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Cree, Inc, (NASDAQ:CREE)

Q3 2014 Earnings Conference Call

April 22, 2014 17:00 ET

Executives

Raiford Garrabrant - Director, IR

Chuck Swoboda - Chairman & CEO

Mike McDevitt - CFO

Analysts

Paul Coster - JPMorgan

Brian Lee - Goldman Sachs

Andrew Huang - Sterne, Agee

Jed Dorsheimer - Canaccord

Vishal Shah - Deutsche Bank

Brandon Heiken - Credit Suisse

Edwin Mok - Needham & Company

Mark Heller - CLSA

Craig Irwin - Wedbush

Harsh Kumar - Stephens

Avinash Kant - D.A. Davidson

Operator

Good afternoon my name is Patrick and I will be your conference facilitator today. (Operator Instructions). As a reminder ladies and gentlemen this conference is being recorded today, Tuesday, April 22nd. Thank you.

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

Raiford Garrabrant

Thank you, Patrick, and good afternoon. Welcome to Cree's third quarter fiscal 2014 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 Mike McDevitt, our CFO, will report on our results for the third quarter of fiscal year 2014. 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 posted in the Investor Relations section of our website at www.cree.com under Quarterly Results on the Financial Information tab.

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 and 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 the SEC filings noted in the release mention important factors that could cause actual results to differ materially. Also, we'd like to note that we will be limiting our comments regarding Cree's third quarter of fiscal year 2014 to a discussion of the information included in our earnings release. 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 ask that analyst limit themselves to one question and one follow-up. 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 May 6, 2014.

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

Chuck Swoboda

Thank you Raiford. Q3 was a solid quarter with revenue of $405 million and non-GAAP net income of $47.7 million or $0.39 per diluted share. Revenue and operating income were in-line with our target range and the business is well-positioned to grow in Q4. The sales trends in Q3 were as follows, lighting sales increased 35% year-over-year to $177 million, LED sales increased 3% year-over-year to $201 million and Power and RF sales increased 21% year-over-year to $27.4 million.

Non-GAAP gross margin was 37.8% in Q3 which was within our target range. LED and Power and RF margins were inline with our targets while lighting was slightly lower as LED bulb price reductions offset a more favorable lighting mix. LED bulb cost reductions that support the lower price points have already being implemented and are targeted to benefit Q4. Non-GAAP operating profit increased 20% year-over-year to $53.6 million in Q3 which is inline with our target range for the quarter and non-GAAP operating margin increased 30 basis points year-over-year to 13.2%.

These results once again demonstrate our ability to deliver strong operating results while continuing to make longer term investments in new technology and building the Cree brand.

Cash and investments increased $39 million to $1.22 billion which puts us in a great position to increase the level of capacity investments over the next year which Mike McDevitt will explain in his remarks. We’re also in the process of working at potential strategic opportunities to expand the Cree product portfolio and gain access to new customers. Company backlog for Q4 is ahead at this point last quarter and inline with normal Q4 booking trends and a targeted growth in sales. We’re forecasting growth in all three product segments in Q4 led by double digit growth in lighting in both LED fixtures and LED bulb.

LED component sales are also forecasted to grow nicely in Q4. As the leader in LED lightning lighting we continue to take advantage of the global shift to LED lighting and our strategy to use new product innovation to drive our growth by taking share from traditional technologies. The strategy is working and we’re well-positioned to continue growing our business in fiscal 2015 as LED adoption increases.

Our brand investments have produced good results and we plan to continue to invest in this area in the year ahead.

I will now turn the call over to Mike McDevitt to review our third quarter financial results in more detail as well as our targets for the fourth quarter of fiscal 2014.

Mike McDevitt

Thank you Chuck. 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 to the corresponding GAAP measures for all quarters mentioned on this call is posted on our website along with a historical summary of other key metrics.

For the third quarter of fiscal 2014 revenue increased 16% year-over-year to 405 million which was in the middle of our targeted range of 390 million to 420 million. GAAP earnings increased 27% year-over-year to 28 million or $0.23 per diluted share for the third quarter of fiscal 2014 and non-GAAP earnings increased 17% year-over-year to 48 million or $0.39 per diluted share.

Non-GAAP earnings excluded 20 million of expense net of tax or $0.16 per diluted share from the amortization of acquired intangibles and stock based compensation. Revenue, pretax income and GAAP and non-GAAP earnings per share were all in line with our target ranges.

Q3 GAAP gross margins were 37% and non-GAAP gross margins were 37.8% which excludes 3.1 million of stock based compensation. This was within our target ranges. Fiscal 2014 third quarter revenue and gross profit for our reportable segments were as follows; LED products revenue grew 3% year-over-year to 201 million and gross profit grew 7% to 91.6 million for a 45.6% gross margin which was a 180 basis point increase year-over-year. Our Q3 LED gross profit and margin increase was due to a combination of higher sales, lower cost new products cost reductions and higher factory utilization.

Lighting products revenue grew 35% year-over-year to a 177 million and gross profit grew 21% year-over-year to 48.5 million or a 27.4% gross margin. Lighting fixtures revenue had strong double digit growth year-over-year. Gross profit and margin growth was slower than revenue growth as we had a full quarter of LED bulb sales this year versus last year. Power and RF products revenue grew 21% year-over-year to 27 million and gross profit grew 30% year-over-year to 15.7 million for a 57.1% gross margin which was a 410 basis point increase year-over-year. The revenue in gross profit growth was due to higher sales, cost reductions and higher factory utilization.

In determining gross profit for our segments we do not allocate certain employee benefit cost, stock-based compensation and acquisition related costs. These non-allocated costs totaled 5.8 million for the third quarter of fiscal 2014 and are included to reconcile through a 150 million GAAP gross profit.

Operating expenses for Q3 were 120 million on a GAAP basis and 100 million on a non-GAAP basis both of which were within our targeted range. Non-GAAP operating expenses exclude approximately 30 million of stock-based compensation expense and 7 million of charges for amortization of acquired intangibles.

Our non-GAAP operating income grew 19% year-over-year to 54 million as we realized a 140 basis point improvement in our operating leverage year-over-year. Net interest income and other for the quarter was 3.2 million. Our Q3 GAAP and non-GAAP tax rate was 16% for the quarter which was less than our 21% target for Q3 primarily due to the recognition of discreet tax benefit.

We ended the quarter with 1.2 billion in cash and investments a 39 million increase sequentially. For the quarter cash from operations was 60 million and capital expenditures were 41 million including 5 million related to patents which resulted in a free cash flow of 19 million.

Day sales outstanding was 49 days as compared to 46 days at the end of December which is inline with our 50 day plus or minus target range. Inventory days on hand increased to 89 days as compared to 81 days for the end of December. Our inventory growth is primarily raw materials and work in process to support our targeted lighting and LED growth. We’re raising our inventory days on hand target from 80 to 90 days plus or minus to reflect the increased lighting mix as we plan greater flexibility to support our quick ship program and better service our sales channels.

Property, plant and equipment additions were 36 million in the third quarter. For fiscal 2014 we have raised our target to 175 million plus or minus of property, plant and equipment spending to support our new product priorities and provide incremental capacity as needed. This increase from last quarter’s forecast is primarily to make capacity investments to support forecasted growth in the business over the next year and infrastructure investments to support longer term forecasted growth.

At this time we target Q4 revenue to increase to a range of 430 million to 460 million which is comprised of double digit growth in lighting sales, LED growing single digits and Power and RF sales slightly higher.

We target Q4 non-GAAP gross margins to be similar to Q3 at 37.5% plus or minus and GAAP gross margins to be 36.8% plus or minus. This Q4 target is based on the number of factors that could vary including overall demand, product mix, factory execution and a competitive environment. Our GAAP gross margin targets include stock based compensation expense of approximately 3.2 million while our non-GAAP targets do not. We’re targeting Q4 operating expenses to increase approximately 7 million sequentially due primarily to higher sales cost associated with higher targeted revenue. The marketing cost to support two major lighting trade shows within the quarter increased patent related legal cost and a slight increase to our Cree brand spending.

We target both GAAP and non-GAAP operating profit to grow faster than revenue sequentially even with the incremental operating expense spend. Our GAAP operating expense targets include non-cash stock based compensation expense of approximately 30 million and charges for amortization of acquired intangibles in the amount of 7 million.

Loss of disposal of assets is target to be similar to Q3. Net interest income and other is targeted to be approximately 3.5 million for Q4. We target our Q4 tax rate to be 21%. As a reminder our Q4 and fiscal 2014 tax rates will fluctuate based on our overall earnings, the tax jurisdictions in which our income is actually earned. The potential reinstatement of the U.S. R&D Tax Credit and other tax benefits that may or may not become available to Cree in future periods.

GAAP net income for Q4 is targeted to be between 28 million to 36 million. Based on an estimated 124 million diluted shares outstanding our GAAP EPS target is between $0.23 to $0.29 per diluted share. Non-GAAP net income is targeted to be between 47 million and 55 million or $0.38 to $0.44 per diluted share. Our non-GAAP EPS target excludes amortization of acquired intangibles and non-cash stock-based compensation in the amount of $0.15 per share.

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

Chuck Swoboda

Thanks Mike. We remain focused on four priorities to drive our growth in fiscal 2014. Our first priority is to continue to lead with innovation across our product line and drive the cost parity with conventional technology. In lighting we continue to make great progress on both fixtures and bulbs. Our new lighting fixture products continue to gain traction in the market which helped drive sales growth in the quarter. We saw good sales growth in indoor and outdoor even grew slightly despite an extremely cold winter in the Central and North Eastern U.S.

From an R&D standpoint we established a completely new efficiency benchmark for lighting systems with the first 200 lumen per watt LED concept luminaire that is more than twice the efficiency of the best linear fluorescent luminaires. We also reinvented the concept of lighting controls with our self-programming one button SmartCast technology, which reduces energy consumption by more than 70%.

We continue to raise the bar in LED price performance with our new ZR LED troffer which delivers excellent light quality and aesthetics for under a $100. We extended our breakthrough XSP street light series with the XSP Area and XSP W Wall Pack products. Our lighting fixture product line continue to build momentum in Q3 with good business growth and new product momentum that is not only closing the GAAP with conventional technology but also redefining what is possible in lighting.

We made the Cree LED bulb brighter and more affordable in Q3 as our relentless focus on innovation enable us to reduce pricing and expand the LED bulb product line with the introduction of a 100 watt warm and cool white LED replacement bulbs. LED bulb sales to consumers increased again in Q3 as the Cree LED bulb gained momentum and brand recognition. As I discussed last quarter we continue to work with the Home Depot to test the price to consumers and the trade-off between volume and margin. The lower retail price points we announced a few weeks ago across most of the Cree LED bulb product line have already increased sales and confirm that there are significantly more opportunity to drive LED adoption.

We remain focused on product innovation to expand our product offering and develop even lower cost next generation bulb to enable new price points and further adoption. We’re reinvesting most of the profits to fund additional marketing investments and generate even more awareness that the Cree LED bulb pays for itself.

In LEDs we continue to push the boundaries of LED performance as we demonstrated the first LED component to break the 300 lumen per watt performance barrier by demonstrating a 303 lumen per watt white high power LED. From a product standpoint we have established a new class of high density lighting components by releasing a series of products across our components platforms. These new product families utilize our market leading LED chip technology to set new standards in lumen density and deliver the first family of high density lighting components. We introduced the XLamp XB-H high-density LED component which delivers unrivaled lumen density and optical control from a discreet LED component. We introduced a new series of CXA high-density arrays that double the white output of existing CXA arrays and enable new applications that have previously not been able to switch to LED.

We also introduced higher density 6000 and 8000 lumen versions of our LMH2 LED module family which enable the complete replacement of ceramic-metal-halide lamps. In Power and RF we continue to make incremental sales progress and win new designs. The power product line delivered incremental growth in the quarter as we started to see some of the first small volume applications for our silicon-carbide MOSFETs go into production.

This is likely to be a slow ramp but the design win activity continues to indicate that we’re on the right track. The RF product family also continues to gain momentum as more companies are working to bring to bring gallium nitride RF devices based on our gallium nitride chips in the wireless infrastructure application. This is primarily design activity at the stage but based on the increased activity we target additional gallium nitride based telecom hardware to be released over the next year.

Our second priority is to build the Cree brand and selling the Cree bulb continues to be the foundation of our brand strategy. The market has responded to the success of the Cree LED bulb with new products from a number of different companies. Despite the new competing products Cree LED bulb sales continue to grow in Q3. The increased choice is great for consumers and good for LED adoption. Our partnership with the Home Depot continues to grow with the increase in LED bulb sales but we must remain focused at earning our place in this market with new products that move the market and give consumers more reasons to switch to LED.

We look forward to continuing to work together with the Home Depot to enable this market and continue to evaluate complimentary channels as appropriate. Our third priority is to focus on select market segments but we can upgrade existing lighting and drive adoption. We have made good progress on new applications like automotive dealership lighting and we continue to expand this activity. We also continue to test new channel approaches to engage lighting owners with complete solutions.

We have had some small scale initial success but we’re still in the early stages of determining the most effective way to do this. However it is clear that there will be, well there will likely be a number of new approaches that evolve to sell LED lightings to the very large and mostly untapped base in install lighting customers. Our fourth priority is to build on our new product momentum and continue to grow revenue and profits.

For the first three quarters of fiscal 2014 we continue to demonstrate that we’re on the right track with revenue up 20% from the first three quarters of fiscal 2013 and non-GAAP operating profit up 32%, all while making significant investments in new technology, sales channels and building the Cree brand.

As I mentioned earlier Q4, total company backlog is ahead at this point last quarter and inline with normal Q4 booking trends and the targeted growth in sales. We are forecasting growth in all three product segments in Q4 led by LED fixtures and LED bulbs. Factory utilization remains high; we’re expanding capacity in the short term and making investments for the mid to longer term. Execution is a critical factor to supporting growth in all three product lines, which continue to operate with short lead times. This adds variability to our forecast for the quarter.

Based on our current backlog, forecast and trends in the business we’re targeting strong Q4 revenue growth in a range of $430 million to $460 million which is comprised of double digit growth in lighting sale driven by strong growth in both LED fixtures and LED bulbs, single digit growth in LEDs and slightly higher Power and RF sales.

We target non-GAAP gross margins to be similar to Q3 at 37.5% plus or minus. We target non-GAAP operating expenses to increase about $7 million in Q4, even with the increased investments we target non-GAAP operating profit to sequentially grow faster than sales and target non-GAAP earnings to increase to a range of $0.38 to $0.44 per diluted share.

Please note that our non-GAAP targets exclude amortization of intangibles, stock based compensation expense and the related tax effects. As a technology company we’re passionate about fundamentally changing the customers lighting experience for the better. Our strategy is working but we’re still just getting started. Our balance sheet gives us the flexibility to continue to invest for the future. We currently target investments in capacity which Mike described earlier and strategic opportunities to enhance the Cree portfolio.

We have begun to look as strategic opportunities across all our product lines. We’re very comfortable with our current product portfolio we believe some opportunities may emerge over the next 24 months to leverage the Cree brand as the shift to new technology accelerates and industry begins to go through a consolidation phase. The strength of our operating model gives us the flexibility to make these investments and continue to maintain a strong balance sheet to support the future growth as we could remain focused on our long term customer goal of a 100% upgrade to LED lighting.

We will now take analyst questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Paul Coster with JPMorgan. Your line is open.

Paul Coster – JPMorgan

The comments are already around strategic opportunity, why now? What kind of consolidation do you’ve in mind? And why over the next 24 months is it suddenly in your wheelhouse?

Chuck Swoboda

Yes Paul I think it's more of an indication that as we see LED adoption picking up pretty much across the industry, I think there is a perspective that as that accelerates the landscape is going to change and I think the opportunities will start to become obvious that those that can access the customers and build brand and have channel that there are opportunities to combine maybe product portfolios or use some deals to access new markets. Well that being said, this is not an eminent thing. It's something that I thought that was important that we let people know we’re starting to look at more seriously than we have for the last couple of years.

Paul Coster – JPMorgan

Okay and I have another question, little bit more sort of picky but you have increased your inventory levels intentionally in order to facilitate the quick shift and to better service your channels. Can you give us a little bit of color to what’s going on here? What it means in terms of foregone sale or margins or mix that we think should therefore improve with using a balance sheet in this manner?

Chuck Swoboda

Yes Paul actually the first thing I think is that part of the build you saw last quarter is actually just in raw materials. It's the nature of trying to scale up the production to be in much higher volume supply of both fixtures and bulbs. So that’s kind of the first phase, it's just really building of that supply chain. The second piece is the finished goods which is really in quick ship in bulbs and we’ve two different ideas there, in the quick ship we have a series of high runner fixtures that as we start to do more projects that are relatively not long design cycle projects but ones where someone decides to do a building renovation having that inventory is critical to serving the customer. So this is really for a series of high running products and then when it comes to bulb you know we explained last quarter that we went through a transition with Home Depot where they were for the first three quarters holding strategic inventory and really let it shift it to us and so as that business scales up some of that is also flowing to us.

So I think it's less about margin and more about servicing two growing pieces of the business in a way that we think it's the most appropriate to meet the customer expectations.

Operator

Our next question comes from Brian Lee with Goldman Sachs. Your line is open.

Brian Lee - Goldman Sachs

I guess first off on the margin outlook. I was just wondering if you could help delineate a little bit around the different moving pieces here for June and the near term and in terms of what’s having an impact. So if I look at commercial I would assume you’re having a higher mix of outdoor versus last quarter on seasonality and then in consumer lighting, the lower price points that you recently introduced certainly for June, for a full quarter here and lastly, the additional fixed cost that I assume you would be incurring on the increased capital investments that you’re making here. I’m just wondering how much of the impact on the near term margin profile each of these moving pieces are having and are they all effectively, directionally weighing on the margin outlook and then I’ve a follow-up.

Chuck Swoboda

Yes Brian I would say that it's more about product mix than it is about the fixed cost investment. So while we’re making those -- the way we’re doing that it's essentially fairly highly utilized right now, as those come on I would expect them to turn on and to support the additional revenue. So I don’t see that as the big swing factor. If you look at within the company, really what you’ve is two things going on, right? You’ve lighting has become a higher percentage of the total so that affects the overall company gross margin and mix within lighting and so what we have is that last quarter we did get a swing to a more commercial or fixture products, but the reality is that that was offset by the fact that we implemented the cost reductions.

Going forward this quarter lighting is the fastest growing segment and we have both fixtures and bulbs growing. So I think what you’re looking at more than anything is a product mix that’s driving the guidance which is pretty similar. So what that suggest is as we think we can make cost reductions in the product line so that even with the increased mix of lighting we can overall deliver an overall gross margin quarter-over-quarter and if you step back a little bit the way we kind of think about that is, the bigger picture is we control cost which is what we’re working on, mix is going to move around, we’re not going to control that overall but we’re pretty confident that with revenue growth really in all the segments that we can deliver some operating margin over the mid-to-longer term and so that’s kind of the big picture the way we think about that.

Brian Lee - Goldman Sachs

My follow-up is on LED products. Just wondering if you could provide a bit more color on expectations for pricing trends in that segment, it sounds like you guys have sounded a bit more optimistic on that front in recent quarters and given how tight you’re on capacity. I’m wondering if you’re thinking about as the more of a potential tailwind to the margin profile on that particular business segment. Thank you.

Chuck Swoboda

Yes so LED products in the short term I would say the competitive environment, well otherwise known as the pricing environment is pretty similar to what it has been over the last few quarters and I would say that’s what we’re targeting for Q4. With that being said there is obviously, there are two things to keep in mind. One, we have a fairly different LED components business than most people. Essentially, very focused on the high power, high density segment and I think you can see the difference in our business, in our margins versus a lot of the other guys out there. But with that being said, the natural question is as we start to increase capacity because we’re fully utilized and you start to hear other people in the industry talk about rising utilization, there is an obvious semi-cycle that you would think is coming. We don’t see it yet but I do think at some point we will see that tightness that will probably will do two things, we will see the lead times move out first and then we will see some pricing power shift to the suppliers. But we’re not there yet and it's not in our target. So I think it's likely but little early and I think the reason we haven't seen it is that well most of the major players our senses are pretty full in terms of capacity utilization. I sense there is still a bit of extra capacity in kind of that next tier that hasn’t fully being utilized in the market.

Operator

Our next question comes from Andrew Huang with Sterne, Agee. Your line is open.

Andrew Huang - Sterne, Agee

The first is if I take your June quarter guidance to get to the full year for fiscal ’14 and then compare that to fiscal ’13, it looks like revenue will be up around 20%, gross margin is down slightly. Operating expense dollars up around 15% which gets you to about mid-20% EPS growth, so when I look at the fiscal ’15 can you give us some general guidance of how to think about gross margins and operating leverage and then I have a follow-up.

Mike McDevitt

Hey Andrew you’ve done more math while we’re on the call than I have on those metrics but let me give you kind of some high level. So as I think about gross margin, I look at it a couple of different ways. We think there are things we’re fairly confident that there are cost reductions that we can get to in Power and RF, in the LED segment and in the lighting segment. So we feel comfortable that there is lots of innovation that will drive cost down. The market is going to have some effect on how much of that cost could be margin versus it's just price erosion and it's a little hard to call that right now but that’s the piece we control on the one side.

From a company gross margin standpoint or even a segment gross margin one of the challenges is as the mix changes let’s just use within lighting, the mix between fixtures and bulbs or even the mix within different types of fixtures there is a swing factor. So the way I kind of think about it is we’re going to work on the cost reductions, we’re going to continue to drive revenue growth and we currently see the opportunity to grow revenue obviously in lighting both fixtures and bulbs but also we see growth opportunities next year in the Power and RF as well as on the LED segment. So however you want to model that mix that’s going to drive one of the variable to the equation from -- as I step back the way I think about it is that we can drive the revenue growth we’re targeting, I think we can deliver operating leverage and the gross margin will kind of take care of itself because it's more about mix between those businesses than major swings within them, that’s conceit at this point.

Andrew Huang - Sterne, Agee

And then on your comments on the strategic transaction, if you look at the lighting industry today like all the big players here in North America if you look at their home pages you see like maybe 15 different brands under -- whether it's Acuity or Copper or Phillips. So I’m just curious how you feel about having other brands under the Cree name or will you instead maybe focused more on the channel?

Chuck Swoboda

Andrew, honestly we’re looking at both opportunities. I think that we’re making a pretty big Cree brand investment but that doesn’t mean we would be against if there was something out there that really is complimentary to the overall portfolio we consider doing that. And from a channel standpoint I think it's the same idea, right? What customers are underserved that we think that with our product portfolio and the other investments we’re making could we generate more benefit and again I want to caution, I know that I put it out there in the script. I did that just because I don’t want people to be surprised if and when we get to the point of doing something but it's more about just of kind of share little bit about of our thinking. We get asked that question a lot by investors, is M&A on the horizon? The answer is we’re working on it. But it's not eminent or short term and I would say right now if you try to guess if it's a product or [ph] channel you would be wrong right now because we haven't decided yet, because we’re still looking at lots of different things and I don’t think it's -- as I said this is something I think will evolve over the next couple of years.

Operator

Our next question comes from Jed Dorsheimer with Canaccord. Your line is open.

Jed Dorsheimer - Canaccord

My first is around on the lighting products. It's interesting to see that you guys have really emerged as one of the leading LED bulb manufactures here, 10 years ago I wouldn’t have guessed that. My question is around channel and sort of how we should read into lack of a contract with Home Depot. It seems as if from your scripted comments that the relationship is strong as ever, it looks as if the products are selling pretty well and you have got elasticity. So I guess my question is will we, is this sort of the new normal should we expect that some relationship would be inked or was that just sort of a startup phase to get the bulb into the market? And then I’ve a follow-up.

Chuck Swoboda

Jed, I think you can anticipate where that answer is going. Especially when we’re starting up, when you’re a brand you’re a consumer brand in a brand new channel. There is both sides kind of want to go through the process of having a fairly formal relationship. I think now we got a formal relationship but it's called a very large business that both of us are benefiting from and so I think that the concept of the contract was really an early stage piece and I think at this point this is a new normal because it's really the business relationship that’s driving it and frankly that relationship is as good as it ever has been in the last year and so I feel like, it's like anything else. If both companies benefit from growing the business, that’s usually stronger than anything else you can do.

Jed Dorsheimer - Canaccord

I guess the obvious is to that end should we start seeing Cree pop up in some additional channels and then just as my second question looking at or maybe as a follow-up to one of the previous questions, in the LED components one of the things that’s difficult about trying to model your company is percentage of what’s captive versus merchant in the LED components. So should we think, your comments about sort of hoping to see some pricing power in a positive semi-cycle, should we expect that some of that leverage will be used or most of that leverage will be used internally in terms of captive capacity for the lighting products business as a tool to further differentiate your lighting products business or how should we understand that mix?

Chuck Swoboda

So let me catch the end of the first one. So on additional channels what we have done so far Home Depot is our primary focus, we have launched the bulb in the commercial distribution and it's got a nice I think we’re getting some nice traction but it's not at the scale of selling bulbs to the Home Depot. So really our 98% of our effort is on working with the Home Depot and frankly scaling up that business which takes up most of the energy. I think we will look at some other complimentary channels Jed but really as a secondary thing I would, you shouldn’t expect any significant announcements there in the near term because frankly with the growth at Home Depot and the things we’re doing with them as well as what we’re doing in distribution, I just don’t think it's through what -- we don’t need that distraction in the short term and frankly when we do it, it's really about accessing a demographic of customer that we think we’re not getting to today. So by complimentary it's really is there a customer that we don’t access in one of our current channel. To me secondary, it will happen eventually but I think it's a little bit more mid to longer term.

To your LED components question you know, clearly, people look at the LED segment and they think it's a business that’s up some amount year-over-year. I think roughly probably about I don’t know 9% - 10% something like that year-over-year. So the merchant side has grown. Obviously if you look at the lighting business you can pretty much get a proxy that that part of its growing even faster. With that being said I think what happens, as the pricing changes that will benefit our merchant business, so there is some benefit there but we’re little bit unique already because I think we already have pricing power slightly different than others because we’re in a fairly high power -- we are in a segment that’s pretty much about technology anyways.

In terms of will we keep that to help fixture business, how will we use that? In my mind there is really two different ways to think about it. We’re in the Merchant LED components business and we plan to stay there for the indefinite future. So to me we will get the benefit there just because the market will have, there will be more demand and supply and we will get some pricing benefit. In terms of the captive side of it I think it's more important to think about it from a we want much better ability to access the technology to keep the innovations going. I think one of the challenges will be, if we get into a short supply situation you’ve to make some comprises if you can’t get the LEDs you have by having our own factory I think it gives us -- we are in a better position to manage through that and maybe if it was just a pure buy/sell thing on that side of the business.

Operator

Our next question comes from Vishal Shah with Deutsche Bank. Your line is open.

Vishal Shah - Deutsche Bank

Just wanted to better understand your OpEx trends, OpEx is going to be up about 7 million in Q4, how should we think about the areas of investment -- I think you will be spending in the near term and also how should we be think about OpEx growth in 2015 in terms of in relationship to the revenue growth.

Mike McDevitt

Yes 7 million, this is a bit of a unique quarter so what we have going on here is that you’ve got part of that growth is just a timing of widening [ph] marketing season. So the way to think about it is that in spring we have two major trade shows light and building which happens every other year and then we have the light there and between those two that’s a big chunk of money for the lighting and the LED business. So that’s one of the big marketing spend numbers that’s different in this quarter than in most other times. We also have, the fact is that when lighting grows, specifically lighting fixtures that drives the sales, incremental sales cost. So that’s just going to scale with the growth in the fixture business. Then kind of more of a non-normal items or maybe not within that trend is there is some incremental spending on the brand and frankly bulb advertising that you will see later this quarter and that’s just really a time to refresh some of the messaging that we’re doing out there.

So I think there are logical things, we think it's still on an overall basis. We’re going to get more return for that in the short term and honestly long term we think those are great investments. As far as how do you think about modeling ’15? The way we’re thinking about it is that the revenue growth should faster than the OpEx growth. So our goal next year is to deliver operating leverage of some amount.

Obviously it's going to fluctuate a bit based on product mix and where those investments are but overall our targets are as to grow revenue and grow operating profit a bit faster than that.

Operator

Thank you. Our next question comes from Brandon Heiken with Credit Suisse. Your line is open.

Brandon Heiken - Credit Suisse

I was hoping if you could clarify about the capacity expansion plans. It sounds like that the CapEx guidance is a little bit higher for this year, what do you think for next year and what do you think the strategy will be for further outsourcing chips?

Chuck Swoboda

Yes so we just raised this in this quarter and we raised it a bit last quarter, raised it again and so what’s going on there just a couple of things to think about. So obviously the March quarter is typically our low quarter so we have come out of that, business looks pretty strong, we’re relatively optimistic about growth and really all the product lines going into next year. So that’s guiding part of the increase, second, the other thing to think about is as we look out to the industry, our sense is, is that as capacity becomes tighter we also want to get a little bit ahead of the curve from a lead standpoint. So we’re doing two different things there, that are both religious investments to support the growth in LED lighting whether it be from a lighting systems fixtures and bulb standpoint or frankly selling more component so that’s kind of how I would think about that piece of it. For next year we don’t have the targets yet but I would say roughly the exit rate of Q4 is probably the best starting point. I think I’m looking at Mike and he is shaking his head. So I think that’s how I would start modeling it. With that being said we have some more work to do there because we do outsource some today and I think we will continue to look at that lever and how much we can utilize that going forward.

If you think about it that well this is an increase it's significantly lower capacity utilization for the amount of revenue growth and what we’re seeing in past growth cycles. So I feel like we’re in a good spot right now. Obviously the business is helping, we have plenty of balance sheet to do this but I feel pretty good that we have got a nice balance right now and outsourcing will be something we will continue to look at whether or not we can expand that going forward depending really on product mix and what parts of the market growth.

Brandon Heiken - Credit Suisse

And can you clarify when you mentioned you want to do further brand investments? Is that simply mean driving the price down on the bulb, or are there additional increases in OpEx that we should expect or other investments for instance strategic acquisition.

Chuck Swoboda

No, so when I say brand investments, take strategic out of that and take out bulb pricing. What I’m talking about there is for example in Q4 we will spend incrementally more in Q4 than we spent in Q3 simply promoting the Cree bulb or the brand through a combination of marketing activities. That's everything from things we do, digital advertising to a variety of things that are really just about building the Cree brand. Those other things would be in different parts of the OpEx bucket. And if you just think about that again as I mentioned on the previous question but if you just net all that out and look forward we think that the OpEx investment is a lower rate than the revenue growth. So we’re still targeting for next year but even with these investments we get operating leverage.

Operator

Our next question comes from Edwin Mok with Needham & Company. Your line is open.

Edwin Mok - Needham & Company

So my question is kind on your cost lever that you can pull on the LED components side of business right. If I look at -- you mentioned your utilization is pretty high already and you previously had this SCQ platform that you guys are rolling out that seems like it's already fully rolled out. I was wondering just what cost lever -- can you identify some cost lever for us? We can’t think about what you can do to drive cost down for LED components in terms of maybe a new platform that you guys are working on and maybe kind of a timeframe or how we should think about that?

Chuck Swoboda

Edwin, we think about it really as two levers. There is kind of the traditional levers, we’re still not fully converted to 150 so we will continue to get some benefit from full conversion that I think will happen really -- we are over 50% but I think it will really be probably most of the next year before we get fully converted there. So we have that as a bit of tailwind for the next fiscal year and then obviously lots of productivity, things that come when you get scale. There is productivity happening [ph]. So that’s kind of a blocking and tackling side of it.

The other piece of it is really what you’re poking at I think is on the innovation side and so while we’re doing lots of different things, let me give you an example, what we have done, the LED that’s in the current Cree LED bulb I think it's the 5th iteration in 13 months. So to give you an idea that’s a lot of innovation and that’s about performance and cost and so we’re going to do those types of things which are really improvements on what we started and then from a platform standpoint I don’t expect you’re going to see a big SCQ like announcement but we actually have if you look at the most recent products, there is technology that’s starting to show up in our components that is almost I think the buzz where a lot of people like to use is chip scale packaging but if you look at what’s going on there are some of our newest LED components are approaching what I would call chip scale package and so there really is a “new platform” but it's not a -- we are not branding it as such. It's really going to start showing up, it has some initial products and you will see it continuingly start show up over the next year which gives us additional cost performance leverage. So I think you’re seeing it, it probably won't have any cool nick name this time but it's there.

Edwin Mok - Needham & Company

And then you talked about some of the new application I think you highlighted auto dealership in one area, one channel you’re looking at right? If I look at your recent margins, the strength is really in high power, right? Does that because where your LED margin [ph] is strong there, does that preclude you going off to other applications or are you effectively driven by the fact that you have the strength in this technology and therefore just focus on application (indiscernible). How do you finally think about that?

Chuck Swoboda

There are two different things, so the reason automotive became a big focus for us, that’s just really playing off really the systems technology that is part of what was three years ago the Ruud Lighting acquisition. So there is some really great technology around high power outdoor lighting with really precise optical control that fits great in that application and we also have some very innovative products on the indoor side. Some of it's built around our high power platform, absolutely, our LED components strategy is high power, high density light that can show up either in the types of products you’re thinking for outdoor or you can see it do very different things with the technology like what we’re doing in the bulb. So most people would not consider a consumer LED bulb, a high power, high density light source but the same technology we’re using to win an outdoor is being used in a very different way with that chip scale packaging to compete in a very you know high volume tough low end consumer market.

So I think we’re using it in both places. In our minds it's, you got to be a little careful of applying it too broadly because it's really about what’s the right application to technology for the right specific application and they really have to be optimized and so I think we’re trying to match those as we go along but as a merchant component supplier it's much of a high power, high density. But the reality though is you could and we prove it in our own systems products every day, use it differently in many of the indoor style applications.

Operator

Our next question comes from Mark Heller with CLSA. Your line is open.

Mark Heller – CLSA

Just back on the lighting gross margins for the March quarter, I know that originally you had guided for it to be up a bit. I think you had anticipated a price reduction to the bulbs in the quarter, so I guess I’m just curious what was surprising to you guys in terms of lighting margins in the March quarter?

Chuck Swoboda

Yes so lighting margins generally from a -- we had predicted that lighting fixtures would be a higher percentage so we would get some benefit from that and we did get the benefit of the mix shift. What we had not fully baked into our targets was we were testing consumer price points when we did our call in January but there has not been a decision of when those price points will get implemented. There was actually no -- it has not been worked out yet with the Home Depot and how we were going to do that and so frankly I would have thought that would have more likely happen probably early in this quarter than it would have at the end of last quarter.

So it's really as much as anything it's a timing of where we decided given some other market situation specifically how the Home Depot promotional cycle works but it was better to get those done sooner than wait till this quarter and that’s really what changed the numbers. That’s the biggest difference from what we had targeted to what actually happened.

And just to put in perspective if you look at it only takes a couple of million dollars which is like 1.5% of COGS in our lighting segment to move that number that much. It's not a big number.

Mark Heller – CLSA

And then looking at the LED segment I guess based on the guidance for the June quarter, it looks like it will be about flat year-on-year. Should we expect that segment to grow in a year-over-year basis in the second half of calendar ’14?

Chuck Swoboda

I haven't looked at the number on a second half basis. I know for the year it's targeted to grow year-over-year and it will grow again, and I would target it would grow again next year year-over-year. As far as what's happening quarter-to-quarter. I’m not as worried about what those dynamics are because there is lot of things going on in the current situation given that level of utilization we have to where -- there is a variety of constraints right now in the market. So I think overall we feel pretty good about the growth we had last year and I would -- looking ahead to next year we’re targeting a similar level of growth.

Operator

Our next question comes from Craig Irwin with Wedbush. Your line is open.

Craig Irwin – Wedbush

Chuck in your comments earlier you referred to obviously tightening capacity across the industry and a potential for the market being short components. Can you discuss whether or not those any potential any benefit from that that’s included in your guidance for the fourth fiscal quarter or whether or not this is something that’s further out on the horizon? Maybe can you give us some color about how you had planned for this as far as a way to capitalize on this and potentially increase the earnings power.

Chuck Swoboda

Yes Craig, the way we think about it it's a first one is no. No, I think at least for the horizon we have which is this quarter. I don’t think it's going to have a dramatic effect on the business. We basically built our targets this quarter not assuming that there will be a short term shift but if I look at over the next several quarters and I honestly don’t know if that’s two quarters or six quarters, my sense is given the trends in the industry and the growth in LED lighting that the capacity is going to get tight and so our short term strategy is to make sure that we’re prepared to support both our external components customers as well as our internal customers and the growth that we’re targeting there and that’s why the additional capital investments.

As far as how we would capitalize, since it's not predictable exactly when that will happen and exactly what level that will be because it's partially a function of what other people’s capital investment strategy does. I don’t bake it into the model, I think it's generally a good thing when it happens for a finite period of time but we’re not building it in. Generally what happens is lead times move out so you get a more predictable factory and two pricing pressure eases for a period of time. So my guess is what you would see that is in the LED components business, but that being said I’m not building into the model because we don’t fully control what will happen. It's more of an estimate of what’s likely to happen given the investment cycle we have seen over the last few years and a lack thereof.

Craig Irwin – Wedbush

Excellent and my second question is SKU mix, so when we look at some of the other public competitors you’ve with significant volumes of LED lighting fixtures. Obviously their gross margins on what they are selling are materially different because of the SKU mix, Cree versus these different competitors. Can you maybe discuss for us how you prioritize your new product development and how you might prioritize potential M&A as far as whether or not you will look specifically for higher margin products or if you’re really just looking for products that will be profit accretive and growth accretive for the company?

Chuck Swoboda

The way I would think about it is, is that I think if you actually -- we don’t break out our lighting fixture business but I don’t know that our margins there are LED margins for that product line are significantly different than what’s going on in the industry. There is a little bit of variation but if you just look at the combined fixture business there is not too big of a discrepancy there and I think it's less from SKU mix and more from the way we’re approaching the market.

The difference in Cree and other companies is they are in the business today. So they have an existing alternative and they can offer an LED alternative and frankly they use that to maximize the value of both of those but the way we Cree sells is, why would you ever buy that outdated energy wasting technology, buy LED now. And so we tend to be pretty aggressive on trying to get the value to the customer, to get them to move sooner than they might otherwise. And so it's truly at this point it's more about our intent to drive adoption and drive our business growth than being able, what I would say take a more balanced approach because I have both sides of the portfolio.

The balanced approach is great in one respect but it also means that you have to manage the declining side of your business at that transition and so I kind of like our more limited SKU approach. We’re very focused on just driving adoption and making that happen.

As far as future acquisitions, what we would focus on, obviously we’re going to look at all the elements but right now it's about helping Cree drive adoption and really gain brand and share of mind that what we do in LED lighting is really the best way to solve a lighting problem and it's more about how to continue to compete against this idea that it's still okay to buy the conventional technologies. I understand a lot of people believe that but we’re selling something different.

Operator

Our next question comes from Harsh Kumar with Stephens. Your line is open.

Harsh Kumar - Stephens

Chuck quick question on the bulb strategy for you guys. I know you’ve said that this is a branding exercise for most part. Is this a business that you’re long term committed or is this just strictly a branding tool? I’m just curious.

Chuck Swoboda

Well obviously it's a pretty large business already. So I mean it's something that we take very seriously and we think that as long as there is opportunities to lead the market and drive adoption and really give consumers what we think are differentiated in better products, we’re going to continue to invest in that. With that being said we don’t measure it in the same way, we think about a traditional business right? Part of the benefit we get from being at business is the brand building and so as we look at that it is a product business, we’re serious about giving consumers better lighting products than I think -- we have done a pretty good job so far. Obviously we can keep doing better but at the same time there is a real branding benefit and so I think they go hand in hand and I don’t even think of them separately and I think you should assume that Cree is going to trying to drive this market and get more adoption for the foreseeable future because despite the growth LED bulb is still a tiny percentage of the overall market and so I think there is just so much more to be done.

Harsh Kumar - Stephens

I want to go back to one of the questions asked earlier about and your comments on global components capacity, the major as they are running close to full with the delta smaller incremental, maybe getting there. In the past the Asian capacity adds have been at best non-rational. Is that a concern of yours as you basically start to see the folks in Asia start to add capacity, maybe even the majors add capacity?

Chuck Swoboda

One of the comments earlier was is when does that happen? How do you factor it in your business? And that’s a challenge right, is that I think some of the relatively logical approach to capacity but we have gotten some companies in certain parts of Asia. They are frankly being funded by their government’s right? And so that’s not necessarily a logical approach to access to capital. Well I’ve to see what they do, you know, I think we’re in a different place Harsh because you’ve a lot of these companies that made all those investments and even though they are starting to fill their factories there is a number of them that are still frankly losing money if you look at the real numbers and so -- we will have to see how much capital one wants to chase that. I think it's hard to call, what I do know is that the current rate of the last two year’s rate of capacity investment has been much lower than it was before that. So even if people start to invest again, my sense is semi-companies usually have a cycle to them because it's hard to react early when most of these other companies aren’t making much money at it yet. So but I think once they fill up what we will see is a different reaction and people start to invest again. So in my mind there is logically, it's logical to expect some type of semi-cycle that we also come out of it as well right? It's a short term part of the market.

Operator

Our next question comes from Avinash Kant with D.A. Davidson. Your line is open.

Avinash Kant - D.A. Davidson

Two questions, first one is that you talked about operating margin actually improving better than the revenue growth this year and the next year most likely, what kind of cost or price decline assumptions do you have in that assumption?

Chuck Swoboda

Yes well that’s pretty hard because it's going to vary across all the businesses. So right now we’re factoring an LED component -- essentially we’re assuming the market is similar, and then we have typical erosion in Power and RF and lighting I think we’re basically assuming not a big change one way or another from this year. It's a high level model at this point, I will be honest with you, but I would say that we’re not projecting into our current thinking that we’re going to see a significant swing one way or another. It's really just about the fact that we think that we can grow revenue faster than we have to spend in OpEx and that between those two that that generates the leverage.

Avinash Kant - D.A. Davidson

Okay and the second question is that you did talk about some efficiency improvements and you said that you had five different version of the chips that you’ve been using. Could you give us some idea in terms of maybe either the surface area of the chip that is been used historically versus now or what kind of efficiency gains have you been able to have thus far?

Chuck Swoboda

Yes I don’t have a good number for you, I think it's fair to say that part of those cost reductions along the way has been reduction in chip area. So clearly shrinking the chips, making the chip more efficient so you can shrink it is one thing, but there is also things that are being done at the package level. You know this idea of chip scale packaging it's not just shrink the chip, it's shrink the package but there is also technology improvements to more effectively extract light and they can operate better in different operating conditions. There is really a bunch of variables that are still at work that are about maximizing the performance and so that’s our approach so far and it has really given us the leverage you’ve seen over the last year.

Operator

Thank you. Due to time this ends our Q&A session today. I will turn it back to management for closing remarks.

Chuck Swoboda

Thank you for your time today. We appreciate your interest and support and look forward to reporting our fourth quarter and fiscal 2014 results on August 12th. Good night.

Mike McDevitt

Thank you.

Operator

Ladies and gentlemen thanks for participating in today’s program. You may all disconnect. Have a good day.

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