Cree Inc. F3Q08 (Qtr End 03/30/08) Earnings Call Transcript

Cree Inc. (CREE)

F3Q08 (Qtr End 03/30/08) Earnings Call

April 22, 2008 5:00 pm ET

Executives

Raiford Garrabrant - Director of IR

Chuck Swoboda - Chairman, President and CEO

John Kurtzweil - EVP Finance, CFO and Treasurer

Analysts

Andrew Huang - American Technology Research

Yale Reino - Oppenheimer and company

Amit Kapur - Piper Jaffray

Carter Shoop - Deutsche Bank Securities

Jiwon Lee - Sidoti & Company

Bennett Notman - Davenport and Company

Hans Mosesmann - Raymond James

Michael Burton - ThinkEquity Partners

Jonathan Dorsheimer - Canaccord Adams

Presentation

Operator

Good afternoon. My name is Heather, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Cree Incorporated third quarter 2008 fiscal year financial results conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator Instructions) As a reminder, ladies and gentlemen, this conference is being recorded today, April 22, 2008. Thank you.

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

Raiford Garrabrant - Director of Investor Relations

Thank you, Heather, and good afternoon. Welcome to Cree’s third quarter fiscal 2008 Earnings Call. By now, you should have all received a copy of the press release. If you didn’t 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 third 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 March 30, 2008.

Today's presentation includes 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 would like to note that we will be limiting our comments regarding Cree’s third quarter of fiscal year 2008 to a discussion of the information included in our earnings release and the metrics posted on our website. We will not be able to answer any questions that would involve providing additional financial information about the quarter beyond the comments made in the prepared remarks.

This call is being recorded on behalf of the Company. The presentations and the recording of this call are copyrighted property of the Company, and no other recording or reproduction 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 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 to allow more flexibility for our conference call attendees. A replay of the webcast will be available on our website through May 06, 2008. Now I would like to turn the call over to Chuck.

Chuck Swoboda

Thank you Raiford. We delivered another good quarter in Q3, as revenue increased to a record $125 million with GAAP earning of $5.7 million or $0.06 per diluted share, and non-GAAP earnings of $12 million, or $0.14 per diluted share. During the quarter, we took a bold step in leading the LED lighting revolution with our acquisition of LED lighting fixtures, which added approximately $700, 000 in revenue, and reduced earnings per share by approximately $0.01 for the third quarter.

Excluding this acquisition revenue, gross margin, and earnings were all within our target range for the quarter. Revenue growth was led by another double digit sequential increase in XLamp LED sales, which enabled total LED component revenue to exceed LED chip revenue for the first time in Q3. LED chip and high brightness component sales were inline with both our target and the previous quarter, and [will power] and RF products grew sequentially, which partially offset lower sales for our silicon carbide materials product, and lower government contract revenue.

Overall, we continue to successfully execute our strategy to drive the growth of our business to higher LED component sales. As we look ahead into Q4, we target growth from XLamp LEDs, high brightness LED component, and our new LED lighting solution. All these product lines are being driven by LED lighting applications, where the global momentum continues to build for sustainable energy efficient lighting products.

We recently participated in the biannual light and building trade show in Frankfurt, Germany, where LED lightening was featured prominently throughout the trade event, and our XLamp LEDs were widely recognized as the gold standard for power LEDs and lighting. Despite the high profile of LEDs at this lightening event, it was interesting to note that the large traditional suppliers still seemed to be trying the downplay of the timing of LED lightening adoption, which we see as a great opportunity for Cree.

I'll now turn the call over to John Kurtzweil, to review our third quarter financial results and our targets for Q4.

John Kurtzweil

Thank you, Chuck. In January, we targeted the following financial results for the third fiscal quarter. The revenue was targeted to be in the range of $120 million to $125 million. Gross margin was targeted between 34% and 36% with GAAP R&D and SG&A expenses targeted to increase by $1 million. Non-GAAP R&D and SG&A expenses excluding stock option expense were targeted to remain flat. Interest income was targeted to be at $4.5 million, and diluted average share count was targeted to be 87.3 million shares. EPS for the quarter on a GAAP basis was targeted to be in a range of $0.07 to $0.09.

On a non-GAAP basis excluding amortization of acquired intangibles and stock based compensation, EPS for the quarter was targeted at $0.14 to $0.16. And, finally, in connections with the announcement of our acquisition of LED Lighting Fixtures, we announced that we expected to add approximately 1 million to our revenue and reduced EPS by approximately $0.01 for the quarter.

Our financial results for the third fiscal quarter are: revenue of $125 million, which includes approximately 700,000 from our acquisition of LED Lighting Fixtures or LLF. LED revenue increased 7% to $105.5 million in Q3, as compared to $98.9 million in Q2. The XLamp product line sales again increased by double-digits during the quarter, as we made significant progress increasing capacity to meet our customers’ needs. LED chip sales and High Brightness component revenue were similar to Q2 and within our targeted range. This is the first quarter that the LED component product sales were more than half of overall LED revenue.

Q3 materials revenue, which includes wafers and gemstone products, was $6.3 million, or 5% of sales. High powered products revenue, which includes our Schottky diodes and wide-band gap microwave sales, increased to $6.2 million, or 5% of revenue and contract revenue was $6.8 million or 5% of revenue for Q3. GAAP gross margins of 35% included stock based compensation of $0.6 million, or approximately one half of a point of margin.

GAAP R&D and SG&A expense was $36.5 million. This was $2.4 million higher than targeted primarily due to higher patent litigation cost, the acquisition of LLF, increased R&D, and higher sales expenses.

Non-GAAP R&D and SG&A expense was $32.9 million excluding stock option expense of $3.6 million. Interest and other income was down to $3.9 million from lower interest rates.

Diluted average share count increased $1.6 million shares above our target to $88.9 million from the shares issued for the LLF acquisitions and the exercise of option. GAAP profit was $5.7 million and GAAP EPS for the quarter was $0.06, which includes the impact of lower interest income and an increase in the share count. And, non-GAAP profit was $12 million with non-GAAP EPS of $0.14, which excludes stock option expenses and amortization of intangibles.

Please note that non-GAAP results are consistent with one of the ways management internally measures Cree’s results. 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 as supplement to and not a substitute for financial statements prepared in accordance with GAAP. As Raiford mentioned at the beginning, a reconciliation of the non-GAAP information for all quarters mentioned on this call is posted on our website.

Moving on to the balance sheet, it has continued to strengthen with cash and investments of $398 million as of the end of Q3, an increase of 36.4 million from Q2, and no debt. Capital expenditures were 16.4 million for the quarter and we have targeted capital expenditures in the range 45 million to 50 million for fiscal 2008.

Accounts receivable were 116.6 million at quarter end, an increase of 21.1 million from Q2, and our day sales outstanding increased to 80. Inventory was 83.3 million at quarter end, an increase of 8.3 million from Q2, which included approximately 1.6 for LLF. Our [days] of inventory rose to 92, and inventory turns declined to 3.9. More than half of the increase was in raw material and from LLF.

As we become more vertically integrated and continue to ramp our component product lines, the internal supply chain is no longer viable, and we will inherently be carrying more inventory. We are working to streamline the internal supply chain, which will help us to be more responsive to our customers's requirements and improve our profitability.

I will now take sometime to go over more of the financial details of the LED Lighting Fixtures transaction, which was announced on February 8th and closed on February 29th. We acquired all the outstanding shares of LED Lighting Fixtures in exchange of approximately 1.9 million shares of Cree's common stock valued at 58.8 million and cash of 16.5 million.

Additional shares or additional consideration of up to 26.4 million in cash may be payable over the next three calendar years tied to new product milestones and key employee retention. We have commissioned a valuation analysis and the acquisition would be accounted for under the purchase method of accounting as described by SFAS 141 business combination. And all related goodwill and other intangible assets will be accounted for in accordance of SFAS number 142 goodwill and other intangible assets. We target this valuation analysis to be completed during the fiscal fourth quarter.

Now I'll give you an update regarding our outlook for the fourth fiscal quarter, which ends on June 29th. We are targeting revenue to increase to a range of 129 million to 133 million, primarily due to higher LED sales. XLamp product revenue is targeted to increase to double-digits along with growth of our high brightness LED components for both displays and lighting applications. LLF revenue is targeted to be in a range of 2.5 million to 3 million in the fourth fiscal quarter.

LED chip revenues target to be down slightly quarter-over-quarter due to the slowness in mobile demand. We target a sales increase for our high power products, which include our Silicon Carbide Schottky Diodes and RF products to offset lower sales of materials and lower contract revenue. Gross margin is targeted to be in a range of 34% to 36% on a GAAP and non-GAAP basis, with approximately one million of stock based compensation.

This target includes continued yield gains in LEDs, increase XLamp production in Asia, and a slight increase in expense from the new ramp-up of 100 millimeter wafers in our LED chip fab. GAAP R&D and SG&A are targeted to increase in the aggregate by approximately 2 million to 2.5 million over GAAP expenses from the prior quarter. On a non-GAAP basis, R&D and SG&A are targeted to increase by the same amount. These targeted increases are expected to result primarily from increases from the acquisition of LLF and incremental legal expenses associated with patent litigation.

As a reminder, non-GAAP expenses exclude non-cash stock based compensation of approximately 3.7 million and amortization of intangibles of $4.7 million. Interest income is targeted to be down to 3.2 million based on our full quarter of lower interest rates on a conservatively invested portfolio. We estimate our effective tax rate to be 24%, based on an estimated 91 million diluted shares outstanding, which includes a full quarter of 1.9 million shares issued as part of the purchase price of LLF, and a full quarter of the 2.2 million shares added from the exercise of employee stock options in the third quarter.

Our GAAP EPS target for the fourth fiscal quarter of 2008 is expected to be in a range of $0.04 to $0.06 per diluted share, when amortization of acquired intangibles and stock-based compensation is included. We target non-GAAP earnings per diluted share in a range of $0.12 to $0.14 for the fourth quarter of fiscal 2008. And arriving at our GAAP and non-GAAP EPS targets, we forecast lower interest income, higher patent litigation expense, and the dilution resulting from our acquisition of LED Lighting Fixtures, which together we estimate to account for approximately $0.04 per diluted share of our GAAP targets, and $0.03 per diluted share of our non-GAAP targets.

Our non-GAAP EPS targets exclude amortization of acquired intangibles in the amount of $0.04, and non-cash stock based compensation in the amount of $0.04. Thank you and I'll now turn the discussion back to Chuck.

Chuck Swoboda

Thanks John. We remain focused on five key areas that continue to drive our transformation into a global leader of energy efficient LED components and solutions. Our first priority is to continue to grow our XLamp product sales and enable the LED lighting revolution. We continue to make great progress in Q3 as orders and shipments for XLamp products grew nicely, and we target double-digits order and shipment growth for XLamp LEDs again in Q4.

On a broader objective of enabling the LED lighting revolution, we announced today that five leading universities in the US and China have joined a new LED University initiative, and are deploying LED lighting to save energy, reduce cost, and help protect the environment. The LED City initiative also gain support in Q3 with the addition of the Tianjin Economic Development Area, as the first LED City in China, and we increased U.S participation with the addition of Austin, Texas.

In addition to these marketing activities, we recently increased our ability to directly enable LED lighting with our acquisition of LED Lighting Fixtures, which gives Cree direct access to the lighting market, expands our total market opportunity, and gives us a no compromise [retrofit] LED Downlight that can enable LED lighting today.

Our second priority is the integration of our recent acquisitions COTCO and LED Lighting Fixtures. The integration of COTCO is essentially compete as the high brightness LED products are now part of our overall LED component product line, and the COTCO team has become the Cree Hong Kong and China team. High Brightness product sales were on plan in Q3, and are targeted to increase in Q4 due to higher sales in China for both lighting and display applications. We are also starting to develop new high brightness growth opportunities in North America and Europe that we target to start to come online in the first half of fiscal 2009.

The integration of LED Lightning Fixtures is well underway. The business has been [remained] Cree LED Lightning Solution, and we are working on a number of important test installations with large potential customers to demonstrate the energy savings, light quality, and maintenance benefits of our LED lighting products. The initial feedback for our products has been very positive including the recent comments from an IHOP franchise operator in Northern Virginia who said that when comparing our LR6 Downlights to CFL, quote “LED light is more energy efficient, generates less heat, has a longer life and it's just a better quality light”.

These comments are very encouraging, but we need to keep in mind that this business is still in the early stages, and our focus over the next six months will be to build sales momentum for the LR6 product, while we finish the development of the LR4 and LR24 product platforms and get them into fully released production.

Our third priority is to continue to expand our global sales coverage and drive growth with our distribution partners. The distribution strategy continues to payoff in Q3 with strong order and shipment growth to our distributors for LED component. Our distributors also reported a solid increase in their outgoing shipments for the quarter. Based on results from Q3, we are getting good traction in Asia and North America, and we are now focused on working with both our global and regional distributors to increase our LED component sales momentum in Europe. Our fourth priority is to further expand our manufacturing capabilities in Asia to support increased LED component capacity requirements and reduce cost. We made solid progress again in Q3, as we were able to increase excellent capacity at our China factory to support the double digit shipment growth.

Based on the additions we made in Q3, we should be in good position to support the targeted growth for XLamp LEDs again in Q4. Overall yield and productivity were on plan, and in some cases slightly ahead of our targets for the quarter, which enabled us to make progress on XLamp cost and meet our overall gross margin targets for the quarter.

Our fifth priority is to continue to develop our power in RF product lines to drive incremental growth and high value energy efficient applications. Our commercial power and RF business continued to grow nicely in Q3, led by higher sales of our Schottky diodes and commercial RF products. This increase in product revenue helped to offset lower government contract revenue for the quarter as this business is starting to become less dependent on government funding.

We are also seeing lower cost in our Schottky product resulting from the conversion of the 4-inch wafers. We target higher power and RF device sales again in Q4, which should offset a further decline in government contract revenue for the quarter. Although our focus is on integrating LLF in the near term, we continue to look for additional ways to lead the LED lighting revolution, and since the adoption of this technology is faster in some of the large traditional lighting sectors, suppliers seem to want it to happen. We review this resistance to change as a tremendous business opportunity for Cree. And we continue to evaluate ways to leverage our strong balance sheet with $398 million in cash and investment and no debt.

As we look ahead to the fourth quarter, we target revenue to increase to a range of $129 to $133 million driven primarily by the strength of our LED business. We target the growth in LEDs to come from double-digit growth in XLamp LED sales, the addition of LED lighting solution sales for a full quarter, and an increase in high brightness LED component sales. LED chip sales are targeted to be a little lower than Q3 due to softness in mobile demand, but still within our target quarterly range. We also forecast higher power and RF sales that should mostly offset lower material sales and government contract revenue. We target non-GAAP earnings in Q4 of $0.12 to $0.14 per diluted share, which include approximately $0.03 per diluted representing expected lower interest income, higher patent litigation expense, and dilution from the LLF acquisition. These non-GAAP targets exclude amortization of intangible, stock-based compensation expense, and related tax effect.

Our strategy to drive revenue growth by focusing on LED lighting is working. For the third quarter, our business grew 38% year-over-year, driven by the success of our LED component, and we're on track for a strong finish for fiscal 2008. The global momentum continues to build for sustainability and energy efficiency. We see reports in the newspapers and on the news almost everyday about how world built on the premise of abundant low cost powerful fuel and unregulated carbon emission is being forced to find new alternative.

The addition of the LED Lighting Solutions product line to our existing LED components platform has procreated in an even better position to be one of the solutions for this global problem as we had in the fiscal 2009.

We'll now take analyst questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Andrew Huang with American Technology Research.

Andrew Huang - American Technology Research

Good afternoon guys. Can you hear me okay?

John Kurtzweil

We can hear you fine, Andrew.

Andrew Huang - American Technology Research

Okay. First question, XLamp has been growing a double-digit sequential for sometime now. Can you give us some color as to what's driving that growth?

John Kurtzweil

Well Andrew, the easiest way to answer that question is to say lighting generally is actually a combination of application. If you look at XLamp out there today, our top five applications are probably portable lighting, outdoor commercial lighting, indoor commercial lighting, architectural lighting and then also some transportation. Those will be the big five and those are really what's making up the current revenue growth over the last year. Looking forward what you'll probably see is that the indoor and outdoor commercial lighting segments are what I would expect to really be the bigger growth drivers going forward.

Andrew Huang - American Technology Research

Okay and then since you mentioned indoor and outdoor, when do you think that's really going to start to see some real sequential growth?

Chuck Swoboda

I think it's already been a part of it. I think people may underestimate that both the indoor and outdoor segments have over the last year gone from really an idea, to something that's starting to gain traction. Now, they are not the largest segment yet, but they are definitely the fastest growing and I would expect it in FY'09. They will start to really drive the new application especially based on our current coating activity, which is really the majority of them were in those two segments.

Andrew Huang - American Technology Research

Okay and then kind of a detailed question. I was wondering can you give a sense of what the gross margin would have been if LLF was not part of Cree?

Chuck Swoboda

I am not sure I can break that out. I think given that it is was only $700,000 this last quarter and although it did cost us a little bit on the earnings side about a penny. I don't think it would have affected it a lot but I don't have that breakout for you right here Andrew.

Andrew Huang - American Technology Research

Okay and then just one last follow-up and then I'll get back in the queue. I think there was some mention about additional patent litigation expense. Can you comment on that?

Chuck Swoboda

Sure. So well two things, one we saw higher expense in Q3 than we had originally expected, so John mentioned that in Q3 one of the reasons are our SG&A was a little higher than we had originally thought was that and what we are forecasting is that it will go up fairly significantly again Q4 and what that is, is that’s really just the timing of the patent litigation that's going on. So we don’t control exactly when the Courts decide to schedule different parts of the process, but it looks like in Q4 and maybe even in Q1 we’re going to be in a little harder spending time just because it's the nature of where those cases are in the court system.

Andrew Huang - American Technology Research

And can you comment just to name which cases those are?

Chuck Swoboda

It's a combination of all of them, but the main one's driving it are the BridgeLux cases which there is two of those and that's probably the biggest driver in the near term, but then there is also at some point will be the Newmark suite.

Andrew Huang - American Technology Research

Got it. Thanks very much.

Operator

Our next question comes from the line of [Yale Reino], with Oppenheimer and company.

Yale Reino - Oppenheimer and company

Thanks for taking my question. Couple of quick questions on the balance sheet, total cash was up 35 million in the quarter. What was the source of the cash?

Chuck Swoboda

Okay. The source of the cash primarily came from the exercise of options during the quarter. And then we had general cash from operations.

Yale Reino - Oppenheimer and company

Okay, but the cash from operations was 5.5 million?

Chuck Swoboda

Yes.

Yale Reino - Oppenheimer and company

And

Chuck Swoboda

So the majority of it came from the exercise of options.

Yale Reino - Oppenheimer and company

So, there is about 60 million in exercise of options, is that about right.

Chuck Swoboda

No. There are 2.2 million shares that were exercised during the quarter, and we received cash of about, 30 some million.

Yale Reino - Oppenheimer and company

Okay.

Chuck Swoboda

But the market value, I think you drive the market value is closer to that, yes.

Yale Reino - Oppenheimer and company

That's not the cash value.

Chuck Swoboda

But not the cash value to the company.

Yale Reino - Oppenheimer and company

Okay, and I guess you haven't paid out the money to LLF, is that what happened?

Chuck Swoboda

No, we paid that’s all net of the LLF transaction.

Yale Reino - Oppenheimer and company

Okay, maybe I will follow off-line I am not understanding the math. In terms of AR can you explain whether -- what caused the account receivables to kind of a move up a little bit during the quarter?

Chuck Swoboda

Yeah, I think if you look at the nature of our business we are shifting pretty quickly to a more components driven business. So we are really changing customer mix and expanding the number of customers pretty quickly. So in that situation we are changing the dynamic from a fairly limited number of big customers so we can drive payment terms pretty easily to one where or the terms haven't changed. It's a larger collection exercise for us. I'd tell you that while it was up, I think it's something we would expect to make some fairly significant progress on in the quarters ahead. I think John alluded to that in his comments. I think it’s really just the nature of us managing a more diverse customer base going forward.

Yale Reino - Oppenheimer and company

Fair enough. One final question in terms of the BIU market. Are you seeing any progress there? What are some of the things that you feel that Cree can maybe do to increase its exposure to backlighting unit goes in laptop and in the television?

Chuck Swoboda

Yeah obliviously that's an exciting market that, is on the horizon I think it's still relatively small today in terms of the actual number of product and production, but there is a lot of design activity going on. Our approach to that market is really one of as a primarily LED chip supplier working with several partners that try to provide them with chips and help them go and win that application. We have a number of projects underway none of them we can comment on at this time, but I would expect that, as we did in the fiscal 2009 it will be one of the growth drivers the overall chip business, really it will become a larger percentage of our chip business next year.

Yale Reino - Oppenheimer and company

Thank you very much.

Chuck Swoboda

Sure.

Operator

Our next question comes from the line of Amit Kapur with Piper Jaffray.

Amit Kapur - Piper Jaffray

Thanks a lot guys. I apologize, I got disconnected for this. I apologize if this question was already asked. But, were there any supply constrains for XLamp during the March quarter and how does that impact your CapEx plans into 2008?

Chuck Swoboda

Yes so, I think that we're able to get enough capacity online to pretty much immediate. We were adding capacity throughout the quarter to meet the growth, but I think we got it pretty close to imbalance by the end of the quarter. From a CapEx standpoint, our target is to finish the year 45 million to 50 million, which is one more quarter and then we're still working on our targets for the next fiscal year at this point in time.

Amit Kapur - Piper Jaffray

Okay. And what are some of the key drivers to your gross margins going forward, and how should we think of the timing of returning the 40% gross margin?

Chuck Swoboda

Yeah, the way we're looking at right now is, we have a fairly significant mix shift going within our businesses. The new product lines are obviously becoming a larger percentage of the business, so the focus is really, how do we drive the yields up and reduce the cost there so that those gross margins get up closure to corporate average, and then can have drivers higher beyond where we are at today. I think in the near term we're kind of in a transition period where we're really working on improving the gross margins on the new products as they become a larger percentage of the total. We don't have a target for, yes, to when we're going to get the 40, but we're going to work on the same thing, it's really about continuing to scale up China at component level, yield improvements as well as we get more into fiscal '09, the fact that we have more of our chips built on four and should start to give us a little bit leverage on the chip side of the business.

Amit Kapur - Piper Jaffray

Okay, great. And maybe one final question, more of a big picture as you integrate LED Lighting Fixtures, what's the feedback you've gotten from potential customers? Are we seeing any signs of maybe revenue synergy now that there is a little bit more coordination between your products and the fixtures out there?

Chuck Swoboda

Yes so, I guess it's really two sides, when you say potential customers, you mean at the end-customer level or at the fixture level?

Amit Kapur - Piper Jaffray

At the end customer level or at the fixture level?

Amit Kapur - Piper Jaffray

At the end customer level.

Chuck Swoboda

Yeah, so one of the things we're finding is that, it's interesting to be able to have direct access to them. I think there will be much better appreciation of what's driving their decision process than we did even six weeks ago. And, what your finding is that there is a pretty significant pent up demand for people that really want to implement real sustainability programs, and frankly the biggest complaint we hear is, give me a real product that I can install, so I can start moving forward. Right now that real product for us is the LR6 which is the Downlight and it's obviously has some pretty, we’re getting some pretty great feedback. I alluded earlier to the IHOP comments. We have some other interesting test going on that we can't release yet, but I would tell you that and generally people looking for energy efficient lighting, we get very positive feedback. The challenge for us is those that’s one product and we really efficacy have to get the LR4 and the LR24 out there as well because in most cases what we find is that people wanted news. They have more than one application for the technology and so generally what you’re looking for is people would like to use a combination to LR6 and LR4 and LR24 which are products that are coming, but not yet released yet. And so, it's good at this point. It's a lot of positive news and as I said earlier really the focus right now is back, do we got to get these other products out there in the market and released.

Amit Kapur - Piper Jaffray

Right, thanks guys.

Chuck Swoboda

Sure.

Operator

Our next question comes from the line of Carter Shoop with Deutsche Bank Securities.

Carter Shoop - Deutsche Bank Securities

Hi good afternoon.

Raiford Garrabrant

Hi Carter.

Carter Shoop - Deutsche Bank Securities

This is a quick follow-up there, when do you expect LR4 and LR24 to be in commercial production?

Chuck Swoboda

Both of them should be in volume production some time over the next six months. The LR4 will come first and then the LR24. I don't have a specific date for you, but I think we are targeting LR4 sometime here mid summer and the LR 24 early Feb.

Carter Shoop - Deutsche Bank Securities

Okay, thanks. In regards to future acquisitions would it make sense to continue down the acquisition line here possibly making that as fixture acquisitions down the road or do you think that what you currently have with LLF is going be sufficient for at least the next few years?

Chuck Swoboda

Well right now our focus is on integrating LLF, and I think we have a lot of work to do there, and I think there are a lot of opportunities. I think there are more opportunities versus synergies there that we would probably appreciate it even through the process of deciding to make that acquisition. And, the challenge for us and that’s pretty unique. They are focused on a segment that’s really about providing an LED lighting solution that is for existing infrastructure.

Most of our traditional customers are trying to design LED lightning solutions that are really new construction type things. So right now the way it's working is, LLF looks pretty complementary to what our LED component customers are doing. They are kind of throughout working hand in hand. In the near term, the goal is we want to obviously drive some incremental growth from the LED lighting solutions business, but really want to use it to drive LED lighting adoption, which I think we’re going to see next year as well they help build momentum on the component side.

And third, they go together. In terms of where we might go beyond that – I think short-term focus is integrate what we have and we're going to keep our eyes open, but it will have to be something that truly gives us this synergy to drive LED lighting. I think one of the challenges is that we think that model is changing pretty dramatically, and so the question is you better all try to built it yourself like we are going with the LED Lighting Solutions Group, or you better off trying to buy an existing business, and I don’t think we made our mind up there, and what’s best yet for the short-term focus is use them to drive the market and sell more component.

Carter Shoop - Deutsche Bank Securities

That’s helpful. When you think about the power LED market, when do you think that market will start to come commoditize a little bit? Obviously it’s in a very high growth period now. There is not lot of competition, but given the rapid pace of change that we’ve seen in some of the other markets within LED space. How do you guys envision that this market developing? Is it going to be two years down the road and what we will see lot of Asian competitors in the market place with comparable products, so you think it's going to be further down in the road?

Chuck Swoboda

Well, it’s real hard to figure how faster come up the curve. There are really several key things for the power LED business. You obviously have to have access to the best dye technology, and I think there, clearly, we have a gap and compared to what else is available in the market place today. I mean, when we saw our power LED, we really only see generally Philips Lumileds as one competitor, and if there is a second competitor we see it's probably Nichia but that’s about it.

That's a combination of access to the dye technology and also access to some packaging technology, and then the third piece is as we really have the IP to do it the way you want to do it. What we see out there today is that and I think Lumileds is probably my by best proof point. Right, here is a company that essentially invented the first power LED more than 10 years ago, and we saw them stumble last quarter because the technology is extremely complicated path. Creating a really a high end power LED and then packing is, there is a lot of technology lesson, so I think we're several years down the road to where there is a differentiator on the a performance sense. And, Carter that doesn’t mean there won't be people who won’t come out in the mid-to-lower end of the market place, and I think you are going to always see that. But, I think there is a segment, as long as the lighting market is driven by lumens per watt, and efficiency, and performance, I think then we're in a pretty good position to really drive that segment further at least in near future.

Carter Shoop - Deutsche Bank Securities

That’s helpful. And, the last question is the housekeeping question here. Could you talk a little bit about the revenue to distribution channel, maybe how that compared in the March quarter to the March ’07 quarter?

Chuck Swoboda

Yeah. Well, so March ’07 distribution was a pretty small part of our business, March ’08 distribution is the driver of the power LED component side of the business, and it's a growing piece of the regular components as well. Our goal as we came into the year was really to build up that channel to drive the market, because we're talking about really trying to approach 100s and 1000s of customers. And, I would say that it's going well. It's a combination of the big guys, the [arrows] and the world peace, but also a lot of regional distributors. And, that combination is working pretty well. And, we definitely have work to do. I would say today, while we've had good success in North American and Asia, there are a lot of opportunities for us to have more success in Europe right now. And, that's kind of our focus is, but, it'll continue to be an important part of the gross strategy in '09.

Carter Shoop - Deutsche Bank Securities

Thanks.

Chuck Swoboda

Sure.

Operator

Our next question comes from the line of Jiwon Lee with Sidoti & Company.

Jiwon Lee - Sidoti & Company

Good afternoon.

Chuck Swoboda

Hey.

Jiwon Lee - Sidoti & Company

Just a couple of quick questions here, your 4-inch wafer transition, where do you stand in terms of translating that to your LED and other lighting business?

Raiford Garrabrant

Yes, that last quarter we got started and we did produce, we were able to get some initial products qualified into a relatively small percentage of the total production, but it went pretty well. We're now shifting our focus to starting to qualify somewhat what I'll call the more new products of that newer generation, which is the combination of both the very bright small chip as well as the power LEDs. That's going to happen here over the next couple of quarters. So, I think, we're on track after one quarter, but we haven't seen a significant impact really to the big runners yet, and I think it's something that we'll see more in kind of the first half of fiscal '09. So, it's going to take another quarter to get more of these products to qualify to start to make it a significant part of the production. So, if you're looking for an affect on the business, it’s really first half of '09.

Jiwon Lee - Sidoti & Company

Okay. And I missed that comment on your inventory growth quarter-over-quarter, the inventory was mainly on the raw material side including substrate or what was that?

Chuck Swoboda

That's not substrate since we make it on substrate that would be with. Most was on raw materials, so if you -- more than half of the growth in inventory was raw materials and the addition of LLF acquisition. So those two things or just a nature of us as we grow the supply chain out and add a bunch of new product lines. The rest of that was in WIP and FGI kind of split between the two of them but it less than half of it and it's really the nature of you know -- we have a vertical integrated supply chain from wafers to chips to packaging in Asia and as we extended that supply chain to Asia. We are working through how we manage that and the reality is that it's longer than it was six months ago, but that's what we are working on.

Jiwon Lee - Sidoti & Company

Okay. And then back to these litigations that you have, especially with the Bridgelux. I know you expanded the scope a little while ago and I think the law suit has been going on as much as I can tell at least a year and a half. So, I mean does thing kind of typically drag out like this or can you tell us a little bit more about where you are in terms of the stage and why you are projecting this lengthy sort of expenditure?

Chuck Swoboda

Well, so I think whenever you get an IP litigation you know at some point the expenditures are going to go up when they get near time, when you are going to start actually. The cases get beyond, the discovery phases and actually get into the court phase and so we are starting to get close in and part of the BridgeLux suit to get into that and then the BridgeLux suite is more than one. There is the Texas case as well as the case in California and so it's just a nature of where those are in their process and this is the time where it ramps up and we get to pay the outside more as a lot of money to try and do their job. So it's not unexpected but it's hard to predict because the courts really control the timing and until you get to a certain point they don't start scheduling these things firmly and you don’t see those in incremental expenses. So I think in the short-term we are in a kind of probably a fairly heavy period for the next couple of quarters, at least at this point. But again, the court's can reschedule things, change the timing and we are just going to have to react to it as it happens, little bit out of our hands.

Operator

[Operator Instructions]. Your next question comes from the line of Harsh Kumar with Morgan, Keegan.

Harsh Kumar - Morgan Keegan

Guys this is (inaudible) coming in for Harsh. Just a couple of quick questions. Were there any 10% customers during the quarter?

Chuck Swoboda

We'd only break those out in the K. I can tell you there were no significant customer shifts in the quarter.

Unidentified Analyst

Alright. And then on CapEx, can you give a little color on that are you'll capitalizing some things that you'll previously expensed?

Chuck Swoboda

No, not really. The 45 to 50 is the same target range we gave you last quarter. So we are pretty much staying within that range and it's pretty much the same as usual.

Operator

Your next question comes from the line of Bennett Notman with Davenport and Company

Bennett Notman - Davenport and Company

Hi. Couple of housekeeping items that I missed. I know you gave guidance for gross margin in the coming quarter, but I missed the number, what did you say it was?

Chuck Swoboda

The quarter, for Q4 it's34% to 36%

Bennett Notman - Davenport and Company

Okay. And then on the LED chip business, you said that was flat sequentially pretty much?

Chuck Swoboda

Yeah.

Bennett Notman - Davenport and Company

So, I’m just trying to understand sort of what falls into the buckets of the component business. How much of the COTCO is in that versus I guess other products?

Chuck Swoboda

Yeah, basically chips is in chips and then basically component is the combination of our XLamp products and the former COTCO products, which we call High Brightness components now. Both of those combined are what we called LED components.

Operator

Our next question comes from the line of Hans Mosesmann with Raymond James.

Hans Mosesmann - Raymond James

Thanks. Chuck, government contracts you mentioned that’s going to be less and less of the factor. How should we view that over the next several quarters, what magnitude are we going to model that?

Chuck Swoboda

Yes, I think John gave you a sense for that, that’s going to be down a little bit more in Q4. I don’t know John if you give him a specific.

John Kurtzweil

I didn’t give him specific.

Chuck Swoboda

Yeah, but it’s going to be down a little bit more and I think this is probably the level we'll settle at here for at least the next couple of quarters. It doesn’t mean there is not additional government funding out there and we continue to work on things. It's kind of the nature of the timing right now. So, I think my best estimate at this point is after we get to the Q4 level, it will probably sit there for at least the next couple of quarters and then there maybe some opportunity to slightly increase it, but on a relative basis Hans. As a percentage it’s probably likely to continue to shrink on a percentage basis in either case.

Hans Mosesmann - Raymond James

Okay. And two quick follow-ons. On inventories I know that you want them to come down a little bit. How should we view inventories that with this new model or transitioning to more of a component company?

Chuck Swoboda

Yeah. When we make components, unlike most people in the components business we own our whole supply chain, so we own the chips and the wafers. I think at the current levels we are at, we are going to try to keep at these ranges, we are going to see for things we can do to squeeze it down a little bit. I think, I am not going to put a projection out there for you, because it’s really, you know with this much business now that the chips are being made here and then moving to Asia for packaging, I think we are still putting in place some systems, and will really get a better handle on it going forward. I would imagine our goal would be not to have it grow significantly from this point, at the same time I think we do have a different model and so we are still really down at it…

Operator

Our next question comes from the line of Mike Burton with ThinkEquity Partners.

Michael Burton - ThinkEquity Partners

For the LLF revenue expectations for Q2 can you give us a target gross margin for that segment. Should we think in the lines of where Color Kinetics was in the mid 50s?

Chuck Swoboda

What I would tell you is that we don't break it out specifically, but I can tell you that it will start out below the corporate average. So we have some opportunities there to reduce the cost and improve the margin in the product going forward. It's not at a mature product line level at this time.

Michael Burton - ThinkEquity Partners

Okay. And then, following up with one of the Carter's questions, can you talk a little bit about your strategy as it relates to perhaps licensing your IP to some of the Asian chip manufacturers. There have been some rumors about that this morning out of Taiwan that you were involved with the licensing deal. I would like if you could just comment on that and if and going forward?

Chuck Swoboda

We generally haven't been very active in licensing our technology or IP to anyone in Asia. I shouldn't say Asia that's too broad. In Taiwan, I think we have done somethings in the past. We have a fairly broad cross licensing arrangement with Nichia. And I think, we view that there will be some more of that, we have more of an approach to cross licensing than straight out licensing our technology or IP. And I think that's kind of our approach going forward, does that mean we won't make an exception, now there is always a chance we can make some exceptions if the business case made sense. But as of right now I think our focus is more about -- if we're going to do some licensing it will probably be more of the nature of cross licensing, with some of the people it's really deep IP portfolios.

Operator

Our next question comes from the line of Jed Dorsheimer with Canaccord Adams.

Jonathan Dorsheimer - Canaccord Adams

Hi, thanks. My first question is, Chuck you mentioned BridgeLux and Newmark in terms of litigation, but I didn't hear Honeywell or Honeywell Intellectual Properties. Any comments on that and then I have a follow-up. Thanks.

Chuck Swoboda

Yeah Jed, no. On the Honeywell I just didn't mentioned it, because it’s not a significant driver to the cost increase in the near term, and it's the only reason I didn't mentioned. It is out there, but it's really still early stage tough so. It now what's driving our financial. It’s forecast from a patent litigation expense standpoint. So, it just early on that one and it's the only reason I didn't mentioned it.

Jed Dorsheimer - Canaccord Adams

Alright. And then my second question has to do with some of your related party transactions specifically some of the ones that Mr. [Lo] is involved with. As we look at Lighthouse, COTCO, LLF, United Luminous International and Light engine, the $21 million sequential jump in receivables, could you provide any additional color on how much of that sequential increase was to any of those five companies?

Raiford Garrabrant

I'm a little confused in the five companies, I think one of the..

Jed Dorsheimer - Canaccord Adams

Oh, it's, so Lighthouse I think through gold peak right is the..

Raiford Garrabrant

The Lighthouse, Lighthouse, and who else did you say?

Jed Dorsheimer - Canaccord Adams

Well you've acquired COTCO and LLF, so COTCO's output

Raiford Garrabrant

Yeah, the COTCO is us now right, so.

Jed Dorsheimer - Canaccord Adams

Yeah, yeah, so United Luminous I'm sorry. So, United Luminous International and Light Engine, which I think is now a 10% customer of yours.

Raiford Garrabrant

I think, United Luminous and Light Engine are kind of the same company, but I would tell you that a two things. One is that they are important customers. We obviously don't break up the percentage at this point in the year, but they are important customers to us. I would point out you by the way that they have actually been declining percentage wise somewhere to actually lower but they are still big important customers for us. The daily parts of the business have actually grown a little bit faster and from our payment standpoint, I don't think they represent any of the increase in AR. I don't have specifics in front of me, but I don't believe they make up any of the change.

Operator

Our next question comes from the line of Mike Burton with ThinkEquity Partners.

Mike Burton - ThinkEquity Partners

Hey thanks one more was, I just wanted to know a little bit more about, with the closure of the LLF acquisition, can you talk a little about some of the management teams roles there, in particular Neal Hunter, Cindy Merrell, are they have been given incentives to stay on or any insight into what their plans are? Thanks!

Raiford Garrabrant

Yeah, Mike they are definitely incentivized to be a part of not only staying on a near term, but really helping to grow that business. It’s actually part of what we described that there was the earn out is designed around some product milestones as well as employee retention. And, in terms of what their roles are, Neal is running that business. So, Neal is the president of LED Lightning Solutions and he continues to drive their push into the lighting market. Some of his key people Mike Roger, Cindy Merrell, Gerry Negley, Tony van de Ven founders of the company, those guys are still there. Basically, in very similar roles to what they had before the acquisition, and we are letting them run and we want them to make it successful. It's part of one larger Cree company. We are on the same team, but that being said we are really trying to let them continue to be aggressive and drive the market.

Mike Burton - ThinkEquity Partners

Alright, good to hear thanks.

Operator

Our next question comes from the line of Hans Mosesmann with Raymond James.

Hans Mosesmann - Raymond James

Thank you, I had, that was the question I wanted the answer. Thank you.

Operator

Our final question for today comes from the line of Andrew Huang with American Technology Research.

Andrew Huang - American Technology Research

Hi just a couple of quick follow ups. John could you repeat the gross margin guidance on a GAAP and non-GAAP basis please.

John Kurtzweil

The gross margin guidance for next quarter is 34% to 36%, and it’s the same for both GAAP and non-GAAP.

Andrew Huang - American Technology Research

Okay, got it and then Chuck, I think during the press release out in the last couple of days talking about the Cree Solution provider network. So, I was wondering if you could kind of give us an idea of how that's going to work, and maybe then give us some sense of the traction that we are getting?

Chuck Swoboda

Yeah, so the way to think about the solution providers is that the third parties that are out there they basically understand our XLamp products pretty well, but more than just understanding XLamp they bring some design expertise from a lighting system standpoint. One of the challenges that is making LED lighting happen is that that a lot of our customers have frankly never design with LEDs and don’t understand a lot of subtleties. So there will is to bring expertise whether that be thermal, optical, drivers or combination of all that really kind of bring that together for the customers. So, the easiest way to think of them is the kind of an extension of our sales force, and we really use them to complement not only our direct sales activities, but actually what the distributors are doing as well.

Andrew Huang - American Technology Research

Got it. Okay, thanks a lot.

Chuck Swoboda

Alright thank you. Okay, thank you for your time today and we appreciate your interest and support and look forward to reporting our fourth quarter of fiscal 2008 results on August 12^th 2008. Have a good evening. Thank you.

Operator

Thank you for your participation in today’s Cree Incorporated third quarter 2008 fiscal year financial results conference call, you may now disconnect.

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