Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Raiford Garrabrant - Director of IR

Chuck Swoboda - Chairman of the Board, President, CEO

John Kurtzweil - CFO, EVP- Finance, Treasurer

Analysts

Steve Milunovich - Bank of America-Merrill Lynch

Chris Blansett - JPMorgan

Dale Pfau - Cantor Fitzgerald

Yair Reiner - Oppenheimer & Company

Ahmar Zaman - Piper Jaffray

Andrew Wang - Sterne Agee

Joshua Paradise - Morgan Stanley

Harsh Kumar - Morgan Keegan

Daniel Amir - Lazard Capital

Jed Dorsheimer - Canaccord

Carter Shoop - Deutsche Bank

Cree Inc. (CREE) F1Q2010 Earnings Call October 19, 2010 5:00 PM ET

Operator

Good afternoon. My name is Amanda, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Cree Inc. 2011 First Quarter Earnings Release Conference Call. (Operator Instructions)

And as a reminder ladies and gentlemen this conference is being recorded today October 20, 2010. Thank you I would now like to introduce Raiford Garrabrant, Director of Investor Relations for Cree Incorporated. Mr. Garrabrant, you may begin your conference.

Raiford Garrabrant

Thank you, Amanda, and good afternoon. Welcome to Cree's first quarter fiscal 2011 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 first quarter of fiscal year 2011. 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 quarterly results in 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 in revenue, gross margins 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'll be limiting our comments regarding Cree's first quarter for fiscal year 2011 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 calls, we are requesting that only sell side analysts ask questions during the Q&A session.

Also since we plan to complete the call in the allotted time of one hour, we recognize that other investors may have additional questions, and we welcome 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 November 2nd, 2010.

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

Chuck Swoboda

Thank you Raiford. Fiscal Q1 was another record quarter for Cree as revenue increased 1.5% from Q4 to $268 million and non-GAAP net income increased 10% sequentially to $66 million or $0.60 per diluted share. Revenue in lighting, LED components and power but in total was on the low end of our target range of $270 million to $280 million due to an almost 20% decline in LED chip sales as a result of weakness in notebook and monitor backlighting demands. The growth drivers remained on track with strong double-digit growth in LED lighting product sales for both our commercial products and the initial rollout of LED downlights for Home Depot. Growth in LED component sales driven by outdoor lightings and LED bulb application and growth in power products.

Net income exceeded our targets for the quarter due to solid growth margin lower than planned operating expenses and a favorable tax rate. Non-GAAP gross margins was 29% in Q1, which is on the high end of our target range for the quarter of 48% to 49%. Gross margin was driven by solid execution across the factory.

Higher yields and a heavier mix of components which mostly offset slightly lower factory utilization and increased LED pricing pressure especially in the LED chip product line.

Cash and investments increase to $1.1 billion and we remain in the strong position to continue to invest in our business and made the adoption of LED lightings. Our QC backlog is running behind last quarter's order rate primarily due to soft LED chip demand, as the business has shifted from a capacity constrained environment, to short lead times and terms oriented business.

LED chips were targeted to be down about 10% in Q2 due to a continuing inventory correction related to back loading applications. As we had explained in the past chip sales to backlighting are opportunistic and not part of our core lighting strategy. This trend is inline with historical LED chip business pattern and we expect demand to begin to increase again in the first half of calendar 2011, driven by lighting demand and renewed up momentum in the conversion to LED backlit TVs.

Looking beyond the LED chip effects, LED lighting and power orders remained strong and ahead of last quarter, while LED component orders are booking a little slower we believe this is primarily function of our customers and distributors using shorter lead times to manage their inventory.

And with the lighting adoption continues to gain momentum and we continue to see strong design activity. The growth rate of this new light applications are converting to LEDs fluctuates from quarter-to-quarter, but this is not surprising, given the early stage of adoption and its disruption being caused by LED technology. Our own lighting business is probably the best leading indicator for indoor commercial applications, is positive to continue to grow at a strong rate again in Q2. LED components is also targeted to continue to grow primarily in outdoor lightning and bulb retrofit in the short term where we expect to start to see growth in indoor commercial application over the next few quarters based on the trends we see in our own lighting product lines.

The one area where we have seen a recent slowdown is in the China outdoor lighting market as new LED streetlights specification has delayed some projects. We believe this is a net positive for CREE as the new requirements raise the efficiency and lifetime standards which should favor higher performance LED designs.

I'll now turn the call over to John Kurtzweil to review our first quarter results in more detail as well as our target for the second quarter of fiscal 2011.

John Kurtzweil

Thank you Chuck. I will be providing commentary and our financial statements on both the GAAP and non-GAAP basis which is consistent with our 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 to all quarters mentioned on this call is posted on our website as well as a historical summary of other key metrics.

So the first quarter of our fiscal 2011, revenue was $268.4 million compared to a targeted range of $270 to $280 million. This is a 1.5% increase sequentially and 59% increase year-over-year.

GAAP net income was $58 million, an increase of 10% sequentially and 176% increase year-over-year. GAAP diluted earnings per share were $0.53 and exceeded our targeted range of $0.53 to $0.51. On a non-GAAP basis, net income was $56.3 million, an increase of 10% sequentially and 142% increase year-over-year.

Non-GAAP diluted earnings per share was $0.60, which exceeded our targeted range of $0.56 to $0.59. Non-GAAP net income excludes $8.2 million of expense net of tax or $0.07 per diluted share from the amortization of acquired intangibles and stock-based compensation expense. We continue to strengthen our balance sheet and ended the quarter with $1.1 billion in cash and investments, which increased $32 million since the end of June.

Cash provided by operations was $88.5 million, which included $24.4 million of depreciation and amortization. We spent $61.6 million on capital expenditures in Q1 which resulted in free cash flow of $26.9 million.

I will now provide more details on the results of the first quarter. LED products revenue increased 2% sequentially to $244.4 million. Power and RF revenue was essentially flat with Q4 at $24.1 million as growth in power product sales was offset by a decline in government contracts. In total, this product line capacity constraints during the quarter.

Q1 GAAP gross margins was 48.6% while non-GAAP gross margins was 49%, which excludes stock-based compensation of $1.1 million. This is at the high-end of our targeted non-GAAP range of 48% to 49%.

Operating expenses for Q1 was $51.7 million on a GAAP basis and $47.5 million on a non-GAAP basis. R&D expenditures were on target in the quarter, an increase of $2.8 million sequentially on a non-GAAP basis.

SG&A expenditures were approximately $3 million below our targeted range and on a non-GAAP basis primarily due to lower legal expenses related to the timing of IP litigation costs and lower compensation related expense. On a sequential basis SG&A declined approximately $9 million from Q4. This included the expenses related to an IP settlement in Q4. When the impact of the IP settlement and other one-time items was taken into account core SG&A increased about 4% sequentially from Q4.

Non-GAAP operating expenses exclude approximately $6.9 million of stock rate compensation expense and $2.7 million of targets for amortization of acquired intangibles.

Net interest income and other for the quarter was $2 million. The effective tax rate for the quarter was 23% which was below our target of 25%. This lower tax rate was primarily due to a new foreign tax holiday we received during the fourth quarter.

Day sales outstanding was 41 days as compared to 40 at the end of June. Inventory days on a hand were 82 days as compared to 76 days at the end of June. Inventory increased by $13.7 million to $125.9 million during the quarter. Half of the increase was raw and WIP as it was intended to provide more flexibility in the factory to meet customer request in the shorter league time environment. The other half of the increase is in finished goods. Though we had planned to increase inventory in LED components and LED lightings. We also had an increase in LED chips due to the slowdown in revenue through target days of inventory to remain in a similar range for Q2.

Capital additions is $61.6 million in the first quarter. We were actively managing capital additions to be inline with the growth projects of the company. And we continue to impact on our strategic priorities such as the 150 nanometer production line in the US and building out our backend operations at our new factory in China. Our revised capital commitment target for the year is between $250 nm and $260 million as compared to $300 million that we previously disclosed.

At this time, we targeted Q2 revenue to be in the rank of $270 million to $280 million which is being driven by numbers including double-digit growth in LED lighting product sales. Mid-single digit growth in LED components as we work through the transition to shorter lead times, power and RF at similar levels and lower LED chip sales due to a soft market for backlighting.

GAAP and non-GAAP gross margins are targeted to be 48% plus or minus. This is similar to Q1 but factors in a lower factory utilization due to a further decline in LED chip volume and the competitive pricing environment.

Our GAAP gross margin target includes stock-based compensation expense of approximately $1 million of our non-GAAP targets did not. And we are targeting non-GAAP R&D expense that increased by approximately $2 million. Our non-GAAP SG&A expenses are targeted to increase by approximately $2.5 million. The R&D increase is primarily related to the ramp in our 150-millimeter development program, new LED components and new LED Lighting fixture product. The growth in SG&A is primarily for an increase in sales and marketing to support growth in LED lighting and LED components plus increased legal expense related to the Fox Group litigation along with the patent infringement lawsuit that Cree recently filed against SemiLED.

We target asset impairments to be approximately $0.5 million for the quarter. Our GAAP operating expense target includes non-cash stock based compensation expenses of $2.7 million in R&D and $7.6 million in SG&A. And charges for the amortization of acquired intangibles in the amount of $2.7 million. Interest income and other is targeted to be flat at approximately $2 million. We target our tax rate to be 0.3% next quarter and for the full fiscal year. GAAP net income for Q2 is targeted at $51 million to $55 million. And based on an estimated 110.1 million diluted shares outstanding, our GAAP EPS target is $o.46 to $0.50 per diluted share. Non-GAAP net income is targeted to be $61 million to $65 million.

Our non-GAAP EPS target is $0.56 to $0.60 per diluted share and non-GAAP EPS target excludes amortization and acquired intangibles and non-cash stock based compensation in the amount of $0.10. Thank you. I will now turn the call back to Chuck.

Chuck Swoboda

Thanks John. We are focused on four key areas to continue to drive our business in fiscal 2011. Our first priority to build on our leadership in LED lighting and continue to be a catalyst for LED lighting adoption by challenging people's addiction to old energy wasting technologies.

Along these lines we recently launched the EcoSmart LED Downlight with Home Depot and it is off to a great start. The product was only first as a web product in mid-August and the initial sales had been strong with essentially no advertisement. The product has recently arrived in stores and the initial sales are ahead of plan and customer feedback is very encouraging. The product was recently featured on the Home Depot home page and as part of their weekly product promotion on FOX TV Saturday morning. This product launch is an important part of our effort to [spun] a memory change in people's perception about LED lighting. While there are many companies currently counting consumer LED [ball] products that are cheaper, they generally make compromises that result in mixed consumer response and limited sell through.

While we agree that initial cost is an important factor, our strategy is to focus on delivering no compromise LED lighting that is as good, or better than what it would prices and that the consumer expects. And [pays] works itself in terms of long life time and energy savings.

I believe our success in creating the LED downlight category of the last three years and our initial success EcoSmart Downlight at Home Depot validates that we are on a right track with this approach.

Our second priority is to further enable lighting fixtures companies to develop and introduce their own high quality LED system products to drive demand for LED components. We continue to be reminded that ramping up new lighting applications does not happen overnight.

Our LR6 Downlight which was launched over three years ago and has set the standard for LED downlight, has continued to grow each quarter as our original value proposition that it is better than CFL any additional alternative, is validated and the product we expect in the more projects. We have learned in designing our own lighting products that the best system level solutions often require high performance, lighting class LED that are optimized with specific lighting applications. Our goal is to bring this concept to our LED component customers through application optimized lighting class LEDs.

We recently launched several new component products targeted at indoor lighting and bulb retrofit applications. The XLamp MLE is a half watt lighting class LED optimized linear lighting application. This product is already designed into several customer indoor lighting products. This XLamp MX-3S and MX-6S are higher volt LEDs that are designed to enable more efficient LED bulb products. We also launched our first Easy White LED modules which enable our customers to quickly expand their product offerings by leveraging the same design as our True White modules.

Our third priority is to further invest in capacity expansion to dry scale and accelerate our transition to 150 millimeter wafer production. We have chosen to build the first 150 millimeter line in our existing RCP wafer fab that currently produces silicon carbide power devices. By locating this line in an existing facility near our current LED manufacturing and R&D centers, we can leverage our existing infrastructure to reduce costs and speed innovation. We're on track with the first phase of the 150 millimeter expansion and the initial equipment is being installed. R&D spending is planned to increase over the next several quarters to support this development which is critical to maintain our competitive edge in the market. We continue to target the first 150 millimeter products to be qualified by the end of the fiscal year with the first production launched to start in early fiscal 2012.

Our fourth priority is to further develop our silicone carbide power product line with investments in new products and capacity to drive growth. We finished Q1 with another record quarter for Silicon-Carbide Schottky Diode sales as demand for solar applications had continued to grow. We are working to qualify new equipment to support additional sales growth in fiscal Q3.

We target releasing our first silicon carbide switch product by the end of this calendar year which will be a significant milestone in the power market and should expand the market opportunity for our products. We continue to see growing demand for energy efficient power switching technology and believe this product line is well positioned to grow over the next several years.

As we look ahead to Q2, we target revenues in a range of $270 million to $280 million. These targets are driven by a number of factors which include double-digit growth in LED lighting product sales, mid-single digit growth in LED components as we work through to transition the shorter lead times, power and RF at similar levels and lower LED chip sales due to a soft market for backlight.

We target Q2 non-GAAP gross margins at 48% plus or minus as we look to maintain margins in a similar range as Q1. Factory execution in yield improvement will be critical then in Q2 as we adapt to managing shorter lead times, lowering the innovation lights at a more competitive pricing environment.

We target increased investment in R&D to support new product development in LED including 150 millimeter development as well as increased spending in sales and marketing to expand our abilities to enable our customers and grow the market. As a result, we target non-GAAP earnings in Q2, up $0.56 to $0.60 per diluted share. Please note that our non-GAAP target exclude amortization of intangibles, stock-based compensation expense and related tax effects.

We continue to be the leader in LED lighting and our lighting products are a good indicator of what is coming. Design activity on our LED component customers is increasing. Overall LED adoption is growing and the growth drivers for our company remain on track. Although we have seen a slowdown in some applications like the Chinese streetlight market, this should be a net positive going forward as the new specifications raise the bar in performance which is exactly where our product line is positioned.

The LED chip business is going through a normal cycle. It is declining as a percentage of the total which further reduces our near term exposure to the backlighting market. Our strategy is working. We just have to remember that our biggest competitors are still the old incumbent energy wasting technologies, and the key to growing our business is to lead the market and drive LED lighting adoption.

Disrupting markets can be messy, but history suggests that the winners are those with the courage and conviction to drive the change, not those who wait for it to happen. We need to keep innovating and enable our customers to deliver high performance, no compromise LED lighting products that save energy and save money. Thank you and we will now take analyst's questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Steve Milunovich from Bank of America-Merrill Lynch. Your line is now open.

Steve Milunovich - Bank of America-Merrill Lynch

On the backlighting side, I think you said total chip sales were down 20%, so could you review for us again how much of total revenue backlighting represents? It seems like you've talked in the past about that being maybe 10% or less, and yet to get a 20% decline in chips assuming most of it's in back lighting, and it looks like it almost has to go to zero. So, were there other things in the chip side going on besides backlighting? Is backlighting bigger than what you've told us in the past? I'm just trying to get a little clarity on that.

Chuck Swoboda

No, I think you got the right number Steve. I think maybe what's surprised people is that I think the backlog in demand went down a little quicker than we had originally targeted and put out our targets for the quarter but it was a 20% decline in back in shift. It was pretty much all backlighting related and it has been significantly reduced our exposure to that market. Now, we do have some exposure but I think if you look at the list of applications now backlighting probably falls number 67 on the list. So it’s becoming a very small percentage. With that being said, we see Q2 for the backlighting market to continue to be pretty soft. So that's why we've gone ahead and build in some additional decline in shifts, and that's really primarily related to the rest of our backlighting exposure. But I think if you work the math backwards, you'll see, it is a business that represents less than 10% of the total and now represents significantly less than that.

Steve Milunovich - Bank of America-Merrill Lynch

And then, second, could you just talk a little about the competition? You mentioned pricing maybe increasing a little bit. You said mostly on the backlighting side, but can you talk about it in the core general illumination side, what's going on there and which competitors you see today?

Chuck Swoboda

Yes, just let's get chip piece out of the way. Obviously it's a buyers' market and chip demand is soft so it’s been in a pretty significant price erosion there. With that being said obviously the net result is our margin still hold up pretty well. So I think it kind of gives you an idea of maybe how much leverage we have in our factory to drive costs down.

I think more importantly though is your question about what's happening in the larger market. And if I look at the LED component business, which is obviously the biggest piece, pricing has continued to come down each quarter but I would tell you that it's more of a corporate thing that we are doing as well as our competitors.

One thing we've shown over the last year is that we are able to be pretty successful bringing costs down and as a result used that to drive up and you know what I'll call the lumens per dollar so essentially improve the value proposition for the LED. And so we continue to be aggressive. But I would tell you we were being aggressive six to nine months ago as well because when we look forward, today LED lightings probably a few percent of the total market. If we want to drive that with 50% higher then its really going to come down to reducing the cost of LED lighting and I think we want to be one of the people pushing it, not waiting for it to happen.

So did it move? Yes. But frankly it was within what we had targeted for the quarter, and the best way to see that is that you see that happen, the revenues on the low side and the margin's obviously still holding there.

Operator

Your next question comes from the line of Chris Blansett from JPMorgan. Your line is now open.

Chris Blansett - JPMorgan

A quick question related to the demand side on the backlighting consumer electronics. You mentioned it's a buyers' market right now. Is that really affecting the volumes or is it really in addition to the pricing or is it really just a pricing issue at this moment?

Chuck Swoboda

Its both. And its basically, there's less total demand. Effectively what we've seen is those guys basically got ahead of themselves, had too much inventory, who had hundreds of reports about what's going on in both the notebook and the TV market. And as they go through that there is just less total volume, and so what volume is there, there is more pricing.

And Chris one of the things I do want to point out though is the net result is, is from where we sit today looking forward. We have relatively small exposure. The exposure at market's getting pretty small. So I think its going to have an even less of an effect on our business going forward. It's really going to be more about how do we win in LED lighting.

Chris Blansett - JPMorgan

And Chuck, what I was trying to get at is, obviously you've had pretty strong demand for the general lighting side and I wasn't sure how much of your capacity this potentially opens up for lighting versus maybe selling into that opportunistic backlighting market.

Chuck Swoboda

Yes, I would tell you that we definitely have capacity that we have opportunities now that we can grow faster in the lighting segment as applications turn on. So I think we have shifted that. With that being said, depending on how demand looks as we get into the first half the next year, I think our approach to backlighting is not going to change. When it comes to chips I think there are some applications, you can add value and then it makes sense to participate opportunistically and if that helps us lets keep the fab loaded great. But at the end of the day obviously our priority is lighting first and then need that business really is kind of a balance from the fab standpoint.

Chris Blansett - JPMorgan

And then one quick last one for me is just, could you give an update on how much of your revenue for the quarter was for general lighting so we can kind of keep track of how this is trending?

Chuck Swoboda

Yes. If you think about, I can't give you the specifics but I can give you a pretty good sense. I think if you look at the LED business, over two thirds of it is now related to the lighting segment. I think after that it dropped a long way. The next biggest segment, well I think it's probably the video screen market and then after that you're getting down in the things like gaming, automotive, mobile and I think its only after all of those you get through what's left of our exposure to the backlighting market. But it’s really, over two thirds of its now lighting driven.

Operator

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

Dale Pfau - Cantor Fitzgerald

Questions here. First of all, what is the specific reason for the slight downtick in the CapEx guidance for the year?

Chuck Swoboda

Dale, as we look out for the whole year you basically have two pieces of CapEx; we got our strategic CapEx, 150 getting nearly ready for where we're going, we're still spending that money. But I think as we look at right now where we're at in terms of just total revenue in the short-term and we really look at slow down in chips, I think what we've realized is that we can back off that a little bit. It still gives us opportunity to grow the business pretty significantly and I think we have a lot of flexibility. One thing you should keep in mind is that although we slowed that down a little bit we are still going to try to stay a quarter ahead or two of where we are going to be. And so, I think it's just a recognition of we've gone further ahead than we have originally thought in the opportunity to kind of go slow and what I will call the variable capacity side of the strategic capacity, we are not making any changes.

Dale Pfau - Cantor Fitzgerald

And then could you just review for us again as you bring new higher luminosity chips on, about how long before you see the big, the knee in the uptake, and then how long before you start seeing ASP competition in those product families?

Chuck Swoboda

Well, so Dale, today the product line is pretty broad, right. So we'll basically bring chips in a lot of different packages. It's going to kind of vary on the product and the application. I think you know our XPE probably competes most directly with few other company's but there is only a few and generally speaking, it's kind of the mainstream and then there's higher end. I'd say, in the higher end markets we still enjoy a bit of a performance advantage, but really what we are seeing there is many applications are really about meaningful dollar, right. So, meaning for matters but there are some applications where you can get enough even for what, even if you are trying to use that to really optimize their design. So there's really two pieces of the market, there is the peer performance and then there is a performance with the lumens per dollar angle and I'd say those are kind of running in parallel.

So, back to your specific question, your XPG, the product that came out well over a year ago, it is in a series of designs that I would ask you to tell you there is a whole another series of designs that will only start turning on here over the next few quarters. So, we trying to run through an initial phase of conversion and now there is probably another round of designs that we'll come around here over the next six to 12 months. So, its kind of a two phase in that product that being said XP was different, XP kind of happened more together. I would think with the XM which is a product that should be coming out pretty soon, that's the one that takes the brightness up even further, I think XM will take a little bit longer just because it is a new footprint and we have actually already done out sampling and shipping some small lines to customers to get them ready for that. So that one will come and take a little bit longer just because it does change the footprint of the design.

Dale Pfau - Cantor Fitzgerald

And one last question, how are power margins and your lighting products, Chuck?

Chuck Swoboda

Our lighting in the systems business?

Dale Pfau - Cantor Fitzgerald

Yes, the systems business.

Chuck Swoboda

So, I would tell you that components continue to be a little over to corporate average and lighting is making some improvements but both it and chips they'll run a little bit over the corporate average right now.

Operator

Your next question comes from line of Yair Reiner from Oppenheimer & Company. Your line is now open.

Yair Reiner - Oppenheimer & Company

My question is about looking past December. Seasonality for the business has been a bit hard to model, partly because last year has been so strong. As you look out to the first half of calendar 2011, do you expect that would become negative seasonality in March or do you think the trend will continue to be up and to the right?

Chuck Swoboda

Yes, so obviously we were going to normally worry about seasonality, the traditional businesses that are more consumer-driven tend to worry about March quarter a little because we got that in the Chinese New Year. With that being said, obviously for example the LED chip business is already going through a cycle now, so I think that's a little harder to predict. I'm not pretty sure. We are going to see a normal trend there and frankly it's too early to call. A wildcard in all this is, we are working on the number of projects and designs that we are working on continue to increase and so it's a function of when do those designs and projects turn into business and when do they ramp up our customers and at the end of the day it's going to be that phenomenon that's going to drive Q3 more then anything and unfortunately we just don't know enough about Q3 yet to see what seasonality might do versus the new designs. At a macro level, we see adoption growing and we see the basic market growing. So, you know but in terms of what happened in Q3 specifically it's a little hard to call right now.

Yair Reiner - Oppenheimer & Company

Geographically, can you give us a sense of the degree to which China ticked down, and then if you can also give us maybe a flavor of how you see the lighting market panning out in the US and Europe? Thank you.

Chuck Swoboda

Yeah. So when I think about the three reasons, let me kind of go in reverse order. Europe was basically flat and that was expected to be kind of built into our target. China actually didn't go down, it just didn't grow as much as we had originally targeted, so I want to make sure that that's clear. There was some slight growth there what we saw in growth on a lot of applications that was offset by a little slower quarter in terms of the streetlight business. And again we think we understand what happened there, and frankly that should be a net positive going forward. And then the US had some nice growth. So Europe was flat, US grew and China was flat to up a little bit and it was actually pretty a positive sign because it means that even with the streetlight thing in the market in general is still growing.

Operator

Your next question comes from the line of Ahmar Zaman from Piper Jaffray. Your line is now operating.

Ahmar Zaman - Piper Jaffray

Historically, we've seen almost double-digit growth in your components business and now we're looking at about mid to high single-digit growth in the lighting component business. Is that the new normal in that business or how should we think about that going forward?

Chuck Swoboda

Yeah, I don't think we should pick normal's yet, you got to expect, if we step back, the market was 3% to 4% on the markets LED today and the rest was conventional lighting. So as we go through this adoption cycle I think we are going to see, you are going to be able to see periods of fairly significant growth in the market and that's going to create lots of opportunity.

I think in the near term, obviously as we go through each quarter and you have lots of different applications moving in directions and its not consistent. You know its in mid-single digits or its in the double-digit area. I think anywhere in that range purchase on the right growth track. And then when I try to bring out a little bit earlier, you know we are not dealing with a market, right, so lighting is really a bunch of different markets and we are still in so many cases of the early stage of getting the market to turn on.

So to me the fact that it comes in lumps or it's a little bit lumpy doesn't surprise me too much and frankly as long as adoption grow and we can see it growing in the future, you know we are pretty optimistic that we will have some quarters in the future that will be back to double-digits and exactly what order they come in it can get a little harder to predict.

Ahmar Zaman - Piper Jaffray

Thank you for that. And then just on your operating margins, your operating margins continue to grow sequentially and there's been some concern in the past about operating margins, and you've guided them to be around the 25% range with increasing OpEx. In the near term in the next few quarters should we continue to expect strong operating margin performance or with increasing OpEx should that start to slow?

Chuck Swoboda

I think if you look at where we are at right now, if you look at the, we have the gross margin and then we have got basically OpEx and one of the things we have found is that the OpEx, we can grow a certain amount each quarter but fundamentally when revenue grows faster its hard to grow at that rate, and if revenue slows down we might catch up a little bit. But right now we're still investing; I think we're in the right range. We're probably a little bit on the high end of the target range where we've been operating, so we're going to continue to make some investments right now. But that's really something we can choose to do going forward.

I think right now we see a tremendous opportunity from an R&D standpoint and from a sales and marketing investment standpoint. To drive further growth we're going to make those investments. And to some extent the revenue growth looks so strong in the last few quarters, we essentially couldn't make the investment this fast as we would have otherwise targeted.

So I think you'll see it balance out a little bit. In Q2 our targets we don't set any significant change there. In Q2 you can see it's moved a little bit from last quarter just as OpEx grows a little bit, but I think going forward it'll move on a little bit, but I don't see any tremendous change one way or another at least in the next few quarters what's something we can see changes.

Yes, in fact just to clarify I think Q2 if you run the targets I think they'll run it somewhere in the high 20s, maybe around 29, plus or minus 6, somewhere in there.

Operator

Your next question comes from the line of Andrew Wang from Sterne Agee. Your line is now open.

Andrew Wang - Sterne Agee

Just a couple questions. First, there was an earlier question on general lighting pricing specifically. My question, to be more specific is would you say that the ASP erosion in general lighting, is the rate of erosion accelerating or staying the same?

Chuck Swoboda

I would tell you that it's been going down probably faster than you have perceived over last six to nine months. But people don't necessarily talk about it when the numbers in the 90s keep going up, right?

So I would say, keep in mind Andrew, it's a little hard because the ASP for last quarter they are actually right in line with what we targeted maybe even on average a little bit better, that's where the margins sank one of the reasons the margins came in on the high end of the range. With that being said I think people confuse that with what we are quoting on new business and absolutely the people are quoting on new business at prices that are more aggressive than what we are selling out today. But those projects typically come online six to 12, in some cases 18 months from now.

So I think we are unlike some businesses where you quote the price and it instantly changes the whole business. That's not the nature of the lighting business, this is project based in a lot of cases. So I think there maybe a little bit of confusion out there in the market. Is it accelerating? No, but we are continuing to be aggressive. So as ASP is basically tracking according to the plan, but we are making aggressive prices but I also think we have aggressive cost reduction road maps to make that happen so that's why, I am not answering your question exactly because the ASP trend is different than what the quoting is and the quoting is really being driven by Cree and others who are trying to open new applications.

Andrew Wang - Sterne, Agee & Leach

Okay. Now, it looks like you are scaling back your CapEx plans a little bit. I think originally you were saying $300 million, and now you are saying $270 million to $280 million. Is that correct?

Chuck Swoboda

No. $250 million to $260 million.

Andrew Wang - Sterne, Agee & Leach

$250 million to $260 million. So my question is at that level of CapEx, at $250 million to $260 million, will you still be able to double your XLamp capacity?

Chuck Swoboda

Yes. We also have the ability to do that if we want to, yes.

Andrew Wang - Sterne, Agee & Leach

So in other words (inaudible) would have been…

Chuck Swoboda

We were probably trying to get further ahead of the curve and maybe its obvious to outsiders.

Andrew Wang - Sterne, Agee & Leach

There has been a lot of talk about the ability of some of your competitors to transition from backlighting to general lighting. And I was wondering if you could go back to a couple years, maybe to the late '90s when Cree started getting into the general lighting market and maybe remind us of some of the biggest challenges that you faced to get into the general lighting market, and maybe specifically from their perspective of channel.

Chuck Swoboda

Let me work backwards. First of all what we see, when we go out and compete for business each day, we're generally I'd say nine out of ten times and that's a rough approximation. We are going to compete with either Lumileds, Nichia or Osram. That is what we see every day. So, I know there is a lot of other talk but that's actually what's happened in the near term. In terms of getting into the business, one of the things we find is that lighting is not like a traditional market, its not one application. So, its selling an LED to a street light guy is not the same thing as selling one to a guy making a consumer A lamp which is not the same thing as selling to someone who wants to make an architectural down light and I can go on and on, because its hundreds of lighting applications.

And what we found is that the ability to do that one is, it starts with thinking about your products and how to fall back specific application from. One of the reasons we've seen Cree product line change so much in the last year turns up a number of products is that we found the best way to solve those lighting problem is to optimize LEDs for those applications. Once you do that but you say that to get to those customers and help through the design cycle and basically support that which is the channel but it gets down to its not just channel to the customer, it's the ability to actively support the customers. There's a lot of design support as well as a lot of specialty requirements in terms of can you adjust this, this way or can you optimize this that way?

And so I would tell that when we first launched the XLamp, when Lumileds was in the market and we got in with our XLamp, even designs we won, we thought we could win, we probably spend the first the two years before we ever got any real traction and realized that it was more than just making widgets that were bright but also doing the other stuff.

Now that being said Andrew, there are going to be some applications, but we'll probably be more consumer like, that I think will act like more traditional markets that I would put that in them, in the minority of things we're working on not the majority.

Andrew Wang - Sterne, Agee & Leach

Got it. Okay. One last question. I think it was in the March quarter when you actually raised your long-term gross margin goals to the mid-to-upper 40s and operating margins to low to mid-20s. So then my question is whether or not your long term margin targets take into account kind of these periods of where there might be some oversupply.

Chuck Swoboda

They are long term targets Andrew, I think we're looking at where the market goes and tries but not look at what might happen in any one particular quarter. I think for us it's simpler because we've been chasing LED light for such a long time I think we've developed a different perspective. But lighting market doesn't adapt a nice quarterly with chunk. It actually adopts over long periods of time and you talk about an industry that has many cases eighteen months design cycle. So as I look out there, we're not changing our model at this point in time but I am prefer that we probably shouldn't look at any one quarter with data point too much because frankly that's not what we're trying to do. To answer your question may be in another way, we are assuming that we have to drive up the lumens per dollar which is we'll to reduce the costs per lumens significantly to enable the market and maximum what we have built into our plan and now its up to us to figure out if we can develop the products to do that next in Q1 operation side to make that happen as well.

Operator

Your next question comes from the line of Joshua Paradise from Morgan Stanley. Your line is now open.

Joshua Paradise - Morgan Stanley

So, you've talked a bunch about competing on a lumen per dollar basis. Can you maybe give a little bit of color on, are your prices at a price premium, but there's advantages on a system level to using Cree or you pricing the parity with competitors? How does that work in a search day, and then for the six to 12, 18 months out that people are quoting?

Chuck Swoboda

I would tell you that it works in different ways depending on different applications. There are some applications where we have an LED that's very optimized to solve a problem, so for example in out NC product or NPL products. Those work very well in certain application to where it's going to be lumens per dollar but the customers lumens per dollar is what we're driving there, because we solve several other problems in their application.

In other cases with your MX-6 products, we have to go out and we have to compete against people like Nichia. So there you have a more standardized form factor and its going to be a much more near term view of lumens per dollar and then with some of our high performance products you're going to see a range of different things and its going to depend on the application. So I would tell you that the net result of most customers' choice is, they figure out what gives them the best lumens per dollar.

In some cases, there's a system benefit, in other cases gives our product is more competitive straight up lumens per dollar and its going to vary right so, when you get under the higher performance applications, its going to be more system driven and when we get in to more of the medium performance application it's going to be more of a heads up kind of competition. So, I think it's all right today and I would expect that to continue. There is going to be some application that you are going to get a double threshold for performance that may be both Cree and Lumileds and Osram can hit and then it's going to be who can deliver the best lumens per dollar and in other cases, we're are going to have optimize LED in application that's going to change their business model and they are going to calculate the numbers differently and there is no one answer, its just not that homogenous of the market. It's just too many different things.

Joshua Paradise - Morgan Stanley

Then just one more, if I could. So it seems like you still have a lot of costs if you take out of the system, because as prices are coming down margins will stay pretty stable. So can you give a little bit of color? I know you don't give utilization levels or yield levels, but what are you doing that enables you to take cost out continually and rapidly?

Chuck Swoboda

I'll say what we [have them] over the last year and then giving ideas some of the things we are doing going forward. So one of the things we have seen as a huge benefit in terms of adding scale to our factory. Yes, we also got a benefit of very full utilization, but what we have seen last quarter is we pull back utilization down and we were able to offset that with yield improvements and other things that were going on in the market place so I think you got to be, definitely as a factor, I would rather have higher utilization in any short period of time, but I think right now you know we were running the business probably almost two half here, the first half of the last calendar year.

Now that being said, we are right now is the chip slowing down, we'll have a little lower utilization so that applied you know little bit more pressure on the business but at the same time there are [still things] is doing from the yield standpoint to drive cost down and the other thing that is as we design new products we are not just trying to get the yield with our existing one. We are trying to continually look at how we make our products in the one, the next one, hopefully to take cost out of that. And we don't just do that. We look at that at the chip level, at the package level; rather look at those at the lighting system level.

So for example the products we are selling at Home Depots an example. We did it with all levels; right we actually reengineered everything to be able to sell a downlight that works almost as good as the LR6, but at half the price. And I think that's what people misunderstand and realize we are so early in this game in lighting there is a lot of engineering optimization left that really can change the leverage. And so that's kind of what we've done. Going forward, we see continued scale driving benefit. We still have yield benefits available to us in almost all our product areas.

And then the third piece is really we are making a big investment and a 150 millimeter. So, as that product is qualified and starts to come online next year that gives us additional leverage as well.

So I hate to say it's kind of more the same, but it is. And those are the things we think it will also keep driving the cost down. And we've been able to support very aggressive moves in this market in terms of bringing down the cost per lumen and still be able to deliver pretty healthy margins.

So we got to keep executing, but I think we know what the levers are.

Operator

Your next question comes from the line of Harsh Kumar from Morgan Keegan. Your line is now open.

Harsh Kumar - Morgan Keegan

Can you talk about maybe what your utilization was in the September quarter? And, Chuck, as you bring this another $250 million to $260 million of capacity out, when does a big part of that hit us? How should we think about the timing of that and what will it do to your utilization and this kind of a slowdown market that we're in? And then I've got a follow-up.

Chuck Swoboda

Yeah, I think last quarter Harsh I don't have the exact number. I think we came in a little under 90%. That will drop a little bit more this quarter, but that gives you an idea about where the fabs are running.

Try to be careful though because remember that since we're vertically integrated that's not an exact number, right. But I use the wafer fab benchmark just because that tends to be the most common one.

I would say going forward we are looking at how we bring that capital on and trying to make sure that we do that what I would call smart way. This is like there is $100 million that shows up one day and they didn't know what's coming. So I think we are trying to make those investments in places where we are supporting actual growth in these product areas and I think we got it fairly to hand along it. Also now we got a chunk of that capital also for the 150 millimeter investment. So that's really effectively like we are building capacity for next year. And the short-term of mostly than the R&D because we got to develop the technology, but essentially we have an R&D program this year that frankly provides capacity as we get ready for the next year. So I think we are kind of making an investment for 2012 and the short-term is going to be low fit R&D expenses as we develop it first.

Harsh Kumar - Morgan Keegan

And a lot of my other questions have been asked, but let me ask you this one. With the CR6 product, obviously a great product seems to be doing really well. Could you discuss maybe the ideal price point to make that sort of a mainstream product? I still think at $50 maybe it's a little bit high, but I'd love to get your thoughts on it.

Chuck Swoboda

Yes, so I would say that there is a group of people that think you have to have a 19.95 LED bulb and there is some think you can sell at 49.95 LED downlight replacement. And I think what we have proven is that if you sell a upgrade style product like a downlight you can actually potentially drive different demand than you can. And so I think [multi understand] ideal to consumers respond to price point. And if you are selling a bulb that is nothing more than a bulb, I agree, that probably to continue going to think of it is own right. But we are not solving the problem that way and I think what we are trying to explain is that value in what we sell that consumers are responding to right and the sales is that there is they can see the benefit of paying that and not having to mess with that light for the next 20 years and so I think that many people who are talking about consumer price points in this market, well yes, I understand if you are going to make nothing more than a bulb with a prop, I get where that comes from. That’s not what we are trying to do, the value of LED is much more than that and we are going to spend the time to get people to understand that because I think what we have proven is the consumer is a lot larger than people think, but you got to market it the right way and hopefully the initial success we are having at Home Depot is kind of a proof point that if you solve real problems, they will buy that.

So, I think we’re going to go through a different path, it doesn’t mean we don’t sell LEDs to the bulb guys trying to do the other thing, we will. I just think that we'll try to solve a different problem and my senses is that that what we learned in the LR6 business first is a much bigger market for products that last a really long time and save energy than people think, you just got to take the time to sell the value.

Operator

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

Daniel Amir - Lazard Capital

A couple questions here. First of all, on the LED chip business, just to understand it better, if we assume that the market stays soft the way it is on the backlighting side from now on it's going to have a much more minimal impact. Is that fair to say that?

Chuck Swoboda

Yes so we basically took the biggest hit last quarter. Obviously we are targeting it down rough numbers plus or minus 10% in the next quarter. So, you can see it’s kind of diminishing as the percentage of the total. Obviously what I would like to do is that have that business flat to go in a little bit, but right now that’s about the impact.

Daniel Amir - Lazard Capital

And then the second is on the China outdoor lighting side, can you give us an idea how much this really impacted you? Has it been as big of an impact as the LED chip decline? And also, when do you think that you're going to resume growth in that market?

Chuck Swoboda

If you take the chip decline, we just took the chip business kind of out of the numbers and I don’t have the exact ones in here, but just to give you an idea Daniel, I think the company probably would have grown in the probably mid to upper single digit quarter-over-quarter, okay. So that’s where the core of the company was growing to just take out the backlighting issue. And so then if you look at that, that’s a little bit slower than we were growing in other areas over the last couple of quarters, but I think China didn’t effect it, not due on a gross rate a little bit, but the neat part was and frankly the positive thing is even though that’s big application for us, that market can be soft and even down a little bit and net China was actually flat slightly last quarter.

So I think it’s kind of showing that there is enough application growing right now that I think we have seen some, I think we fairly encourage that we can have the backlighting market need move so fast and still deliver a little bit of topline growth and though that the core is actually still growing at a reasonable rate I guess you can look at it and maybe that’s glass half full, but I am in the business of trying to convince people to get rid of their light bulbs, so that is kind of how I start each conversation.

Operator

Your next question comes from the line of Jed Dorsheimer from Canaccord. Your line is now open.

Jed Dorsheimer - Canaccord

Two questions for you. One, on the lighting side I'm glad you're talking about dollars per lumen. Do you think that you can get to $0.005 to lumen sometime by middle of next year? The reason I'm asking, I'm just trying to get a better understanding of hitting the key inflection points in terms of the adoption.

Chuck Swoboda

If you pick the right products and design the application that use our LEDs in some of the ways they are designed we can target pretty close to that today.

And as you know Jed a lot of things that are working now people understand it. You could take an LED that’s designed to run at high currents and you run at low currents, you're wasting most of the benefit, but if I can deliver high enough efficiency at high currents and reliability, a lot of this is working with the customers to think about the design different.

Jed Dorsheimer – Canaccord

Sure. And then I just wanted to dig a little bit into some of the yields benefits. If I look, you did a great job on gross margins this quarter, but inventory grew, it looks like, by about $11 million. And so if I keep days of inventory flat, it looks like gross margins would have been sort of 45 range. And so with that in mind, it looks like the margin expansion is based on some yield benefits, as you mentioned. As we look at the coming quarters, can you give us any indication on where these sort of the costs savings is coming from? Is this mostly from the start of the transition to the 150-millimeter? Although it sounds a little bit premature on that or are you seeing some other area in the packaging? Could you give us any better visibility into that?

Chuck Swoboda

Yeah Jed, first of all on the inventory, remember about half of that is raw and WIP, so it didn’t have really any impact whatsoever, that's really a positioning of the line phenomenon, and of the rest of it I'd say a couple million dollars of that inventory in the chip area and I don’t know exactly what it was. That was probably more than we had originally targeted just because chips slowed down faster than we had planned. But the rest of it I don't know that it changed the margins too dramatically. I think it probably got some small benefit on chips, but I don’t think it’s of the magnitude we have said. Come to the cost leverage, one of the thing is that we still have pretty good yield leverage. So on our products, we're still making nice consistent yield improvements quarter-to-quarter and because of that I think its helping us more than maybe, I think would be obvious on the outside, and so as we've had to support markets and go after new applications and really try to drive dollars per lumen or lumens per dollar, whichever way you want to look at it, I think we've really developed more leverage over the last year from a cost standpoint and maybe it was obvious from that price.

Operator

And your last question comes from the line of Carter Shoop from Deutsche Bank

Carter Shoop - Deutsche Bank

I just wanted to clarify a comment you made earlier and make sure I'm understanding this correctly. As it relates to pricing for the components business, it sounds like the rate of ASP erosion hasn't changed much for the business that you're shipping today but you do expect it to accelerate going forward based on the design bids that you're putting in today. Is that accurate?

Chuck Swoboda

Not exactly. So you think about it this way. So the ASPs, we have targeted for a while to come down each quarter, probably more significantly than might be appearance on the outside because we have more cost leverage on the inside. So I think that's kind of the first starting point. But with that being said, it's kind of a lagging indicator of what we were bidding in the past.

The second piece is that in terms of new designs we are quoting more aggressively but we've also attempted to build that into the model as well. So the idea is that we're also trying to drive cost reductions that hopefully keep us in a similar range. Now that's an execution challenge for us in a lot of different areas. So is it going to decline faster? I am not so sure about that but I do want you understand we are quoting aggressively on new projects. It's really a rate how faster the new projects turn on relative to the existing business, and as they'll turn on what percentage of the business do they become, and so because this industry has a fairly long design cycle and there's a lot of business that wants your design in, I think the word they used in the Phillips call the other night was sticky. I think when you realize that it tends to the ASP while they tend to move, they just don’t change quite as fast as what we have seen in other businesses like chips and our consumer-driven markets in fact, and that kind of makes sense of what I'm describing it.

Carter Shoop - Deutsche Bank

Yes, that makes sense. The newer business coming on is going to be a little bit more aggressive, but then you have the whole mix shift to factor into.

Chuck Swoboda

Yes, and there's a lag to it, right. And so the point is that I might get busy on something today that turns on in three months. It might also not turn on for 15 months. And I don’t exactly control that.

Carter Shoop - Deutsche Bank

You made an earlier comment also that the business that you're shipping today in the components, you're competing primarily with Nichia, Lumiled, Osram, et cetera. Can you comment about how the competitive dynamics have changed for the design business, and who are you competing against today for the design business that maybe you weren't six months ago on the general lighting applications?

Chuck Swoboda

So I’d say that's actually what I was referring to that for new designs it's those guys we see I would say, rough numbers, nine out of ten times. I'd say occasionally we might see a citizen in one application or a Sol in another application or a Samsung here, but really not very much. In fact I would say that there are certain applications you might be someone who has a product design right through there, but on average for most of the designs we're working on it generally starts with the same guys we've been competing with, and although we do see the other guys occasionally in some specific areas, you don’t see any one of those apps broadly in the market right now. So they are trying to be more focused on specific niches here and there. So I am here and take the competition seriously and we should. That's kind of what we are seeing.

Carter Shoop - Deutsche Bank

That's very helpful. I appreciate the clarification. One last question, if I may. Without giving too much information to competitors who might be listening to the call, can you help us understand the size of the chip business? We've talked about backlighting market, we've talked about general chip trends, but is there a way to comment on the overall merchant chip business?

Chuck Swoboda

I see decline from quarter but we don't break out specifics because I am not, so I can give you a number around that since we don't break it out.

Operator

And I will now turn the call back over to the presenters for any closing remarks.

Raiford Garrabrant

Thank you for your time today. We appreciate your interest and support and look forward to reporting our second quarter fiscal year 2011 results on January 18, 2011. Good bye.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Cree Inc. CEO Discusses F1Q2010 Earnings - Call Transcript
This Transcript
All Transcripts