Cree Inc. F2Q08 (Qtr End 12/30/07) Earnings Call Transcript

| About: Cree, Inc. (CREE)

Cree Inc. (NASDAQ:CREE)

F2Q08 Earnings Call

January 22, 2008 05:00 pm

Executives

Raiford Garrabrant - Director of Investor Relations

Chuck Swoboda – Chairman, CEO

John Kurtzweil – CFO

Analysts

Ahmed Kapoor – Piper Jaffray

Andrew Wong- American Technology

Vijay Rakesh – Oppenheimer

Dennis Thompson – Davenport

Hanz Osmond – Raymond James

Jed Dorsheimer - Canacccord Adams

Operator

At this time I would like to welcome everyone to the CREE Incorporated Second Quarter 2008 Fiscal Year Financial Results Conference Call.

(Operator Instructions)

As a reminder ladies and gentlemen, this conference is being recorder today, Tuesday, January 22, 2008. Thank you.

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

Raiford Garrabrant

Welcome to Cree’s Second Quarter fiscal 2008 Earning’s 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 of CEO and John Kurtzweil, Cree’s CFO will report on our results for the Second Quarter of Fiscal Year 2008. 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 which is posted in the Investor Relations Section of our website at www.cree.com under financial metrics quarter ending December 30, 2007.

Today’s presentation includes forward-looking statements about our business outlook and we may make other forward-looking statements during the call. This may include comments concerning trends in revenues, gross margin and earning, plans for new product and other forward-looking statements indicated by words like “anticipate,” “expected targets” and “estimates.” 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 of different materially. Also, we would like to note that we will be limiting our comments regarding Cree’s Second Quarter of Fiscal Year 2008 to a discussion of the information included in our earnings release and the metrics posted in 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 or reproduction is permitted unless authorized by the company in writing. Consistent with our previous conference calls, we are requesting that only qualified analysts ask questions during the Q&A session.

Also, because 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 to allow more flexibility for our conference call attendees. For replay of the webcast will be available on our website through February 5, 2008. Now, I would like to turn the call over to Chuck.

Chuck Swoboda

We had a strong second quarter as revenue increase to a record $119 million with GAAP earnings of $6.6 million or $0.8 per diluted share and non-GAAP earning of $12.2 million or $0.14 per diluted share.

Both revenue and earnings came in at the high end of our target range for the quarter. Gross margin increased to 35% in Q2 which exceeded our target range to the yield improvements across several product lines. Higher factory utilization in Durham and increased production in China.

The revenue growth was driven by higher LED sales where both XLamp orders and shipments increased by double digits as we made good progress addressing the XLamp capacity by bringing online additional capacity on China.

LED chips and cargo sales remains solid and inline with both our targets and the previous quarter. Our power and RF products grew sequentially in Q2 which also set lower sales for our silicon carbide materials products.

Overall, we continue to be successful during the second quarter in executing our strategy to increase sales by growing our LED component product line while maintaining the current level of LED chips sales.

As we look ahead, we continue to target growth in our LED business due to increase components sales driven by the growing number of LED lighting application.

Over the last quarter, the global momentum for sustainable energy efficient lighting product has continued to build with the passage of the new Energy Bill that will require the use of more efficient lighting technology by 2012. This legislation is important and will force the lighting industry which has been relatively slowed to adopt new technologies in the past to change.

Although the momentum continues to build, we are still in the early stages of adoption. Until our lighting class LEDs were released 15 months ago, LED base general lighting was simply not practical. These LEDs enabled a few leading companies to release the first commercially viable LED lighting products to the market last summer. These products have now validated that LED lighting is real for both indoor down lights and outdoor parking and street lights. We expect the success of this first installation to spawn a wave of new products this spring from a larger number of the more traditional lighting suppliers.

These should expand the choices available for the end customer and further accelerate the adoption of LED lighting technology. We target that this cycle of new product will continue to fuel the growth of our LED product lines over the next several years.

I will now turn the call over to John Kurtzweil to review our Second Quarter Financial Result and our targets for Q3.

John Kurtzweil

For the Second Quarter of Fiscal 2008, we reported revenue of $119 million with GAAP net income of $6.6 million or $0.8 per diluted share which includes $5.6 million of net expense or $0.6 per diluted share from the amortization of the acquired and tangible stock based compensation expense and a one time property tax gain in G&A.

On a non-GAAP adjusted to exclude this item, net income for the second quarter was $12.2 million or $0.14 per diluted share. These non-GAAP results are consistent with one of the ways management internally measures Cree’s result. 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.

As Raiford mentioned at the beginning of the call, a reconciliation of the non-GAAP information for all quarters mentioned on this call are posted on our website.

Overall LED revenue increased 6% to $98.9 million in Q2 as compared to $93.4 million in Q1. Excellent product lines were (audio gap) during the quarter, as we made significant progress and increasing capacity, LED chip sales and CaCo high-brightness component revenue were similar to Q1 and in our targeted range.

Q2 materials revenue which includes wafers and gem stone products was $7.5 million or 6% of sales. High-powered products revenue which includes Scholtky diodes and wide-band gap microwave sales proved double digits to $4.8 million or 4% of revenue.

Contract revenue was $7.7 million or 6% of revenue for Q2.

Q2 GAAP gross margin was 35% which included stock-based compensation of $0.7 million or less than one point of margin. Overall, this is 400-basis point improvement over the first quarter due to better factory utilization to support higher demand for our internal components growth. The initial contribution from a portion of our XLamp production yield improvement and the transition of our power products to 100 mm wafers.

Included in the gross margin is approximately is approximately 150-basis points related to the inventory build, above our forecast during the quarter and we do not I expect to occur in the third fiscal quarter. This should provide you with some indication of potential cost leverage as we continue to grow the business.

GAAP R & D expenses where $14.9 million in Q2 and it included stock based compensation expense is $1 million, total R & D expenses were as expected. GAAP, SG&A expenses were $18.2 million for second fiscal quarter and included $2.2 million of stock based compensation expense and a one time gain of $0.7 million related to a property tax audit. Non-GAAP SG&A expenses were $16.7 million as compared to $15 million non-GAAP SG&A expense in Q1.

These increases primarily reflect the planned spending to increase the size of the sales force, patent-related litigation expenses and an extra week of expenses. As Q2 was a 14-week quarter versus our standard 13-week quarter, as a note, Q3 and the Q4 were both the 13-week quarters.

Also, during the quarter, we recorded $4 million of charges for amortization of acquired intangibles, which we do not include in our GAAP results and $0.5 million of obsolete asset write offs, which we do include in our non GAAP financial.

Net interest income of $4.5 million increased from Q1 as a result to the increased cash balances, resulting primarily from our higher cash flow from operation and the extra week of interest. GAAP and income tax expense for the quarter is $2.1 million for an effective tax rate of 24%, which is also our targeted tax rate for the balance of the year.

Our balance sheet has continued to strengthen with cash, short-term and long-term investment of $362 million as of the end of the Q2, an increase of $29.5 million from Q1. Cash flow from operations was $35.1 million and capital expenditures were $9.9 million for a free cash flow of $25.2 million during the quarter.

As I mentioned last quarter, we find to increase to our targeted capital expenditures to a range of $45 to $50 million.

Accounts receivables were $19.5 million as the quarter end, an increase of $4.5 million from Q1 which is primarily related to an increase in revenue.

Our daily sales outstanding were flat at 68. We target the day sales to stay in a similar range going forward for the growth and receivables to match our growing revenue. Inventory was $75.1 million at quarter end, an increase of $10.3 million from Q1. Our days of inventory rose to 88 and the inventory terms were 4.1. The increase in inventory was primarily due to higher than expected yield and we also utilized the extra production week to add work and process inventory for our component product lines to support the targeted growth over the next two quarters. We are targeting our inventory to be flat for Q3, which would decrease our days of inventory and increase our inventory term.

Now, I will give you an update regarding our outlook for what is typically a seasonally, slower third fiscal quarter which ends on March 30th.

We are targeting revenue to increase the range of $120 million to $125 million primarily due to higher LED sales. XLamp product revenue is targeted to grow double digits once again. The CaCo high brightness product line is targeted to be in a similar range of Q2 and the LED chip revenue is also targeted to be similar to the last quarter and inline with our planned range.

Targeted increase sales of high-powered products, which include our silicon-carbide Scholtky diodes in our products is expected to mostly offset lower sales of gem stone materials and lower contracts revenue.

Gross margin is targeted to be in a range of 34% to 36% on a GAAP and non GAAP basis with approximately $700,000.00 of stock based compensation. This target include continued yield gains in LEDs, increased XLamp production in Asia and a slight increase in expense from the initial ramp up of 100 mm wafers in our LED chip sale.

GAAP R&D and SG&A are expected to increase in the aggregate by approximately $1 million over GAAP expenses from the prior quarter. This increase is primarily due to the non-recurring property tax gains in the Fiscal Second Quarter.

On a non-GAAP basis, R&D and SG&A are targeted to remain flat and as a reminder non-GAAP expenses exclude non-cash stock based compensation expense of approximately $3.1 million and amortization of intangibles of approximate $4 million.

Interest income is targeted to be flat at $4.5 million based on an increase on our cash balances being offset by lower yielding investment due to lower interest rate. We are estimating our effective tax rate to be 24%. Based on an estimated $87.3 million diluted shares outstanding our GAAP EPS target for the third Fiscal Quarter of 2008 is expected to be in a range of $0.07 to $0.09 cents per diluted share, when amortization of acquired and tangible and stock based compensation are included.

We target non GAAP earning for diluted share in a range of $0.14 to $0.16 for the third fiscal quarter of 2008. Our non-GAAP bases EPS target exclude amortization of acquired and tangibles in the amount of $0.04 per share and non-cash stock based compensation in the amount of $0.03 cents.

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

Chuck Swoboda

We were in focus on five key areas that continue to drive our transformation into a global leader of energy efficient LED component. Our first priority is to continue to grow excellent product sales and enable the LED lighting revolution. We continue to make good progress in this area in the second quarter.

Orders and shipments for XLamp products grew double digits and our distributors continue to report growing numbers of new business opportunities related to LED lighting.

We had good execution on our capacity ramp up in Q2 and we exited the quarter with significantly higher production output and an improved ability to meet near term customer requirements. We drove continued industry momentum as Ann Arbor joined the LED city initiative in early Q2 and we launched the first phase of our LED work place to promote the use of LED lighting to help lead to sustainability initiatives across the commercial sector.

We target double digit order and shipment growth for this product line again in Q3.

Our second priority is the integration of CaCo, many of the integration items have been completed and we are starting to operate as a global company. We are in the process of transitioning to CaCo brand in China to Cree, which should be complete by the end of our fiscal year.

As we make this transition, we will start to refer the CaCo product line as high brightness component instead. High brightness component sale in Q2 were inline with Q1 despite lower sales for gaming application.

Our largest market for high brightness components remains large video screens for the China market. And, we are focus on expanding our sales and marketing activity to serve a broader range of application and a more global customer base. We target a similar level of high brightness sales in Q3 despite a shorter sales and production quarter in China due to the Chinese New Year holiday. We continue work with our key packaging partners and some of the major systems companies to provide our new high performance, small LED chips for back lighting applications.

This is a growing segment of our LED chip business and has enabled us to shift some of our production away from the low price, mobile products to new higher value chip products. As a result our external chip demand has remained stable and inline with past quarters, while we have been able to improve our margin due to a more stable product mix and higher factory utilization from increased internal customer demand.

We target external LED chip sales to be in a similar range as Q2 over the next few quarters.

Our third priority is to continue to develop our global sales coverage and drive growth with our distribution partners. We continue to add incremental global sales resources and we recently filled the key position with a hiring of a Regional Vice President of Sales for Europe.

Our investment and distribution continue to pay off with strong order and shipment growth to our distributors in Q2 for LED components. And, our distributors also reported a strong increase in there outgoing sale.

We are in the process of adding field application resources to our global-wide sales team, both internally and at our distributors. We are working with our distributors to leverage their existing capabilities to ramp up our high bright LED sales outside of China over the next two quarters.

Our fourth priority is to further expand our manufacturing capabilities in Asia to support increase packaged LED capacity requirement and reduce cost. We made good progress in Q2 as we were able to get the first phase of our new XLamp line installed and qualified at our China factory. This additional capacity was able to significantly reduce our major XLamp capacity constraints and we are now in a better position to support the plan growth of this product line.

We target additional XLamp capacity additions, coming online over the next two quarters and we are on the planning stages for further capacity additions for fiscal 2009 and fiscal 2010.

We saw the benefit of higher factory utilization, improved yields and increased Asia production that led the margin gains for both LED chips and components in the quarter.

Our fifth priority is to continue to develop our power in RF product line, to drive incremental growth and high value energy efficient application. Our power and RF business continue to grow in Q2 primarily due to increase orders for Scholtky diodes for power supply application where energy efficiency is becoming a more important product requirement. We are working on several new power products to expand a range of applications we can serve which are targeted to be introduced over the next two quarters.

Our RF revenue also increased in Q2 and we are focused on continuing to expand our gallium nitride product offering for broadband wireless applications with WiMax. We have started to see the benefit from converting our power products to four-inch wafers and we targeted additional revenue growth from power and RF in Q3.

I would also like to clarify some of the recent confusion regarding Cree’s use of silicon carbide substrates to make our LEDs instead of a sapphire substrate used by our competitors.

First, the customer does not care what substrate the LED Epi is grown on. They only care about the price and performance of the end product. Keep in mind that we are uniquely qualified to assess the benefits and tradeoffs. Since we are one of only two companies that has produced LEDs on both platform, we are the world’s only volume producers of silicon carbide and we are the first LED Company to start converting to four inch.

We could use either substrate, but we choose to use silicon carbide because it give us a lower substrate cost per chip than sapphire and just as important, it provides us a performance advantage. Although we believe we have the best solution for today’s products, we have not stopped inventing and continue to research a wide range of substrate and other material’s technologies for next generation products.

As we continue to look for the ways to build on our leadership and high performance lighting class LED. And, I mentioned last quarter, we are also focused on expanding our management team to help us build a global business. We made great progress in this area with the recent addition of two industry veterans. Soo Ghee Lee brings more than 25 years of LED industry experience with both HP and Avago and has joined Cree as our Vice President and general manager for Asia Pacific.

Wayne Nesbit who brings more than 20 years of global semi connector manufacturing management experience with both Motorola and Mindspeed has joined Cree as our Vice President of Manufacturing. We are very pleased that both of these industry leaders have chosen to join the Cree team and help us lead the LED lighting revolution.

We believe that the LED business will further consolidate over the next several years and we continue to evaluate ways to leverage our strong balance sheet with $362 million in cash and no debt, to move additional scale in terms of customers, channels, technology, people and manufacturing capability.

We are passionate about leading the LED lighting revolution and we continue to look for new ways to drive the adoption of this technology faster than some of the large traditional lighting suppliers seem to want this to happen. We view this resistance to change as a tremendous business opportunity for both Cree and the LED industry.

As we look ahead of fiscal Q3, we target higher LED revenue due to double digit growth in XLamp LED sales combined with LED chip and high bright component sales, in a similar range of Q2. In total, we forecast that the growth in LEDs combined with higher power and RF sales will more than offset lower material product sales to result in revenue increasing to a range of $120 million to $125 million with non GAAP earning of $0.14 to $0.16 cents per diluted share. These non-GAAP targets exclude amortization of intangibles, stock based compensation expense and related tax effect.

Although we are still in the early stages of the LED lighting revolution, the initial instillations are proof that LED lighting is real and it is happening now. We will now take analysts question.

Question and Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Ahmed Kapoor.

Ahmed Kapoor – Piper Jaffray

You could have mentioned that you were working to fix some of production bottlenecks for XLamp, can you maybe talk about exiting the quarter? Did you have all those bottlenecks fixed and then to what extent might some of those bottlenecks carry over into your March quarter expectations?

Chuck Swoboda

You know I think we made great progress to be able to deliver on our revenue targets that we have laid out for the quarter; so I feel like we did the things we needed to do last quarter are kind of in line with our plan, and more importantly got the CaCo factory up and running support that product line so I think we are in pretty good shape as we head into Q3. It does not mean we do not have more work to do obviously we are planning on adding additional capacity in Q3 and in Q4, but I think it is really more about capacity additions now than some of the bottleneck issues.

Ahmed Kapoor – Piper Jaffray

Okay, you mentioned some of the strengths coming out of China, are there any other particular end markets that are driving the strength and given some of the obvious concerns out there about the macro economy; can we even talk about how you are seeing the market shape up for the next several quarters?

Chuck Swoboda

Yes, I think all companies are affected to some extent by the macro factors, I think the difference for us in what we are seeing is that, our growth drivers are really about getting our new LED technology into some new applications and these are really not about further use of, this is not about the demands for cell phones or the total demands for TV’s but it is really about adopting or adapting those technologies to use LED technologies. So it is going to be more about how the general lighting adopt LED’s and how does notebook computers and TV has used the technology. So I think what we will not be immune, I think in a bit of the unique position that this is really about technology adoption which is what is going to be the determining factor whether or not we can hit our growth target.

Ahmed Kapoor – Piper Jaffray

Okay great. I have maybe only final question before turning it over, can you talk about some of the key drivers of your gross margins going forward and how shall we should think maybe of the timing of returning to 40% gross margin?

Chuck Swoboda

Yes, if you look at last quarter, it was factory utilization, it was yield improvement, it was getting a 100 mm for the power of business and it was getting to China for XLamp; those are really the big drivers. As we look ahead in the next couple of quarters, it is going to be continuing to drive factory utilization, we have obviously have lots of continuing opportunities and yield improvements, we are really just getting started bringing up the China factory for XLamp, so we would look for opportunities there, and you know although I do not think we will see a big impact in Q3; we are also starting a 100 mm conversion for LED’s now so I think maybe not at this quarter, but as we start to go into Q4 and early Q1, I think those are kind of the key things.

So it is really more of the same what we have been doing and it has not changed our target; it has not really changed our targets going forward. We are going to keep looking and try to make progress each and every quarter. That is the goal.

Operator

Next question comes from the line of Andrew Wong of American Technology.

Andrew Wong - American Technology

Great, so you mentioned in your prepared remarks that it is still early in the adoption curve for LED lighting, I am just kind of curious, when do you think the average consumer will be able to walk into a Lowe’s or Home Depot and then maybe find an LED fixture that he can buy himself?

Chuck Swoboda

Today, obviously you can walk in Lowe’s or Home Depot and you can find some specialty lighting products, personal lighting and things like that. In terms of, I guess you are talking about more general illumination type fixtures, I think what we are going to see, Andrew is that that will come, but I think where it is going to come first is really the more value added channel, places where LED lighting get specified in where people are actually out there trying to say, “I want to do more energy efficiency.” I think it is going to come more from the commercial sector in the beginning and then it will then move to the retail or individual home owner sectors.

So I think it will come, but I think it is going to start more commercial, but there is definitely a lot more attention to this idea of energy efficiency and sustainability, and so I think it is going to be more than traditional lighting distribution channels that will drive this at least in the beginning.

Andrew Wong - American Technology

Okay great, then I kind of have a separate question. I think there maybe some confusion out there of who the players are in power LEDs, so first if you could help clarify who you view as your major competitors for power LED’s and then second, can you just talk a little bit about the risks of commoditization for power LEDs?

Chuck Swoboda

To answer your first question, the majority of the time we are competing for the power LED business it is generally against Philips Lumileds. And look they have been in the business for the longest I think it is the reasonable for everyone to assume that they kind of started, they created the segment, so they are going to be the ones that kind of earned that starting position and that is what we see most first, and really what we are competing there is price performance.

To a lesser extent we are going to see Nichia and OSRAM, and they really have a different approach to the market and I would not really put them in the classic high power, they are coming at it from more of a little bit lower power, lower cost angle, but I would say it is probably right now premium Lumileds for the segments we are targeting especially general illumination; and then as we get on to some of the other related segments we are going to see Nichia and OSRAM in some of it; well but that is about it who we see in the marketplace today.

As far as commoditization goes, look I think all markets are going have people raising volume, investing in the technology and trying to get up the curb. What we are seeing in the power LED segment today is a lot of technology that is driving these things, it is pretty clear that not everyone has the same technical capabilities and none of us are standing still. So I think it is going to be a little while before we see some of those classic sign for two reasons: one, I think it is going to take time for everyone to try to catch up from a capability stand point and we are not done yet, and then second, I think really getting access; being able to get access to the channels and to the end customer and really be able to drive total solutions is not a simple part of the process, so I think it is a lot more variance to driving this thing than in the traditional consumer driven components businesses.

Andrew Wong - American Technology

Got it okay, and then since you mentioned Lumiled, it looks like last week they announced the major product recall, so it would seem to me that this opens up a pretty significant opportunity for you, so if you were to take a reasonable best case scenario for Lumileds and then a reasonable worst case scenario for Cree, can you assess the potential magnitude and timing of this opportunity and also just to clarify, did you see any benefit at all in the December quarter from this Lumiled take up.

Chuck Swoboda

Alright so the Lumileds take up was announced last week, so we did not see any impact last quarter, I will kind of take this in reverse.

What we have seen, but that is really only been in the last seven days or so, is a pretty significant increase in inquiries; one thing to keep in mind is power LED’s are like analog semiconductors, they are not dropped-in replacements. So we have a significant amount of increased activity, but for someone who has a design of one to switch the other it is not only board redesign, but it is probably an optics redesign and a product re-qualification, so it is going to be a time lag there.

When we looked at what is the potential impact, one thing it is going to be is how fast can Phillips Lumileds recover, I think that is still to be determined on their side; and the only to keep in mind is that it is more about new designs, so if you look at their business the products that are affected from our understanding are really their high-end K2 and the rebel products that use a new chip design.

So those are really not their mainstream business but really what is primarily focused on their new design opportunities.

So I think it impacts a fairly small percentage of their existing business and it is much more about, I think there are new designs that there are going to be a lot of opportunity created on. I am not sure we are prepared to give you a magnitude yet, but I think, it should be a positive, at least in terms of customer activity it already is and we will have to see where it goes that being said, I fully expect that they will get this resolved and be back in the game, we fully expect them to be a real competitor force in the long term.

Andrew Wong - American Technology

Got it, okay then, just one last question then I will get back in queue and I think you mentioned a little bit about this in your prepared remarks, but with Rubicon having done the right PO in mid November, it seems like there has been a lot of talk on silicon carbide versus sapphire. Could you just give us a little more color specifically on cost and technology?

Chuck Swoboda

Yes, at the end of the day the choice is what do you want to grow your Epi on? And as I said earlier, we choose to grow it on silicon carbide but we are pretty uniquely qualified that we have the expertise and how to do it on both and we have done it on both. That being said, at the end of the day, our cost, the substrate contribution cost to our LED chip is lower when we use silicon carbide than when we use sapphire, and so that is a pretty big reason for us to stick with our current approach, second we get better performance and so it does not make a lot of sense for us to switch if we do not get those two advantages, I think the confusion comes from the fact there is a lot of companies out there buying sapphire wafers, but the reality is we are not competing with most of them in the high performance setting such as the market place, and so I think there is a little confusion and mixing of apples and oranges here, and we are going to keep evaluating different options but for right now we feel pretty confident about where we are at. And, at the end of the day our customer care about price performance and their application and that is where we focus on delivering.

Operator

(Operator Instructions)

Your next question comes for the line of Vijay Rakesh of Oppenheimer.

Vijay Rakesh - Oppenheimer

Just a questions on those margins. So, is going forward the 35% , it that going to be sustainable level here?.

Chuck Swoboda

Well I think our targets for this quarter are going to be 34 to 36, so we are in a similar range and actually our goal is that, we are trying to drive increased throughput, more yield improvements and additional Asia production.

So, our goal affects it to drive it up. Kind of more mid to longer range targets is to get our gross margins in the low 40s and that is going to take us a little while. So, the goal is try to make a little bit of improvement each and every quarter on our way to that longer term goal.

Vijay Rakesh - Oppenheimer

A couple of reasons why your margins went up, so if you were to prioritize that, would yield improvements be the major one that has a skew in your gross margin side?

Chuck Swoboda

When we look at the different factors I would say, I would equally wait it between additional throughput, yield improvement and getting the initial act plant production up in China. I would say those three probably are the three bigger drivers and we got them a smaller benefit, but we have got to benefit from getting the power devices on a 100 mm, they are obviously smaller part of our business, so they contributed less to the overall. But, I would say those three were pretty easily weighted to driving the improvement.

Vijay Rakesh - Oppenheimer

And, here when you look at your revenues, can you explain by end market between lighting and the mobile or notebook blues, where is it today and where do you see that, let us say by the end of calendar 08?

Chuck Swoboda

Yes, right now for the December quarter, we look at our LED business, lighting and the video screen business. Those are the two biggest markets and they end up a little over 50% of the total with lighting being a little bit bigger than the video screen business but those are the two big ones. And, that is over half and then you get into the next segment with the combination of mobile is still important, but obviously a lot smaller than it used to be. Gaming still important and automotive would probably be the next three that make up the rest and then a lot of smaller applications after that.

Vijay Rakesh - Oppenheimer

And, do you see this kind of being the same split towards the end of the year also?

Chuck Swoboda

I think what you will see is that by the end of the year, lighting will continue to increase as a larger percentage of the total and then the other application that will start to get a little bit more attraction will be the notebook kind of TD backlighting, but that will be kind of a second half of the year effect.

Vijay Rakesh - Oppenheimer

Do you still notebook and on TV start to pick up in the second half?

Chuck Swoboda

Yes, I mean, there are a lot of activity going right now, but in terms of when it is going to drive, to be more effective on our business I think it is more of a second half of calendar 08.

Vijay Rakesh - Oppenheimer

Got it, one last question here, going back to the question on sapphire, Rubicon is moving to six inch sapphire and you guys are going to 4-inch silicon carbide, how do you think you are competitive with your competition here I guess?

Chuck Swoboda

The six inch sapphire is not the reason that people are not making LED’s on bigger wafers using sapphires, the Epi technology to use the larger substrates. Most LED companies are using two inch sapphire and a few are using three inch, and unless someone has recently changed, there is no one that has acknowledged that they have even started to go forage in any kind of real volume production so this is not about the source of the substrate supply, this is about who has the Epi technology to use those substrates. I do not think anyone is particularly worried about having enough sapphire, I think it is more about the Epi technology.

Operator:

Your next question comes from the line of Dennis Thompson (ph) of Davenport.

Dennis Thompson - Davenport

Can just talk a little bit about how the notebook opportunity has developed in terms of your ability to get market share or how you feel sort of just your overall position in that space and then also could you talk a little about whether or not intellectual property issues are popping up either trying to sort of penetrate the notebook market or just in general in the market these days?

Chuck Swoboda

Yes so what we are seeing in the notebooks side is that this is primarily, for Cree, this is really a LED chip business opportunity. And what is happening is that the notebook guys are pushing pretty hard for high performance LED chips for these applications and when I say high performance these are the high power, these are the smaller chips similar, basically an upgraded version of what you would use for a backlighting smaller LCD screens. And there is a lot of push and I will be honest, the notebook guys are probably the most stringent customers we have today about wanting to discuss and review the IP situation as they go forward.

So I think it is obviously helping drive some of the overall demand on the chip side for us, and we feel like we are in a pretty good position through our packaging customer to address that market.

Dennis Thompson - Davenport

And then could you just talk a little bit about how much work you might have left to do in building out your sales force for the general lighting opportunity and then maybe what channels are proven the most successful for you in the various relationships you have created that you focused on?

Chuck Swoboda

We feel like we are in good shape here in North America. We feel like we have a good position in China. Our Asia team is in pretty good shape as well. We probably got a little more work to do in Europe right now, I think we just got our new VP of Sales there so we have got a little bit more work to do from internal of Cree investment, but I think it is going to be less about additional direct sales and more about the applications and technical field sales support is where you are going to see the investment shift to now which is I think we are accessing the customers, but it is really about helping the lighting guys work through the design process to really make their end product work.

From Cree channel and partners which are working better, our distribution strategy is really focused around Rebel, and then as well as world peace groups, really are two big distributors, but we also have regional distributors in most market and I would say that generally, distribution as a whole is doing a nice job obviously, it takes a little while for us to work with them, get them up to speed on the product offering, get that momentum going, but I think, we are feeling pretty good about the rate at which they are identifying new opportunities, the rate in which we are starting to see some closure to them and then also the fact the funnel, even though we are getting new business the funnels continues to expand so that is pretty good.

And it is not just us supplying them, but also seeing some decent sell through on their part that continues, it is growing sequentially. So it think feels pretty good distribution channels working. I would tell you that we still feel like we have a lot of work to do on the technical sales side, but overall it is working pretty well.

Dennis Thompson - Davenport

And then last question just what are your thoughts or comments on the Philips Genlyte acquisition and does that change the dynamic for you guys in any way.

Chuck Swoboda

If you know what I see from the Philips Genlyte is really just a kind of further acknowledgement that if you are a traditional light bulb company you have got to do something to compete in this market longer term.

From my stand point they have made a lot of investments on the LED side and now you see them working on the fixture side and if you buy into the model and I think Philips does that the LED is just going to disrupt the light bulb industry then it is pretty clear to me that they are positioning themselves as a fixture company so that they have a long term proposition so, from our standpoint, it kind of further validates what is going to happen out there.

Operator

(Operator Instruction)

Your next question comes from the line of Hanz Osmond with Raymond James.

Hanz Osmond – Raymond James

Chuck, there are a couple for you and then a couple for John. The CaCo side, the business has been flattish for the past couple of quarters and you are guiding flat, is that within the expectations when you made the acquisition and when do you expect it to resume some kind of growth?

Chuck Swoboda

When we made the acquisition we had three objectives, one of them was we wanted to access their China sales force to drive the overall lighting sales strategy which is really XLamp product. When we are talking about CaCO or high brightness LED’s we are excluding the fact that there are actually growing their business if you include the growth of their power LED products, we are putting those in the XLamp numbers.

Well so far that was really our first focus; the second big focus was obviously to get their manufacturing capability brought up to speed for the XLamp because we knew we needed that; so that is going pretty well. And then the third piece was how do we expand the overall breadth of the high bright component product sales.

And we have made progress in getting new customers and really expanding primarily in the video screen application, unfortunately we did that at the same time that we saw our gaming sales there slow down. So the games we made in one instead of growing the business really just offset the losses we had on the gaming side.

I think going forward, now that we have the other two things done, as we expand that product line we really take it outside of China as well as bring on some additional packages that will service more than just the video screen market, I think we can see some growth probably not a lot obviously this quarter, we are guiding relatively in line and that has a lot to do of the fact that it is also the Chinese New Year quarter.

But I think as we get into Q4 and then into the new fiscal year, our target is to start to see growth as well on the high bright components, but probably not really in Q3 more of an opportunity starting in Q4 and that is really the function of the time it takes to get the new parts out there get them qualified with the customers and get the channel up to speed.

Hanz Osmond – Raymond James

Okay and then one more for you Chuck and then I go to John, on the LED chip business, is this going to be flat for some time, it has been, why would you not outsource some of that business, it seems to be a little more commoditized, why would not you go to like a startup something like that and get chips there and use your brand to sell these products?

Chuck Swoboda

For right now, I think our focus is kind of the strategic vision of the chip businesses kind of keep it in this range and because we feel like the resources are to drive the growth or better focus at the components level, it does not mean we do not want to continue to support the chip business, but really focus it on the more high value applications and frankly one of the things we see is as we continue to drive chip performance to get new products out there, what we saw last quarter is, when we are able to grow things like our higher valued chip products, we are able to kind of get out to some of that older business which in effect is really from a mixed stand point, is actually driving up our margin even in the chip areas, so we kind of feel like it is a good use of Cree resources, you could argue that we could resell or sub contract out some other products, but I am not sure right now that we feel like that is the best use of our sale team’s time or our resources.

We really feel like we need to want to drive the growth to the components level, but I am not going to say never, but it is really not a new year team focus for us.

Hanz Osmond – Raymond James

John, just two items; what was the stock based compensation portion of your guidance for your Q3 and then some guidance sort of interest income how you see it going forward since it jacked up here quite a bit, Do you expect it to be 4.5 million or so for the next several quarters?

John Kurtzweil

Let me take the stock based compensation first and then I will hit the interest.

Now what we have said is that there will be about $700,000.00 of stock based compensation in cogs and then there will be approximately $3.1 million in our R& D and SG&A. so for a total about $3.9 million in total before you tax effect it. And as far as the interest income, what I see is that, we expect to see that be flat this quarter, even though we have higher cash balances, we are generating cash, now you can imagine the move by the Fed to lower interest rates, over the last couple of quarters. What they just did today is going to put a squeeze on that so I would keep it in that similar range for the next couple of quarters until we can sort out what is happening with rates.

Operator

Your next question comes from the line of Michael Burton with Thinkequity Partners

Michael Burton – Thinkequity Partners

Just a clarification first, when you spoke on the new high brightness component segment, is that just going to be an aggregation of XLamp and CaCo and going forward? You are going to break that out? Was that 10% of revenue in the previous quarter?

Chuck Swoboda

Yes, no. Let me clarify that. What I am trying to say is that we have been talking about CaCo as a product line, but also as a part of Cree and they do more than just make high brightness LEDs, obviously, they sell high power components.

What I am talking about, when I say high brightness, we are not going to break it out but I want to make sure that investors will have a chance to kind of get a sense for the trends whether it would be chip, high brightness component, what you should think of as the traditional CaCo product line and then separately, XLamp or high power or lightning component.

So, we are still going to try to give you at least qualitative view of those three sections within the LEDs, but it is not combined. It is really the old CaCo product line as a way to think about it.

Michael Burton – Thinkequity Partners

Okay and the 10% customers in the quarter?

John Kurtzweil

We do not break out 10% customer accepting, but no significant customer shifts in the quarter.

Michael Burton – Thinkequity Partners

And then lastly, nice job on the guidance for the Apex being flat, certainly coming down at the percentage of the revenues, how should we think about the Apex going forward? Or, will you maintain this level and bring it down as a percent of sales? Or, should we be modeling some modest increases toward the end of this calendar year in that?

Chuck Swoboda

We appreciate the compliment. I think we are getting a little bit of benefit from the fact that we going for 14 back to 13 weeks. Right, so, we are growing it a little bit, but as the percentage obviously, it is starting to shrink a little bit. I think what you are going to see is, we will continue to invest in R&D.

I would imagine in total dollars that will grow in the future but I think the SG&A line, G&A definitely should not grow as fast and I think sales, although there is additional investment, we have been in pretty high spend loan. So, I think we will see incremental investments going forward, but I would not expect it to have it grow at the rate it has been growing over the last year.

So, there would be some but hopefully the biggest gross should be at the R&D and the other areas hopefully we will get a little bit more leverage.

Operator

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

Jed Dorsheimer - Canacccord Adams

First question, Briggs Locks (ph), do you not see them as a competitor?

Chuck Swoboda

We do not see them as a competitor in any of our accounts today although we do have a lawsuit against them at this point.

Jed Dorsheimer - Canacccord Adams

And why are you suing them?

Chuck Swoboda

For IT infringement.

Jed Dorsheimer - Canacccord Adams

Alright, but they are not a competitor?

Chuck Swoboda

Not a significant one in our day to day business. No.

Jed Dorsheimer - Canacccord Adams

Alright, what about Semilead, Citizens, Epistart and SEMCO? You see those guys competitors on the power site?

Chuck Swoboda

So walk me through them one at a time again, Jed.

Jed Dorsheimer - Canacccord Adams

Semilead is a private company over in Taiwan, making 90 lumens per watt, type of power chips? Then Citizens Electronic which I think is a customer of yours, but they also have a light bar in the power chip market, Epistar which I think you are familiar with, over in Taiwan and then SEMCO, which is Samsung’s Manufacturing Arm.

I am just wondering if you see any of those four as competitors in the power chip business.

Chuck Swoboda

Power chip or power package LED business?

Jed Dorsheimer - Canacccord Adams

Power packaged LED business.

Chuck Swoboda

Excuse me, so in a case of Semilead, they are not making the packaged LEDs, they are making the chip, which would sell to a packager that would create a power packaged LED?

John Kurtzweil

Yes, so let me walk you through those. And again, it does not mean these guys do not offer products on our segment, but I am telling you which ones we actually run into in any regular basis that we would be competing with. We know that Semilead offers chip, we do not view them as a significant threat to our business today despite their claims.

Citizens, we view them as a potential customer for our chip products and we know that they have components out there, but we really do not see them as a competitor to Cree on these things we are doing. Epistar, yes we see them on the low end of the chip. They are obviously a very large supplier of gallium nitride LED product.

But, we really see them on the low end of the market. We do not see them at the high end for any of our big chip application and SEMICO as a packager is really focused. We know that they are pretty active at SAMSUNG itself, but we do not sell components directly at Samsung right, we are generally a chip supplier so we do not really see them as a chip competitor. SEMICO maybe competing with our packaging customers, but we do not really see ourselves competing with them directly in any accounts out there.

Jed Dorsheimer - Canacccord Adams

Alright thanks that is helpful, and then on the four-inch, I think OSRAM and two companies in Japan, one in Korea and then another one in the US that has manufacturing in Malaysia have some four inch capabilities that are processing products, are you not seeing that?

Chuck Swoboda

No we do not see any significant amount in that volume making it to the market, we know there are people are working on it, but we do not see a significant impact on that in the market place from the people we are talking to.

Jed Dorsheimer - Canacccord Adams

Alright and then on the—it looks like (inaudible) some aluminum game nitrate patents that expire I think there is a Japanese patent that expires March 1st and then there is a US patent that expires on the 16th, are you at all concerned that this may allow other or existing chip companies that are already operating using an aluminum gallium nitrate buffer layer and to the market with IP-free technology or you are not concerned about that?

Chuck Swoboda

You know when we look at the TG patents that have been around a long time and I do not think there has been a barrier to anybody getting into the business so far, so I always think they will never file this suit against anyone on them, so they are out there I do not really view them as part of the big part of portfolio. I do know that those are expiring but I do not think most people consider them a major barrier maybe they do but I am not aware of it.

Jed Dorsheimer - Canacccord Adams

Alright and then just a follow up on Hanz’s comment in terms of CaCo, if the CaCo business is staying flat basically on a quarter to quarter perspective, but the agreement that you have with Light Engine I think requires if I read the addendum correctly, it requires to actually see a 10% sequential increase of purchases from CaCo. So is that growing as a percentage of the CaCo, the question is, is Light Engine growing as a percentage of the CaCo business and is it over 50% at this point?

Chuck Swoboda

The answer is no, it is not growing as a percentage, it is about the same old over all level that was before we bought them, and it is not growing as a percentage.

Jed Dorsheimer - Canacccord Adams

Alright, should I look at that if I look at the 10% from the $9.7 million back in June sequential increase starting in September, is it about $12 million is that the right level to look at for Light Engine?

Chuck Swoboda

You lost me on the math there.

Jed Dorsheimer - Canacccord Adams

The 9.7 million was the amount I think that you disclosed in your 10K.

Chuck Swoboda

Jed, $9.7 million what?

Jed Dorsheimer - Canacccord Adams

In sales for Light Engine.

Chuck Swoboda

Jed, I will be honest. I would have to pull out the queue, what I know is in total they are running about the same, the business has not grown really significantly since we bought it right. It has been basically flat the last few quarters, they are running about the same level in total business now as they were when we bought them, I do not have the specifics in front of me.

Jed Dorsheimer - Canacccord Adams

Alright the yield increase that you saw during the quarter. could you elaborate on that at all?

Chuck Swoboda

We saw improvements in yield pretty much across the factory. We saw improvements in dye production, we saw improvements in XLamp production, and actually even in substrate production, so it is generally a pretty good quarter overall.

Jed Dorsheimer - Canacccord Adams

Alright and then so the XLamp, are those running at corporate averages at this point?

Chuck Swoboda

No, we still have a lot of room for improvement. We definitely made progress, we are pretty much on the track what we are trying to do last quarter, but no, they are not at the corporate averages. We still got some opportunities there and I think what we will see is that, and I am not talking about the yield I am talking about from a margin stand point, I think that the yields are doing fine, but I think as we continue to increase production in China we will start to see continued improvement there over the next couple of quarters.

Jed Dorsheimer - Canacccord Adams

And then two last questions and then I will jump back in the queue although I think I might be last. One, are you outsourcing any of your packaging for the XLamp at this point?

Chuck Swoboda

Yeah we have had subcontract that is qualified for about a year now.

Jed Dorsheimer - Canacccord Adams

And it is not CaCo.

Chuck Swoboda

Correct.

Jed Dorsheimer - Canacccord Adams

I guess I was confused, I thought that CaCo was going to be doing the packaging for you there.

Chuck Swoboda

They are but remember, before we bought CaCo, we had already qualified a sub contractor to support the additional capacities, so that they have been online for probably I do not know, 18 or 24 months now, so before CaCo, we had already brought up a subcontractor and we are continuing to work with them as well, because we think the multi-source definitely is the way to go here.

Jed Dorsheimer - Canacccord Adams

All right, and John depreciation, why was it down quarter over quarter?

John Kurtzweil

Depreciation is down, we have been adding fewer and fewer assets as you look at our casual statement when it comes out. The increase in capital is not there and older equipments rolling off.

Jed Dorsheimer - Canacccord Adams

All right, and then last question, Chuck, just on the silicon carbide versus sapphire, I think a lot of the confusion probably had to do with not to be the cost of the silicon carbide versus sapphire but the processing, and just to clarify, when you are doing your thinning, are you actually thinning from roughly 350 microns down to a 100 microns and using a lapping process. And I think that that actually compares to some of the sapphire manufacturers are doing with the laser ablation. So I guess my question is, are you to using lapping process to thin or you are using a laser?

Chuck Swoboda

Yes Jed, as I mentioned last quarter, I think we discussed it then that we do not disclose process that we are using. We are pretty sure we are the only one using it and it is proprietary, and I think cost is the only metric. I mean, if the cost is lower what other metric matters? As long as the performance is high and the cost is low, what metric should we be using?

Jed Dorsheimer - Canacccord Adams

So I would argue that the overall cost, the end result is not lower than using an OSRAM process that is using a laser ablation or the Philips Lumled process to remove the sapphire.

Chuck Swoboda

I am not sure you want a benchmark Philips Lumiled’s process right now. It is the standard we are going for but we feel pretty good. Look, I think not only our cost of the substrate but our overall cost, we feel like it is pretty darn competitive out there, and we think our approach works. Yes, I understand the perspective but don’t think that—I think we probably have a more efficient process than maybe is perceive by some of our competitors.

Jed Dorsheimer - Canacccord Adams

All right fair enough, thanks for letting me ask questions. I will jump back in the queue.

Operator

Our last question comes from the line of Andrew Wong, American Technology.

Andrew Wong - American Technology

This is just three quick follow ups, first do you think you can comment in general of whether your visibility has improved relative to what date two quarters ago.

Chuck Swoboda

Well Andrew, I am not sure about two quarters ago, I can tell you we are sitting in about the same position now as we were at this point last quarter. So, I am trying to remember what it was like in the July quarter, in our Q1 but I can tell you relative to last quarter about the same point.

Andrew Long - American Technology

Okay got it. And then secondly with respect to your new XLamp line in China, I know that it just got third in December quarter so would you say that the yield in China are comparable those of North Carolina, just directionally I am just kind of curious.

Chuck Swoboda

Yes.

Andrew Long, American Technology

Okay great. And then third, given how quickly it looks like demand is accelerating here, do you think you can give the little more color on your expense for additional capacity expansions beyond 2008?

Chuck Swoboda

Well, obviously we already announced what we are going to do for this year, for beyond 2008 basic additional equipment and we our China facility to support growth so we are looking at that from a packaging stand point, and we definitely have an opportunity to continue to grow there.

At some point between in 2009, 2010 it is going to depends on what the overall growth continue to look like but there is probably, at some point and not in the too distant future, we have got to look at the second factory for packaging and then in parallel to that the dye fabs still have some capacity but at some point here in the next couple of years we are going to have to bring online Asian-based dye fab, and so we are looking at that as well right now. We have not made up a final decision on which way we are going to go there but it is likely we are going to have to be making a capital investment in Asia to also increase dye fab capacity within the next couple of years.

Operator

At this time, there are no further questions.

Chuck Swoboda

Thank you operator and what I would like to do is thank you for your time today, and we appreciate your interests and support and look forward to reporting our Third Quarter of Fiscal Year 2008 results on April 22 and good night to you all. Bye.

Operator

This concludes today’s conference call, you may now disconnect.

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