Cree Management Discusses Q1 2013 Results - Earnings Call Transcript

Oct.16.12 | About: Cree, Inc. (CREE)

Cree (NASDAQ:CREE)

Q1 2013 Earnings Call

October 16, 2012 5:00 pm ET

Executives

Raiford Garrabrant - Director of Investor Relations

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

Michael E. McDevitt - Interim Chief Financial Officer and Vice President

Analysts

Brian K. Lee - Goldman Sachs Group Inc., Research Division

Christopher Blansett - JP Morgan Chase & Co, Research Division

Dale Pfau - Cantor Fitzgerald & Co., Research Division

Andrew Huang - Sterne Agee & Leach Inc., Research Division

Smittipon Srethapramote - Morgan Stanley, Research Division

Jonathan Dorsheimer - Canaccord Genuity, Research Division

Mark J. Heller - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Vishal Shah - Deutsche Bank AG, Research Division

Amir Rozwadowski - Barclays Capital, Research Division

Satya Kumar - Crédit Suisse AG, Research Division

Harsh N. Kumar - Stephens Inc., Research Division

Operator

Good afternoon. My name is Huey, and I'll be your conference facilitator today. At this time, I'd like to welcome everyone to Cree, Incorporated's Fiscal Year 2013 First Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, ladies and gentlemen, this conference is being recorded today, October 16, 2012, at 5:01 p.m. Eastern Standard Time.

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

Raiford Garrabrant

Thank you, Huey, and good afternoon. Welcome to Cree's First Quarter Fiscal 2013 Earnings Conference Call. By now, you should have all received a copy of the press release. If you did not receive a copy, please call our office at (919) 287-7895 and we'll be pleased to assist you.

Today, Chuck Swoboda, our Chairman and CEO; and Mike McDevitt, our Interim CFO, will report on our results for the first fiscal quarter of 2013. Please note that we will be presenting both GAAP and non-GAAP financial results in our remarks during today's call, which are reconciled in our press release and financial metrics posted in the Investor Relations section of our website at www.cree.com under Quarterly Results in the Financial Information tab.

Today's presentations include forward-looking statements about our business outlook, and we may make other forward-looking statements during the call. These may include comments concerning trends in revenue, gross margin and earnings, plans for new products and other forward-looking statement indicated by words like anticipate, expect, target and estimate. Such forward-looking statement 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 like to note that we'll be limiting our comments regarding Cree's first quarter of fiscal year 2013 to our discussion of the information included in our earnings release and the metrics posted on our website. We will not be able to answer any questions that would involve providing additional financial information about the quarter beyond the comments made in the prepared remarks.

This call is being recorded on behalf of the company. The presentations and the recording of this call are copyrighted property of the company, and no other recording, reproduction or transcription is permitted unless authorized by the company in writing.

Consistent with our previous 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 1 hour, we ask that analysts limit themselves to one question and one follow-up. We recognize that other investors may have additional questions, and we welcome you to contact us after the call by email or phone at (919) 287-7895. We're also webcasting our conference call, and a replay will be available on our website through October 30, 2012.

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

Charles M. Swoboda

Thank you, Raiford. We started the year strong in Q1 with record revenue of $316 million and non-GAAP net income of $32 million or $0.27 per diluted share. Revenue was in the middle of our target range as LEDs, Lighting and Power and RF were all in line with our forecast.

Non-GAAP earnings per share were on the high end of our target range for the quarter due to improvement in gross margins and lower than targeted operating expenses. Our results are beginning to demonstrate the enormous leverage that we have in our fully integrated vertical lighting model. As we continue to increase performance and reduce costs in LED components, we are seeing the positive impact these gains have on our LED and Lighting businesses.

The revenue trends in Q1 were as follows: Lighting sales increased more than $7 million, or 7% from Q4, as we continued to see good growth from both our agent and direct sales channels. LED sales increased more than $2 million from Q4, which was in line with our target for the quarter. Power and RF sales decreased a little less than $1 million from Q4, which was also in line with our target for the quarter. Non-GAAP gross margin increased 120 basis points to 37.5% in Q1, which was on the high side of our target for the quarter. The overall improvement in margin was once again driven by a combination of factory cost reductions, lower-cost new products and slightly higher factory utilization. While the LED market remained very competitive, pricing declines were in line with our targets for the quarter.

We continue to closely manage inventory across our factories while working to respond to short lead time expectations in both LED and lighting markets. Overall, we reduced inventory by $9 million in Q1 to 81 days. Cash and investments increased to $816 million due to solid execution, focused capital spending and higher profitability. Free cash flow was $68 million in Q1, and the last several quarters have demonstrated our ability to convert R&D investments into innovations that result in strong free cash flow. This is a different model than most other companies in the LED or lighting industry today, and our balance sheet gives us the ability to continue to invest in our -- growing our business and the market for LED lighting.

Overall company backlog is ahead of this point last quarter, with lighting and LEDs trending higher and Power and RF at similar levels. We continue to be encouraged by our progress in LED lighting, but the macroeconomic environment is a headwind on our growth outlook and our customers' outlook. We're focused on using new product innovation to drive growth through share gains against traditional technologies and opening new applications for LED lighting.

I'll now turn the call over to Mike McDevitt to review our first quarter financial results in more detail, as well as our targets for the second quarter of fiscal 2013.

Michael E. McDevitt

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

For the first quarter of fiscal 2013, revenue increased 3% sequentially to a record $316 million, which was within our targeted range of $305 million to $325 million. GAAP earnings increased to $16.1 million or $0.14 per diluted share for the first quarter of fiscal 2013, and non-GAAP earnings increased to $31.8 million or $0.27 per diluted share. Non-GAAP earnings exclude $15.7 million of expense net of tax or $0.13 per diluted share from the amortization of acquired intangibles and stock-based compensation. GAAP and non-GAAP earnings per share were at the high end of our targeted range.

Q1 GAAP gross margin increased 200 basis points sequentially to 36.8%, while non-GAAP gross margin increased 120 basis points to 37.5%, which excluded stock-based compensation of $2.3 million. This was at the higher end of our non-GAAP target of 37%, plus or minus. The gross margin improvement was a result of factory cost reductions, slightly higher factory utilization, improved production yields, product mix and lower-cost new products.

First quarter of fiscal 2013 revenue and gross profit for our reportable segments was as follows: LED products revenue and gross profit were $187.6 million and $75.4 million respectively for a 40.2% gross margin. Lighting products revenue and gross profit were $108.1 million and $34.1 million, respectively for a 31.6% gross margin. Power and RF products revenue and gross profit were $20.1 million and $10.4 million respectively for a 51.8% gross margin. In determining gross profit for our segments, we do not allocate certain employee benefit cost, stock-based compensation and acquisition-related cost. These non-allocated cost total $3.9 million for the first quarter of fiscal 2013 and are included to reconcile to our $116 million GAAP gross profit.

We ended the quarter with $816 million in cash and investments, a $71 million increase sequentially, which resulted from higher profitability, good working capital management and focused capital spending. For the quarter, cash provided by operations was $86 million and capital expenditures were $18 million, including $5 million related to patents, which resulted in free cash flow of $68 million.

Operating expenses for Q1 were $98.8 million on a GAAP basis and $80.9 million on a non-GAAP basis. Non-GAAP operating expenses were $1 million less than targeted due to lower R&D spending. Non-GAAP operating expenses excluded approximately $10.2 million of stock-based compensation expense and $7.7 million of charges for amortization of acquired intangibles. Net interest income and other for the quarter was $3.4 million, which included a onetime payment received from the SemiLED patent litigation settlement. Our Q1 effective tax rate was 22% for the quarter, which is higher than the 19% we targeted, as we currently target a greater portion of our fiscal 2013 earnings being in higher tax jurisdictions.

Days sales outstanding were 46 days as compared to 45 days at the end of June, as accounts receivable increased $10 million to $162 million. Inventory days on hand were 81 days as compared to 85 days at the end of June, as inventory decreased by $9 million to $180 million during the quarter, primarily due to a reduction in our work-in-process inventories. Property plant and equipment additions were $13 million for the first quarter.

For fiscal 2013, we are continuing to actively manage our capital spending. In the near term, we target similar levels of investment as Q1 to support our strategic priorities to lead the market, drive adoption of LED lighting, accelerate cost reductions and support incremental capacity as needed.

While our Q2 includes a 14th week due to our fiscal calendar, we do not target a benefit to the bottom line as the extra week falls during the holiday season. As a result, we target average expenses for the 14th week, but lower revenue due to the holidays and the current demand environment. At this time, we target Q2 revenue to be in a range of $320 million to $340 million. We target Q2 GAAP gross margins to be 37.5%, plus or minus, and non-GAAP gross margins to improve to 38.5%, plus or minus. This target is based on a number of factors that could vary, including overall demand, product mix, cost reduction programs, factory execution and the competitive environment. Our GAAP gross margin targets include stock-based compensation expense of approximately $2.6 million, while our non-GAAP targets do not.

We are targeting Q2 non-GAAP operating expense to increase approximately $5 million from Q1, most of which is due to the higher expense related to a 14th week as well as increased sales and marketing to support the higher revenue and new product promotion. Our GAAP operating expense is targeted to increase approximately $7 million from Q1 and includes noncash stock-based compensation expense of approximately $12.4 million and charges for amortization of acquired intangibles in the amount of $7.7 million. Loss on disposal of assets is targeted to be similar to Q1.

Net interest income and other is targeted to be approximately $1.8 million for Q2. We currently target our tax rate to be 22% for Q2 and for fiscal 2013. GAAP net income for Q2 is targeted to be between $13 million to $19 million. Based on an estimated 116 million diluted shares outstanding, our GAAP EPS target is between $0.12 to $0.16 per diluted share. Non-GAAP net income is targeted to be between $31 million to $36 million or $0.27 to $0.31 per diluted share. Our non-GAAP EPS target excludes amortization of acquired intangibles and noncash stock-based compensation in the amount of $0.15 per share.

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

Charles M. Swoboda

Thanks, Mike. We're focused on 4 priorities for fiscal 2013. Our first priority is to accelerate adoption of LED lighting and increase sales of our indoor and outdoor lighting products. The big news is our new 10-year LED lighting warranty that covers the industry's broadest range of products. Our new 10-year warranty, which is based on our unrivaled experience with lighting-class LEDs and LED lighting system design, is unheard of in the traditional lighting industry and is critical to reducing the cost of ownership.

We also announced the Cree EDGE High Output LED Area and Flood Light luminaires which are capable of replacing high output sources, such as 1,000-watt metal halide, and use 50% less energy in most applications.

LED adoption continued to gain momentum in Q1 with new installations, ranging from CR22 LED troffers in the Hart Senate Office Building, to LEDway streetlights in Oyster Bay, New York, to the EDGE area and parking structure luminaires for the exteriors of 7 schools in Newport News, Virginia. We're investing in sales and marketing to expand our channels, and we continue to evaluate opportunities to move the market, access new customers and promote Cree LED lighting.

Our second priority is to drive growth in our LED component product line through innovation by leveraging the SC 3 LED technology into a range of new products. We continue to deliver on our LED components goal of more lumens per dollar with our new XLamp XP-E2 LED, delivering higher lumens per watt and more lumens per dollar to lower system costs. This product is targeted for new designs and as an upgrade for existing XP-E and XP-G-based designs.

The transition to the new SC 3 products has helped our profitability and is critical to driving the market and maintaining our competitive positions. But as a result, the amount of light sold, measured in lumens, has increased a lot faster than revenue and limited top line growth in the near term. We target increased adoption to drive LED revenue growth in the latter part of fiscal 2013.

Our third priority is to leverage our technology lead in Power and RF to open a new generation of applications for these products. We are working with a number of customers on next-generation designs based on our silicon carbide Power devices. The focus is on higher Power levels than we currently serve where silicon carbide has the biggest advantage over conventional technology. In the short term, the business is operating in a similar range as the last couple of quarters based on the current generation of Power and RF designs.

Our fourth priority is our ongoing effort to translate our product innovation into revenue and profit growth. Our new products are driving growth in sales for LED lighting and enabling Cree to deliver more lumens per dollar in LED components. We made solid progress improving margins over the last 3 quarters despite an LED market that remained highly competitive. Our goal is to continue to leverage our new products to drive revenue growth and deliver incremental margin improvement through factory cost reductions, process improvements and lower-cost new product designs. We remain focused on closing the price gap with conventional technology to drive adoption of LED lighting in the market.

As I explained earlier, Q2 total company backlog is slightly ahead of this point last quarter. The lighting demand forecast is trending higher for Q2, while the LED forecast is also up, mostly due to the incremental benefit from an extra week in our fiscal quarter. The benefit to the bottom line is minimal as the extra week falls during the holiday season. This means we have a below average revenue week, but still have an average expense week. The LED and lighting product lines continue to operate with short lead times, which add variability to our forecasts. The macroeconomic environment continues to be a headwind and continues to make some customers more cautious.

Based on our current backlog, forecasts and trends in the business, we are targeting Q2 revenue in a range of $320 million to $340 million, which is comprised of solid growth in Lighting, LED product sales flat to slightly higher and Power and RF sales flat to slightly higher. We target non-GAAP gross margins to improve in Q2 to a range of 38.5%, plus or minus. This target improvement in gross margin builds on the momentum from the last several quarters by delivering higher revenues from the similar fixed cost base and a higher mix of lower-cost new products.

We target non-GAAP operating expenses to increase approximately $5 million in Q2, mostly due to higher expense from the 14th week. As a result, we target non-GAAP earnings in Q2 of $0.27 to $0.31 per diluted share. Please note that our non-GAAP targets exclude amortization of intangibles, stock-based compensation expense and the related tax effects.

We remain focused on driving adoption through innovation. Our new products have improved payback and fueled growth in LED lighting. Our SC 3 LED platform is delivering more lumens per dollar, which means lower-cost LED lighting systems. This transition has limited top line growth and LED components in the near term, but more importantly, it has helped drive LED lighting adoption while improving our competitive position and delivering margin improvement.

Based on the trends over the past few quarters, I think it is clear that we're on the right track. As mentioned earlier in my remarks, Cree is the only pure play LED lighting company with a fully integrated vertical model. This puts Cree in a strong position to drive innovation and drive the market without the burden of traditionally inefficient incumbent technologies.

We probably have the strongest balance sheet in our industry, and there's no question we positioned ourselves to be the leader and bring innovative new products to market faster than our competitors. We continue to be intensely focused on our long-term goal of 100% upgrade to LED lighting and high efficiency power conversion solutions. We believe this adoption will significantly reduce global electrical energy consumption and drive the growth of our business.

We will now take analysts' questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first questioner in the queue comes from the line of Brian Lee with Goldman Sachs.

Brian K. Lee - Goldman Sachs Group Inc., Research Division

Quickly on the gross margins, they're up 100 basis points for a few quarters running here. So I'm wondering when you look at the drivers, which ones have run their course in your view, and where do you still have more leverage? And I guess, I'm also wondering, is the 40% bogey now a reasonable fiscal 2013 target?

Charles M. Swoboda

Yes, so Brian, for your first question, if you look at our targets for this quarter, we're targeting effectively -- the middle of our range is another 100 basis points at 38.5% on the non-GAAP number. So I would say that there's -- pretty much in all cases, it's the same levers as the previous quarters. We're still doing things to reduce factory costs. So I think there's more efficiency to be gained there. We're seeing an increase of the new products, which are fundamentally new lower cost, both in LEDs and lighting. So I think that continues to give us some opportunity going forward. I don't think in Q2 we'll see much utilization benefit just with the 14th week. It's probably going to be relatively similar to last quarter, plus or minus. But then, we're also still working on yield improvements. So if I look at the major drivers of the last few quarters, most of them are still available to us in our targets for Q2, and we're going to try to continue to deliver incremental benefit going forward. Obviously that's a bit of a function of volume and the overall revenue growth. But I think there's continuing things that we can do. As far as where the long-term target is, I have to say our focus at this point is keep our heads down, try to make incremental improvement, focus on the drivers, and we'll see where it takes us. I don't want to make any productions at this point. I'm pleased that this is the fourth quarter in a row we've made progress, and I think we really just want to build on that. And part of the variability is it's -- while it's possible, it's hard to give anyone timing because we just don't have great visibility on the demand environment. Without that, it's a little bit -- it's a little hard to put out a target.

Brian K. Lee - Goldman Sachs Group Inc., Research Division

Okay, fair enough. That's helpful. Maybe just a quick follow-up. Since you mentioned utilization rates, it doesn't sound like you're getting a whole lot of leverage right now from that particular lever. But can you help us frame maybe the margin impact that you could see for, let's say, every 5 percentage points of higher utilization for me?

Charles M. Swoboda

I think it's becoming a less of a lever and the reason I say that is we still have an opportunity to increase utilization. It's probably more of a benefit in terms of giving us volume upside than it is to give us a significant gross margin impact. Because if that was all LED chip revenue, it's a big number. But when you're really looking at the fact that most of the revenue is coming from the LED components business, which gets a partial benefit from fully using the factory, but the LED lighting business gets -- it's even a lesser impact. So there's some incremental benefit left there, but I think in terms of to the overall business, it's probably smaller than we perceive only because so much of the growth is coming in the higher value-added products. It doesn't mean we won't get some as we drive that out, but I think it's as important to focus on some of the things we're doing in terms of the new products, the yields and just the factory costs that -- as it is the utilization at this point.

Operator

Next questioner in queue comes from the line of Chris Blansett with JPMorgan.

Christopher Blansett - JP Morgan Chase & Co, Research Division

Chuck, I wanted to touch on a couple of events that happened in the past and how you think they're going to affect the company going forward. One was your agent transition, we're about 6 months past that, 6 to 9 months past that, and secondly with the acquisition of Ruud and the potential disruption of supply to other competitors. So maybe if you could give us an update on how you think that's going to affect the company over the next 6 months. Are we largely through those disruptions? Is there still some more to come?

Charles M. Swoboda

Yes, Chris, I'd say -- so I'll take first one, agent transition. We're 6 months into it now. You can see that the lighting business had a nice sequential growth quarter again. So I feel pretty good that we're on the right track there. Obviously, the agent -- your agent team is always kind of a slowly evolving thing because people come and go, but I think overall, we're in the right place there. And probably more of our focus is less on the transition and more on the fact that at the rate we're introducing new products, I think one of the challenges, not just for Cree but for everyone, is that the lighting industry has never had to absorb this many new products this fast that are constantly changing. So I think we're going to have to, as well as the rest of industry, get better at dealing with more new products fast and making sure that we always got the best product in front of the customer. It's just the product cycle is so much faster. But I think that's something we all face, and we're working on that. So I feel pretty good about where we're at. When it comes to the acquisition of Ruud and what that did to our customers, and I think I may have even made a similar comment last quarter, I feel like we've kind of moved beyond that at this point. There was obviously some customers that raised some questions and concerns, but we're over 1 year into it, and we've been competing on the merits of whether our LEDs help our customers or not. So at this point, I don't see that being a significant factor on the business, at least in terms of changes to it. I think that's then built into how people think about us and what we're doing in the market, and we're back to trying to compete on the merits of the LEDs. And the fact is, is that the only place that had an impact, really, was in North America. So I think it's had a much less effect globally than anyone thought, or at least -- then people perceive, I should say, it's very similar to what we thought. And in North America, I think there was a little bit of disruption, but about what we thought there as well, and I think we're moving forward.

Christopher Blansett - JP Morgan Chase & Co, Research Division

Okay. I had a quick follow-up related to your thoughts on seasonality of LED lighting this year. A lot of new products coming and going and how you think that affects the trends this year or next year with a lot of changes, as you said, in the product availability.

Charles M. Swoboda

Yes, so I think the good news is, is as we bring new products out there generally better in terms of price performance, they have better payback. So I think we're making the business model better, at the same time, there's a lag, as you know, because it's just the cycle to take a new product out there, get it put on -- put into a project and convert that, it's typically a 6 to 9-month process at a minimum. And on some of the bigger jobs, it can be longer. Obviously, there's upgrade-type business where you're basically switching out products, so that's a little bit quicker. But I think it adds an interesting dynamic. I don't know if I can quantify it for you other than it's a constant cycle, and it's one that I think if the channel had its way, it will be a lot easier if things went a little bit slower. But we're still chasing incumbent technologies. So we're going to keep pushing really hard to get the best products out there to take on the incumbents. Because as I made a comment earlier, our goal is 100% LED, and so I think we're going to just have to manage that and work through it with the channel. And at the end of the day, if it makes the economics better, I think it'll carry the day.

Operator

Next questioner in queue comes from the line of Dale Pfau, with Cantor Fitzgerald.

Dale Pfau - Cantor Fitzgerald & Co., Research Division

A couple of questions, Chuck, could you break out just a little bit for us your regional distribution on both lighting and LEDs? And then I've got a couple of follow-ups here real quick.

Charles M. Swoboda

Dale, I don't have a specific number for you. In the -- we only do the regionals on an annual basis. And so I think as you saw that we're sitting there at about -- boy, I'm trying to remember what the numbers are. It's, I think, about a 1/3 China, about 15% is in Europe, about 40% of our business or a little bit less is North America and the rest of the world makes up the rest. But that's for the whole company. In terms of lighting versus LED, I would tell you that most of the lighting revenue, the vast majority, is North American. There's a little bit of business in Europe and there's even less business elsewhere, so it's primarily a North American business. And then I would say that the LED business is probably Asia first, North America second and Europe third, but I don't have a specific breakout for you.

Dale Pfau - Cantor Fitzgerald & Co., Research Division

Okay. And could you talk a little bit about where you're seeing particular pockets of strength and where you're seeing pockets of weakness, maybe on the lighting side? Talk about indoor, outdoor, and I'm particularly interested in North America and Asia right now.

Charles M. Swoboda

Yes, so if I think about the lighting business, so the fixture business, I think we're seeing growth in both indoor and outdoor at this time. We know there's a bit of seasonality coming. We know that outdoor tends to slow down a little bit in the winter months. So we're not there yet, but I would expect that business to go a little slower as we get into probably end of this quarter, early next quarter. But in terms of what we've seen in Q1 and what our targets are in Q2, I think we're targeting growth in both of them. If I look at it on a more global basis, which now is not really the lighting business, but really a way to think about it from an LED standpoint, we saw solid business across the world. So Asia, U.S., Europe did fine. Europe's obviously a lot smaller than the rest of them. And it's probably had the least -- or it has probably the most caution in that business for us. And then I would say that in Asia, what we're seeing is, there's definitely -- there's building momentum for LED lighting, although I would say that the market there is a bit cautious in the short term. But I think the caution there has much to do with the fact that I think we underestimate what it's like for them to go through a leadership transition. And my sense is, after spending some time there a few weeks ago, that people are optimistic, but they're cautiously optimistic, kind of waiting to go through this transition. And I think we'll get a lot better sense of China and how that market's going to respond after we get through that later this quarter and we get to the holidays. So I think it'll be interesting to see where that goes, but I'm cautiously optimistic about China as we get into the first part of next calendar year. And right now I think we're going to kind of just see what happens given that there's a lot of things going on there right now.

Operator

Our next questioner in queue comes from the line of Andrew Huang with Sterne Agee.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

So I know you don't provide guidance beyond the current quarter, but can you give us a sense of whether there's going to be any kind of seasonality in the March quarter, especially now that Lighting's about 1/3 of your revenue?

Charles M. Swoboda

Andrew, to kind of follow up what I was saying earlier, I think we have 2 trends in our business that, at least we've seen in the past, have a seasonality to them. We know that the outdoor lighting team -- the outdoor lighting piece of the business tends to be lower, seasonally lower in the winter months, which would be our Q3, and we know that the LED components business tends to be seasonally lower on average in the March quarter because of Chinese New Year. You effectively have 1.5 weeks that don't exist in the quarter just because of the shutdown there in the holiday. So I think those are kind of the things that we're keeping an eye on. With that being said, the offsetting factors are what's going on in the rest of the business. A little too early to give you any specific numbers there, but I think -- and we just don't have that much visibility. But I think we'll have to keep in mind -- my guess is we'll have some seasonality in the 2 areas I mentioned, the question will be is what the offsetting factors are. At this point, it's too early to call.

Andrew Huang - Sterne Agee & Leach Inc., Research Division

Okay, and then I think at the last call, you talked about pricing your lighting products aggressively in order to displace incumbent lighting solutions. So my question is, with this strategy, how should we think about the direction of gross margins in lighting products over the next few years?

Charles M. Swoboda

Well, how about I give you maybe a more short to mid term view. Maybe not few years out, but if I think about what we're doing today is, we've been working like crazy to get to the next generation of products and then get to the next generation. The idea being is that as we shrink the gap between LED lighting and the conventional technology, we are going to increase the rate of adoption, which is good for Cree and good for the industry overall. We continue to take a pretty aggressive approach as we go after new projects, and it doesn't mean we don't want to make some incremental improvement. That is our goal, and you saw that in the last quarter, but at the same time, its to drive adoption is probably the overriding factor. So I think we'll stay in an aggressive mode here for the next foreseeable future. We are trying to target, at the same time, incremental margin improvement, but I think we're going to balance of those 2 with drive in the market. And as far as exactly how that balances out, it's going to be a function of a lot of different things, some of which we control and some of which we don't. So I don't really have a specific forecast for you on that.

Operator

Next questioner in queue comes from the line of Smitti Srethapramote with Morgan Stanley.

Smittipon Srethapramote - Morgan Stanley, Research Division

So you mentioned on the last quarter's call that you saw macroeconomic headwinds also, but you've mentioned that macro fundamentals in North America were stronger than the rest of the world. Can you comment on whether you've seen any changes to the outlook for the North American market over the past quarter?

Charles M. Swoboda

Yes, I would say I haven't seen a change in pretty much in any of the markets. I'd say that still the same general feeling both in North America, what we're seeing in Europe and what we're seeing in Asia. So there's a caution generally, but if I was to say of the 3 markets, the North American market feels a little less cautious than the other 2 right now.

Smittipon Srethapramote - Morgan Stanley, Research Division

Great. And maybe a quick follow-up to that. As you think about top line growth in the coming quarters, can you help us get a sense of how much is coming from increased penetration among existing customers versus orders from new customers?

Charles M. Swoboda

Well, you have to think about that probably a little bit by product line. So in Lighting, almost everything we get is new customers. I mean essentially, we're trying to drive adoption. One way to think about LED lighting is almost every LED lighting order is effectively share gain from some conventional technology that would have been purchased otherwise. So it doesn't mean we don't have repeat customers. We clearly do. But it's much more about expanding the number of customers, the number of projects in LED lighting. I'd say in the LED business, it's probably more mixed. We obviously are trying to get designed in to some of the major players. And so growing shares there or growing with them is an important piece of it. But at the same time, if you look at the level of LED lighting penetration, there's still so many lighting companies that have not fully engaged in the LED side of the business. I think it's probably -- there's a significant way down both sides. I don't have a percentage for you, but dare I say it's a little bit more balanced between the 2 approaches.

Operator

Our next questioner in queue comes from the line of Jed Dorsheimer with Canaccord.

Jonathan Dorsheimer - Canaccord Genuity, Research Division

Chuck, the first one, components business and the sort of the successful introduction of the SC 3 product family. You saw a benefit this quarter certainly in gross margin, we're seeing that flow-through next quarter. What gets -- the customers that have transitioned from sort of the XP-E product family to sort of the XP-G, XP-D product family under this SC 3 or SC 3, what percentage do you think at this point have now been qualified? Or where are you in this transition? Are we sort of 50%, 1/3, or do you think you're closer to sort of 75%?

Charles M. Swoboda

Jed, what I would say is we are, in terms of customer activity, we're ahead of the actual revenue. So in Q1, it's significantly less than 50%, but it was significant. So it's significant, but it takes a while. I'd say probably in terms of customers, getting them to design in, we're probably at the customer level -- and this is not revenue, but this would be who's working on it. I think we're past the 50% point. I don't have a great number for you, how far, but I think we're over 1/2. But there's a lag obviously as you know, between getting the customer to essentially start the new design or build the new design and turning that into production. So I think if you're looking at it from a customer activity standpoint, we're pretty far down the road. I think in terms of how fast it flows through the revenue and how the product line shifts over, it's going to take several quarters. I think -- and even then, there's going to be legacy designs where there's some customers that aren't going to switch any time in the near term just because, for whatever reason, their particular lighting product, it may not be worth it to them to go through the design until they get ready to do a new rev cycle there. So I think it will be mostly throughout this fiscal year in terms of converting the product line and revenue, but there will still be some holdovers. And frankly by then, hopefully, we'll be working on the next generation, whatever that will be.

Jonathan Dorsheimer - Canaccord Genuity, Research Division

And then as my follow-up, just moving over to the lighting systems business. And just digging into the channel a little bit more and this idea in terms of driving the market and sort of the balance between what we as investors want to see in terms of getting some of that leverage, as we look at the sort of the outdoor versus the indoor, we look at your product portfolio, I mean, in the depot here in the Northeast, your products are right around $20. And certainly, we've seen a massive increase in terms of percentage of adoption. At what point do you think that you'll be able to pull back a little bit there, or do you think it's just going to be a shifting between leverage and indoor and then sort of giving it back to the outdoor and then it kind of balances off for the next year or 2 years? Or just a little bit more detail on the strategy there would be helpful.

Charles M. Swoboda

Yes, Jed, I think it's probably -- I understand why -- so indoor, outdoor is probably some convenient buckets, but probably not how we're thinking about it. It's probably more application-driven. So obviously, we've done some things at Home Depot to really drive consumer awareness of that product. At the same time, we have activities, depending on certain types of outdoor projects, where we might be equally as aggressive on that side because we want to go after some incumbent technology that hasn't been taken on. I could probably come up with a similar example in downlights for the commercial markets, or troffers, or some of the canopy lighting. So it's kind of moving around. It's a bit of a -- it changes as we come out with new products that give us the ability to go after it. And it happens to also come down to which incumbent technology is available or ready to be gone after. So the example I'd give you is our new EDGE High Output Area Light, think about it as something you might go after a car dealer. I mean, that was really designed to go after a very specific application. We're going to try to push that one over the edge because we know that there's an incumbent technology that, really, we think have a much better value proposition on. At the same time, frankly, there's a lot more streetlights we're doing, with that business we've got some more momentum, so we're going to potentially position that a little bit differently. So it's going to move around. I think its going to vary with -- it's a combination of strategy and opportunity available to us in the market and what the channel's giving us access to. So it's hard to give you any one of them, but I would say, just generally we're going to be in investment mode in various product categories in terms of trying to move them for the foreseeable future, just because in the grand scheme of things, there's still, in most commercial applications, still a gap between LED and the incumbent and we just want to close it.

Operator

Next questioner in queue comes from Mark Heller with CLSA.

Mark J. Heller - Credit Agricole Securities (USA) Inc., Research Division

Just a follow-up on the March quarter. Again, you're on the 14-week quarter this quarter but going to 13 for next. Should we assume that OpEx will go back down in the March quarter?

Charles M. Swoboda

Mark, what I would say is the majority of the increase this quarter is the 14th week, but we are making incremental additional investments in the business. So as you think about the March quarter, we obviously won't have the 14th week, but at the same time, we have generally been making incremental investments each quarter. Now we haven't set that plan and fully fleshed out the target, so it's a little hard to give you an exact number at this point. But yes, we'll lose the 14th week, but the kind of thing I'd keep in mind is, is that we are also still investing in OpEx. So it's a little hard to give you an exact number to put in there at this point.

Mark J. Heller - Credit Agricole Securities (USA) Inc., Research Division

Okay. And can you also give us an update on the 6-inch wafer transition?

Charles M. Swoboda

Yes. So we made some incremental progress again. So what I'd say it's a pretty methodical approach. We're trying to slowly increase the volume as the business warrants. But it's not something we're pushing to do really quickly just because of the same trade-off we've had in the past, which is we prefer not to bring on new capital when we have existing capital to solve the problem. It just doesn't give us as much leverage. But we are moving down that road, and I think over the next several quarters, we should incrementally be shifting that percentage. That being said, at the current rate we're going, while 150 will continue to grow, we'll still have a reasonable portion of production on 100-millimeter at the end of the year. It will be decreasing each quarter, but I'd say it's pretty methodical at this point. It's not a quick transition.

Operator

Next questioner in queue comes from Daniel Amir with Lazard Capital.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

So a couple of questions. First of all, what needs to happen in order to kind of return to the growth rates that the company saw 18 months ago, a couple of years ago? Is it really your lighting products? Is it really more China needs to take off? Is it more new construction needs to happen in the U.S.? I mean, what's kind of your takeaways, how we should -- what factors we should be looking at?

Charles M. Swoboda

Well, so Daniel, we know we don't control the macro, so we're not even going to try to there. And obviously, that's going to always be something that's either a headwind or a tailwind. I don't control it. I'm not going to worry too much about it other than we're cognizant that it's out there and it does affect the business. If I think about what the growth drivers are, we obviously have the Lighting business which has been growing nicely each quarter over the last few. And I think we're going to continue to push that, and it's really a game of how do you drive adoption? So get the new products out, build the channel, access more customers, make them aware what LED lighting can do, keep improving the value proposition. And if you drive adoption, we should be able to drive growth in that business. On the LED side, which is the other piece of this, really over the last several quarters, we haven't had much top line growth. Now that being said, we've actually made gross margin improvement each of the last few quarters, which I think is probably the more important piece. And that has a lot to do with the SC 3 transition. We've offered our customers twice the lumens per dollar. So the lumen growth in our business is significant year-over-year, but because of the significantly lower cost of new products, we've really limited the top line. It is the right thing to do for our business, not only in terms of our competitive position, but as I said it helps the margin. But it's going to take several quarters to work through that. And so I think as we get more and more products through that transition -- then with LED lighting adoption growing, then I think they give ourselves the opportunity for the LED product line to also start to deliver more sequential growth than you've seen. So that's the plan right now, and we're going to kind of just keep going down that road knowing that the macro is going to have -- it's either going to be helping us or hurting us a little bit. But again, I think, our focus is what we control.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Okay, and then on the gross margin, you mentioned a number of factors here in terms of impacting gross margins. What's kind of the biggest factor? Is it really utilization? Is it really yields? Is it really product mix? I mean, what's kind of the biggest factor that would be determined? Kind of how we should look at gross margins into next year?

Charles M. Swoboda

Yes. Look, I know everyone wants it to be one thing, it's not. If you look at what we've been doing over the last few quarters, without a lot of the -- the easy lever is, like it's -- the semiconductor company that gets a bunch of volume and fills their factory, you get that one pretty easily. We've only gotten very incremental benefit from utilization over the last few quarters. This is being done -- I'll call it the old fashion way. We're basically figuring out how to run the factory more efficiently. We're developing new products which are cheaper to make and fundamentally designing cost out of it. And in addition to some utilization, we're working the yield side of the equation, which also gives us benefits. And its going to take -- it's taken all those things to get here. They're all significant contributors, and we're going to have to keep doing the same thing. I think that as you reduce the factory costs, you start to wonder how much more efficiency can you squeeze out. We've been doing that for a while, so we're going to keep trying to do that. I think the lower-cost new products, that's a function of how well we do the -- drive innovation. And so we're going to keep looking not just to get the new products converted -- but we're not stopping R&D. We're trying to develop the next generation of lighting products and the next generation of LEDs. So I think if I look at those 2 things plus yields, those are probably the levers that we have the most control over, and those are the ones we're going to focus on. Obviously, additional LED volume will give us some utilization benefit, but in the grand scheme of things, it's probably a secondary benefit to those first 3.

Operator

Our next questioner in queue comes from the line of Vishal Shah with Deutsche Bank.

Vishal Shah - Deutsche Bank AG, Research Division

Chuck, just 2 questions. First, you mentioned margin improvement in the next quarter. Can you talk about whether it's going to be similar in both the lighting and LED products, or should we assume one benefits over the other?

Charles M. Swoboda

Well, the goal is, is that our target is to basically make incremental improvement in all 3 product areas. Obviously, Power and RF is a lot smaller, and it's going to vary a bit with just -- what that revenue does in the short-term, but on the other 2, we're really targeting some incremental improvement in both. And that's been working for us over the last few quarters, and so that's where the focus is. It's by no means -- each quarter, you've got to find a way to squeeze a little bit more out, but so far, the combination of the new products, as well as the cost reductions and the yield, has been working. And so we're really going to look at that. And that applies in LEDs, but it applies in the lighting business too. There are things we can do from an efficiency standpoint, as well as these new products we're bringing out, give us some better cost leverage and will let us go after some different price points. So it's going to be -- both LED and lighting is going to be the 2 drivers of it, but we need to -- our targets are built on that concept that we really need to make progress in both of them.

Vishal Shah - Deutsche Bank AG, Research Division

Okay, great. And then just one other question, you increase your tax rate assumptions for second quarter and the full year. Is this based on the assumption that you're going to see more revenues from North America relative to some of the other regions? What are your thought process on that?

Charles M. Swoboda

I'll let Mike jump on that one.

Michael E. McDevitt

Yes. I think relative to North America or other higher tax jurisdictions, that's where we're seeing the earnings in.

Vishal Shah - Deutsche Bank AG, Research Division

And is that just being driven mostly by better penetration and improving momentum in the outdoor lighting market, or what is the...

Charles M. Swoboda

Actually, I'd say it's more of a regional -- I think what you're saying is, is that we've seen the North American market overall be a little stronger than the other markets than we originally targeted. So I think it's really just a shift regionally. Not only in the lighting product line, but a little more broadly than that.

Operator

Our next question on the phone queue comes from Amir Rozwadowski, with Barclays.

Amir Rozwadowski - Barclays Capital, Research Division

Chuck, I was wondering if we could talk a bit more on the pricing front. Particularly, where do you stand in terms of sort of price points? I mean, your systems business versus the traditional side? Clearly, you guys have been making a number of product improvements and launching new products. But I was wondering sort of what that gap is and where do you expect it to go over the next year or so?

Charles M. Swoboda

Yes, so that's a little bit tough if you think about lighting fixtures because it's going to vary in every price point, and it's going to depend on what we're competing with. So there are examples today where we have our new XSP street light is going to compete very favorably against certain types of outdoor lighting, and it's going to still be more expensive than some of the cheapest low-end outdoor lighting products, for example. If you look at the downlight business, we have our -- as I think Jed mentioned it earlier, you can buy our CR6 downlight from Home Depot. I think they're around $20 with rebate in the Northeast. That's going to compare really favorably with some traditional things. At the same time, if you take a commercial view, we have commercial LED downlights that are almost at price parity with CFL commercial downlights. So we have examples where we're very close, but then if you go into the troffer business, we have -- our new CR22 and CR24 troffers that we came out with are fundamentally cheaper than the previous generation, but if you get into some of the really lower-cost linear fluorescent products out there, then there's still a price gap. And so it's hard to give you any one number because there is no -- there really is not such a thing as a standard in lighting. You've got to pick what you're competing with. So I would say we're ranging from being with almost at price parity or within 20% in probably a few cases to 2x the upfront cost in a number of other cases. And in some cases, we're probably still 3x to 4x the cost depending on what you're looking at. So there's a range. And really the goal is, for the target markets, how do we keep driving that down, generation by generation? But I know it's kind of a broadbrush answer. Unfortunately, there's no one answer to the question.

Amir Rozwadowski - Barclays Capital, Research Division

Its helpful. I guess sort of as a follow-up, as we approach price parity for some of these applications on a like-for-like basis, for example, do you believe that, that is what will drive sort of the initial inflection point for demand? Or do we need to have sort of a better improved macro environment with respect to new construction builds, or people feeling a little bit better about spending capital on retrofit in order to see that inflection? I'm just trying to assess whether it's a sort of you folks driving the price down to get that more competitive, or it's more of the you're already there, now we're just kind of waiting for that end-market demand to pick up?

Charles M. Swoboda

Yes, I want to make sure -- I think we have some examples of where we're there against certain types of conventional alternatives. For the vast majority of lighting, LED is more expensive today. So I want to make sure I didn't misrepresent the previous question. There is definitely a gap in most of the high-volume applications. That being said, we know it's possible because we're getting there in certain select applications. What drives the market? I think as you get close enough, LED adoption goes up. And I think it goes up even if we're in a relatively tough economic situation. And the reason I believe it is, is as you get close enough, then you really -- at some point, the payback is so quick on LED lighting that you're really making a fundamentally more expensive decision to put in the traditional one. And I'll give you an example. If someone today is building a parking garage, or doing -- relamping a parking garage, they're going to have to look long and hard about why they're not putting LED lighting in because the paybacks, versus what was typically used in a parking deck when you look at both the electricity consumption and the maintenance, it's pretty overwhelming today that you might pay a little bit more for LED lighting, but you're going to get your money back several times over during the warranty period. And that's maybe the other subtlety, as we extend the warranty period, you make this a more compelling argument. So I think we're working the different variables. I think the biggest key is, is that we still got work to do to get closer to price parity.

Operator

Next questioner in queue comes from Satya Kumar, with Crédit Suisse.

Satya Kumar - Crédit Suisse AG, Research Division

Looking in on the gross margins, I guess a year ago, it's been said that component gross margins will actually be up for you 1 year from now. I don't think people would have believed that. But I guess you have benefited from these new products, like SC3, like you said. I guess over the last year, your competitors have also benefited from a big adoption increase in LEDs and TVs. I know you don't play in that market, but is there a risk that competition could increase more than usual than the lighting component side of things as we look into next year, because the TV part won't be as big a tailwind [ph] for your competitors next year?

Charles M. Swoboda

Yes, well -- so look, if you look at our gross margins, they've actually followed a fairly different path than many of the other guys in the business. And I think it's a function of the markets we compete in. I think it's also a function of the fact that we made our very big investment on the R&D side to try to innovate our way into some new fundamentally lower-cost platforms, and that's what's paying off. And we really worked our platforms to optimize for certain applications. Clearly, what happens in the backlighting market, I would say it generally doesn't affect the short term, but in the midterm, what that capacity does and what those guys try to do has an effect on the market. Given what we've seen over the last year, it's been a pretty darn competitive environment. So I don't think we're thinking it's not going to be competitive, although at the same time, I'm not sure -- I don't see a catalyst to make it one way or another at this point I guess. I think it's going to remain competitive. I guess I'm not a pessimist to think that there's going to be a significant new round of competition. I think people have made their investments, and we're dealing with it. And I think if you look at the capital rate people have been putting into the industry, it's really moderated over the last 18 to 24 months. So I think -- will there be increased competition? As long as we have a growing market opportunity, that's going to happen. I think what we've got to focus on is keep innovating, come up with different ways to compete. And that should continue to give us opportunities to win business in different ways than just by building big factories and trying to fill them up.

Satya Kumar - Crédit Suisse AG, Research Division

Understood. And then quick follow-ups. On CapEx, I like the cash flow, how should we think about how much more room you have to grow your manufacturing before you start to significantly scale up your CapEx? And on inventory, I like the fact that you've lowered inventory reserve. Can you also give a sense of what your inventories are at your distribution customers and in the channel?

Charles M. Swoboda

Yes, I'll take that backwards. Inventory -- distributor inventory is relatively flat quarter-over-quarter. So there hasn't been a significant change from the previous quarter. And I don't really have a better sense of the customers. My sense is customers are still maintaining very low inventories, but we have less visibility there. As far as CapEx, I think as Mike said earlier, we're thinking, at least in the near-term, the CapEx is going to be in a similar range. It's a little bit hard to answer your question because we've done so much innovation that if you asked me 2 years ago, I wouldn't have thought we could have supported this volume with this capital. I mean, clearly, the innovation side of the business has given us a lot more leverage than we expected 1 year or 2 ago. And so we're going to keep pushing that as hard as we can. We have some availability. And the key point is, is that the chip factory is the -- has the most upside in it right now. And so the idea is, is that we have available capacity, plus we have the ability to bring on the 150, much of that capital investment that we already made. So I think, at least for the foreseeable short to mid-term, we're in a pretty good position. Obviously, market adoption rates and demand can change that fairly quickly on us, but at least for the next few quarters, it feels like we should be operating in this range.

Operator

Next questioner in queue comes from Harsh Kumar, with Stephens Inc.

Harsh N. Kumar - Stephens Inc., Research Division

Chuck, I was wondering if you talk about how we should think about the growth rate of your lighting business? Just either mid-term or longer-term, however you want to address it.

Charles M. Swoboda

Harsh, look, I think what we're hoping to do is continue to drive sequential growth on that business. I'm not sure -- I think it's a little premature to know what the seasonality might do to it, but generally speaking, we're trying to drive sequential growth each quarter there. And with that being said, that means we've got to keep innovating, we've got to keep investing in the channel. What that rate turns out to be, I'm not spending a lot of time trying to make those predictions in the short term. I think we're more focused on what are the levers to get there, which is really back to the conversation we had earlier. We got to keep bringing out products that improve the value position because really what we're talking about is, how do you drive LED versus a conventional alternative? That's really where the focus is over the next couple of years. And this is about how do you make that value proposition more compelling? If we do that, then I think not only Cree, but LED lighting in general should see pretty solid growth. And I think we're seeing that from a number of other people, too. LED lighting looks to be gaining some traction, not only at Cree, but at a number of other lighting-related businesses.

Harsh N. Kumar - Stephens Inc., Research Division

Fair enough. And then, Chuck, as a follow-up, I was wondering on the same business unit, on the Lighting side, you showed a little bit of improvement about 70 bps this quarter in margins. Can I ask you what you think is the biggest driver there? Is it just the new products? Is it something else other than that?

Charles M. Swoboda

Harsh, I'd say it's both cost reductions, figuring out how to do things more efficiently, taking cost out of the production, as well as getting new products to start ramping up. I think it's a combination of both of those that's driving the business right now.

Operator

And with that, that does conclude our time for questions. I'd like to turn the program back over to Mike McDevitt for any additional or closing remarks.

Michael E. McDevitt

Thank you for your time today. We appreciate your interest and support and look forward to reporting our second quarter results on January 22. Good night.

Charles M. Swoboda

Good night, thank you.

Operator

Thank you, gentlemen. Again, ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.

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