of the overall market. But LEDs are very energy efficient. They don’t generate a lot of heat so I did see an article. I forget what newspaper it was in about that.

I think like any other technology there’s probably a fairly simple solution from what we’ve heard is that in the cold weather climates, just to add a few heating elements into there in terms of into the lens itself.

So I think it’s interesting. It kind of proves that LED lighting is a lot more energy efficient and I think the corollary to that is that while you have that one problem, I wonder how many times they have traffic lights that are out in the conventional technology that cause issues that they never talk about.

What I hear within the industry is that it was an interesting article but it’s not a serious concern. It’s a fairly simple engineering solution to it where it matters and they've moved on.

Ahmar Zaman – UBS

On gross margins again, your incremental gross margin in the quarter was about 67%. Is that how we should think about incremental gross margin going forward?

Charles Swoboda

I think you should think about it as 47% plus or minus in Q3. I don’t have any other way. I don’t want to necessarily have you read too much into that at this point in terms of that incremental growth.

Operator

Your next question comes from Hans Mosesmann from Raymond James.

Hans Mosesmann - Raymond James

Can you tell us what MOCVD lead times are these days equipment wise?

Charles Swoboda

From what I hear they are, I think from what people are talking about they’re out in the six month range, but I don’t know that would be accurate to apply that to Cree at this point.

Hans Mosesmann - Raymond James

Why is that? Are you making your own equipment? Are you outsourcing?

Charles Swoboda

I can’t answer that question for you. It’s proprietary.

Hans Mosesmann - Raymond James

How much of your production if any is based on silicon carbide and have you moved to sapphire and what’s the mix?

Charles Swoboda

The majority is on silicon carbide so I would say you should model essentially almost all of it. We are doing some sapphire work but it’s very relatively small volumes at this point.

Hans Mosesmann - Raymond James

In terms of things stabilizing, lead times, in terms of prices and lead times expanding, would you expect ASPs to move up because they’ve been stable. They haven’t actually gone up. Would you expect to see that if the current environment continues?

Charles Swoboda

I’m not sure about that because I think especially because -- the big driver for Cree is the lighting segment. You may see some of that on the back lighting side which doesn’t affect us much just because that market is a little bit more sensitive to that.

I think in lighting, because the cost of LED lighting is a key driver to getting adoption over the long run, what we see is not only our behavior but some of the other competitors in the market, I think we all know that we have to continue to drive the cost down and slash the price down over time to open up the market. So I don’t think we’re actually going to see them rise.

Hans Mosesmann - Raymond James

Do you think you’re gaining market share versus your European competitor?

Charles Swoboda

I think we have to look and see what they’re disclosing about their growth. I feel like we’re doing pretty darn well in the lighting segments we’re focused on today. I feel like we’re having more than our share of success. But I think it based a lot on product performance right now.

But that being said we take these other guys very seriously and we do see a renewed focus by other competitors of trying to be successful in the lighting market. So we expect to have a number of serious competitors over time.

Operator

Your next question comes from the line of Jonathan Dorsheimer from Cannacord Adams.

Jonathan Dorsheimer – Cannacord Adams

Congratulations on a solid execution. In the quarter, could you break out or give any additional color on what percentage came from capacity expansion and what percentage came from seeing a shift from chip customers that ended up taking your components?

Charles Swoboda

I think the chip product line actually had some small growth quarter to quarter so I think in terms of our lighting business I would say it was primarily from new customers and capacity expansion.

Jonathan Dorsheimer – Cannacord Adams

In terms of if you look at your components business, where do you see the biggest cost roadmap? Do you see it equally spread between epi chip and package or does one area stand out in terms of if we look out a year or two years? What does that road map look like?

Charles Swoboda

I think they all have factors. I think if you look at it on a pure cost basis you might get a different answer as to which ones, it’s going to vary by application I guess is the point. So some applications are pushing the performance limits of what we can do from an epi technology standpoint. Some are really kind of packaging constrained.

I think it kind of varies by application. What’s happening in lighting from a component standpoint is the products are really kind of evolving into solving specific problems. So the product you sell to solve a high power spot type source application might be very different than the product you evolve to do a more broad based kind of an area light versus it might be different from something that’s optimized to be put in a streetlight for example.

So I think there’s no good one generic answer. I think they all remain important drivers to the technology, but I think they’re going to evolve differently depending on which application.

Jonathan Dorsheimer – Cannacord Adams

Just digging into the epi a little bit more, if we look at your success that you’ve had on the 100 millimeter and now as you start to focus on the 150, what we’ve seen on the 100 millimeter on sapphire is typically a little counter intuitive, but a yield increase of roughly 3% to 5%. And we would expect as you go to 150 to also see yield increase. I’m curious as to your thoughts as you’ve gone through this transition on the 100 and then as you’re staring to explore 150 whether or not you think you’ll continue to see a yield step up as you go to the larger wafers and also on the 100 is that basically consistent with the silicon carbide?

Charles Swoboda

I would say that I think independent of the substrates that those trends kind of hold and they go beyond just LEDs. So the traditional rule of thumb in silicon is you get a yield improvement as well and one of the most simple reasons is that larger wafers have less edge area, and so effectively you lose on a percentage basis, you have less edge die loss when you go to larger wafers.

So I think we saw that benefit when we went to 100 millimeter and I’d expect that will hold true to 150 millimeter, kind of across the board.

Jonathan Dorsheimer – Cannacord Adams

As you look out not getting into ASPs but in terms of a cost per lumen type of target on the lighting market, any comments on where you think either from Cree or from an industry perspective you think we’ll be maybe two years out?

Charles Swoboda

I don’t have an updated projection for you there. I’ll have to think about that, but we’ve kind of put some general charts out there, but I don’t have a specific target for you.

Operator

As we have run out of time, we will not be taking any more questions. I'll now turn the call back over to the presenters for closing remarks.

Charles Swoboda

Thank you all for your time today. We appreciate your interest and support and look forward to reporting our third quarter of fiscal year 2010 results on April 20, 2010. Good night.

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