Cree's CEO Discusses Q4 2011 Results - Earnings Call Transcript

| About: Cree, Inc. (CREE)

Cree (NASDAQ:CREE)

Q4 2011 Earnings Call

August 09, 2011 5:00 pm ET

Executives

John Kurtzweil - Chief Financial Officer, Chief Accounting Officer, Executive Vice President of Finance and Treasurer

Raiford Garrabrant - Director of Investor Relations

Charles Swoboda - Chairman of the Board, Chief Executive Officer and President

Analysts

Jonathan Dorsheimer - Canaccord Genuity

Carter Shoop - KeyBanc Capital Markets Inc.

Ahmar Zaman - Piper Jaffray Companies

Andrew Huang - Sterne Agee & Leach Inc.

Mark Heller - Credit Agricole Securities (NYSE:USA) Inc.

Hans Mosesmann - Raymond James & Associates, Inc.

Olga Levinzon - Barclays Capital

Joshua Paradise - Morgan Stanley

Dale Pfau - Cantor Fitzgerald & Co.

Satya Kumar - Crédit Suisse AG

Jesse Pichel - Jefferies & Company, Inc.

Steven Milunovich - BofA Merrill Lynch

Harsh Kumar - Morgan Keegan & Company, Inc.

Christopher Blansett - JP Morgan Chase & Co

Operator

Good afternoon. My name is Keisha, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Cree Inc. 2011 Financial Results Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded today, August 9, 2011. Thank you. I would now like to introduce Raiford Garrabrant, Director of Investor Relations of Cree Inc. Mr. Garrabrant, you may begin your conference.

Raiford Garrabrant

Thank you, Keisha, and good afternoon. Welcome to Cree's Fourth 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's CFO, will report on our results for the fourth 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 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 fourth 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 will 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 analysts 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 e-mail or phone at (919) 287-7895.

We are also webcasting our conference call, and a replay will be available on our website through August 23, 2011. Now I'd like to turn the call over to Chuck.

Charles Swoboda

Thank you, Raiford. Fiscal 2011 was both a successful and challenging year for Cree. We continue to have success leading the LED Lighting Revolution and growing our LED Lighting business, while at the same time managing through a tough business cycle for our LED component and LED Chip product lines.

For the year, revenue increased 14% to $988 million, while non-GAAP earnings increased 4% to $187 million or $1.70 per diluted share. For fiscal Q4, revenue increased 11% from Q3 to $243 million, and non-GAAP net income increased 2% sequentially to $30.6 million or $0.28 per diluted share. Revenue was at the high end of our target range, while profits were in the middle of our target range for the quarter.

The revenue growth in Q4 was driven primarily by strong growth in sales of LED lighting products to our commercial and retail customers, solid growth in XLamp LED component sales, driven by a rebound in demand across applications from our direct customers and through distribution, which offset slightly lower LED chip, Power and RF sales, but were in line with our targets.

Non-GAAP gross margin was 39% in Q4, which was within our target range for the quarter of 40% plus or minus. Consistent with our plan for the quarter, the gross margin was driven by several factors: lower factory utilization as we slowed LED production to reduce inventory and a very competitive LED pricing environment, which was partially offset by yield improvements and other cost reductions.

Cash and investments increased to $1.1 billion. We remain in a strong position to invest in our business to lead the market. We also continue to evaluate potential opportunities to enable us to drive change in the industry and accelerate the adoption of LED lighting. We made progress on all 4 of our key objectives for fiscal 2011. We continue to build momentum in growing our LED lighting business and delivered a range of revolutionary new market-leading products, including our CR6 downlight, high-output power lamps and CR series troffers that set new standards for performance, color, quality, cost and payback. Our success over the last year has reinforced the value of having a lighting systems product line to complement our components business and give us the ability to drive the market and LED lighting adoption.

We drew the -- we grew the LED component business year-over-year despite a very tough business cycle by continuing to enable the market with innovative application-optimized new product platforms, including our XM, ML-E, MT-G, CXA arrays and LMR modules. The 150-millimeter development is on schedule. We have qualified the first products, and the initial production ramp has started in our fiscal Q1.

We made progress in growing the Power and RF product line, and we released the first silicon carbide power MOSFET. Orders are tracking slightly ahead at this point last quarter as overall demand has rebounded from earlier in the year. The growth in demand is coming from LED components and LED lighting, although we continue to operate in a competitive environment with short lead times and limited visibility. Sales through our LED component distributor partners grew nicely in Q4, and we were able to reduce channel inventories during the quarter.

I'll now turn the call over to John Kurtzweil to review our fourth quarter and year-end financial results in more detail, as well as our targets for the first quarter of fiscal 2012.

John Kurtzweil

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

For fiscal 2011, revenue increased 14% year-over-year to $988 million as compared to $867 million for the prior year. GAAP earnings were $146.5 million and $1.33 per diluted share for fiscal 2011, while non-GAAP earnings increased 4% year-over-year to $186.8 million and $1.70 per share.

Non-GAAP earnings exclude $40 million of expense net of tax or $0.37 per diluted share from the amortization of acquired intangibles and stock-based compensation expense. Cash provided by operations was $253 million. Free cash flow was $14 million, and we exited fiscal 2011 with $1.1 billion in cash and investments while continuing to be debt-free.

For the fourth quarter of fiscal 2011, revenue was $243 million, which was on the high end of our targeted range of $225 million to $245 million. This is an 11% increase sequentially. GAAP net income was $19.8 million, an increase of 5% sequentially. GAAP diluted earnings per share were $0.18.

On a non-GAAP basis, net income was $30.6 million, an increase of 2% sequentially. Non-GAAP diluted earnings per share were $0.28. Non-GAAP net income excludes $10.8 million of expense, net of tax or $0.10 per diluted share from the amortization of acquired intangibles and stock-based compensation expense.

We ended the quarter with $1.1 billion in cash and investments, which increased $13 million since the end of March. Cash provided by operations was $64.5 million. Depreciation and amortization was $30.2 million. CapEx for the quarter was $48 million, and free cash flow was $16.6 million.

Q4 GAAP gross margin was 38.1% while non-GAAP gross margin was 38.8%, which excludes stock-based compensation of $1.5 million. This was in line with our non-GAAP target of 40% plus or minus.

Operating expenses for Q4 were $72.5 million on a GAAP basis and $61.4 million on a non-GAAP basis. Non-GAAP operating expenses exclude approximately $8.4 million of stock-based compensation expense and $2.7 million of charges for amortization of acquired intangibles.

Non-GAAP R&D expenditures decreased $0.8 million sequentially and were $1.4 million lower than our target for the quarter, primarily due to the timing of various R&D projects. We successfully qualified our first products as part of our 150-millimeter wafer development program.

Non-GAAP SG&A expenditures were $1.9 million higher than target, primarily related to IP litigation expenses. This resulted in non-GAAP operating income of $32.8 million, which was in line with our target.

Net interest income and other for the quarter was $3.1 million. The effective tax rate for the quarter was 14.8%, which is above our target of 14%. For the year, we ended with a tax rate of 17.8%.

Days sales outstanding were 44 days as compared to 52 at the end of March. Inventory days declined to 106 days from 119 at the end of March. Inventory increased by $6.9 million to $176.5 million during the quarter. The increase was primarily related to our LED lighting product line to support targeted growth in fiscal Q1. LED chips and components inventories declined sequentially.

For fiscal 2011, we authorized capital additions of $204 million. Our capital authorization target for fiscal 2012 is approximately $160 million, although our current capital spending is focused primarily on new product-related areas as our current factory utilization could provide sufficient first capacity in the near term.

At this time, we target Q1 revenue to be in a range of $245 million to $255 million, which is being driven by a number of factors, including: double-digit growth in LED lighting, mid-single-digit growth in LED components; flat to lower LED chip sales; and Power and RF slightly lower due to lower demand from our solar inverter-related customers.

GAAP and non-GAAP gross margins are targeted to be 38% to 39%. This target factors in the competitive pricing environment and higher inventory costs from Q4, partially offset by incrementally higher factory utilization and cost reduction programs. Our GAAP gross margin targets include stock-based compensation expense of approximately $2.1 million, while our non-GAAP targets do not. Our long-term goal for gross margins continues to be in the mid-40s but over the short to midterm, our goal is to get back into the low 40s. To hit the short-term goal, we target improvements later in our fiscal year for new product introductions, higher factory utilization rates and cost reductions from programs such as the transition to 150-millimeter wafers.

We are targeting non-GAAP R&D expense to increase by approximately $2 million in Q1 to further support new LED chip development, the 150 LED -- 150-millimeter LED chip product qualification, new LED component platforms and continued investment in our LED lighting products. We target non-GAAP selling expense to increase by approximately $1 million and for G&A to be down approximately $2 million based on lower litigation costs. We target asset impairments of approximately $0.5 million for the quarter. Our GAAP operating expense targets include non-cash stock-based compensation expense of $2.6 million in R&D plus $7.6 million in SG&A and charges for amortization of acquired intangibles in the amount of $2.2 million.

As a result of the higher targeted revenue, similar gross margins and a slight increase in operating expense, we are targeting a sequential increase in operating income for fiscal Q1. Net interest income and other is targeted to be approximately $2.2 million. We target our tax rate to be 20% for both fiscal Q1 and fiscal 2012. This is an increase of slightly over 2 points from fiscal 2011 and is primarily related to the expiration of the R&D tax credit at the end of December 2011, along with the mix shift of income to countries that have higher tax rates. The resulting impact for fiscal Q1 is approximately $0.02 over the fiscal Q4 rate.

GAAP net income for Q1 is targeted at $16 million to $19 million. Based on an estimated 110.2 million diluted shares outstanding, our GAAP EPS target is $0.14 to $0.17 per diluted share. Non-GAAP net income is targeted to be $27.5 million to $31 million or $0.25 to $0.28 per diluted share. Our non-GAAP EPS target excludes amortization of acquired intangibles and non-cash stock-based compensation in the amount of $0.11.

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

Charles Swoboda

Thanks, John. As we begin fiscal 2012, we are focused on 3 priorities to drive our business in the year ahead. Our first priority is to continue to lead the market and drive adoption of LED lighting. We are focused on developing innovative new LED lighting systems to drive adoption and new LED components that enable our customers to deliver a more competitive payback versus traditional lighting. We understand that our leadership in indoor lighting system can cause some anxiety among our LED component customers. But I believe they are finding that our success is accelerating adoption and therefore expanding the overall market opportunity for LED lighting. Our lighting product line has clearly helped us set new standards in the industry, and we can't afford to slow down because we've already scratched the surface in what is possible at the lighting systems level. We plan to continue to invest in this product line to foster LED component innovation and find new ways to drive the market and obsolete the old energy-wasting technology in all lighting applications.

We made great progress over the last year with the growth in our lighting business and continued technology leadership in both components and systems. The introduction of our CR Series downlights and troffers, our success with new channels like the Home Depot and overall LED performance gains had given us a solid foundation and are helping us lead the market. Our new application-optimized LED platforms have enabled our customers to deliver higher-performance and lower-cost products to compete against traditional lighting across a range of new applications.

We need to continue to innovate and drive the technology to increase performance at both the LED component and systems level, so we can deliver even shorter paybacks for our system-level products and enable even lower costs for our component customers products.

Our second priority is to accelerate cost reductions and drive operational improvements to increase the profitability of our business. We are targeting improvements in several areas over the next year. We target lower LED costs from the conversion to 150-millimeter wafers, higher factory utilization, as well as yield and productivity improvements. We target lower LED and system costs from near lower-cost product designs that are under development, and we target improved operating leverage from higher revenues across our LED system and component product lines.

We have successfully qualified the first 150-millimeter chip-level products, and we have started production of these products in our fiscal Q1. This transition is scheduled to continue throughout our fiscal year as we qualify additional product families on the larger wafers. While we target 150-millimeter-based LED chips to be 30% lower cost than chips produced on 100-millimeter wafers, we forecast that we will see most of this benefit in the second half of fiscal 2012 after we have come up the learning curve in manufacturing and once we have converted a majority of products to the larger wafers. This benefit will also be affected by factory utilization levels. We are currently targeting incrementally higher factory utilization in Q1 as we increase production volumes over the next several quarters. However, this may change depending on market demand and other competitive factors.

Our third priority is to grow the Power and RF product line and expand beyond niche applications. We made solid progress over the last year improving yields, expanding the product line and getting our first silicon carbide MOSFET released. The core value of this product line is energy savings for power switching applications. Our success over the last couple of years demonstrates that silicon carbide power devices can deliver better performance and a better payback against silicon-based power devices.

We target continued investment in R&D for new diode and switch products, focused on more mainstream and higher volume power switching applications. We made good progress growing the revenue of this product line in the first half of fiscal 2011 until the slowdown in solar inverter demand. We see this as a temporary market correction, and we target the combination of new products and expanded sales coverage to drive growth in the power product line in the second half of fiscal 2012.

As we look ahead to Q1, demand has improved from earlier in the calendar year, but we are still operating in a short lead time environment with limited visibility. Our backlog is slightly ahead of this point last quarter and distributor sales trends are positive, but we target Q1 revenue to increase to a range of $245 million to $255 million, driven by double-digit growth in LED lighting products, mid-single-digit growth in LED components, flat to lower LED chip sales and lower power sales due to lower demand from our solar inverter-related customers.

We target Q1 non-GAAP gross margins in a similar range as Q4 at 38% to 39%, as we get some benefit from incrementally higher factory utilization and cost reduction programs, which are offset by higher inventory costs from Q4 and the competitive pricing environment.

We target higher gross profits to be partially offset by incrementally higher R&D, sales and marketing spending, which result in incrementally higher operating profit. The targeted increase in operating profit will be partially offset by an increase in our tax rate to 20%. As a result, we target non-GAAP earnings in Q1 of $0.25 to $0.28 per diluted share. Please note that our non-GAAP targets exclude amortization of intangibles, stock-based compensation expense and related tax effects.

Fiscal 2011 was a year of continued progress in driving the LED Lighting Revolution. Our LED lighting product line has enabled us to reinvent the market for downlights and our new CR troffer product line opens up large new markets for LED lighting and general office indoor applications.

Despite our success, the reality is that we are just getting started changing this industry, and we need to continue to invest in this area to drive adoption and lead the market. Our LED components product line has continued to set the standard in brightness and efficiency, and we need to keep pushing the limits to make LED lighting more successful against traditional lighting technology and stay ahead of the competition. We are well positioned to continue to lead the lighting revolution, and we look forward to taking on new challenges and building on our track record of innovation to continue to change the market in the year ahead.

Along these lines, we are off to a great start in fiscal 2012. It has been said that the cheapest, lowest impact and most abundant energy is the energy that we never use. We recently announced the achievement of a prototype LED light source that exceeds the DOE's L Prize 21st Century lamp targets of 150 lumens per watt and 1,200 lumens before the complete specification has even been defined. This revolutionary LED system delivers 20% more light than a standard 75-watt incandescent bulb, but consumes only 8.7 watts of electricity. If LED lights with this level of performance are fully deployed, this ultra-efficient lighting could reduce our nation's total annual electrical energy consumption by 16.5%, which would take us back to annual consumption levels last seen in 1987, which coincidentally is the year Cree was founded. This incredible achievement could be accomplished by simply replacing our existing lighting with the new LED-based lighting systems like the one we demonstrated. This large-scale potential reduction in energy consumption is the foundation for the LED Lighting Revolution, and we are focused on continuing to lead. We will now take analyst questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Chris Blansett. [JPMorgan]

Christopher Blansett - JP Morgan Chase & Co

I had a quick one here. You mentioned that your utilization rates are going to uptick slightly in the first fiscal quarter. I wanted to get a feel for how you think your inventories are going to trend during the quarter? And then the second question was related to the impact of the ramp of 150-millimeter on your overall gross margin profile for the quarter?

Charles Swoboda

Yes. So right now, the idea is that we should start to see utilization come up a little bit, and the assumption there in that is that we will -- actually, our target is to reduce inventory, internal inventory from where we exited last quarter. So if we're able to achieve the revenue targets, then inventory goes down, that will move the days down even further than where we exited last quarter.

As far as the 150-millimeter impact, in Q1, what we're really going to see is we're really starting the first products in the production. And they've been -- they're in the fab now, and they're processing through. I don't think that you're going to see the gross margin impact in the near term because really, what we're doing is just getting the first products ramped up. The bigger lever in the short term is going to be some of the traditional yield activities, the utilization increase, as well as a variety of new products that we're bringing online that are designed to be lower cost to start with. Those are probably the bigger near-term drivers. And as I commented earlier, I really think 150 is going to be more of a second half benefit, not that we won't get some incremental mental benefit along the way, but the reality is until you get the majority of the products converted and you get the utilization rates up, it's really you're battling utilization as a bigger cost driver in the short term. But clearly, it should help us in the more of the second half of the year at this point.

Christopher Blansett - JP Morgan Chase & Co

Quick follow-up was did your -- so your utilizations in the fourth fiscal quarter were relatively sideways with the third fiscal quarter?

Charles Swoboda

No, they were actually lower, Chris. We actually saw that -- it varies across the factory, but to give you a little bit of color, I think in some parts of the factory, we probably had utilization as low as about 60% during the quarter. So I don't have a specific target for you this quarter, but it should go up incrementally, especially as we proceed through this quarter. So I think Q4 right now looks like the low point over the last couple of quarters.

Operator

Your next question comes from Steve Milunovich. [Bank of America Merrill Lynch]

Steven Milunovich - BofA Merrill Lynch

Chuck, could you dive a little bit more into the demand side? Last couple of quarters, distributors have been the problem. It sounds like that came back a bit. And I think you said inventory app distributors is down, so it sounds like there was reasonable sell-through. Can you talk about what applications you think are improving and specifically talk about what's going on in Asia from what you can tell and particularly in the China street lamp area when that's likely to pick up?

Charles Swoboda

All right, let me see if I can get all those. And if I don't, remind me. So overall, disti sales definitely picked up last quarter. We saw solid sales from the distributors to their customers across geographies and across applications. So -- and we also saw an increase in direct sales. So we actually had relatively broad-based growth of application, geography and by channel. The result was is that we actually had distributor inventory decline quarter-over-quarter, and that's actually 2 quarters in a row. So I feel like we're -- that's in a pretty healthy position. Obviously, that's subject to continuing to drive demand, which is the biggest lever we have there but obviously, that continued to improve through the quarter. As far as Asia or China-specific, I would say that what we saw in Asia and as well as in China is we didn't see any one application. I think we saw growth really across applications. So everything from streetlights, indoor, commercial, some of the bulb replacement markets really we're seeing demand kind of across applications. So I wouldn't put it on any one specific area. It was really incremental growth across a range of applications that was driving the business.

Steven Milunovich - BofA Merrill Lynch

Could you indicate what percentage of your revenue for the full year was from China?

Charles Swoboda

I know that's going to be in the K. I want to say it's in -- I don't want to say roughly, I want to say 36%. It might be plus or minus, is that right, John?

John Kurtzweil

Yes.

Charles Swoboda

It's 36%. So what that would say is that, well, China grew last year, the non-China business grew faster, but China was up incrementally and the rest of the business was up a little bit more last year.

Operator

Your next question comes from Dale Pfau. [Cantor Fitzgerald]

Dale Pfau - Cantor Fitzgerald & Co.

If we kind of call last quarter then -- your third quarter the bottom and we're starting to see demand pick up, could you talk a little bit about the competitive landscape? Anybody new, anybody old dropping away? And also talk about the pricing pressure. It looks like over the last, say, 12 months, it's been a little bit stronger than historical norms. Do you think you see that pricing pressure in the next several quarters being in the range of historical norms or continuing pressure? And then I've got a follow-up.

Charles Swoboda

Yes, okay, Dale. So definitely from a demand standpoint, it looks at this point, given where the orders and Q4 and what our targets are for Q1, that Q3 was the bottom. With that being said, we are in a short lead time environment, so that given the trends that we're seeing today. With that being said, what's going on with the competition? I would say our main competition comes from our traditional competitors. So more times than not, it's going to be one of the big 3 that we've traditionally competed with, primarily lighting class LEDs for lighting class applications. We do see and depending on the market, the application, some amount of competitors that I recall that next year generally, these are competitors based out of Asia. It will range on different accounts, different applications and different approaches. But I would say that we see the activity, but today, it's really -- the real pressure is coming from the traditional competitors from what's driving the business standpoint, but we're obviously watching the new guys as well. In terms of pricing pressure, definitely Q2 and Q3 were more competitive, more severe pricing than I would consider to be a historical average. Last quarter, the pricing, still competitive, but I think the words I would use is it's moderated, and I think we're now getting back more into a historical range, and that would be -- that was our old range. Annually, we'd see 25% to 30% a year. Now that's a little premature to say we're in that range, but I would say given what we saw in Q4, what we're targeting for this quarter, it feels more like that. But again, Dale, when you don't have a big backlog and the lead times are relatively short, I hesitate to try to forward project that too much, but that's what we're seeing at least in the near term.

Dale Pfau - Cantor Fitzgerald & Co.

And then my follow-up has to do with out there on the technology improvements side that you've been pushing your luminosity and so on pretty quickly. And are you still leading your competitors? Are your customers saying no, they don't really care about that anymore? And I don't know, 120 is good enough? Can you just talk about that a little bit and any changes you see over the next, again, 12 months?

Charles Swoboda

I would say clearly from a pure capability standpoint, R&D result-wise, I feel very comfortable. We're still setting some standards that most people aren't expecting. I think when it comes to production business, I think against our main competitors, on average, we still have a lead, but it's become a more competitive environment with everyone fighting for the same pieces of business. But I would say overall, clearly, it's a more competitive environment there, but I think our trick is how do we take more of these R&D results and bring it into production, because we've demonstrated capabilities significantly beyond what we're doing in production today. So that's our challenge over the next year. And what it comes to is there are good enough markets for the things we're focused on, we see customers pretty rapidly continuing to go after the higher output devices in terms of both total lumens per package and lumens per watt. And what we're seeing is -- and again, this may not be true in all applications, but so many of the applications today are on the limits of what it takes to really meet, for example, even a light bulb to try to meet ENERGY STAR that puts a lot of pressure at a very small package to get high efficiency with low wattage. In some of the street lighting applications, it's about driving more payback in terms of performance and also simplifying their designs and solving some of the thermal issues there. And in the indoor commercial, it's the cost lever. So today, I am still seeing lots of demand for the high-end devices. In fact, if anything, in the last 6 months, the high-end devices have probably even become more of a focus of our customer base.

Operator

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

Harsh Kumar - Morgan Keegan & Company, Inc.

Two questions. Chuck, how would you characterize the inventory and pricing in LED lighting products versus non-LED lighting components? So in other words, general lighting versus the rest?

Charles Swoboda

When you say -- are you talking about the systems products versus components?

Harsh Kumar - Morgan Keegan & Company, Inc.

No, I'm talking about components.

Charles Swoboda

So, Harsh, most of our business today is -- I would say that we're -- over 3/4 of our sales are lighting-related, so pretty much what we're reporting is lighting trends. We still obviously have a nice business in video screens, but the rest of those applications are pretty small. So pretty much most of our sales and our inventory is focused on the lighting market in application. This is probably a little different than the chip business, but in terms of the big numbers, it's really lighting-oriented within components.

Harsh Kumar - Morgan Keegan & Company, Inc.

Got it, got it, helpful. And then if I was to look at your margins, Chuck, of 38% and change and guidance, as well, how much do you think is the pricing, the step decline versus yields? And which do you think is a bigger factor here?

Charles Swoboda

I would say that -- actually I think we've made -- I think our yields is what helped us continue to deliver pretty good price -- pretty good margins relatively speaking. I know they're not what they were, but if you look at what's happened from a utilization standpoint and a market pricing competitive standpoint, our yield improvements have been a real benefit to us. I think the other thing to keep in mind is, I would say, if utilization and pricing are 2 biggest levers on the business right now, so our focus really gets back to what can we do to drive adoption? If you drive adoption that drives demand and demand drives utilization, and the whole model works. And that's really where -- why you'd hear me keep coming back to that. The way we want to drive this business is if we can enable our customers to be more successful against the traditional technology, we can drive demand, and that will load up the factory and the rest of the leverage comes from there.

Operator

Your next question comes from Jesse Pichel. [Jefferies & Company]

Jesse Pichel - Jefferies & Company, Inc.

It's nice to see some stability in the market. Do you have a view on liquidity available for energy savings, ROI projects, high ROI projects? And given your balance sheet, would Cree consider any such opportunities to finance energy savings projects such as streetlights, for instance, just to pick some demand?

Charles Swoboda

Yes, so, Jesse, today obviously, from a -- as a component supplier, we have not ventured down that road. So for example, in the streetlight business, we're a supplier to a number of companies there, and so that would really be more of an opportunity for them. When you get into the indoor lighting applications, with the new CR Series troffers and our CR Series downlights, the whole idea was how do we drive some of those energy savings type applications? What we have found is there is money available and there is an interest in the larger energy-saving industry to use lighting as one of their projects, but it's a -- what I'd say, it's one of many they're trying to do. Our focus is a little bit different. With our troffer, we try to push the price and the payback so low that we can have a lighting-specific discussion. And what we're seeing is in some applications, we can get down into that 1- to 2-year range, depending on what technology is in there today. And when we push it into that range, most people are looking at a self-finance because the payback is relatively short. So our basic model is, how do we push the paybacks so low that we can go after straight up capital projects where we don't have to get into complicated financing? With that being said, if that's something it takes to enable some of those applications, I think we'll absolutely consider it, but it's not on the short-term list of things to do. And really, our focus there is innovate our way into products that pay for themselves quick enough, it's not necessary.

Jesse Pichel - Jefferies & Company, Inc.

And as maybe a follow-up to that, can you give us any color on the traction of the troffer product, for instance, which was pretty busy at the Lightfair show, your booth was, that is. How much sales have you had from the product? Or what kind of distribution have you received thus far?

Charles Swoboda

Yes. So far, I would say that the initial sales are as good or better than what we expected. But we didn't -- I would have to tell you, one of the things we learned with the downlight before is a new lighting product doesn't -- what no one's ever seen or considered before is not something that you're going to instantly design in. So really, we launched it in May at the light show. We spent the last 2 months getting all of our agents and a lot of the specifiers up to speed on how the product works, what is that cost savings, and I would say they're now really getting into the mode of going after the bigger projects. So I would estimate that -- and we saw this in our other products. We'll see a lot more over the next 6 to 9 months as the normal cycle of going and bidding on a project, getting the capital approved and doing the installation. We're going to have to go through that phase to truly measure this. There's nothing I've seen that's disappointing. In fact, I think that what we had to solve after the last show was almost -- we had to work through a process of where it was almost a phenomenon, is it too good to be true. And so we spent some time really educating people, it truly does work this way, here is the payback, we really can give you these savings. So there's a bit of an education lag. But I mean I'm pleased where we're at, but in terms of revenue, we're probably 6 to 9 months from really seeing what kind of leverage we can get there.

Operator

Your next question comes from Andrew Huang. [Sterne Agee & Leach]

Andrew Huang - Sterne Agee & Leach Inc.

Chuck, so just a big picture question. Obviously, everyone's concerned about the global economy and the effect that has on spending. So maybe could you share with us what your biggest customers are saying on LED lighting?

Charles Swoboda

When you say LED lighting, the customers that are buying lighting systems or the customers that are buying components?

Andrew Huang - Sterne Agee & Leach Inc.

Customers that are buying components.

Charles Swoboda

Yes, so, Andrew, what we see there is that we see continued activity across the applications. We haven't seen any significant change. In fact, there are some specific things like, obviously, Japan's a good market right now, but it's not a big component business for us, but that's an example. There are some specific things that are related to pure energy-saving programs. With that being said, it's more of a general market. I think what we're seeing is that most of our customers are continuing to expand their lighting product line and starting to find ways to get products that are instead of being just a niche, "Hey, I've got an LED system," starting to look for how do they really go out and deliver products that have legitimate paybacks head-to-head against the traditional technology. Now I say that -- remember, we're still early days, right? If the market's 4% to 5% adoption, we're still really early in this cycle. But I think that's what most of our customers are working on. And although we have some large customers, we're at a relatively broad customer base, a lot of it is through distribution. So it's more broad market trends then. If there is an effect from the recent market issues, we have not yet seen it flow through our customer order patterns and we haven't seen it flow through the demand. So at this time, obviously, we're going to watch that closely, but the trends we gave you is what we've been seeing up until through today.

Andrew Huang - Sterne Agee & Leach Inc.

Okay. Can you give us a sense of how much lower your LED lighting systems margins are relative to the corporate average? So are they more in the 20% to 30% range or more like the 30% to 40% range?

Charles Swoboda

Yes, so I would say that components is clearly ahead of the pack there. And then chips and lighting systems are in a similar range. I can't give you a specific number, but I don't think the gap is maybe quite as big as some people might perceive. So -- but I really just can't break it out for you. It's -- we're lagging but not significantly behind, making progress, but we have more work to do there.

Operator

Your next question comes from Ahmar Zaman. [Piper Jaffray Companies]

Ahmar Zaman - Piper Jaffray Companies

Just switching topics to backlighting. What are you seeing on that front? And do you need backlighting to return to meet your -- to continue to grow your utilization meaningfully over the next few quarters?

Charles Swoboda

So today, we have almost no exposure to backlighting. We have a little bit of incremental business there, it's through our chip business. So there is some marginal benefit or not, but it's a relatively small number. In fact, it's a very small percentage of the overall applications today. I don't think -- we built our plan really focused on driving lighting and then continuing to focus on our video screen business for our high-bright LEDs. So that's really the 2 biggest markets that drive our plan right now. There will be some incremental benefits along the smaller applications, but it's not a big part of our plan. Now I say that, but there as the related effect of what happens in backlighting does affect overall industry capacity and utilization. So I think today, most people are bracing for pretty low backlighting demand in the near term from what I've read from the other companies out there. And so I think my sense is if there is a pickup, the one benefit we might see is it might reduce -- it might help overall industry utilization, which is probably a net benefit to Cree, but that's not a direct part of the strategy right now for our sales.

Ahmar Zaman - Piper Jaffray Companies

And as a follow-up, I guess just your tone sounds markedly more positive this quarter than last quarter. What has changed in general lighting specifically to -- that has turned things around, that turned demand around so meaningfully for you?

Charles Swoboda

Yes, well, the tone's pretty -- it's going to generally fluctuate when revenues are going up or down a little bit there, so that's probably why you hear a different tone. Obviously, it's very encouraging for us to see some of the activities. I think the market continues to incrementally move forward. I think the challenge is, is that there's so many different applications, and they're all moving at different rates at different times. And we've been working as well through some inventory corrections, which has kind of muted the results. So I would say that what's encouraging to us is, is that it's relatively broad. We're seeing combination, not just of our products that we've been selling, but some of the new products. Over the last 9 months, we've introduced a wide array of products designed for specific applications. Our strategy was if we optimize the LED around the application, we can help the customer develop a better product to make their -- to make it effectively lower cost and better in the end market. I think we're starting to see the first parts of traction there. Designing a new LED component doesn't happen overnight, so it's always been a business that takes good 6, 9, sometimes 12 months to get through that cycle to get some momentum going. So I think that's what's encouraging us. And the only caution really is, is that the business isn't where we've got big backlogs or great visibility going forward. So we're really responding to the business in a short lead time environment. And so that's where you get the encouraging revenue trends but still some caution because we just don't have great visibility.

Operator

Your next question comes from Joshua Paradise. [Morgan Stanley]

Joshua Paradise - Morgan Stanley

Can you give some more detail on how big that business is today as a percent of sales, and how big -- what percent of the business you think it could become?

Charles Swoboda

So it's still a relatively modest piece of the business. We don't break it out specifically in any of our other filings, so I can't give it to you, but I would say that what could it become.

What the core strategy is get the market moving, get some revenue -- incremental revenue growth there, at the same time, drive component. And what we've seen though is that our ability to actually focus on an application, and we really only participate in a couple of applications there today. We can generate some pretty good traction. So I think I would expect that business to continue to grow over the next year. That's certainly our goal. Whether that will happen, there's going to be a lot of different factors. But we're going to continue to come up with innovative products and build that. So I think what you'll see is that components is still the major part of the revenue and the earnings. At the same time, I think we can start to make that business add some incremental upside, both from a revenue and hopefully some earnings as we get the margins up there. So to me, it's an opportunity to maybe offset some of the competitive factors that we see on a day-to-day basis in components by being able to focus on specific applications and drive adoption.

Operator

Your next question comes from Mark Heller. [Credit Agricole Securities]

Mark Heller - Credit Agricole Securities (USA) Inc.

Had a quick question, John. Can you say -- I know you said utilization was maybe as low as 60%, but is there an average utilization you have for the quarter? And I was wondering if you could estimate what the gross margin impact was from the low utilization? So say if you're running at 95% utilization, whatever normal is, what would the normalized gross margins be in the fiscal fourth quarter?

John Kurtzweil

So what we saw last quarter, as Chuck said, we saw some areas of the factory down in the 60% range. Now for that, we saw higher inventory costs that are going to fall through this quarter. In terms of the gross margin impact, you saw a little bit lower than what we had targeted at the lower end of our target range. So that's about what the impact is. And going forward, what we expect to do is see a little bit better utilization, and that's going to help offset some of the pricing pressures that we see.

Charles Swoboda

But keep in mind on that, that while the utilization should start to improve this quarter incrementally, we do have the higher cost from Q4. Some of those will still have to flow through this quarter. So the key is if we continue to drive revenue, those lower costs should start to affect the business as we exit this quarter and put us in a better position, subject to end demand next quarter.

Mark Heller - Credit Agricole Securities (USA) Inc.

Okay. And on ASP, I know you talked about it a little bit but sequentially, can you talk about how they've trended in fiscal Q4 and what they're looking like in Q1? Was it like a double-digit decline in fiscal Q4 and sort of single-digit decline in Q1? Can you just talk about that?

Charles Swoboda

Yes. So ASP, we got to be little more careful because ASPs include mix. So I see what you'd see is our ASPs are up, but that's a mixed phenomenon between product lines. If you look at it on a LED component product-to-product basis, the best color I can give you is that it moderated in Q4 from where it was in Q3. So the declines are less, and they're becoming more in line with the historical range, and we're targeting a similar level in Q1. So we're not -- we're targeting Q4 and Q1 to be kind of similar, and I would put it within the boundaries of that historical 25% to 30% annual range. With that being said, again, we don't have visibility beyond Q1 at this point, but that's what we're modeling.

Operator

Your next question comes from Carter Shoop. [KeyBanc Capital Markets]

Carter Shoop - KeyBanc Capital Markets Inc.

Could you help us better understand how your visibility has improved over the past 3 months, maybe try and provide a few numbers on lead times or kind of the bookings growth that you're seeing? And I noticed that you narrowed your revenue range for the third quarter, but it's not clear to me how much of that is just due to the fact that you guys have an extra month of visibility this quarter versus last quarter?

Charles Swoboda

Yes. Carter, the way I would think about it is that on a total visibility, the backlog at this point is slightly ahead of where it was last quarter. I would say that we don't have -- we don't really have forward-looking visibility much better at this point. The narrow range is exactly what you guessed. We're later in the quarter, so we're narrowing the range because we're later in the quarter. I think the one thing that's encouraging is we obviously now have several months worth of positive sales trends. So that's not visibility, it's more of a -- we're seeing what the industry is doing around us. So I'd say we're encouraged by the trends we have backwards looking, but we still don't have that forward-looking view like we had a year ago to where we could kind of really project it. So the best example I could say is the revenue trends are better than they were 6 months ago, but that's more backwards looking. And as far as forward-looking goes, it's still -- short lead times are roughly, I'd say, roughly still 4 weeks now, that's on average. There are definitely new products that have longer lead times. But in terms of the average, you're still running at a relatively short lead time environment, and that's really a function of the fact that our utilization is relatively low and so is the industry.

Carter Shoop - KeyBanc Capital Markets Inc.

That's helpful. As a follow-up question, maybe a little bit of longer-term question here. How do you see the geographical mix changing over the next 2 to 3 years for the company? Do you expect to see China continue to decrease as a percentage of sales going forward?

Charles Swoboda

It may come down a little bit. We still have a lot of emphasis there. I think what you meant -- probably see is, is that we've made an investment to really improve our channels in North America, in Europe and the non -- and in Asia outside of the China market specifically. And so I think what you'll see is that I would expect China to grow, but I would expect the growth rates from some of those other markets to potentially be higher simply because 2 or 3 years ago, we -- our best sales team was in -- we had more sales resources in China than anywhere else. And I think we're building a more balanced sales force, so that's kind of the way I think about it.

Operator

Your next question comes from Jed Dorsheimer. [Canaccord Genuity]

Jonathan Dorsheimer - Canaccord Genuity

I have 2 today. I guess the first one, with China sort of falling off with -- the fact that you've successfully gone the old price before the specs are out, have you changed your tune on the -- and you partnered with a nice large traditional bulb guy, have you changed your tune on the -- and become more bullish on the replacement bulb market?

Charles Swoboda

So that's a great question. The answer is no. I think what we've -- I think you got to think about the bulb market 2 ways. There's kind of the consumer replacement bulb market and I think there, our strategy is to be a component supplier to the major systems companies. I think the consumer bulb business is a unique business with lots of different factors, and I think we can be most effective selling LEDs. I think you will see us continue to do some things on the professional side. So we have our PAR38 and our LBR-30. Those are really professional, more very almost retrofit-type applications. We will still do some things there, but I think when it comes -- at least, for the foreseeable future, when it comes to the consumer market, I think we see those as opportunities to drive technology, stir innovation. But there's a difference between doing that and being able to effectively get products to the market and -- for all the channel issues. And at least for the time being, our plan is, is that we're going to leave that to our component customers and focus really on where we think we can drive innovation really at more some of the other system areas like the troffer.

Jonathan Dorsheimer - Canaccord Genuity

Sure. I guess what I was trying to get at is did you see that a bit more as a growth driver whereas before, I think you were, maybe you still are, but I think the growth driver that you talked about was some of the street lighting market. And then as my follow-up question, in terms of carrying your inventory levels, typically going into a transition, you want to carry higher inventories. So if we just took a scenario analysis and looked at hypothetically keeping sales flat, post the transition, where do you think inventories would come out in terms of days sales as you go through that 6-inch transition?

Charles Swoboda

Wow, I don't -- so you're kind of question is years from now, if we get through the transition, we have the majority of products, worst days sales. I think over time, you'll see the days sales come down. But we actually -- last quarter, we actually reduced inventory both in chips and components. Actually, the growth was in the lighting business. And I think in the short term, we're actually not increasing inventory in the chip area for the 150-millimeter transition. And the reason is, is that you don't have to be quite so conservative on the inventory when you have low utilization. We have tons of flexibility in the factory right now. So given that utilizations are lower, we're going to be able to work on the transition and probably do it leaner than we might do it if the factory was full. So I think we have a little more flexibility. So I think when you have to look at our inventory, there's so many moving pieces. Chips was down last quarter. Components was down. Lighting was actually up as we built really up the supply chain, both from a raw lift and a finished good standpoint for some projects we're working on. So I'm not sure that -- we've already kind of started to manage that inventory, and I don't see dramatic shifts in the inventory here over the next couple of quarters because I think we're already kind of got ahead of the curve a little bit on the chips and components.

Operator

Your next question comes from Olga Levinzon. [Barclays Capital]

Olga Levinzon - Barclays Capital

I was hoping you can talk a little bit more of on the implications for your gross margins from the move or the increasing mix in the actual LED modules and the lighting systems themselves. Specifically, I guess outside of the fact that it's a little lower than the components business, how do you think about the actual transfer pricing between components and systems? And whether this move will actually pull down the component gross margins as you go forward?

Charles Swoboda

Yes. Well, when we sell products between the businesses, we're not reporting the gross margin on that. So you only get it reported once we sell the lighting system. So it's transferred internally at costs. So essentially what you're seeing is, is the real gross margin, whether we sell a chip at the chip level or component, those are the margins for products that are sold as finished products, not within the company. So that's how we manage that today. As far as the implications going forward, well, our goal is to continue to drive improvements at the systems level so that as that business, if it does incrementally increase, that we're able to still drive the business towards our near-term target of getting it back into the low 40% range.

Olga Levinzon - Barclays Capital

Got it. And then in terms of your comments on the potential CapEx into fiscal '12 of $160 million, can you talk about what percentage of that is targeted at incremental capacity rather than just convert into 150-millimeter?

Charles Swoboda

Yes. So most of the short-term spending there is really technology-oriented. So there's capacity, there's capital for pure capacity and there's capital really to support new technology. We're continuing to do new developments, new chip design, new process technologies, new manufacturing steps. These -- the investments we're making in the near term are really going to be technology oriented. And then as the utilizations come up, that's when we would start to spend more of the money on capacity. As John said in his comments earlier, in the short term, very little of our short-term CapEx is for capacity just because the utilization rates give us plenty of buffer in the near term. So we will continue to invest, but it will be at a lower rate until we see the demand in the utilization rates pickup.

Olga Levinzon - Barclays Capital

Got it. And then just a final question...

Operator

Your next question comes from Satya Kumar. [Credit Suisse]

Satya Kumar - Crédit Suisse AG

I know you guys mentioned that your lead times are lower. I was wondering if you could quantify that in terms of weeks.

Charles Swoboda

Yes, I would say on average, our components lead time is probably 4 weeks, and that would be for the main high runners. There are definitely products that are farther than that. They would tend to be some of the application-optimized products or some of the high-end ones have longer lead times but it -- and that's about what it was 3 months ago. So the lead times have not changed dramatically right now. What we've seen is an increase in demand, but the industry is taking an advantage of the fact that Cree and others have very short lead times.

Satya Kumar - Crédit Suisse AG

And do you break out sales -- what portion of sales was to disti versus others and how that portion might have grown in fiscal Q4?

Charles Swoboda

We don't break it out. What I can tell you on a qualitative basis is that both of them grew. I don't have it in front of me which one grew faster, but both of them grew last quarter.

Operator

And our final question comes from Hans Mosesmann. [Raymond James & Associates]

Hans Mosesmann - Raymond James & Associates, Inc.

Can you guys confirm what was your long-term gross margin model? I think you said mid-40s, I thought it was in the mid to high 40s.

Charles Swoboda

Yes, Hans. What we've done is -- really the point there was to focus people on right now, last quarter, we were right around 39%. This quarter's target is 38% to 39%. And really, it's more of a shift. In the near to midterm, our goal is how do we drive the business back in the low 40s and then we'll worry about what the model is from there. So that's really more of a focus on -- we still have our long-term goals, but at the same time, the reality is, is what most people are focused on, including us, is how do we drive up that utilization? How do we drive demand which will then basically give us the leverage to get the margins back up, at least at the next step in the below 40s?

Hans Mosesmann - Raymond James & Associates, Inc.

Yes, I understand. I just want you to confirm that it's mid to high 40s. And I have a follow-up just on the use of sapphire versus silicon carbide.

Charles Swoboda

Hans, actually, I think what John said is he threw out mid-40s, and my point to that would be is, we're not -- I'm not overly trying to push that number one way or another right now. So mid-40s is as good a long-term target as any, but that's not really what our focus is. Our focus is really how do we in the near to midterm get the business back and to the low 40s and then we'll worry about the next step from there. So it's definitely on our long-term goal. We're using mid-40s. But the focus is really internally and where we think what most investors is really on how do we get it moving back in the right direction in the near to midterm.

Hans Mosesmann - Raymond James & Associates, Inc.

Okay, clear enough. And then can you parse out, if you can, if you're using sapphire wafers or substrates versus silicon carbide and what's the mix, if that matters?

Charles Swoboda

Yes. Hans, we're only using sapphire and R&D at this point. We still are doing all of our volume production on silicon carbide wafers.

Operator

And there are no further questions.

Raiford Garrabrant

Okay, thank you for your time today. We appreciate your interest and support, and look forward to reporting our first quarter results on October 18. Good night.

Charles Swoboda

Good night, thank you.

Operator

This concludes today's conference call. Thank you for your participation.

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!