UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 26, 200525, 2006

or

For the transition period from                      to                     

Commission file number 0-21154

CREE, INC.

(Exact name of registrant as specified in its charter)

(919) 313-5300

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

NoneCommon Stock, $0.00125 par value

(Title of Class)

Securities registered pursuant to Section 12(g) of the Act:None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No¨

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesx No¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filerx            Accelerated filer¨            Non-accelerated filer¨

Indicate by check mark whether the registrant is an accelerated filera shell company (as defined in Rule 12b-2 of the Act). Yesx No¨ Nox

The aggregate market value of common stock held by non-affiliates of the registrant as of December 23, 20042005 was approximately $2,479,977,967$1,490,751,656 (based on the closing sale price of $38.82$26.22 per share).

The number of shares of the registrant’s Common Stock, $0.00125 par value per share, outstanding as of July 27, 200526, 2006 was 75,578,486.

77,233,461.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held November 3, 20052006 are incorporated by reference into Part III.

CREE, INC.

FORM 10-K

For the Fiscal Year Ended June 26, 200525, 2006

INDEX

PART IForward-Looking Information

Information set forth in this Annual Report on Form 10-K contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act). All information contained in this report relative to future markets for our products and trends in and anticipated levels of revenue, gross margins and expenses, as well as other statements containing words such as “may,” “will,” “anticipate,” “target,” “plan,” “estimate,” “expect” and “intend” and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business, economic and other risks and uncertainties, both known and unknown, and actual results may differ materially from those contained in the forward-looking statements.

Factors that could cause or contribute Any forward-looking statements we make are as of the date made and we have no duty to such differences include:update them if our ability to complete development and commercializationviews later change. These forward-looking statements should not be relied upon as representing our views as of products under development, such as our pipeline of brighter light emitting diodes; our ability to lower costs; potential changes in demand; the risk that, dueany date subsequent to the complexitydate of our manufacturing processes and the transition of production to three-inch wafers, we may experience production delays that preclude us from shipping sufficient quantities to meet customer orders or that result in higher production costs and lower margins; risks associated with the ramp up of production for our new products; risks resulting from the concentration of our business among few customers, including the risk that customers may reduce or cancel orders or fail to honor purchase commitments; the rapid development of new technology and competing products that may impair demand or render our products obsolete; the potential lack of customer acceptance for our products; cash expenditures related to the discontinuation of Cree Microwave operations in Sunnyvale, California; Cree Microwave’s ability to sublease the Sunnyvale facility; and our ability to complete the Cree Microwave-Sunnyvale wind-down process by the end of calendar year 2005.this annual report. See “Certain Business Risks and Uncertainties”“Risk Factors” in Item 71A of this report as well as other risks and uncertainties referenced in this report, for additional risk factors that could cause actual results to differ.

PART I

Item 1.Business

Introduction

Cree, Inc., a North Carolina corporation established in 1987, develops and manufactures semiconductor materials and devices based on silicon carbide (SiC), group III nitridesgallium nitride (GaN), and related compounds. Our SiC and GaN materials technology istechnologies are the basis for many of the devices that we develop and produce. The physical and electronic properties of SiC and GaN offer technical advantages over traditional silicon, gallium arsenide (GaAs), sapphire and other materials used for certain electronic applications. We currently focus our expertise in SiC and GaN materials on three product areas: light emitting diodes (LEDs), including blue, green and near ultraviolet (UV) LED chips and high power packaged LEDs, high powerhigh-power products, including power switching, radio frequency (RF) and microwave devices, and near UV lasers. We have products commercially available in each of these categories except for near UV lasers.

As of the end of fiscal 2005, weWe derive the majority of our revenuesrevenue from sales of our LED products. We also generate revenue from sales of SiC and GaN materials, including gemstone materials, and we earn revenue under government contracts that support certainsome of our research and development programs to the extent the contract funding exceeds our direct cost of performing those activities. In addition, we derive a small portion of revenues from our sales of gemstone materials and devices for wireless infrastructure and power switching applications. We currently are working to develop near UV lasers that are targeted for future optical storage markets and high definition digital versatile disk (HD-DVD) applications.

Most semiconductor devices are fabricated on wafers made from silicon crystals. Silicon evolved as the dominant semiconductor material because it is relatively easy to grow into large, high quality single crystals that are suitable for fabricating many types of electronic devices. Alternative semiconductors such as GaAs were developed to enable the fabrication of improved RF devices and optoelectronic products such as red

LEDs and red lasers. Wide bandgap semiconductors, such as SiC and GaN, have emerged to provide improved capabilities for certain types of solid-state devices. SiC is most commonly targeted for power and RF devices, while GaN is generally targeted for RF and optoelectronic applications such as blue, green or UV LEDs and near UV lasers, as well as higher frequency microwave devices.lasers.

ThroughIn fiscal 2005, we have operated our business in two segments, the Cree segment, which consists of our SiC- and GaN-based products and research contracts, and the Cree Microwave segment, which consists of silicon-based RF transistors and RF transistor modules. In June 2005, we announced plans to close the silicon-based RF business by December 2005 and will no longer report Cree Microwave as a separate segment beginning in fiscal 2006. See “Cree Microwave Segment” below in this report for additional information about this business.reportable segments. In the fourth quarter of fiscal 2004,2005, we acquiredannounced the GaN substrateclosure of the Cree Microwave segment, our silicon-based RF and epitaxymicrowave semiconductor business located in Sunnyvale, California. Effective December 25, 2005, we reported Cree Microwave as a discontinued operation. For further information about this business closure, see Note 3, “Discontinued Operations,” in our consolidated financial statements included in Item 8 of Advanced Technology Materials, Inc. (ATMI). We accounted for this acquisition underreport. As a result of the purchase method.

closure of the Cree Microwave silicon business, we now operate our business in one reportable segment.

The majority of our Cree segment products are manufactured at our main production facility in Durham, North Carolina, in a six-part process, which includes SiC crystal growth, wafering, polishing, epitaxial deposition, fabrication and

testing. Additionally, we package certain high powered LEDs and high-power products in both our Durham facility and in foreign countries through the use of subcontractors. We also package certain high-powered LED and wide bandgap products in our Durham facility. The Cree segment also operatesoperate a research and development facility called the Santa Barbara Technology Center (SBTC) in Goleta, California. Our Cree Microwave silicon-based products are produced in Sunnyvale, California at a silicon wafer fabrication facility, where we buy silicon wafers from third parties, fabricate devices in a clean room environment and package and test finished products. We are planning to close this facility in the second quarter of fiscal 2006. Subcontractors located domestically and in foreign countries also package some of our products.

Products and Products Under Development

Cree Segment

The Cree segment producesWe produce LEDs, SiC and GaN materialsmaterial products, SiC-based power devices and RF microwave transistors and monolithic microwave integrated circuits (MMICs)high-power products using our SiC and GaN materials. In addition, we are currently are developing near UV laser devices in this segment.

devices.

LED Products

LED revenue represented 81%, 84%, and 81% of revenue from continuing operations for the fiscal years ended June 25, 2006, June 26, 2005, and June 27, 2004, respectively.

Blue, Green and Near UV LED ChipsChip Products.    Our LED chip products include blue, green and near UV devices made from GaN and related materials grown on SiC substrates. LEDs are solid-state electronic components used in a number of applications, including backlighting for mobile phonesproducts and automotive interior lighting. In addition, LEDs are used for full-color electronic displays and traffic signals, or they can be used as a light source for gaming equipment, consumer products and other electronic equipment. Some of our customers combine our blue LEDs with phosphors to create white LEDs. Our customers’ white LED products are used in various applications for mobile phones,products, including the backlight for full colorfull-color display screens;screens, white keypads and the camera flash function. Our customers’ white LEDs also are used as a light source for a number of specialized lighting applications. Some of our customers use our blue and green high-brightness LEDs for video screens, gaming displays such as pachinko, and automotive backlighting. LEDs offer several advantages over small incandescent bulbs, including longer life, lower maintenance cost andcosts, reduced energy consumption and smaller space requirements. We currently sell the majority of our LEDs in chip form to customers who package and sell them in a variety of applications. LEDs represented 83%, 78% and 75% of our revenue for the fiscal years ended June 26, 2005, June 27, 2004 and June 29, 2003, respectively.

Our LED chips are currently available in threetwo brightness ranges, which we refer to as standard brightness,ranges: mid-brightness and our high-brightness products. Our standard brightness LED chips, offered in blue wavelengths only, target applications requiring high quality and high volume availability at a lower price point. End customers use this product for applications where higher brightness may not be required,

such as for indoor applications, certain automotive designs or as indicator lights. In fiscal 2005, 2004 and 2003, these products comprised 5%, 8% and 10%, respectively, of our LED revenues.

Our mid-brightness range includes our UltraBright^®, SuperBright^™ and UT230^™ LEDs. Our mid-brightness LEDs provide an option for applications that require a higher level of brightness than provided by our standard brightness LEDs, but still need a low price point. End user applications include the backlight source for mobile phones, which includes both the keypad and display areas and other small hand-held devices, and automotive interior lighting. Our customers also use mid-brightness LEDs in gaming displays such as pachinko, consumer products, office equipment and full color video displays. Our mid-brightness LEDs are offered in blue and green. In fiscal 2005, 2004 and 2003, this category of products comprised 36%, 43% and 55%, respectively, of our LED revenue.

high-brightness. Our high-brightness products include our MegaBright^®, XBright^®, XThin^®, XR230^™, EZBright^™, and XB900^™ and XB500^™ power chip LED products. Some of our customers use our high-brightness LEDs, including our XT-21^™, XT-24^™ and XT-27^™ chips, to create white light from blue LEDs by combining them with phosphors. Target applications for blue LEDs that are converted to white light consist of mobile phones, including backlighting for full color displays, white keypads and camera flashes, as well as miniature white lights and other illumination applications. Some of our customers also use our blue and green high-brightness LEDs for traffic signals, video screens, gaming displays such as pachinko and automotive backlighting. Our XB900 and XB500 power chips are intended to address the markets for higher power LEDs. The 900 series LEDs are designed to operate at approximately one watt of power and are nine times larger than industry standard size (300 x 300 microns) LEDs. These chips aim to deliver approximately 10 times the light output than our standard XBright chips due to operation at a much higher input power. The 500 series LEDs are designed to operate at approximately one half watt of power and are targeted for architectural lighting uses. Our high-brightness LEDs are offered in blue, green and near UV wavelengths. In fiscal 2005, 2004 and 2003, this category of LEDs comprised 59%, 49% and 35%, respectively,March 2006, we announced the release of our new EZBright LED revenue.chip platform. The EZBright platform combines high-brightness levels with a chip that can be assembled by our customers into LED packages using industry-standard processes. The EZBright platform potentially increases both the number of customers as well as the number of applications for our high-brightness products. The first product based on this new platform is the EZBright290^™ chip, which is available in both green and blue colors.

Our mid-brightness category includes LED chips that typically offer less than 20 milliwatts of brightness. This product category includes our MegaBright^®, UT230^™, RazerThin^®, UltraBright^®, and SuperBright^™ LEDs.

High Power Packaged LEDsLEDs..    We are continuing to develop    Our LED products also include our high power packaged LEDs designedLED products, which are targeted to compete with conventional and incandescent lighting technology for certain specialty lighting applications. In the near term, we do not anticipate that our LEDs will widely replace incandescent and fluorescent bulbs for conventional lighting markets due to their cost and other factors. However, in some applications, such as architectural lighting, appliance lighting and reading lamps, LEDs can be advantageous because of their design flexibility, and can be less expensive than incandescent bulbs due to lower energy requirements, longer life, and reduced maintenance costs.

In October 2003, we announced the introduction of our XLamp^™ family ofOur high power packaged LEDs. We started shipping our first product inLED products include the high power LEDXLamp^® family. The XLamp family consists of the 7090 series and the 4550 series XLamp LED, in 2004.LED. The 7090 series product combines our XB900 power chip with a high power surface mount package that is designed to operate up to 350 milliamps of drive current. The XLamp 7090 LEDavailable in nominal 1 and 3 watt versions and is available in multiple colors and white, and is designed to provide an alternative solution to incandescent and conventional light sources in architectural and general illumination applications. In the second quarter of 2005, we introduced and started shipping ourcolors. The 4550 series XLamp product which incorporates our XB500 chip and is designed to operate at up to 150 milliamps of drive current. The 4550 series0.5 watts and is also available in multiple colorscolors. The XLamp product is designed to meet a broad range of market needs for LED-based portable, architectural, entertainment, signal and addresses market demand for high-brightness and smaller form factor power LEDs for architectural and accent lighting and other general illumination applications. In fiscal 2005, high power packaged LEDs represented less than 1%transportation lighting.

We continue the development of our LED revenue.Colorwave^™

In the fourth quarter of fiscal 2005, we announced a new initiative for LED backlighting under developmentsolution for large screen liquid crystal display (LCD) applications that reduces power consumption compared to other LED and traditional compact fluorescent backlighting options. Thisapplications. Our approach is based on our high-brightness XThin blue and green LEDs and should enable manufacturers to produce television and computer monitors that can deliver a higher color gamut than what is currently available with larger screens that do not require active cooling, resulting in thinner monitors and lower production costs.existing fluorescent backlight technology.

Materials Products

Our materials products consist of SiC and GaN wafer and epitaxy products and bulk SiC materials used for gemstone applications.

SiC and GaN Wafers.Wafers.    We manufacture SiC wafers for sale to corporate customers who use the wafers to manufacture products for optoelectronic and power switching applications. Corporate, government and university programscustomers also buy SiC and GaN wafers for research and development directed toat optoelectronic, microwave and high powerhigh-power devices. We sell our wafers as a bare wafer or a customized wafer with epitaxial films of SiC or GaN materials. We currently sell both two-inch, three-inch and three-inchfour-inch wafers and are continuing to develop SiC wafers that are larger and of higher quality. Wafer products represented 6%5%, 6% and 7% and 9% of our revenue from continuing operations for the fiscal years ended June 25, 2006, June 26, 2005 and June 27, 2004, and June 29, 2003, respectively.

Bulk Materials Used for Gemstones.    We manufacture SiC crystals in near colorless form for use in gemstone applications. Single crystalline SiC has characteristics that are similar to diamond, including properties relating to color, hardness and brilliance. We sell SiC in bulk crystal form exclusively to Charles & Colvard, Ltd. (C&C), whichCharles & Colvard produces and markets gemstone products made from SiC crystals. SiC materials sold for gemstone applications represented 2%3%, 2% and 3%2% of our revenue from continuing operations for the fiscal years ended June 25, 2006, June 26, 2005 and June 27, 2004, and June 29, 2003, respectively.

High PowerHigh-Power Products

These products include SiC power devices, and wide bandgap RF and microwave devices. Revenue from our high-power products represented 4%, 2% and 1% of revenue from continuing operations in each of the fiscal years ended June 25, 2006, June 26, 2005 and June 27, 2004, respectively.

SiC-based Power DevicesDevices..    SiC-based power devices can operate at significantly higher breakdown voltages than silicon-based power devices and provide faster switching speeds than comparable silicon-based power devices at similar breakdown voltages. These attributes create a lower switching loss, which yields power savings due to higher efficiency, enabling smaller and more efficient systems.

Our current SiC-based power products include 300, 600 and 1,200-volt Schottky diodes. Target applicationsOur customers currently purchase Schottky diode products for these products includeuse in power factor correction and output rectification incircuits for power supplies as well as motor controls. SiC-based power devices represented 1%in computer servers and 1% of our revenue for the fiscal years ended June 26, 2005 and June 27, 2004, respectively. SiC-based power devices represented less than 1% of our revenue for the fiscal year ended June 29, 2003.

other applications. We are developing additional SiC-based power devices, including PIN diodes, bipolar junction transistors (BJTs), and power MOSFETs, whichmetal-oxide semiconductor field effect transistors (MOSFETs). These devices could have many potential uses such as power conditioning and power switching in power supplies and motor control applications.

RF and Microwave TransistorsDevices.    RF and microwave devices made from SiC canor GaN operate at higher voltages which allowsthat allow for higher power densities as compared to silicon or GaAs-based devices. Additionally, this characteristic allows SiC-based and GaN-based devices to be significantly smaller while carrying the same or greater power levelslevel than silicon-based or GaAs-based devices. Currently,At this time, there is a higher cost associated with SiC and GaN than silicon for RF and microwave transistors.

We currently offer both 10-watt and 60-watt SiC transistors, or metal-semiconductor field effect transistor (MESFET) products. In June 2005,During fiscal 2006 we began samplingintroduced a 10-watt packaged SiC MESFET targeted atGaN high electron mobility transistor (HEMT), which is optimized for broadband wireless access and WiMaxfor WiMAX applications. We believe that the reliability, efficiency and high temperature capability of our SiC MESFETs and GaN HEMTs make them well suited for such applications sincebecause power consumption and available cooling are key design considerations.

We also provide a foundry serviceservices for wide bandgap MMICs.monolithic microwave integrated circuits (MMICs). These SiC-based RF circuits can be used in a variety of wide bandwidth communications applications, high-power radar amplifiers, electronic warfare and wireless infrastructure. The MMIC foundry service allows a customer to design its own custom SiC RF circuit to be fabricated in our MMIC foundry, or have us provide custom MMIC design for the customer and

fabricate the chips. We intend to focus future development efforts in this area on creating higher power SiC MESFETs and GaN RF devices. SiC MESFET and MMIC devices represented 1% of revenue for the fiscal year ended June 26, 2005. SiC MESFET and MMIC devices represented less than 1% of revenue for the fiscal years ended June 27, 2004 and June 29, 2003, respectively.

Near UV Laser Diodes

We have demonstrated near UV lasers (sometimes referred to as blue lasers) that operate at power levels ranging from three milliwatts to greater than 100 milliwatts. Our development activity continues to focus on developing more reliable and higher performance devices. The primary target market for our lasers is optical disk drives for next generation DVDs and computer data storage applications. The shorter wavelength of near UV products enables significantly higher storage capacity than the current generation of optical drives, which employ red lasers. In fiscal 2005, we shifted our development efforts for near UV lasersWe are currently focused on working with a partner to GaN substrates from SiC substrates to improve the performance of our devices.

Cree Microwave Segment

Through fiscal 2005, we operated the Cree Microwave segment, which produced laterally diffused metal oxide semiconductor (LDMOS) devices made from silicon substrates. Cree Microwave began operations with the December 2000 acquisition of the UltraRF business from Spectrian Corporation (Spectrian). We renamed the UltraRF business Cree Microwave during fiscal 2002. Its products are manufactured at our subsidiary’s silicon fabrication facility in Sunnyvale, California. In June 2005, we announced plans to cease production of Cree Microwave’s products by the end of the second quarter of fiscal 2006, based on management’s review of the strategic alternatives and financial outlook forcommercialize this business. We plan to concentrate on wide bandgap RF and microwave products based on our SiC and GaN technology. Cree Microwave’s products represented 1%, 3% and 1%, respectively of our total revenue for the fiscal years ended June 26, 2005, June 27, 2004, and June 29, 2003, respectively. We will no longer report Cree Microwave as a separate segment beginning in fiscal 2006. However, we plan to continue marketing our SiC and GaN-based wide bandgap RF and microwave products under the Cree Microwave brand.

Financial Information About Segments and Geographic Areas of Customers and Assets

For financial information about business segments and geographical areas of customers, please see Note 2, “Summary of Significant Accounting Policies and Other Matters,” toin our consolidated financial statements included in Item 8 of this report. AllPrimarily all of our long-lived tangible assets currently are maintained in the United States.

Government Contract Funding

We derive a portion of our revenue from funding that we receive pursuant to research contracts or subcontracts, funded by various agencies of the U.S. Government. We had 26, 31 33 and 1933 government contracts in effect during the fiscal years ended June 25, 2006, June 26, 2005 and June 27, 2004, respectively. For the fiscal years ended June 25, 2006, June 26, 2005 and June 29, 2003,27, 2004, U.S. Government contract funding represented 7%, 6% and 9% of revenue from continuing operations, respectively.

Our government contracts typically cover work performed over several months up to five years.years and require us to conduct the research effort described in the statement of work section of the contract. These contracts may be modified or terminated at the convenience of the government and typically are subject to appropriation and allocation of the required funding on an annual basis. The revenue that we recognize pursuant to these contracts represents reimbursement by various U.S. Government entities that aid in the development of new technology. The applicable contracts generally provide that we may elect to retain ownership of inventions made in performing the work subject to a non-exclusive license retained by the U.S. Government to use the inventions for government purposes.

Contract funding may be based on either a fixed price or cost type award. Cost awards include cost, cost-plus fixed fee or cost-share arrangements. The amount For further information about our government contracts, see Note 2, “Summary of funding under each contract is determined

based on cost estimates that include direct costs, plus an allocation for researchSignificant Accounting Policies and development expenses, general and administrative expenses and costOther Matters,” in our consolidated financial statements included in Item 8 of capital expenses. The specific reimbursement provisions of the contracts, including the portion of our general and administrative expenses and other operating expenses that are reimbursed, vary by contract. Cost-plus funding is determined based on actual costs plus a fixed fee. For the cost-share contracts, based on the terms of the contract, the actual costs relating to activities we are to perform under the contract are divided between the U.S. Government and us. The U.S. Government’s cost share is then paid to us. The contracts typically require the submission of a written report that documents the results of the research, as well as some material deliverables.

We generally must compete with other companies for funding awards from the U.S. Government. In certain cases, such as when the value of a U.S. Government contract exceeds $100,000 and when highly technical research is required, the U.S. Government issues a request for proposal (RFP). In a typical RFP, the U.S. Government requests a product or service and solicits proposals from prospective contractors on how they intend to carry out that request and at what price. Proposals received in response to an RFP can be subject to negotiation after they have been submitted. Many U.S. Government contracts are awarded on a type of RFP called a broad agency announcement (BAA). In a BAA, the U.S. Government requests a broad range of research and development services. Contractors submit bids for research in any of the technical areas mentioned in the BAA. Then the U.S. Government may select winners of the awards and negotiate contracts with those parties. The U.S. Government uses many methods to select contractors to receive awards. Some of these methods include choosing vendors who offer products or services that provide the best value, lowest price and highest level of technology. We also may be the recipients of a sole source contract from the U.S. Government if the U.S. Government determines that we are the only viable source for the work to be performed. In this case, the U.S. Government would publish its intent to award a sole source contract to us, and if there are no viable challenges made to that publication, the U.S. Government might award the contract to us without a competitive bid process.

The contracts require us to conduct the research effort described in the statement of work section of the contract. The contracts also require that we pay a contractually agreed upon portion of the costs of the work with the U.S. Government paying the balance. There are no milestones to be reached for payments from the U.S. Government. We invoice the U.S. Government monthly for their share of the costs of the work performed based on costs incurred for that month. For the fiscal years ended June 26, 2005, June 27, 2004 and June 29, 2003, U.S. Government contract funding represented 6%, 9% and 12% of total revenue, respectively.

report.

Distributorship Agreement with

Sumitomo Corporation

In April 2002, we entered into a distributorship agreement with Sumitomo Corporation (Sumitomo), which has been amended annually, most recently in May 2005.2006. Under the agreement, as amended, Sumitomo became our strategic partner and is the exclusive distributor of certain LED and wafer products in Japan and a non-exclusive distributor in certain other Asian countries through fiscal 2007.countries. Prior to the beginning of each fiscal year, the distributorship agreement requires Sumitomo to commit in advance to purchase a specified dollar value of our products during the next fiscal year. For fiscal years 2005 and 2004, Sumitomo’s advance purchase commitments were approximately $160 million and $100 million, respectively. For fiscal 2006, under the terms of the agreement as amended in May 2005,2007, Sumitomo’s advance purchase commitment is approximately $200$180.0 million. We anticipate that purchases will be made across our full line of LED chip products representing our standard brightness, mid-brightness and high-brightness devices, including MegaBright, XBright and XThin LEDs.wafer products. However, Sumitomo’s purchase commitment may vary under certain circumstances subject to end customer demand and other terms and conditions. For example, thein fiscal 2006, Sumitomo purchased approximately 78% of its advance purchase commitment for that year. The distributorship agreement provides that Sumitomo may decrease its advance purchase commitment and/or terminate the agreement if its inventory of our productsproduct reaches a specified level. If Sumitomo does not purchase at least half of its advance purchase commitment for any fiscal quarter as a result of this inventory limitation, we have the option of terminating the distributorship agreement. The distributorship agreement also requires us to reimburse Sumitomo for certain costs and allows Sumitomo to rotate its inventory in certain situations.

Research and Development

We invest significant resources in research and development aimed at improving our semiconductor materials and developing new device and production technology. Our core materials research is directed toat improving the quality and diameter of our SiC and GaN substrates. We also are working to improve the quality and attributes of the SiC and nitride epitaxial materials we grow to produce devices and to improve device yields by reducing variability in our processes. These efforts are in addition to ongoing projects focused on brighter LED chips, high power packaged LEDs, three-inch and four-inch LED wafer process development, higher power diodes/switches, higher power/higher linearity RF and microwave devices, and near UV laser devices and as discussed above.diodes. We recorded $42.8$54.9 million in fiscal 2006, $40.0 million in fiscal 2005, $36.5and $32.5 million in fiscal 2004 and $31.0 million in fiscal 2003 for direct expenditures relating to research and development activities. In fiscal 2005, 2004 and 2003, customers funded zero, zero and $500,000, respectively, for programs that offset research and development costs. An affiliate of Lighthouse Technologies Limited (Lighthouse) in which we had an investment, was our only source of customer funding in fiscal 2003. When customers participate in funding our research and development programs, we record the amount funded as a reduction of research and development expenses.

For further information about these programs, see Note 2, “Summary of Significant Accounting Policies and Other Matters,” in our consolidated financial statements included in Item 8 of this report.

Sales and Marketing

We actively market our LED, wafer, microwavematerial and powerhigh-power products through targeted promotions, select advertising, and attendance at trade shows. Our directoriginal equipment manufacturers and distribution sales forceteams and senior management work with customers around the world. The production of lamp and display products incorporating LED chips is concentrated among a relatively small number of LED packaging manufacturers. Our sales and marketing team is based in our Durham, North Carolina facility with additional sales and application support offices in Vienna, Austria; Tokyo, Japan; and Hong Kong and Tokyo, Japan.Kong. We also have a salespersonsales personnel based in Taiwan and two sales managers in Korea. We have targeted Asia as a fast growing market for our products and believeare targeting to increase our sales in Asia have continuedand marketing efforts globally to increase, in part as a direct result of localizingsupport our Asian sales presence.

new product lines.

Supported by our Japan office, Sumitomo is our exclusive distribution partner for nitride LED chips and SiC and GaN wafers in Japan. We also use distributors to market our LED products in Hong Kong, China, Korea and Taiwan. We use a separate network of distributors and sales representatives to market our RF and microwavehigh-power devices power devices and high power packaged LED products in North America, Japan, EuropeAsia and Asia.

Europe.

We sell SiC crystal materials for use in gemstone applications directly to C&CCharles & Colvard under an exclusive supply agreement.

Customers

During fiscal 2005,2006, revenues from Sumitomo (which represent sales to approximately 20 Japanese LED customers as well as a number of wafer customers) accounted for 41%37% of our total revenue.revenue from continuing operations. Sumitomo assists in managing customer relationships and imports, handles orders, distributes our products and manages accounts receivable for the Japanese customer base. ForIn fiscal 2005,2006, four of our top ten end customers were located in Japan and their sales, as well as sales to our other Japanese customers, are reported as sales to Sumitomo. Our sales team based in Tokyo, Japan is actively involved with Sumitomo in the sales process to accounts in Japan. Our relationship with our end customers in Japan is critical to our future success.

Sumitomo and Seoul Semiconductor Co., Ltd. (Seoul), individually comprised 10% or more of revenue from continuing operations for fiscal 2006. Sales to Seoul were 11% of revenue from continuing operations during fiscal 2006.

In fiscal 2005, revenues from Sumitomo and OSRAM Opto Semiconductors GmbH (OSRAM) were the only customers that individually comprised 10% or more of our revenue for fiscal 2005. Sales to OSRAM were 11%represented 42% and 12%, respectively, of revenue during fiscal 2005.from continuing operations. In fiscal 2004, revenues from Sumitomo, OSRAM, and Avago Technologies, Inc. (Avago), formerly Agilent Technologies (Malaysia) Sdn Bhd, (Agilent) represented 33%34%, 13%14% and 13%, respectively, of total revenues. During fiscal 2003 revenuesrevenue from Sumitomo, OSRAM and Agilent were 24%, 21% and 10% respectively, of total revenues.continuing operations. The loss of OSRAM or any of Sumitomo’s large customers could have a material adverse effect on our business and results of operation. Revenue from the U.S. Government, representing funding from several agencies,

made up 6% of total revenues for fiscal 2005, compared to 9% of total revenue for fiscal 2004 and 12% of total revenue in fiscal 2003. As our U.S. Government contracts are with multiple agencies, the U.S. Government does not act as a single customer, and we do not regard it as such. In fiscal 2005 and 2004, sales to Remec, Inc. made up 12% and 43%, respectively, of Cree Microwave sales. For further financial information about foreign and domestic sales, please see Note 2, “Summary of Significant Accounting Policies and Other Matters,” toin our consolidated financial statements included in Item 8 of this report.

Backlog

As of June 25, 2006, we had a backlog of approximately $290.4 million, consisting of approximately $235.0 million of product orders and purchase commitments and $55.4 million under research contracts signed with the U.S. Government, for which approximately $41.1 million of the contracted funds have not yet been appropriated.Our backlog includes the full amount of the Sumitomo purchase commitments for fiscal 2007, which may vary under certain circumstances subject to end customer demand and other terms and conditions described above under the caption “Distributorship Agreement.” We estimate our entire backlog could be filled during fiscal 2007, with the exception of approximately $26.9 million in U.S. Government funded contracts.

As of June 26, 2005, we had a backlog of approximately $303.2 million consisting of approximately $229.7 million of product orders and $73.5 million under research contracts signed with the U.S. Government, for which approximately $57.6 million of the contracted funds have not yet been appropriated.The backlog includes the full amount of Sumitomo’s purchase commitment for fiscal 2006, which may vary under certain circumstances subject to end customer demandcommitments and other terms and conditions described above under the caption “Distributorship Agreement with Sumitomo Corporation.” As of June 27, 2004, we had a backlog of approximately $248.5 million consisting of approximately $192.8 million of product orders and $55.7$73.5 million under research contracts signed with the U.S. Government.This backlog also included the full amount of Sumitomo’s purchase commitment. commitment for fiscal 2006. The amount of Sumitomo’s fiscal 2006 purchase commitment was $200 million, however, actual fiscal 2006 sales to Sumitomo amounted to $156.4 million. The decrease in actual sales versus the amount committed by Sumitomo was due to a decrease in end customer demand in Japan.

Our backlog could be adversely affected if Sumitomo or other customers fail to honor their purchase commitments, or reduce or cancel orders, or if the U.S. Government exercises its rights to terminate theour government contracts or does not appropriate and allocate all of the funding contemplated by the contracts. We estimate our entire backlog could be filled during fiscal 2006, with the exception of approximately $44.8 million in U.S. Government funded contracts.

In May 2005, we amended and restated our existing distributorship agreement with Sumitomo. For fiscal year 2006, Sumitomo’s current advance purchase commitment is approximately $200 million, subject to adjustment and cancellation provisions and end customer demand.The orders cover demand for our products in Japan and represent sales to over 20 LED packagers, including Stanley Electric Co., Ltd. (Stanley), Citizen Electronics Co., Ltd. (Citizen), Sharp Corporation (Sharp) and Rohm Co., Ltd. (Rohm). In June 2005, we signed a new purchase agreement with OSRAM. The agreement covers the terms of shipments to be made through June 2008, but does not commit OSRAM to purchase any specific products. Therefore, we only account for amounts set forth in purchase orders from OSRAM as firm backlog.

Sources of Raw Materials

We depend on a limited number of suppliers for certain raw materials, components and equipment used in our products, including certain key materials and equipment used in our crystal growth, wafering, polishing, epitaxial deposition, device fabrication and device assembly processes. We generally purchase these limited source items pursuant to purchase orders and have limited guaranteed supply arrangements with our suppliers.

Competition

Our success depends on our ability to keep pace with the evolving technology standards of the industries that we serve. These industries are characterized by rapid technological change, frequent introduction of new products, short product life cycles, and changes in end user and customer requirements. The evolving nature of these industries may render our existing or future products obsolete, noncompetitive or unmarketable. Any of these developments could have an adverse effect on our business, results of operations and financial condition.

LED Products

Blue, Green and Near UV LED Chips.    The primary competition for our LED chip products comes from companies that manufacture and and/or sell nitride-based LED chips. We consider Nichia Corporation

(Nichia), which sells packaged LEDs and most often competes directly with our chip customers, to be a competitor. Nichia currently sells the majority of its packaged LED products to markets requiring white LEDs, which Nichia fabricates using its efficient phosphor solution for blue LEDs. We believe, based on industry information, that Nichia currently has the largest market share for nitride-based LEDs based on industry information.We also believe Nichia will be very aggressive in product pricing during fiscal 2006, especially as it attempts to defend market share against gains that we target that our customers may make using our die.WeLEDs.We see an opportunity to improve our customers’ ability to compete with Nichia’sin the white LED productsmarket and increase our chip sales with our recently introduced XT-21, XT-24 and XT-27 chips, based on reports from customers that they are able to produce white LEDs with these chips that are similar in brightness output to Nichia’s white LED.brighter LED chips. However, this opportunity depends upon our customers’ ability to source or develop efficient phosphor solutions for the conversion to white light that can compete with Nichia’s solution.light. It also depends on our customers’ ability to achieve certain packaging efficiencies with our chips.

Many Asia-based chip producers also produce blue, green and near UV LED products. They traditionally have been successful in securing new business, primarily in Asia for the blue and white keypad backlight for

mobile appliances and other cost sensitive applications. As these Asia-based competitors have begun offering chips with brightness similar to some of our existing high-brightness products, they are now also making inroads into higher end applications like camera flash units. We believe we can compete effectively in these markets with products such as our UT230 chips, used in keypad handset applications. These chips deliver competitive performance and a low price for blue LEDs.

Our customers indicate that they base their nitride LED purchases on a combination of factors. These factors include price, performance, reliability, quality, usability and stability of supply, intellectual property, customer service and overall customer relationships. Based on conversations with our customers, we believe that our products have an advantage over our competitors’ chips in many of these areas and that we are more successful when end customers value a combination of these factors. The particular combination and importance of specific factors that drive customers’ purchasing decisions at any time varies, depending on market conditions, requirements for end user applications and demand for those applications.Overall, we believe that price and performance are the most significant factors to compete successfully in the nitride LED market and thatmarket. We believe our products are well positioned to meet the market demands.performance requirements; however, there is significant pricing pressure from a number of competitors. We continually strive to improve our competitive position by developing brighter and higher performance LED chips and focusing on lowering costs. For example, we migrated somethe majority of our LED production to three-inch wafers from two-inch wafers during fiscal 20052006 and we will continue our transition to larger wafer sizes in fiscal 2006. Larger wafers have lowered our overall LED chip cost for certain products.

2007.

High Power Packaged LEDs.    The market for power chip products and high power packaged LED lamps is currently limited toprimarily in the specialty lighting applications.area, including portable torch lamps (flashlights); color changing and white architectural lighting; traffic signs and signals; interior and exterior automotive and truck lighting; and emergency vehicle lighting (for example, for fire and rescue vehicles). Philips Lumileds Lighting Company, LLC (Lumileds)(Philips) is currently is positioned as the leader in this market since it has been the most active supplier of high power packaged LEDs for the last few years. LumiledsPhilips sells high power packaged LEDs that compete indirectly with our target customers for power chip products and directly with our XLamp^™ family of high power packaged lamps. Several other companies have announced intentions to enterentered this market with products designed to compete with our XLamp products.products, including Avago, Cotco International Limited, Edison Opto Corporation, Kingbright Corporation, Nichia, OSRAM, and Seoul. We are positioning our XLamp products to compete in this market based on price, performance and usability.

Materials Products

The market for SiC wafers has become more competitive in recent years as other companies have begun to offer SiC wafer products or have announced plans to do so. To our knowledge, none of these competitors currently offer SiC wafers that are being used in high volume manufacturing. We sell SiC wafers to OSRAM, which competes with us in LED markets. In addition to being a large customer of our LED chips, OSRAM, which licensed certain LED technology from us in 1995, currently is producing LEDs using nitride materials on SiC substrates for use in their packages. We sell SiC wafers to Infineon Technologies

AG (Infineon), which competes with us in power switching semiconductor markets. Norstel AB has entered into an agreement to provide SiC materials to C&C as a second source for use in gemstones.

High PowerHigh-Power Products

SiC-based Power Devices.    Our SiC-based power devices compete with similar devices offered by Infineon.Infineon Technologies AG (Infineon). There are also a number of other companies developing SiC-based power devices. OurIn addition, our products also compete with existing silicon-based power devices offered by a variety of manufacturers.

RF and Microwave Transistors.    Currently, there are no companiesEudyna Devices, Inc., is the main company offering products that compete directly with our SiC MESFET products and MMIC foundry service,GaN HEMT products although a few companies have products under development. AlthoughWhile there are nofew direct competitors using SiC or GaN technology, our products still face competition from existing silicon and GaAs-based products. We do not currently offer GaN microwave devices, but we are working to develop these products. In the GaN microwave area, there are a number of companies working to develop these products.

Near UV Laser Diodes

We currently do not offer any laser products commercially. The major competitors in the near UV laser market are Nichia and Sony, as well as a number of other companies that have announced development activities in this area. The market for blue laser products is just beginning to emerge.

Patents and ProprietaryOther Intellectual Property Rights

We believe it is important to protect our investment in technology by obtaining and enforcing intellectual property rights, including rights under patent, trademark, trade secret and copyright laws. We seek to protect our proprietary technologyinventions we consider significant by applying for patents where appropriatein the United States and in other cases by preserving the technology and related know-how and information as trade secrets.countries when appropriate. We have also from time to time acquired, through license grants orand assignments, rights to patents on inventions originally developed by others. As of July 15, 2005,2006, we owned or held exclusive rights licensed under a total of 284333 issued U.S. patents subject in some caseswith expiration dates extending to non-exclusive license rights held by third parties. These patents expire between 2007 and 2026. We jointly own six of these patents with third parties. In addition, we own or hold exclusive license rights under corresponding patents and patent applications in various foreign countries.

Among the patent licenses we hold are exclusive licenses granted by North Carolina State University (NCSU) to U.S. and2026, as well as corresponding foreign patents and patent applications that relate to SiC materials and device technology and to GaN growth technology. These licenses include rights under patents and patent applications relating to processes for growing single crystal SiC and low defect GaN materials. The licenses are worldwide, exclusive licenses to manufacture, use and sell products and processes covered by the claims of patents issued on applications filed by NCSU relating to the licensed inventions. The licenses relating to the growth of bulk single crystal SiC and to other SiC materials and device technology are fully-paid, while the licenses relating to growth of low defect GaN materials require us to pay NCSU royalties on sales of products made using the licensed processes. The patents that we have licensed from NCSU relating to bulk SiC growth expire beginning in 2007, and we may face increased competition in the market for SiC materials as these patents expire.

We also have entered into license agreements with the licensing agencies of other universities, and with other companies, under which we have obtained exclusive or non-exclusive rights to practice inventions claimed in various patents and applications issued or pending in the U.S. and other foreign countries. We do not believe the financial obligations under any of these agreements, or the loss of the licensed rights under any of these agreements, would have a material adverse effect on our business, financial condition or results of operation. These license agreements include a patent cross-license agreement covering GaN-based optoelectronic technology that we entered into with Nichia in November 2002 in connection with a settlement of patent and related litigation then pending between the parties in the United States and Japan and a patent cross-license agreement covering white LED technology that we entered into with Nichia in February 2005.

These license agreements also include license rights granted to us by the Trustees of Boston University (Boston University) under certain U.S. patents and corresponding foreign patents and patent applications which relate to the manufacture of certain GaN-based structures on sapphire and other substrates. The license agreement with Boston University grants us an exclusive, worldwide royalty-bearing license under these patents and patent applications, subject to royalty payments and other obligations under the license agreement. Termination of the license to this patent by Boston University would end our right to assert the patent against future infringements. In May 2005, we entered into licensing agreements with several strategic chip customers, including Stanley and Rohm of Japan, and Cotco Holdings, Ltd. of Hong Kong. These agreements provide rights to manufacture and sell white LEDs incorporating our high performance LED chips. We believe such licensing agreements with our competitors and strategic customers serve to defend and strengthen our proprietary technology and intellectual property rights in key markets.

rights. For proprietary technology that is not patented, or otherwise published, we generally seek to protect the technology and related know-how and information as trade secrets and to maintain it in confidence through appropriate non-disclosure agreements with employees and others to whom the information is disclosed. There can be no assurance that these agreements will provide meaningful protection against unauthorized disclosure or use of our confidential information or that our proprietary technology and know-how will not otherwise become known or independently discovered by others.secrets. We also rely uponown other intellectual property rights, including trademark registrations in several countries for trademarks used in conjunction with our products.

Licensing activities and lawsuits to enforce intellectual property rights, particularly patent rights, are a common feature of the semiconductor industry. We both make and receive inquiries regarding possible patent infringements in the normal course of business. Depending on the circumstances, we may seek to negotiate a license or other acceptable resolution. If we are unable to achieve a resolution by agreement, we may seek to enforce our rights or defend our position through litigation. Patent litigation is expensive and the outcome is often uncertain. We believe that the strength of our portfolio of patent rights is important in helping us resolve or avoid such disputes with other companies in our industry. In addition, we believe that many customers ascribe additional value to our LEDs as trademarks and copyright where appropriate.a result of our portfolio, particularly for high-end products destined for the United States, as compared to LEDs from manufacturers who are not licensed under the relevant patents in the portfolio. Ongoing efforts to enforce our patent rights against infringers are essential to sustaining this higher perceived value.

Environmental Regulation

We are subject to a variety of federal, state and local provisions enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. These include statutory and regulatory provisions under which we are responsible for the management of hazardous materials we use and the disposition of hazardous wastes resulting from our manufacturing processes. Failure to comply with such provisions, whether intentional or inadvertent, could result in fines and other liabilities to the government or third parties, injunctions requiring us to suspend or curtail operations or other remedies, and could have a material adverse effect on our business.

Employees

As of June 26, 2005,25, 2006, we employed 1,3221,364 regular full and part time employees, including 1,015 in manufacturing operations, 195 in research and development and 112 in sales and general administration.employees. None of our employees are represented by a labor union or subject to collective bargaining agreements.

Available Information

We maintain a website at the address www.cree.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission (SEC). These reports may be accessed from our website by following the linklinks under “News & Investor—SEC Filings” on our website.

“Investor Relations,” then “SEC Filings.”

Item 2.     1A.Properties    Risk Factors

Described below are various risks and uncertainties that may affect our business. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties, both known and unknown, including ones that we currently deem immaterial or that are similar to those faced by other companies in our industry or business in general, may also affect our business. If any of the risks described below actually occur, our business, financial condition or results of operations could be materially and adversely affected.

Our operating results and margins may fluctuate significantly.

Although we experienced significant revenue growth over the past few years, we may not be able to sustain such growth or maintain our margins, and we may experience significant fluctuations in our revenue, earnings and margins in the future. Historically, the prices of our LEDs have declined based on market trends. We attempt to maintain our margins by constantly developing improved or new products, which provide greater value and

result in higher prices, or by lowering the cost of our LEDs. If we are unable to do so, our margins will decline. Our operating results and margins may vary significantly in the future due to many factors, including the following:

These or other factors could adversely affect our future operating results and margins. If our future operating results or margins are below the expectations of stock market analysts or our investors, our stock price will likely decline.

If we are unable to produce and sell adequate quantities of our LED products and improve our yields and reduce costs, our operating results may suffer.

We believe that our ability to gain customer acceptance of our products and to achieve higher volume production and lower production costs for those products will be important to our future operating results. We must reduce costs of these products to avoid margin reductions from the lower selling prices we may offer due to our competitive environment and/or to satisfy prior contractual commitments. Achieving greater volumes and lower costs requires improved production yields for these products. We may encounter manufacturing difficulties

as we ramp up our capacity to make our newest high-brightness products. Our failure to produce adequate quantities and improve the yields of any of these products could have a material adverse effect on our business, results of operations and financial condition.

Our operating results are substantially dependent on the development of new products based on our SiC and GaN technology.

Our future success will depend on our ability to develop new SiC and GaN solutions for existing and new markets. We must introduce new products in a timely and cost-effective manner, and we must secure production orders for those products from our customers. The development of new SiC and GaN products is a highly complex process, and we historically have experienced delays in completing the development and introduction of new products. Products currently under development include larger, higher quality substrates and epitaxy, wide bandgap RF and microwave products based on SiC and GaN, SiC power devices, higher brightness LED products such as the new EZBright LED introduced in the third quarter of fiscal 2006, and high power packaged LEDs. The successful development and introduction of these products depends on a number of factors, including the following:

If any of these or other factors become problematic, we may not be able to develop and introduce these new products in a timely or cost-efficient manner.

Our results of operations, financial condition and business would be harmed if we were unable to balance customer demand and capacity.

We are in the process of taking steps to address our manufacturing capacity needs in order to meet current and future customer demand. If we are not able to increase our capacity or if we increase our capacity too quickly, our business and results of operations could be adversely impacted. For example, we are currently expanding our manufacturing capacity, including the build out of the fabrication facility in Research Triangle Park, North Carolina, that we acquired from a third party in the third quarter of fiscal 2005. Delays in bringing that facility on line could impact our ability to meet future demands for high-power products and contract revenue targets could be impacted. If our expansion initiative is delayed, costs more than we anticipate or requires long transition or qualification periods, our business and financial results could be harmed. If our business does not grow fast enough to use this new capacity, our financial results could decline. We are also expanding capacity for our XLamp products and qualifying a subcontractor. If we experience delays or additional unforeseen costs associated with this expansion, we may not be able to achieve our financial targets.

Our LED revenues are highly dependent on our customers’ ability to produce competitive white LED products using our LED chips.

Some of our customers package our blue LEDs in combination with phosphors to create white LEDs. Growth in sales of our high-brightness LED chips used in white light applications is dependent upon our

customers’ ability to develop efficient white LED products using our chips. Nichia currently has the majority of the market share for white LEDs and other companies, such as Toyoda Gosei Co., Ltd., have started to offer highly competitive blue chips and white products to compete with Nichia. The white LEDs that our customers produce with our chips historically have not been as bright as Nichia’s white LEDs. Even if our customers are able to develop higher performance white LED products, there can be no assurance that they will be able to compete with Nichia, Toyoda Gosei Co., Ltd., or other competitors.

We are highly dependent on trends in mobile products to drive a substantial percentage of LED demand.

Our results of operations could be adversely affected if we experience reduced customer demand for LED products for use in mobile products. During fiscal 2006, approximately 56% of our LED revenue was from sales of our products into mobile products. Our design wins are spread over numerous models and customers. Our ability to maintain or increase our LED product revenue depends in part on the number of models into which our customers design our products and the overall demand for these products, which is impacted by seasonal fluctuations and market trends. Design cycles in the mobile product industry are short and demand is volatile, which makes production planning difficult to forecast. Brightness performance, smaller size and price considerations are important factors in increasing our market share for mobile products.

If we experience poor production yields or cannot reduce costs, our margins could decline and our operating results may suffer.

Our materials products, our LED products, and our high-power products are manufactured using technologies that are highly complex. We manufacture our SiC wafer products from bulk SiC crystals, and we use these SiC wafers to manufacture our LED products and our SiC-based high-power semiconductors. During our manufacturing process, each wafer is processed to contain numerous die, which are the individual semiconductor devices. Our high-power devices and XLamp products are then further processed by incorporating them into packages for sale as packaged components. The number of usable crystals, wafers, dies and packaged components that result from our production processes can fluctuate as a result of many factors, including but not limited to the following:

We refer to the proportion of usable product produced at each manufacturing step relative to the gross number that could be constructed from the materials used as our manufacturing yield.

If our yields decrease, our cost per wafer could increase, our margins could decline and our operating results would be adversely affected. In the past, we have experienced difficulties in achieving acceptable yields on new products, which has adversely affected our operating results. We may experience similar problems in the future, and we cannot predict when they may occur or their severity. In some instances, we may offer products for future delivery at prices based on planned yield improvements. Reduced yields or failure to achieve planned yield improvements could continue to significantly affect our margins and operating results.

We depend on a few large customers and our revenues can be affected by their contract terms.

Historically, a substantial portion of our revenue has come from large purchases by a small number of customers. Accordingly, our future operating results depend on the success of our largest customers and on our

success in selling large quantities of our products to them. The concentration of our revenues with a few large customers makes us particularly susceptible to factors affecting those customers. For example, if demand for their products decreases, they may limit or stop purchasing our products and our operating results could suffer. In addition, the Sumitomo contract provides that Sumitomo may decrease its purchase commitment, as we experienced in fiscal 2006, or terminate the contract if its inventory of our product reaches a specified level. Sumitomo’s inventory of our products can vary materially each quarter based on fluctuations in its customer demand. In general, the success of our relationships with our customers is subject to a number of factors, including the dynamics of the overall market. For example, if some of our competitors were to license technology or form alliances with other parties, our business may be impacted.

Our traditional LED chip customers may reduce orders as a result of our entry into the packaged LED markets.

We began shipping packaged LED devices in fiscal 2005. Some of our customers may reduce their orders for our chips because we are competing with them in the packaged LED business. This reduction in orders could occur faster than our packaged LED business can grow in the near term. This could reduce our overall revenue and profitability.

The markets in which we operate are highly competitive and have evolving technology standards.

The markets for our LED and high-power products are highly competitive. In the LED market, we compete with companies that manufacture or sell nitride-based LED chips as well as those that sell packaged LEDs. Competitors are offering new blue, green and white LEDs with aggressive prices and improved performance. These competitors may reduce average sales prices faster than our cost reduction, and competitive pricing pressures may accelerate the rate of decline of our average sale prices. The market for SiC wafers is also becoming competitive as other firms in recent years have begun offering SiC wafer products or announced plans to do so.

Competition is increasing. In order to achieve our revenue growth objectives in fiscal 2007 and beyond, we need to continue to develop new products that enable our customers to win new designs and increase market share in key applications such as mobile products. One major supplier dominates this market and we anticipate that the competition for these designs has intensified and will result in pressure to lower sales prices of our products. Therefore, our ability to provide higher performance LEDs at lower costs will be critical to our success. Competitors may also try to align with some of our strategic customers. This could mean lower prices for our products, reduced demand for our products and a corresponding reduction in our ability to recover development, engineering and manufacturing costs. Competitors also could invent new technologies that may make our products obsolete. Any of these developments could have an adverse effect on our business, results of operations and financial condition.

Our business may be impaired by claims that we, or our customers, infringe intellectual property rights of others.

Vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. These traits have resulted in significant and often protracted and expensive litigation. Litigation to determine the validity of patents or claims by third parties of infringement of patents or other intellectual property rights could result in significant expense and divert the efforts of our technical personnel and management, even if the litigation results in a determination favorable to us. In the event of an adverse result in such litigation, we could be required to:

There can be no assurance that third parties will not attempt to assert infringement claims against us or our customers with respect to our current or future products. In addition, our customers may face infringement claims directed to the customer’s products that incorporate our products, and an adverse result could impair the customer’s demand for our products. We have also promised certain of our customers that we will indemnify them in the event they are sued by our competitors for infringement claims directed to the products we supply. Under this indemnification obligation we may be responsible for future payments to resolve infringement claims against them. From time to time we receive correspondence asserting that our products or processes are or may be infringing patents or other intellectual property rights of others. Our practice is to investigate such claims to determine whether the assertions have merit and, if so, we take appropriate steps to seek to obtain a license or to avoid the infringement. However, we cannot predict whether a license will be available or that we would find the terms of any license offered acceptable or commercially reasonable. Failure to obtain a necessary license could cause us to incur substantial liabilities and costs and to suspend the manufacture of products.

There are limitations on our ability to protect our intellectual property.

Our intellectual property position is based in part on patents owned by us and patents exclusively licensed to us by North Carolina State University, Boston University and others. The licensed patents include patents relating to the SiC crystal growth process that is central to our SiC materials and device business. We intend to continue to file patent applications in the future, where appropriate, and to pursue such applications with U.S. and foreign patent authorities.

However, we cannot be sure that patents will be issued on such applications or that our existing or future patents will not be successfully contested by third parties. Also, since issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, we cannot be sure that any of our patents, or patents issued to others and licensed to us, will provide significant commercial protection, especially as new competitors enter the market.

In addition to patent protection, we also rely on trade secrets and other non-patented proprietary information relating to our product development and manufacturing activities. We try to protect this information through appropriate efforts to maintain its secrecy, including requiring employees and third parties to sign confidentiality agreements. We cannot be sure that these efforts will be successful or that the confidentiality agreements will not be breached. We also cannot be sure that we would have adequate remedies for any breach of such agreements or other misappropriation of our trade secrets, or that our trade secrets and proprietary know-how will not otherwise become known or be independently discovered by others.

Where necessary, we may initiate litigation to enforce our patent or other intellectual property rights. Any such litigation may require us to spend a substantial amount of time and money and could distract management from our day-to-day operations. Moreover, there is no assurance that we will be successful in any such litigation.

We face significant challenges managing our growth.

We have experienced a period of significant growth that has challenged our management and other resources. To manage our growth effectively, we must continue to:

We will spend substantial amounts of money in supporting our growth and may have additional unexpected costs. We may not be able to expand quickly enough to exploit potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development, and administrative support. If we cannot attract qualified people or manage growth effectively, our business, operating results and financial condition could be adversely affected. For example, we are currently trying to build a worldwide team of sales, marketing, development, and application support employees for our LED and high-power businesses. If we are not successful in recruiting personnel, our actual growth may be lower than our forecasts. Conversely, if the product demand from our customers does not expand as we anticipate, our margins may decrease in part due to higher costs associated with the recently added capacity that would not be used.

Performance of our investments in other companies could affect our financial results.

From time to time, we have made investments in public and private companies that engage in complementary businesses. Should the value of any such investments we hold decline, the related write-down in value could have a material adverse effect on our financial results as reflected in our consolidated balance sheets. In addition, if the decline in value is determined to be other-than-temporary, the related write-down could have an adverse effect on our reported net income. We currently hold an interest in one public company, Color Kinetics.

We may make investments in companies which subject us to risks inherent in the business of the company in which we have invested and to trends affecting the equity markets as a whole. Investments in private companies are subject to additional risks relating to the limitations on transferability of the interests due to the lack of a public market and to other transfer restrictions. Investments in publicly held companies are subject to market risks and may not be liquidated easily. As a result, we may not be able to reduce the size of our positions or liquidate our investments when we deem appropriate to limit our downside risk.

Our investments in other companies also may cause fluctuations in our earnings results. In future periods, we will be required to continue to adjust our deferred tax asset valuation allowance in connection with any increase or decrease in the value of our Color Kinetics investment, which could increase or decrease our income tax expense for the period. This may cause fluctuations in our earnings results that do not accurately reflect our results from operations.

We rely on a few key sole source and limited source suppliers.

We depend on a small number of sole source and limited source suppliers for certain raw materials, components, services and equipment used in manufacturing our products, including key materials and equipment used in critical stages of our manufacturing processes. Although alternative sources generally exist for these items, qualification of many of these alternative sources could take up to six months or longer. Where possible, we are attempting to identify alternative sources for our sole and limited source suppliers.

We generally purchase these sole or limited source items with purchase orders, and we have no guaranteed supply arrangements with such suppliers. We do not control the time and resources that these suppliers devote to our business, and we cannot be sure that these suppliers will perform their obligations to us. In the past, we have experienced decreases in our production yields when suppliers have varied from previously agreed upon specifications that have impacted our cost of sales.

Any delay in product delivery or other interruption or variation in supply from these suppliers could prevent us from meeting commercial demand for our products. If we were to lose key suppliers, our key suppliers were unable to support our demand, or we were unable to identify and qualify alternative suppliers, our manufacturing operations could be interrupted or hampered significantly.

If government agencies discontinue or curtail their funding for our research and development programs, our business may suffer.

Changes in federal budget priorities could adversely affect our contract revenue. Historically, government agencies have funded a significant portion of our research and development activities. When the government changes budget priorities, such as in times of war, our funding has the risk of being redirected to other programs. Government contracts are also subject to the risk that the government agency may not appropriate and allocate all funding contemplated by the contract. In addition, our government contracts generally permit the contracting authority to terminate the contracts for the convenience of the government. The full value of the contracts would not be realized if they were prematurely terminated. Furthermore, we may be unable to incur sufficient allowable costs to generate the full estimated contract values and there is some risk that any technologies developed under these contracts may not have commercial value. If government funding is discontinued or reduced, our ability to develop or enhance products could be limited, and our business, results of operations and financial condition could be adversely affected.

If our products fail to perform or meet customer requirements, we could incur significant additional costs.

The manufacture of our products involves highly complex processes. Our customers specify quality, performance and reliability standards that we must meet. If our products do not meet these standards, we may be required to replace or rework the products. In some cases, our products may contain undetected defects or flaws that only become evident after shipment. We have experienced product quality, performance or reliability problems from time to time. Defects or failures may occur in the future. If failures or defects occur, we could:

We are subject to risks from international sales.

We expect that revenue from international sales will continue to be the majority of our total revenue. International sales are subject to a variety of risks, including risks arising from currency fluctuations, trading restrictions, tariffs, trade barriers and taxes. Also, U.S. Government export controls could restrict or prohibit the exportation of products with defense applications. Because all of our foreign sales are denominated in U.S. dollars, our sales are subject to variability as prices become less competitive in countries with currencies that are low or are declining in value against the U.S. dollar and more competitive in countries with currencies that are high or increasing in value against the U.S. dollar.

If we fail to evaluate and implement strategic opportunities successfully, our business may suffer.

From time to time we evaluate strategic opportunities available to us for product, technology or business acquisitions. For example, in July 2006 we acquired the assets and liabilities of INTRINSIC Semiconductor Corporation. If we choose to make acquisitions, we face certain risks, such as failure of the acquired business to meet our performance expectations, diversion of management attention, retention of existing customers of the

acquired business, and difficulty in integrating the acquired business’s operations, personnel and financial and operating systems into our current business. We may not be able to successfully address these risks or any other problems that arise from our recent or future acquisitions. Any failure to successfully evaluate strategic opportunities and address risks or other problems that arise related to any acquisition could adversely affect our business, results of operations and financial condition.

Litigation could adversely affect our operating results and financial condition.

We are defendants in pending litigation as described in “Part I, Item 3. Legal Proceedings” of this report that alleges, among other things, violations of securities laws and patent infringement. Defending against existing and potential litigation will likely require significant attention and resources and, regardless of the outcome, result in significant legal expenses, which will adversely affect our results unless covered by insurance or recovered from third parties. If our defenses are ultimately unsuccessful, or if we are unable to achieve a favorable resolution, we could be liable for damage awards that could materially adversely affect our results of operations and financial condition.

Item 1B.    Unresolved Staff Comments

Not applicable.

Item 2.    Properties

We own our principal manufacturing and office site in Durham, North Carolina where we conduct the business of our Cree segment.Carolina. This site includes approximately 48 acres of developed land, with total facility square footage of 521,747697,140 square feet as of June 26, 2005.25, 2006. This space includes 289,772318,965 square feet used for production, 81,751105,513 square feet used for facility services and warehousing, and 150,224122,662 square feet used for

administrative functions. AtAs of June 26, 2005,25, 2006, included in this total is the recently completed construction of an additional building containing approximately 150,000 square feet is under construction on this site.feet. This building will be occupied in phases during fiscal 2007. We also own approximately 80 acres of undeveloped land near the site.

In addition, in January 2005, we purchased an existing semiconductor manufacturing facility located in Research Triangle Park, North Carolina. This facility is on approximately 55 acres and includes buildings containing 228,650177,000 square feet. AsDuring the fourth quarter of June 26, 2005,fiscal 2006, we have not yet commenced anybegan transferring the operations atof our high-power products to this site.

site and anticipate the completion of this transfer during fiscal 2007.

We also maintain sales support offices, through our subsidiaries, in leased office premises in Tokyo, JapanJapan; Vienna, Austria; and Hong Kong.

We had a lease for another sales office location in Hong Kong that expired in July 2005. Wealso lease a 35,840 square foot facility occupied by SBTC in Goleta, California that is used for research and development and administrative functions.

As of June 26, 2005, theThe discontinued operations of our Cree Microwave segment arewere conducted in approximately 49,600 square feet ofleased administrative and manufacturing space located in Sunnyvale, California. Our Cree Microwave subsidiary currently leases this space under a sublease agreement that expires in 2011. We have guaranteed the obligations of our subsidiary under the sublease. In June 2005, we announced plans to discontinue manufacturing operations at this site by December 2005, and we intend to seek a tenant to sublease the leased premisesremain liable for the remainderoperating lease of the term.

Sunnyvale facility through 2011.

Item 3.Legal Proceedings

In re Cree, Inc. Securities Litigation

Between June 16 and August 18, 2003, certain alleged purchasers of ourthe Company’s stock filed nineteen purported class action lawsuits in the United States District Court for the Middle District of North Carolina. The lawsuits name us,the Company, certain of ourits officers and current and former directors as defendants. On December 17, 2003, theThe court

subsequently entered an order consolidating these actions and appointing a lead plaintiff and lead counsel for the consolidated cases. The lead plaintiff filed a consolidated amended complaint, on January 16, 2004. Thewhich the court later dismissed although it allowed the plaintiff to file a further amended complaint. As finally amended in October 2004, the consolidated complaint asserted, among other claims, violations of federal securities laws, including violations of Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-5, and violations of Section 20(a) and Section 18 of the Exchange Act against the individual defendants and also asserted claims against certain of ourthe Company’s officers under Section 304 of the Sarbanes-Oxley Act of 2002. The amended complaint alleged that wethe Company made false and misleading statements concerning ourits investments in certain public and privately-heldprivately held companies, ourits acquisition of the UltraRF division of Spectrian ourCorporation (“Spectrian”), its supply agreement with Spectrian, ourand its agreements with C&C and our employment relationship with Eric HunterCharles & Colvard and that ourits financial statements did not comply with the requirements of the securities laws during the class period. The amended complaint requested certification of a plaintiff class consisting of purchasers of ourthe Company’s stock between August 12, 1998 and June 13, 2003 and sought, among other relief, unspecified damages and disgorgement of profits by the individual defendants, plus costs and expenses, including attorneys’, accountants’ and experts’ fees.

In February 2004, weThe defendants moved that the courtto dismiss the consolidated amended complaint on the grounds that it failsfailed to state a claim upon which relief can be granted and did not satisfy the pleading requirements under applicable law. OnIn August 30, 2004,2005, the district court entered an order grantinggranted the defendants’ motion to dismiss without prejudice and allowing the plaintiffs a period of time in which to file an amended consolidated complaint. The plaintiffs filed a further amended complaint on October 14, 2004, asserting essentially the same claims and seeking the same relief as in their prior complaint. We filed a motion to dismiss this further amended complaint. On August 2, 2005, the court entered an order granting our motion to dismiss the plaintiffs’ amended complaint in its entirety with prejudice, thus bringing an endprejudice. The plaintiffs thereafter appealed the dismissal to the lawsuit, subject to anyU.S. Court of Appeals for the Fourth Circuit. The appeal that the plaintiffs may file.

is currently pending.

Neumark v. Cree, Inc.

On June 27, 2005, Gertrude Neumark Rothschild commenced a patent infringement lawsuit against us by filing a complaint in the U.S. District Court for the Southern District of New York. In her complaint, the

plaintiff alleges that we are is infringing U.S. Patent No. 4,904,618, entitled “Process for Doping Crystals of Wide Band Gap Semiconductors,” and U.S. Patent No. 5,252,499, entitled “Wide Band-Gap Semiconductors Having Low Bipolar Resistivity and Method of Formation,” by manufacturing, importing, using, selling and/or offering for sale LEDs and/or laser diodes created using processes claimed in the patents. The complaint seeks damages in an unspecified amount, an injunction against infringements, attorneys’ fees and costs. WeOn September 30, 2005, the Company filed an answer and counterclaims in which it denies any infringement and asserts, among other defenses, that the patents are invalid and are unenforceable under the doctrine of inequitable conduct. The counterclaims seek a declaratory judgment that the Company has not infringed the patents and that the patents are invalid and unenforceable. The case is currently in the discovery phase.

The Company believes that the claims in these actions are without merit. However, we are unable to predict the final outcome of these matters. Our failure to successfully defend against these allegations could have not yet fileda material adverse effect on our answer.

business, financial condition and results of operations.

Other Matters

We are currently a party to other legal proceedings incidental to our business. Although the final resolution of these other matters cannot be predicted with certainty, management’s present judgment is that the final outcome of these matters will not likely have a material adverse effect on our consolidated financial condition or results of operations. If an unfavorable resolution occurs, in these legal proceedings, our business, results of operations and financial condition could be materially adversely affected.

Item 4.Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2005.2006.

PART II

Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Common Stock Market Information.    Our common stock is traded inon the Nasdaq NationalNASDAQ Global Select Market and is quoted under the symbol CREE. The following table sets forth, for the quarters indicated, the high and low sales prices as reported by Nasdaq.NASDAQ.

Holders and DividendsDividends..    There were approximately 710698 holders of record of our common stock as of July 27, 2005.August 1, 2006.

We have never paid cash dividends on our common stock and do not anticipate that we will do so in the foreseeable future. There are no contractual restrictions in place that currently materially limit, or are likely in the future to materially limit, us from paying dividends on our common stock, but applicable state law may limit the payment of dividends. Our present policy is to retain earnings, if any, to provide funds for the operation and expansion of our business.

Sale of Unregistered SecuritiesSecurities..    There were no sales of unregistered securities during fiscal 2006, 2005 2004 or 2003.2004.

Purchases of Equity Securities by the Company and Affiliated PurchasersPurchasers..    The following table lists all    There were no repurchases (both open market and private transactions) during fiscal 20052006 of any of our securities registered under Section 12 of the Exchange Act, by or on behalf of us, or any affiliated purchaser.

Issuer PurchasesOn June 20, 2006, the board of Equity Securitiesdirectors approved the extension of our stock repurchase program through June 24, 2007. Under the stock repurchase program we have been authorized to repurchase up to 5,450,000 shares of common stock.

Item 6.Selected Financial Data

The consolidated statement of operationsincome data set forth below with respect to the fiscal years ended June 25, 2006, June 26, 2005, and June 27, 2004 and June 29, 2003 and the consolidated balance sheet data at June 26, 200525, 2006 and June 27, 200426, 2005 are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this report and should be read in conjunction with those financial statements and notes thereto. The consolidated statement of operationsincome data for the fiscal years ended June 30, 200229, 2003 and June 24, 200130, 2002 and the consolidated balance sheet data at June 27, 2004, June 29, 2003 and June 30, 2002 and June 24, 2001 are derived from audited consolidated financial statements not included herein. All consolidated statement of operations and consolidated balance sheetincome data shown below reflect the acquisition ofexcludes Cree Microwave acquired in December 2000. This transaction wasas it has been accounted for under the purchase method. We acquired the GaN substrate and epitaxy business of ATMI in the fourth quarter of 2004. This acquisition was accounted for under the purchase method.as a discontinued operation.

Selected Consolidated Financial Data

(In thousands, except per share data)

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operation

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, our consolidated financial statements, including the notes thereto.

Overview

We develop and manufacture semiconductor materials and electronic devices made from silicon carbide, or SiC, gallium nitride, or GaN, and related compounds. The majority of our products are manufactured at our main production facility in Durham, North Carolina. We also use subcontractors in Asia to perform some of our manufacturing steps for certain LED and power products. We generate revenues from the following product lines:

We also generate revenue under contracts with government agencies. Government entities assist us in the development of new technology by funding our research and development efforts. Revenue from contract research funding represented 6% of our revenue in fiscal 2005 and 9% of our revenue in fiscal 2004.

Industry Dynamics

Our business is primarily selling high-brightness LED products, which is affected by a number of industry factors, including:including design trends in mobile phone designsproducts, overall demand in products using high-brightness LEDs, a constantly changing competitive environment and sales, competitive LED pricing pressures and the strength of intellectual property that supports our products. Theissues. Currently, the most significant market currently for our blue and green LEDs, and white LEDs made by our customers using our blueLED chips is for illumination purposes in mobile phones,products, including LCD, backlighting, keypad illumination and keypad illumination. Industry publications estimate that overall unit sales of mobile phonesflash units for calendar year 2005 may increase up to 16% and that the full color adoption rate for mobile phones is expected to increase, but at a slower rate than in the past few years.camera phones. LED sales for mobile phone applicationsproducts are impacted by the number of LEDs used in an application,a product, which may varyvaries depending on design trends in the features of the application and the brightness of the LEDs used. Competitive LED pricing pressuresused in the blue and green industry arise because averagean application. Average LED sales prices typicallygenerally decline each year as new products are introduced in key markets

and dominant market players may accelerate this trend by implementing aggressiveimplement pricing strategies to strengthengain or protect market share. To remain competitive, LED producers generally must increase product performance and reduce thecosts to support lower average sales price at or above the market rate.prices. Finally, vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry because customers’industry. Customers’ purchasing decisions can be influenced by whether a product is supported bymay infringe valid intellectual property rights.

Highlights and Outlook

FinancialFiscal 2006 Highlights from Fiscal 2005

During fiscal 2005, we reported the highest revenue and earnings in our history. Unit sales increased 53% due to new products focused on high-brightness markets. We continued to face intense competition in our LED markets, and as a result our average sales price declined 13% in fiscal 2005. We were able to offset lower prices by reducing our average selling costs by 21% due to improved yield and our migration from two-inch to three-inch wafers, which increased our profitability. The following is a summary of our financial results:results for fiscal 2006:

Revenue from our mid-brightness chips also increased 11% in fiscal 2005 due to the introduction of the UT 230 chip targeting blue keypad backlighting applications for cost sensitive markets.

Gross profit increased by $58.2 million due to higher revenue and the successful execution of our cost reduction programs.

Research and development expenses increased 17% due to our focus on developing even brighter LED chips as well as products for our emerging business areas such as high power packaged LEDs and power devices.

Net income benefited from a lower tax provision rate of 28% due primarily to tax benefits associated with our investment in a public company and other adjustments. Other factors included in the tax provision rate resulted from two offsetting tax adjustments related to the Cree Microwave subsidiary. One adjustment was a $6.5 million favorable permanent tax deduction, which was offset by a $6.7 million increase in our tax reserve.

Capital expenditures were $141.8 million.

We repurchased 1.5 million shares of our common stock under an authorized share repurchase program at a cost of $35.3 million.

Cash and cash equivalents and short and long-term investments increased from $230.9 million in fiscal 2004 to $277.3 million in fiscal 2005.

Outlook for Fiscal 20062007

In fiscal 2006,2007, we anticipate that selling blue LED chips for white LED lamps in mobile phones will continue to be an important growth opportunity. We also are working to increase the brightness of the XThin family of products.our LED chips and help our customers improve their white package performance for mobile white applications. If we are successful in developing brighter LEDs,achieving these goals, we believe that we will have an opportunity to continue to gain market shareincrease sales in the mobile LCD backlight market for mobile phones that use white LEDs. We believe that we currently have low penetration in this particular market due to Nichia’s dominant share ofand camera flash markets. This includes working through the market. With our higher performance XThin chips, we target that white LED products packaged by our customers can be as bright or brighter than products sold by Nichia, but we must continue to workqualification process with our customers for our new EZBright^™ LED chips, which are targeted to optimize package designs. Based on conversations with our customers, we also believe markets for other high-brightness LED applications, such as specialty lighting, gaming machine designs, displays and other applications, will continue to growbegin volume shipments in the first quarter of fiscal 2006.

2007.

We continuetarget to accelerate cost reductions for both our LED and SiC-based high-power products by starting the conversion to four-inch wafer production. Additionally, we plan to increase production at our subcontractors to lower our product costs.

We plan to expand ourthe product offerings of our XLamp^® family of high-powerhigh power packaged LED products.products by incorporating our new EZBright power chips. We are aiming to introduce higher performance XLamp products to increase sales for specialty lighting, architectural lighting, outdoor lighting (street lights and high bay lighting), emergency lighting and personal lighting (flashlights) markets.

We plan to increase sales of XLampour Schottky diode products in the specialty lighting markets, including channel letters, appliance lights, flashlights and reading lights.

Despite the evolving competitive pressures, we expect that our business will increase if we are successful in developing higher performance, low cost LED chips. We believe our proprietary SiC platform and vertically integrated factory provides us with the opportunity to lower our cost by scaling to larger sized wafers. Somethrough expansion of our significant challengesproduct line and continued penetration into the power supply markets in computer servers and other applications.

We target to continue expanding our sales, marketing and distribution teams to build a global presence and brand that can deliver enabling products and solutions to the key customers who are driving the emerging applications in LED lighting and SiC-based high-power products.

We are targeting to continue to invest in research and development for fiscal 2006 include increasing the output from our factory in North Carolina and our subcontractor’s facility in Asia, continuing the migration of our LED production to three-inchLEDs, larger wafers and developing brighter XThinimproved high-power devices and other LED products. We are planningexpanding our global sales, marketing and distribution capabilities.

During fiscal 2007, we plan on investing $100 million to invest $90-110$120 million during fiscal 2006 in capital equipment additionsexpenditures to expand our factory outputmanufacturing capacity to support unit volume growth and reduce overall product costs in our LED and high-power product lines. The capital expenditures will primarily be in our North Carolina locations, but also in Asia to improve our yields. support increased production overseas.

We plan to continue to migrate more of our LED production from two-inch to three-inch SiC wafers during fiscal 2006, which we target will greatly increase the number of yielded LED chips per wafer and therefore lower our overall LED chip cost. We also are focusing on increasing the brightness for the XThin family of products in fiscal 2006, and we must work with our customers to get these and other products designed into key applications so that we can assist them to gain market share with these products. We also may increase our research and development spending as a percentage of revenue over our fiscal 2005 level.

With the strength of our balance sheet and operating cash flows, we also are evaluatingevaluate strategic investments and relationships to expand and strengthen our technology, product portfolio and to better position us in terms ofincrease access to markets and distribution channels.our targeted markets. For example, we acquired INTRINSIC Semiconductor Corporation (INTRINSIC) on July 10, 2006. We do not need these investments to meet our operating goals for fiscal 2006, butbelieve the technology we see potential opportunitiesacquired in the acquisition will enable us to accelerate the commercialization of low-defect 4-inch and 6-inch substrates. These substrates should not only support our growth longer termcost roadmap for LEDs, but more importantly, they should enable us to more rapidly commercialize higher power devices for motor control applications and we plan to actively explore our options.

hybrid vehicles.

Critical Accounting Policies

The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.States of America. In preparing our financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. On a regular basis, management reviews our accounting policies, assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and we may be exposed to gains or losses that could be material.

Our significant accounting policies are discussed in Note 2, “Summary of Significant Accounting Policies and Other Matters”, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of thisour Annual Report on Form 10-K. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with our independent auditor and the Audit Committee of our Board of Directors. Please see Note 2 of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for a complete discussion of our accounting policies.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
Valuation of Long-Lived Assets:
We review long-lived assets such as property, and equipment and patents for impairment when events and circumstances indicate that the carrying value of the assets contained in our financial statements may not be recoverable. For example, pieces of our equipment may be scrapped or certain of our patents or patent applications may be abandoned. In these cases, we would directly write-off these long-lived assets.   In addition, we evaluate all of our long-lived assets for potential impairment by comparing the carrying value of our assets to the estimated future cash flows of the assets (undiscounted and without interest charges). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows. We recognize an impairment loss if the amount of the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable (amortized) long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. We do not restore a previously recognized impairment loss if the asset’s carrying value decreases below its estimated fair value.		Our impairment loss calculations require management to apply judgment in estimating future cash flows and asset fair values, including estimating useful lives of the assets. To make these judgments, we may use internal discounted cash flow estimates, quoted market prices when available and independent appraisals as appropriate to determine fair value. We derive the required cash flow estimates from our internal business plans.		If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be required to record additional impairment losses that could be material to our results of operations.   Using this impairment review methodology, we recorded long-lived asset impairment charges of $1.7 million during fiscal year 2006 and $5.5 million during the fiscal year ended June 26, 20052005. These impairment charges were primarily related to plans to closethe planned and subsequent closure of our Cree MicrowaveMicrowave-Sunnyvale facility and disposethe disposal of certain assets.
Tax Contingencies:
We are subject to periodic audits of our income tax returns by Federal, state and local agencies.		The estimate of our tax contingencies reserve contains uncertainty because management		To the extent we prevail in matters for which reserves have been established, or are required to pay

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
Tax Contingencies:
We are subject to periodic audits of our income tax returns by federal, state and local agencies. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposures associated with our various tax filing positions, including state and local taxes, we record reserves for what we identify as probable exposures. A number of years may elapse before a particular matter for which we have established a reserve is audited and fully resolved. We have also established a valuation allowance for capital loss carryforwards and unrealized losses on certain securities, as we believe that it is more likely than not that the tax benefits of the items will not be realized.		The estimate of our tax contingencies reserve contains uncertainty because management must use judgment to estimate the exposures associated with various tax filing positions. To make these judgments, we make determinations about the likelihood that the specific taxing authority may challenge the tax deductions that we have taken on our tax return. Based on information about other tax settlements, we estimate amounts that we may settle with taxing authorities in order to conclude audits.		To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would require use of our cash and result in an increase in our effective rate in the year of resolution. A favorable tax settlement would be recognized as a reduction in our effective tax rate in the year of resolution. When we establish or reduce the valuation allowance against our deferred tax assets, our income tax expense will increase or decrease, respectively;respectively, in the period such determination is made. As of June 26, 2005,25, 2006, we had established tax reserves of $15.7$17.3 million and a valuation allowance of $11.2$8.1 million.
Inventories:
We value our inventory at the lower of cost of the inventory or fair market value by establishing a write-down or an inventory loss reserve. We base our lower of cost or market write-down on the excess carrying value of the inventory, which is typically its cost, over the amount that we expect to realize from the ultimate sale of the inventory based upon our assumptions regarding the average sales price to be received for the product.		Our inventory reserve is based upon our analysis of sales levels by product and projections of future customer demand derived from historical order patterns and input received from our customers and our sales team. To mitigate uncertainties, we reserve for all inventory greater than 12 months old, unless there is an identified need for the inventory. In addition, we reserve for items that are considered obsolete based on changes in customer demand, manufacturing process changes or new product introductions that may eliminate demand for a product. WeWhen inventory is physically destroyed, we remove the inventory and the associated reserve from our financial records when the inventory is physically destroyed.records.		If our estimates regarding customer demand and physical inventory losses are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may be exposed to losses or gains in excess of our established reserves that could be material. A 10% increase or decrease in our actual inventory reserve at June 26, 200525, 2006 would have affected net earningsincome by approximately $91,000$45,000 for the fiscal year ended June 26, 2005.25, 2006.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
Accruals for Self InsuredSelf-Insured and Other Liabilities:
We make estimates for the amount of costs that have been incurred but not yet billed for general		Our liabilities contain uncertainties because we must make assumptions and apply		If actual costs billed to us are not consistent with our assumptions and judgments, our expenses could

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
services, including legal fees, accounting fees, costs pertaining to our self-funded medical insurance and other expenses.		Our liabilities contain uncertainties because we must make assumptions and apply judgment to estimate the ultimate cost to settle claims and claims incurred but not reported as of the balance sheet date. When estimating our liabilities, we consider a number of factors, including interviewing our service providers for bills that have not yet been received. For self-insured liabilities, we estimate our liabilities based on historical claims experience.		If actual costs billed to us are not consistent with our assumptions and judgments, our expenses could be understated or overstated and these adjustments could materially affect our net income.
Accounting for Non-Marketable and Marketable Equity Securities:
From time to time, we evaluate strategic opportunities and potential investments in complementary businesses, and as a result we may invest in marketable equity or private company securities. We carry marketable equity securities at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income. Realized gains and losses are recognized when realized upon sale or disposition of the security. We carry private company investments at cost. Declines in value that are deemed to be other-than-temporary are recorded as an investment loss. If we believe that an other-than-temporary decline exists in the value of one of our marketable equity or private company securities, it is our policy to write-down these equity investments to the market value.		Management’s assessment of whether a security is impaired is based on a review of each company’s cash position, its earnings and revenue outlook, operational performance, management changes and competition. We also review stock price performance, liquidity and ability to raise capital. If the company is private, we also review the company’s capitalization structure based on recent financing transactions and ownership changes. Based on this information, we make certain judgments about whether an other-than-temporary decline has occurred.		If our estimates regarding the market value of a security are incorrect, we need to record additional impairments on that security. Such impairment would impact our loss on marketable securities or loss on long-term investments account. As of June 26, 2005, we held investments in a public company that had a market value of $20.9 million and a private company investment valued at $37,000. In the second quarter of fiscal 2005, we recorded a $2.0 million loss for an other-than-temporary impairment on our investment in a private company. This write-down was based on our evaluation of the company’s financial results and a third party offer to purchase our investment. This investment was sold in the third quarter of fiscal 2005 at its then carrying value.

Results of Operations

The following table shows our consolidated statements of operationsincome data expressed as a percentage of total revenue from continuing operations for the periods indicated:

Comparison of Fiscal Years Ended June 25, 2006 and June 26, 2005

Revenue.    Revenue from continuing operations increased 10% to $423.0 million in fiscal 2006 from $384.5 million in fiscal 2005. The increase in revenue was attributable to greater product revenue, which increased 9% to $394.4 million from $362.8 million in fiscal 2005, and greater contract revenue, which increased 32% to $28.6 million from $21.7 million in fiscal 2005. The increase in product revenue resulted from the growth in revenue from sales of high-brightness LEDs, materials and high-power products.

LED revenue grew 6% to $342.1 million in fiscal 2006 from $322.1 million in fiscal 2005, making up 81% of our total revenue from continuing operations. While unit shipments of our LED products increased 34% over the prior year due to new products focused on high-brightness markets, our blended average LED sales price decreased 21% due to increasing price competition for both high-brightness and mid-brightness devices. Sales of our high-brightness products increased by $73.8 million and comprised 38% of our LED revenue, up from 17% in the prior year. The primary driver for the increase in sales of high-brightness products was increased demand for mobile products requiring white LEDs in backlights for LCD displays and mobile camera flashes. In addition, fiscal 2006 high-brightness revenue increased due to the initial success of our XLamp packaged products which were released to production in early fiscal 2005. Sales of our mid-brightness products declined by $53.8 million and represented 62% of LED revenue, down from 83% in fiscal 2005. Although unit shipments of our mid-brightness product increased over fiscal 2005, this was more than offset by a product mix shift to lower priced LEDs and average selling price reductions.

Wafer product revenue decreased 9% to $22.6 million in fiscal 2006 from $24.7 million in fiscal 2005 making up 5% of our revenue from continuing operations. The primary driver of the decrease in wafer product revenue was a 49% decrease in the total number of units sold. The decrease in units sold was offset by a 78% increase in average sales price, which was attributable to a shift in wafer product mix. SiC materials revenue for gemstone use increased 79% to $14.3 million in fiscal 2006 from $8.0 million in fiscal 2005 due to higher demand from our sole customer for these products, Charles & Colvard. Revenue from gemstone materials represented 3% of our total revenue from continuing operations in fiscal 2006.

Revenue from our high-power devices increased 94% to $15.1 million in fiscal 2006 from $7.8 million in fiscal 2005. The increase in revenue resulted from higher sales from of our MMIC foundry services and Schottky diode products. Revenue from high-power devices was 4% of revenue from continuing operations in fiscal 2006.

Contract revenue increased $6.9 million or 32% over fiscal 2005 due to the start of new contracts that were awarded to us in late fiscal 2005 and early fiscal 2006, including a $12.0 million program funded by the U.S. Department of Defense for electronic devices and power modules. Contract revenue was 7% of revenue from continuing operations in fiscal 2006.

Gross Profit.    Gross profit from continuing operations in fiscal 2006 declined 5% to $200.9 million from $211.4 million in fiscal 2005. Gross margin decreased from 55% to 48% of revenue from continuing operations in the year-to-year comparison. The decrease in gross margin was caused primarily by lower gross margins on sales of LED products as average selling prices declined faster than cost reductions due to increasing price competition in the marketplace for our LED products. Our gross margin also declined in fiscal 2006 due to the adoption of SFAS 123R. In fiscal 2006, we recorded a $4.5 million charge to cost of sales for stock compensation expense resulting from the adoption of SFAS 123R at the beginning of fiscal 2006. This decreased our gross margin by 1% of revenue from continuing operations.

Research and Development.    Research and development expenses from continuing operations increased 37% in fiscal 2006 to $54.9 million from $40.0 million in fiscal 2005. During fiscal 2006, research and development costs included $4.1 million in stock compensation expense resulting from our adoption of SFAS 123R at the beginning of fiscal 2006. The remaining increase in research and development spending supported our continued development of higher brightness LED chips, high powered packaged LEDs, larger wafer process development and other high-brightness LED research programs. In addition, we funded ongoing development for high-power devices and near UV laser diodes.

Sales, General and Administrative.    Sales, general and administrative (“SG&A”) expenses from continuing operations increased 42% in fiscal 2006 to $44.8 million as compared to $31.5 million in fiscal 2005. During fiscal 2006, SG&A expenses included $4.5 million in stock compensation expense resulting from our adoption of SFAS 123R at the beginning of fiscal 2006. In addition, SG&A expenses in fiscal 2006 reflected increased spending on sales and marketing to support our incremental growth, building our sales force and distribution channels for our newer products and development of our Cree brand. Furthermore, fiscal 2005 SG&A expense levels were reduced by a $1.1 million reimbursement for certain legal fees related to securities litigation.

Impairment or Loss on Disposal of Long-Lived Assets.    The loss on disposal of property and equipment increased $1.5 million to $2.4 million in fiscal 2006 as compared to $889,000 in fiscal 2005. The increase was due in part to a write-off during fiscal 2006 of $850,000 for the original installation costs of equipment being moved to our new RTP facility. The increase was also attributable to an impairment charge recorded during fiscal 2006 of $1.1 million for building improvements and computer software that were no longer being used at our Durham, North Carolina facility.

Gain on Investments in Securities.    The gain on investments in marketable securities was $587,000 in fiscal 2006 compared to a gain of $737,000 in fiscal 2005. In the first quarter of fiscal 2006 and the third quarter of fiscal 2005, we sold 63,782 and 343,000 shares, respectively, of our investment in Color Kinetics for a realized gain of $587,000 and $2.8 million, respectively. In fiscal 2005, we also incurred a loss of $2.0 million due to an other-than-temporary impairment on our investment in a private company. The write-down was based on our evaluation of the company’s financial results and third party proposal to purchase our investment.

Interest Income, Net.    Net interest income increased by $7.5 million to $12.9 million in fiscal 2006 compared to fiscal 2005 due to a combination of our greater invested balance and higher interest rates received on our investments.

Income Tax Expense.    Income tax expense for fiscal 2006 declined 16% to $32.4 million from $38.7 million in fiscal 2005. Our effective income tax rate was 29% in fiscal 2006 compared to 27% in fiscal 2005. The reduction in income tax expense was primarily attributable to a decline in income from continuing operations, which was slightly offset by an increase in our effective income tax rate and a reduction in the benefit received from the change in the valuation allowance established against capital losses realized in prior years. During fiscal 2005, we received a benefit totaling $6.4 million due to the change in the market price of the shares of Color Kinetics’ common stock, while the fiscal 2006 benefit received was only $3.2 million. We currently estimate that our effective annual tax rate for fiscal 2007 will be approximately 32%, which does not reflect changes in the market price for shares of Color Kinetics’ common stock, which we treat as a discrete item each quarter.

Loss from Discontinued Operations, Net of Tax.    In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” or SFAS 144, effective December 25, 2005, we reported our silicon RF and microwave business as a discontinued operation in the consolidated financial statements because we completed production of all last time buy orders for our silicon products, ceased use of our silicon fabrication facility in Sunnyvale, California, and terminated the employment of the remaining employees of our Cree Microwave subsidiary. The net loss from discontinued operations decreased $12.1 million in fiscal 2006 to $3.3 million from $15.4 million in fiscal 2005. During fiscal 2006, our silicon microwave business generated $4.3 million in revenue from last time buy orders that produced a $6.4 million pre-tax loss, or $3.3 million loss after-tax. We recorded charges related to the closure of the business in fiscal 2006 that included a $624,000 severance expense charge, a $668,000 write-down of inventory that was scrapped, a $264,000 facility decommission charge, a $111,000 charge for the net impairment of fixed assets and patents, and a $3.6 million charge for an accrual relating to the remaining lease contract obligation for the Sunnyvale facility. In fiscal 2005, our silicon microwave business generated a pre-tax operating loss of $19.2 million, or $15.4 million loss after-tax. Revenue of $4.6 million in fiscal 2005 was offset by heavy fixed costs incurred to operate the Sunnyvale facility as well as $6.7 million in charges related to the closure of the business recorded in the fourth quarter of fiscal 2005. These charges included a $519,000 severance expense charge, a $652,000 write-down of inventory and a $5.5 million charge for the impairment of fixed assets.

Comparison of Fiscal Years Ended June 26, 2005 and June 27, 2004

RevenueRevenue..    Revenue from continuing operations increased by $81.7 million or 27%28% to $389.1$384.5 million in fiscal 2005 as comparedfrom $299.6 million in fiscal 2004. Higher revenue was attributable to greater product revenue, which increased 33% to $362.8 million from $272.7 million in fiscal 2004. The increase in product revenue resulted primarily from growth in sales of our LED products, and to a lesser extent from strong growth in materials and high-power products. Contract revenue declined in the year-to-year comparison.

LED revenue grew 33% to $322.1 million in fiscal 2005 from $241.8 million in fiscal 2004, due tomaking up 84% of our total revenue from continuing operations. Revenue growth was driven by stronger demand from our LED customers for applications that include white lighting for mobile phonesproducts for both LCD backlighting and keypads, blue and green LEDs for full color displays, entertainment products (such as pachinko) and general indicator and other illumination applications. LED revenue increased by $80.3 million or 33% to $322.1 million in fiscal 2005 as compared to $241.8 million in fiscal 2004. The most significant increase in revenue in fiscal 2005 came from sales to our Japanese distributor, Sumitomo. Revenue from sales to Sumitomo increased by $59.2 million or 58% to $161.0 million in fiscal 2005 as compared to fiscal 2004 due to strong demand from Japanese packagers using our products. During fiscal 2005, four of our top ten end customers were located in Japan. The sales to these companies were reported in our revenue from Sumitomo. For fiscal 2005, Sumitomo’s advance purchase commitment was approximately $160 million, and revenue recognized from Sumitomo was $161.0 million. For fiscal 2006, Sumitomo’s advance purchase commitment is approximately $200 million; however, Sumitomo’s purchase commitment is subject to end customer demand and other terms and conditions that could affect the revenues actually recognized from Sumitomo.

Revenue from sales to OSRAM increased by 7%, or $3.1 million in fiscal 2005 over the prior fiscal year. In June 2005 we signed a new agreement with OSRAM, which covers the terms of shipments to be

made through June 2008, but does not commit OSRAM to purchase any specific products beyond an initial period. This agreement is in-line with how we have operated with OSRAM during the second half of fiscal 2005 as they fulfilled the previous agreement early.

Revenue from sales to Agilent declined by 40% or $16.1 million in fiscal 2005 over the prior fiscal year due to changes in its business and its procurement strategy. During fiscal 2005, we continued to see an increase in business from a number of Asian LED packagers that serve a variety of mobile phone, gaming and other consumer applications.

Our LED unit shipments increased 53% in fiscal 2005 as compared to fiscal 2004 and our blended average LED sales price declined 13% during the same period. Our average sales price for LEDs was lower due to increasing price competitiveness in the marketplace, which was somewhat offset by a change in the product mix of our sales toward higher brightness products that have a higher average sales price. ForThe most significant increase in revenue in fiscal 2005 came from our sales to our Japanese distributor, Sumitomo. Revenue from sales to Sumitomo increased by $59.2 million or 58% to $161.0 million in fiscal 2005 compared to fiscal 2004 due to strong demand from Japanese packagers using our products.

Sales of our high-brightness products increased by $30.2 million and comprised 17% of our LED revenue in fiscal 2005, up from 11% in the prior year. Demand for our high-brightness LED products increased from 49% to 59% of total LED revenue as our customers designed them into more LED packages for white light applications such as keypads, LCD backlights and camera flashes in mobile phones. High-brightnessproducts. Sales of our mid-brightness products also are used for automotive, displaysgrew by $50.1 million and other illumination applications. These products include our X-class, MegaBright and power chiprepresented 83% of LED products. Inrevenue in fiscal 2005, the majority of the increasedown from 89% in revenue came from our MegaBright and X-class products that were introduced over the last two fiscal years.

Revenue from2004. Demand for our mid-brightness products also increased in fiscal 2005 as compared to fiscal 2004 due to new designs for keypads in mobile phones,products, as well as displays and consumer product applications. In fiscal 2005, we began selling our UT230^™ chips for mobile phones,products, which drove the increase in our mid-brightness category in fiscal 2005. Revenue from our standard brightness products declined 16% in fiscal 2005 in comparison to the prior fiscal year due to reduced demand for automotive and indicator light applications that use these products. For fiscal 2006, we target that our sales of high-brightness LEDs will continue to increase primarily for white light mobile phone applications and other consumer products. In addition, we target an increase in demand for our high power packaged LEDs that are used in specialty lighting applications. LED revenue made up 83% of our total revenue in fiscal 2005.

SiC wafer and epitaxyWafer product revenue increased 14% to $24.7 million in fiscal 2005 from $21.7 million in fiscal 2004 as more of our wafers were sold with epitaxy, which increased our average selling price per wafer and our product mix changed. As a result, sales of our wafer units declined 13% while the2004. The average sales price increased 31% duringwhile units sold declined 13% in the year-to-year comparison due largely to a change in our product mix. Wafer revenue made up 6% of revenue from continuing operations in fiscal 2005. Revenue from SiC crystals used inmaterials revenue for gemstone applicationsuse increased 60%58% to $8.0 million in fiscal 2005 as compared tofrom $5.0 million in fiscal 2004 due to stronghigher customer demand from our sole customer C&C. Materials revenuefor these products, Charles & Colvard. Revenue from wafers and gemstones combined made up 8%gemstone materials was 2% of our total revenue from continuing operations in fiscal 2005.

Revenue from our high powerhigh-power devices increased 6%94% to $12.4$7.8 million in fiscal 2005 from $11.7$4.0 million in fiscal 2004 due to a 93%2004. Much of the increase in revenue resulted from the growth in sales of Schottky diode products and SiC-based wide bandgap microwave devices. Cree Microwave’s silicon-based product sales declined 40% from $7.7 million to $4.6 million due mostly to reduced sales to Remec as we sold legacy Spectrian devices in fiscal 2004 under “last time buy” arrangements. In June 2005, we announced plans to close our silicon-based microwave business located in Sunnyvale, California after accepting “last time buy” contracts to be fulfilled in the first half of fiscal 2006. At this time we target that revenue from silicon microwave products under “last time buy” arrangements may be approximately $3 million in the first half of fiscal 2006, and we target that such revenue will go to zero thereafter. Revenue from high powerhigh-power devices made up 3%2% of total revenue from continuing operations in fiscal 2005.

Contract revenue received from U.S. Government agencies declined by 19% to $21.7 million during fiscal 2005 compared to $26.9 million in fiscal 2004, as we continued to perform under multi-year contract awards that we received in prior years for contracts that were winding down. During the fourth quarter of

fiscal 2005, we determined that the direct costs to be incurred by us over the life of two of our government contracts would likely exceed the funding to be received from the U.S. Government. As a result, approximately $1.2 million of contract funding was recorded as an offset to research and development expenses in the fourth quarter of fiscal 2005. During the fourth quarter of fiscal 2005 and the first quarter of fiscal 2006, we have received funding under new programs, including a $12.0 million program funded by the Defense Advanced Research Projects Agency of the Department of Defense for electronic devices and power modules that reduce the size of power management equipment aboard U.S. Navy sea vessels and other programs. As a result of this, we target that contract revenue will increase during fiscal 2006. Contract revenue was 6% of total revenue forfrom continuing operations in fiscal 2005.

2005, down from 9% in the prior year.

Gross Profit.Profit.    Gross profit increased 40%42% to $204.2$211.4 million, and gross margin increased from 47%50% to 52%55% of revenue in fiscal 2005 as compared to fiscal 2004. In fiscal 2005, our blended average LED sales price declined 13% while our blended average LED costs decreased 21%22% compared to fiscal 2004. Therefore, gross

margin improved in fiscal 2005 primarily because of the significantly lower costs for LEDs. LED costs declined faster than blended average prices as we switched the production of some of our LEDs from two-inch to three-inch wafers which allows for more chips per wafer and lowers the overall cost per die. We estimate that during the fourth quarter of fiscal 2005, approximately 40% of our LED chips were manufactured from three-inch wafers. We expect that the majority of our LED chips will be fabricated from three-inch wafers during fiscal 2006.

In fiscal 2005, we changed our method for estimating sales returns. In connection with the change in our estimate for sales returns, we also recorded an estimate for the value of product returns that we believe will be returned to inventory in the future and resold. This includes an estimate for the value of inventory that may be returned in the future. As of June 26, 2005 and June 27, 2004, the amount of our sales return allowance was $9.6 million and $798,000, respectively. As of June 26, 2005 and June 27, 2004, the amount of our deferred revenue was $67,000 and $8.4 million, respectively. As of June 26, 2005, we estimated the value of future product returns at $1.7 million, which was reflected as a reduction in our cost of product sales in fiscal 2005. We also reduced our warranty reserve by $683,000 in fiscal 2005, since the estimate for sales returns includes the cost of products that may be returned and replaced under warranty provisions. In fiscal 2004, we increased our allowance for sales returns by $154,000 due to business growth, and we increased our reserve for potential future product warranty claims by $507,000, which lowered gross profit by $661,000. The change in our method for estimating sales returns was promptedmade possible by us establishingour accumulation of enough sales return history under significant customer contracts that contain right of return provisions.

Our wafer sales also were more profitable in fiscal 2005 than fiscal 2004 due to a change in mix and a higher percentage of wafers sold with epitaxy, which have a higher sales price than wafers sold without epitaxy. Our wafer average sales price increased 31% while our wafer average cost increased 16%17% due to the change in product mix. Contract margins increased from 17% in fiscal 2004 to 23% in fiscal 2005 due to a change in the mix of programs in each period.

Our Cree Microwave segment reported negative gross profit of $7.2 million and $2.9 million for fiscal 2005 and fiscal 2004, respectively. Lower revenue in fiscal 2005 contributed to an increase in the segment’s negative gross profit. During fiscal 2005, we announced that the silicon-based business located in Sunnyvale would be closing in the first half of fiscal 2006. As a result, we wrote down $652,000 of inventory in the fourth quarter of fiscal 2005 that would not be used. During fiscal 2004, Cree Microwave’s gross margin benefited from adjustments totaling $398,000 for a revision of standard costs and a prior year reversal of the warranty expense accrual. With the expected closure of the Cree Microwave-Sunnyvale facility in the second quarter of fiscal 2006, we target gross profit to improve by approximately $2.0 million per quarter beginning in the third quarter of fiscal 2006 related to the winding down of this segment.

Research and DevelopmentDevelopment.    .Research and development expenses from continuing operations increased 17%23% in fiscal 2005 to $42.8$40.0 million as compared to $36.5$32.5 million in fiscal 2004, due to higher spending to support our conversion

to three-inch production, four-inch wafer process development, our new chip products, including UT230, X-class and power chip LEDs, our high power packaged LEDs and other high brightnesshigh-brightness LED research programs. In addition, we funded ongoing development for higher power diodes and switches, higher power RF and microwave devices and near UV laser devices. We target research and development costs to be higher in fiscal 2006 as we are planning to support more internal programs for brighter LEDs and larger wafers.

Sales, General and AdministrativeAdministrative..    Sales, general and administrative    SG&A expenses from continuing operations increased 18%20% in fiscal 2005 to $34.3$31.5 million as compared to $29.1$26.1 million in fiscal 2004, resulting from increasing general expenses associated with the growth of our business and $2.4 million in outside costs relating to compliance with Section 404 of the Sarbanes-Oxley Act of 2002. Fiscal 2005 results included a $1.1 million reduction in sales, general and administrativeSG&A expenses related to a reimbursement that was received from our insurance carrier for certain legal fees related to securities litigation. During fiscal 2004, we incurred approximately $800,000 of incremental legal and other costs associated with litigation and costs of a special committee investigation conducted by the Board of Directors. We target that sales, general and administrative expenses will be higher in fiscal 2006 to support the growth of our business, which includes increased sales and marketing costs for our high power packaged LED and high power semiconductor business as well as a corporate marketing department.

Impairment or Loss on Disposal of Fixed AssetsLong-Lived Assets..    Impairment or    The loss on the disposal of fixed assets increased 560%6% to $6.7 million$889,000 in fiscal 2005 as compared to $1.0 million$842,000 in fiscal 2004, as we impaired $5.5 million of assets at our Cree Microwave-Sunnyvale location. The Cree Microwave segment is expected to operate at a loss over the next two quarters as it completes “last time buy” arrangements for its customers. As a result, we were required to write down all equipment at Cree Microwave-Sunnyvale to a carrying value of $707,000, which is the estimated salvage value for the equipment that is expected to be sold in the second quarter of fiscal 2006. This write-down resulted in a $5.5 million charge for long-lived asset impairment. The decision to discontinue the Sunnyvale operation was based on management’s review of the strategic alternatives and the financial outlook for the business. Prior to the fourth quarter of fiscal 2005, we planned to move the manufacturing of our high power devices, including SiC Schottky diodes, to the Sunnyvale facility, and considered selling the silicon-based business. In the fourth quarter of fiscal 2005, we determined instead to close the Sunnyvale, California facility by December 2005. During fiscal 2005 and fiscal 2004, we identified certain other equipment that was obsolete and no longer in service. We wrote-off the value of these assets and disposed of them.2004.

Severance Charges.    In the fourth quarter of fiscal 2005, we incurred $519,000 in severance charges in our Cree Microwave segment covering employees at our Sunnyvale facility who were laid off and received their severance payments during the same quarter and employees who have been identified to render service until they are terminated at a later date beyond a minimum retention period. For employees serving to a later date, severance costs are accrued ratably over the period between the communication date of the severance in the fourth quarter of fiscal 2005 and their actual termination date. We currently estimate that we will incur additional severance costs in the first and second quarter of fiscal 2006 of approximately $600,000 to $700,000 associated with the closure of the Sunnyvale facility.

Gain on Investments in Marketable Securities and Long Term InvestmentsSecurities.    .In fiscal 2005, we sold a portion of our investment in Color Kinetics Incorporated (Color Kinetics) for a realized gain of $2.8 million. In addition, we also recorded a $2.0 million loss in the second quarter of fiscal 2005 for an other-than-temporary impairment on our investment in a private company. This write-down was based on our evaluation of the company’s financial results and a third party offer to purchase our investment. This investment was sold in the third quarter of fiscal 2005 at its then carrying value. There were no realized gains or losses on investments in marketable securities or long- termlong-term investments recorded in fiscal 2004.

Other Non-operating IncomeIncome.    .Other non-operating income decreased 98% to a net charge of $8,000 in fiscal 2005 from $519,000$490,000 in fiscal 2004. During fiscal 2004, we recognized a one-time technology license fee.

Interest Income, Net.Net.    Interest interest income net increased 45% to $5.4 million in fiscal 2005 as compared to fiscal 2004, due to a combination of our greater cash balance and higher interest rates on our investments from rate increases during fiscal 2005.

Income Tax Expense.Expense.    Income tax expense for fiscal 2005 was $34.9$38.7 million compared to $25.6$29.3 million in fiscal 2004, an increase of 36%32%. Our effective income tax rate declined to 28%27% for fiscal 2005 compared to a

31% rate for fiscal 2004. During fiscal 2005, we recorded tax benefits associated with our investment in Color Kinetics. Because we had prior year like kind capital losses that were carried forward for tax purposes, we were required to reverse a portion of the tax reserve associated with the capital losses that were recorded in a prior year. As a result, we reduced our income tax expense by $814,000 in the fourth quarter of fiscal 2005 and $4.6 million for fiscal 2005 due to the change in market value of our investment in Color Kinetics. In fiscal 2006, we will be required to continue to record the tax effect of any increase or decrease to the value of any continuing investment in Color Kinetics as a reduction or increase to our tax expense. We also recorded $2.1 million of other adjustments in the fourth quarter of fiscal 2005 that reduced our tax expense. Two offsetting tax adjustments related to the Cree Microwave subsidiary also impacted our tax expense for fiscal 2005. One adjustment was a $6.5 million favorable permanent tax deduction, which was offset by a $6.7 million increase in our tax reserve. For fiscal 2005, the effective rate for our tax provision was approximately 28% of revenue. At this

Loss on Discontinued Operations, Net of Tax.    In accordance with SFAS 144, effective December 25, 2005, we reported our silicon RF and microwave business as a discontinued operation in the consolidated financial statements because we completed production of all last time we estimate our fiscal 2006 effective ratebuy orders for our tax provision to be approximately 33%silicon products, ceased use of revenue due to reduced benefits targeted fromour silicon fabrication facility in Sunnyvale, California, and terminated the extraterritorial taxable income credit that is being phased out as a resultemployment of the American JOBS Creation Actremaining employees of 2004 that went into effectour Cree Microwave subsidiary. The net loss from discontinued operations increased in fiscal 2005.

Comparison of Fiscal Years Ended June 27, 2004 and June 29, 2003

Revenue.    Revenue increased 33%2005 to $307.3$15.4 million in fiscal 2004 from $230.3 million in fiscal 2003. Much of the increase in revenue resulted from significantly higher unit shipments of our LED products due to stronger demand from our customers primarily for mobile appliance, display and automotive applications. LED revenue was $241.8 million and $172.8 million for fiscal 2004 and 2003, respectively. The most significant increase in revenue in fiscal 2004 came from sales to our Japanese distributor, Sumitomo. Revenue from sales to Sumitomo increased by 86% or $47.6 million in fiscal 2004 as compared to fiscal 2003 due to strong demand among Japanese manufacturers for our products for mobile appliance, displays, automotive, consumer products and indicator light applications. During fiscal 2004, four of our top ten end customers were located in Japan. The sales to these companies were reported in our revenue from Sumitomo.

Revenue from sales to Agilent increased by 71% or $16.5 million, in fiscal 2004 over the prior fiscal year. Much of this increased business resulted from demand for our products to be used in mobile appliance keypads, displays and other consumer product applications. Revenue from sales to OSRAM declined by 14%, or $6.5$6.3 million in fiscal 2004. During fiscal 2005, our silicon microwave business generated $4.6 million in revenue that produced a $19.2 million pre-tax loss, or $15.4 million loss after-tax. Revenue of $4.6 million in fiscal 2005 was offset by heavy fixed costs incurred to operate the Sunnyvale facility as well as $6.7 million in charges related to the closure of the business recorded in the fourth quarter of fiscal 2005. These charges included a $519,000 severance expense charge, a $652,000 write-down of inventory and a $5.5 million charge for the impairment of fixed assets. In fiscal 2004, we continued to see an increase inour silicon microwave business fromgenerated a numberpre-tax operating loss of Asian LED packagers who serve a variety of mobile appliance and other consumer applications. With respect to our Cree Microwave segment, sales to Remec increased $2.7$10.0 million, or 460%, for fiscal 2004 as compared to fiscal 2003. A portion$6.3 million loss after-tax. Revenue of our sales to Remec$7.7 million in fiscal 2004 was for legacy Spectrian designs under “last time buy” arrangements.

Our LED revenue increased 40% in fiscal 2004 as compared to fiscal 2003 and made up 78% of our total revenue in fiscal 2004. Our blended average LED sales price declined 16% for the twelve months ended June 2004 compared to the prior fiscal year. Our average sales price for LEDs was lower due to increasing price competitiveness in the marketplace, which was somewhat offset by a change inheavy fixed costs incurred to operate the product mix of our sales toward higher brightness products that have a higher average sales price. For fiscal 2004, our LED chip volume increased 65% over prior year shipments. Sales of our high-brightness LED products more than doubled in fiscal 2004 over fiscal 2003 as our customers designed them into more LED packages for white light applications such as for keypads in mobile appliances, LCD backlights and camera flashes. High-brightness products also are used for automotive, displays and other illumination applications. These

products include our XThin, XBright, MegaBright and power chip LED products. The majority of these products were introduced in fiscal 2004 and 2003.

Revenue from our mid-brightness products also increased in fiscal 2004 as compared to fiscal 2003 due to new designs for keypads in mobile appliances, as well as automotive applications, displays and consumer product applications. In fiscal 2004, we introduced the RazerThin^® and UT230 chips for mobile appliances that offer a smaller and thinner design and a lower forward voltage than our standard chips. The thin design offers more flexibility for smaller phones, while the lower forward voltage extends the battery lifetime for mobile appliances. Shipments of our standard brightness products were slightly higher in fiscal 2004 in comparison to the prior fiscal year due to stable demand for automotive and indicator light applications.

SiC wafer and epitaxy revenue was $21.7 million and $19.5 million for fiscal 2004 and 2003, respectively. Wafer revenue increased 11% over the prior year due to increased sales to corporate and university research customers for wafers with epitaxy layers. Wafer units declined 5% while the average sales price increased 17% during fiscal 2004. Additionally, fiscal 2004 revenues included $398,000 of fourth quarter GaN product sales from the unit we acquired from ATMI in April 2004. Wafer revenue made up 7% of our total revenue in fiscal 2004.

SiC materials revenue for gemstone use was $5.0 million and $7.4 million for fiscal 2004 and 2003, respectively. Revenue from sales of our SiC materials for use in gemstones decreased 32% during fiscal 2004 as compared to fiscal 2003 due to a combination of lower demand and lower overall product yields. We achieved improvements in our product yield in the second half of fiscal 2004. Revenue from gemstone materials was 2% of our total sales for fiscal 2004.

Revenue from Cree Microwave products was $7.7 million and $2.8 million for fiscal 2004 and 2003, respectively. Cree Microwave revenue made up 3% of our total revenue for fiscal 2004. Revenue from these products increased 176% during fiscal 2004 over fiscal 2003 due to incremental orders from new customers for our newer LDMOS devices designed for wireless infrastructure and mil-aero markets. In addition, Cree Microwave’s sales to Remec were $2.7 million in fiscal 2004 compared to $587,000 in fiscal 2003. Some of these sales to Remec were for legacy Spectrian applications under “last time buy” arrangements.

Product sales mix for our LDMOS devices made up 55% of microwave revenue for each of fiscal 2004 and fiscal 2003. Revenue attributable to bipolar devices was 41% and 23% for fiscal 2004 and 2003, respectively. Engineering service revenue decreased to 4% in fiscal 2004 from 22% in fiscal 2003 due to the prior year’s work achieving design wins and generating product sale growth in fiscal 2004. Overall, our average sales price for Cree Microwave products decreased 14% compared to the prior fiscal year while our unit shipments increased 222%.

Contract revenue was 9% of total revenue for fiscal 2004. Contract revenue received from U.S. Government agencies increased by less than 1% during fiscal 2004 compared to fiscal 2003, as we continued to perform under multi-year contract awards that we received at the end of fiscal 2002 and the beginning of fiscal 2003. In May 2004, we were awarded two contracts through the Robert Morris Acquisition Center, providing for up to $25.8 million over five years. These contracts focus on the development of manufacturing technology for high-temperature high-power SiC semiconductor material and power devices for use in electric traction drive power components and associated power conditioning and control electronics for the next-generation of combat vehicles. In fiscal 2004, we recorded $512,000 of revenue associated with these two new contracts. Additionally, fiscal 2004 revenues included $782,000 of fourth quarter contract sales from the business unit we acquired from ATMI in April 2004.

Gross Profit.    Gross profit increased 48% to $145.9 million in fiscal 2004 and gross margins increased from 43% to 47% of revenue. In fiscal 2004, our blended average sales prices declined 16% while our blended average LED costs decreased 22% compared to fiscal 2003. Therefore, gross margins improved in

fiscal 2004 primarily because of these significantly lower costs for LEDs. LED costs declined faster than blended average prices due to improved yields, greater scale and throughput and other process improvements.

Our wafer sales also were more profitable in fiscal 2004 than fiscal 2003 due to a higher percentage of wafers sold with epitaxy. Wafer costs for our SiC materials sales were 9% lower in fiscal 2004 than fiscal 2003 due to the shift in product mix and a $169,000 reduction in wafer inventory reserves. Contract margins declined from 22% in fiscal 2003 to 17% in fiscal 2004 due to a higher percentage of cost-share work performed during the year.

Our Cree Microwave segment reported negative gross profit of $2.9 million and $9.3 million for fiscal 2004 and fiscal 2003, respectively. Higher revenue in fiscal 2004 contributed to reduce the segment’s negative gross profit. Factory throughput due to increased sales volume also has improved our cost per unit.Sunnyvale facility. During fiscal 2004, Cree Microwave’s gross margin also benefited from adjustments totaling $398,000 for a revision of standard costs and a prior year reversal of the warranty expense accrual.

In fiscal 2004, we increased our allowance for sales returns by $154,000 due to business growth, and increased a reserve for potential future product warranty claims by $507,000, which lowered gross profit by $661,000. In fiscal 2003, gross profit included a $1.8 million write-down of inventory at Cree Microwave due to the termination of the supply agreement with Spectrian and other slow moving products. We also recorded a $1.0 million increase to inventory reserves for LED and wafer products in fiscal 2003. In addition, reserves for allowance for sales returns were increased by $189,000 in fiscal 2003.

Research and Development.    Research and development expenses increased 18% in fiscal 2004 to $36.5 million from $31.0 million in fiscal 2003. The increase in research and development spending supported our three-inch process development, our thin chip products (XThin, RazerThin and UT230), X-class and power chip LEDs (XB900 and XB500), our XLamp high power packaged LEDs and other high brightness LED research programs. In addition, we funded ongoing development for higher power/higher linearity RF and microwave devices, near UV laser devices and higher power diodes/switches. During fiscal 2003, we included a $1.0 million charge for costs associated with initial XBright chips that were made in previous quarters and were never fully qualified by customers. From time to time, our customers and companies in which we invest participate in research and development funding for specific programs. We record this customer and third party funding as an offset against research and development expenses. Customers and third parties in whom we invested funded zero and $500,000 in fiscal 2004 and fiscal 2003, respectively. The funding we received in fiscal 2003 came from an affiliate of Lighthouse, in which we held a private company equity investment.

Sales, General and Administrative.    Sales, general and administrative expenses increased 15% in fiscal 2004 to $29.1 million from $25.3 million in fiscal 2003. The increase in expenses primarily resulted from the increasing general expense associated with the growth of our business. During fiscal 2004, we incurred approximately $800,000 of incremental legal and other costs associated with litigation and costs of a special committee investigation conducted by the Board of Directors. Fiscal 2003 included legal costs associated with the patent infringement case with Nichia, which was settled in November 2002.

Impairment or Loss on Disposal of Fixed Assets.    Impairment or loss on the disposal of fixed assets decreased 35% to $1.0 million in fiscal 2004 from $1.6 million recorded in fiscal 2003. During fiscal 2004, we identified certain equipment that was obsolete and no longer in service. We wrote-off the value of these assets and disposed of them. During fiscal 2003, we recorded a $1.4 million write-down for fixed assets associated with a novel epitaxy equipment project that we discontinued before the vendor delivered the equipment to us. The amount represented a deposit that we paid for the equipment. We also disposed of $200,000 of other assets during fiscal 2003.

Severance Charges.    In the first quarter of fiscal 2003, we incurred $400,000 of severance charges at our Cree Microwave segment for employees who were laid off and received their severance payments during the same period. We paid no severance in fiscal 2004.

Gain on Termination of Supply Agreement.    In the second quarter of fiscal 2003, we received a $5.0 million one-time payment from Spectrian associated with the termination of the supply agreement between Cree Microwave and Spectrian. We did not receive any similar payments in fiscal 2004.

Loss on Investments in Marketable Securities.    We recorded a $2.1 million loss in fiscal 2003 related to marketable securities that we sold during the second quarter of fiscal 2003. There were no realized gains or losses on investments in marketable securities recorded in fiscal 2004.

Other Non-operating Income (Expense).    Other non-operating income (expense) increased to $519,000 of income in fiscal 2004 from an expense of $44,000 in fiscal 2003. During the third quarter of fiscal 2004, we recognized a one-time technology license fee.

Interest Income, Net.    Interest income, net decreased 10% to $3.7 million in fiscal 2004 from $4.1 million in fiscal 2003. The reduction resulted primarily from lower interest rates available for our liquid cash and securities-held-to-maturity over the applicable period.

Income Tax Expense.    Income tax expense for fiscal 2004 was $25.6 million compared to $12.3 million in fiscal 2003, an increase of 109%. The increase resulted mainly from our greater pre-tax profitability in fiscal 2004, which increased 77% over fiscal 2003. In addition, our effective income tax rate increased to 30.7% for fiscal 2004 compared to a 26% rate for fiscal 2003. The fiscal 2004 effective rate was higher than the fiscal 2003 effective tax rate as we benefited from tax credits and other permanent tax differences in fiscal 2003. Historically, our reported taxable income has been significantly lower than income reported for financial reporting purposes. The primary reasons for this difference are the timing differences for depreciation, stock option deductions for tax purposes and other tax planning strategies which are net of impairment charges expensed for financial accounting purposes that are not tax deductible.

Liquidity and Capital Resources

Our strong cash generating capability and financial condition givegives us ready accessthe ability to grow our business. Our principal source of liquidity is operating cash flows, which is derived from net income. This cash generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating, financing and investing needs.

Operating Activities:

In fiscal 2005,2006, our operations provided $151.5 million of cash as compared to $175.6 million of cash reflecting our solid business results. Inprovided in fiscal 2004, our operations provided $152.42005. This $24.1 million decrease was primarily due to a net income decline of cash. The year-over-year$14.5 million and increase in cash flows is mainly due to ouraccounts receivable of $35.1 million offset by non-cash expenses which include higher overall profitability. Our net income grew 57% from $58.0 million to $91.1 million in fiscal 2005 compared to fiscal 2004. Depreciationdepreciation and amortization increased by $14.2of property, equipment and patents of $4.6 million in fiscal 2005 due to purchases of new equipment to support our business growth. In fiscal 2005 we also recorded a number of non-cash charges including $6.7and $13.1 million expense for stock based compensation expense resulting from the impairment or loss on the disposal of long-lived assets, $2.0 million for the write-down of long-term investments and $652,000 associated with the impairment of inventory related to the closureadoption of the Cree Microwave-Sunnyvale facility. For fiscal 2004, cash from operations included a benefitprovisions of $20.4 million for deferred income taxes. In fiscal 2005, we also have a benefit of $23.0 million related to tax benefits associated with stock option exercises. In fiscal 2006, we will be required to reflect tax benefits associated with stock option exercises as a financing activity rather than an operating activity under Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”.SFAS 123R.

During fiscal 2005, we used $28.3 million for servicing2006, our working capital mostlyincreased by $20.9 million due to higher accounts receivable, which was partly offset by lower inventory, levels and prepaid expenses and lower accrued expensesexpense and other liabilities. Ourcurrent assets, and higher accrued expenses. As of June 25, 2006, our inventory remained below our industry average at 5943 days on hand; however, the balance grew by $12.5 million during fiscal 2005. As of June 27, 2004 ourhand. The decrease in inventory days on hand was 41 days. The majority of the increase relatedis primarily due to work in process items, which grew by $8.1 million in order to support the production of both three-inch and two-inch wafer platforms during fiscal 2005 and to support the expansion of inventory in our newer product lines, including high power packaged LEDs and high power products. Finished goods increased by $3.0 million in order to support higher LED sales and we maintain more of our continued efforts to manage inventory at locations in Asia as a convenience to our customers.levels. We normally target our accounts receivable balancebalances to average between 45 and 60 days outstanding; however, through focused collection efforts we decreased our daysoutstanding. Days sales outstanding towas 47 days and 32 days atfor the periods ended June 25, 2006 and June 26, 2005, versus 34 days outstanding at June 27, 2004,respectively, based on our monthly revenue profile calculation. Therefore, while our overall revenues increased 27% for fiscal 2005, our accounts receivable balanceAdditionally, prepaid expenses and other current assets decreased 26% or $12.6 million. Our accounts receivable balance also decreasedby $8.1 million primarily due to a change in our estimated sales return allowance that wasthe receipt of an income tax refund recorded in prior years and our accrued expenses increased by $3.5 million during fiscal 2005. As a result of this change, our net accounts receivable balance was reduced by $8.8 million in2006 primarily due to fiscal 2005.

2006 income tax expense.

Investing Activities:

InDuring fiscal 2005,2006, we used $200.1$161.1 million for investing primarily reflecting netactivities. The majority of this was attributable to $212.2 million used for the purchase of investments of $59.2held to maturity offset by $128.7 million made in securitiesmaturities of

investments held to maturity and $141.8$81.4 million in property and equipment including additional deposits for property and equipment.patent and licensing rights. The majority ofdecrease in investing activities from the increase in our spendingprior year was related to the additiona $71.3 million decrease in capital expenditures offset by a $32.2 million reinvestment of new equipmentoperating cash in marketable investments to increase manufacturing capacity in our epitaxy, clean room and die test areas. In addition, we expanded our main facility in Durham, North Carolina and purchased an existing facility in Research Triangle Park, North Carolina to provide additional plant capacity for our planned future growth. We target capital spending in fiscal 2006 to be in a range of $90.0 million to $110.0 million.

optimize investment yield.

Financing Activities:

InDuring fiscal 2005,2006, we generated $19.1$27.4 million from financing activities. We received $54.4 million inThe entire amount represents proceeds that were received from the exercise of stock options by our employees and shares issued under our employee stock purchase program in fiscal 2005 and used $35.3 million to repurchase 1.5 million shares of our common stock.

options.

As of June 26, 2005,25, 2006, there remained approximately 5.5 million shares of our common stock approved for repurchase under athe repurchase program authorized by the Board of Directors that extends through June 2006.2007. Since the inception of theour stock repurchase program in January 2001, we have repurchased 6.6 million shares of our common stock at an average price of $18.28 per share, with an aggregate value of $121.0 million. We intend to use available cash to finance purchasespurchase additional shares under the program. At the discretion of our management, the repurchase program can be implemented through open market or privately negotiated transactions. We will determine the time and extent of repurchases based on our evaluation of market conditions and other factors.

FiscalAs of June 25, 2006, Outlook:

our cash and cash equivalents and short-term investments combined increased $82.8 million, or 48%, over balances reported as of June 26, 2005. Our long-term investments held to maturity increased by $15.6 million, or 15%, over balances reported as of June 26, 2005. The combined $98.4 million increase to cash and investments resulted primarily from profits in fiscal 2006. Our net property and equipment has increased by $1.5 million or less than 1% since June 26, 2005 as investments made to expand production capacity have been almost entirely offset by depreciation expense and disposals of fixed assets. During fiscal 2006, we spent $77.3 million on capital additions. We currently have no debt outstanding or off-balance sheet obligations, commitments or contingencies or guarantees and we do not use special purpose entities for any transactions.

We plan to meet the cash needs for the business for fiscal 20062007 through cash from operations and cash on hand. We also plan to meet long-term cash needs with cash flow from operations or cash on hand over the next two fiscal years. Actual results may differ from our targets for a number of reasons addressed in this report. We may also issue additional shares of common stock or use available cash on hand for the acquisition of complementary businesses or other significant assets. From time to time, we evaluate strategic opportunities and potential investments in complementary businesses and anticipate continuing to make such evaluations. As a result of our planned closure of the Cree Microwave-Sunnyvale facility, we target that we will need to make additional cash outlays for severance costs and possibly to buy out our lease that extends through November 2011. If we choose to buy out the lease, we may incur cash out flows of $4.0 million to $7.0 million to satisfy those obligations.

As of June 26, 2005, our cash and cash equivalents and short-term investments combined increased $46.4 million, or 20%, over balances reported as of June 27, 2004 due to increased cash flow from operations. Our net property and equipment also has increased by $68.1 million or 25% since June 27, 2004 due to investments made to expand production capacity. These investments are intended to aid us in meeting current and what we view as increasing future customer product demands on a cost-effective basis. We target that these investments in additional equipment will allow us to meet increased demand for our products and thus may lead to higher revenue for us. The increased property investment will also result in higher depreciation expense. Our deferred revenue account decreased by $8.4 million to $67,000 at June 26, 2005 as we were able to estimate our sales returns in accordance with Statement of Financial Accounting Standards No. 48.

Contractual Obligations

At June 26, 2005,25, 2006, payments to be made pursuant to significant contractual obligations are as follows (000’s omitted):

Purchase obligations generally relate to the purchase of goods and services in the ordinary course of business such as raw materials, supplies and capital equipment. PurchaseOur purchase obligations reflect commitmentsrepresent authorizations to vendors under purchase orders where the commitments are firm.rather than binding agreements.

Operating leases include rental amountsamount due on our four leased facilities. These facilities comprise bothleases of certain office and manufacturing space. The first facility has a remaining lease termspace under the terms of approximately six and one half years. The second facility lease expires in approximately five years. The third lease is for sales and technical support that expires in approximately three years. The fourth lease relates to a sales office and expires in June 2006. We had a fifth lease that expired in July 2005.non-cancelable operating leases. These leases expire at various times through December 2015. All of the remaining lease agreements provide for rental adjustments for increases in base rent (up to specific limits) property taxes and general property maintenance that would be recorded as rent expense if applicable.

Item 7A.Quantitative and Qualitative Disclosures About Market Risk

As of June 26, 2005,25, 2006, we held a long-term investment in the equity securities of Color Kinetics, which is treated for accounting purposes under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” as an investment in available-for-sale securities. This investment is carried at fair market value based upon the quoted market price of the stock as of June 26, 2005,23, 2006, with net unrealized gains or losses excluded from earnings and reported as a separate component of shareholders’ equity.

It is our policy to write-down these types of equity investments to their market value and record the related write-down as an investment loss on our consolidated statements of operationsincome if we believe that an other-than-temporary decline existed in our marketable equity securities. As of June 26, 2005,25, 2006, we do not believe that an other-than-temporary decline existed in our investment in Color Kinetics, as the market value of the security was above our cost. This investment is subject to market risk of equity price changes. The fair

market value of this investment as of June 26, 2005,25, 2006, using the closing sale price as of June 24, 2005,23, 2006, was $20.9$29.1 million, compared to the fair market value as of June 27, 2004,26, 2005, using the closing sales price as of June 25, 2004,24, 2005, which was $22.0$20.9 million. The potential loss in fair value resulting from a hypothetical 10% decrease in quoted equity price was approximately $2.9 million at June 25, 2006 and $2.1 million at June 26, 2005 and $2.2 million at June 27, 2004.2005.

As of June 26, 2005, we held warrants in the equity of a private company valued at $37,000. We hold and expect to continue to consider investments in minority interests in companies having operations or technology in areas within our strategic focus. We generally are not subject to material market risk with respect to our investments classified as marketable securities as such investments are readily marketable, liquid and do not fluctuate substantially from stated values. Many of our investments are in early stage companies or technology companies where operations are not yet sufficient to establish them as profitable concerns. One of our investments is in a publicly traded company whose share prices are subject to market risk. Management continues to evaluate its investment positions on an ongoing basis. See Note 7,9, “Investments” in the consolidated financial statements included in Item 8 of this report for further information on our policies regarding investments in private and public companies.

We have invested some of the proceeds from our cash from operations into high-grade corporate debt, commercial paper, government securities and other investments at fixed interest rates that vary by security. These investments are A grade or better in accordance with our cash management policy. At June 26, 2005,25, 2006, we had $206.3$286.9 million invested in these securities compared to $149.4$206.3 million at June 27, 2004. This increase in investments was primarily due to our increased cash flow from operations in fiscal26, 2005. Although these securities generally earn interest at fixed rates, the historical fair values of such investments have not differed materially from the amounts reported on our consolidated balance sheets. Therefore, we believe that potential changes in future interest rates will not create material exposure for us from differences between the fair values and the amortized cost of these investments. The potential loss in fair value resulting from a hypothetical 10% decrease in quoted market price was approximately $20.5$28.7 million at June 25, 2006 and $20.6 million at June 26, 2005 and $14.9 million at June 27, 2004.

2005.

We currently have no debt outstanding or off-balance sheet obligations, commitments or contingencies or guarantees and we do not use special purpose entities for any transactions. With two of our larger customers, we maintain a foreign currency adjustment to our sales price if Japanese Yen and Euro exchange rates against the U.S. dollarDollar are not maintained. During fiscal 2005 and fiscal 2004, we recognized $234,000 and $489,000, respectively, of revenue associated with proceeds received from one of these customers for foreign currency adjustments. These revenue adjustments represent our main risk with respect to foreign currency since our contracts and purchase orders are denominated in U.S. dollars.dollars and have not had a material impact to our results of operations in fiscal 2006 or fiscal 2005. We have no commodity risk.

CERTAIN BUSINESS RISKS AND UNCERTAINTIES

Described below are various risks and uncertainties that may affect our business. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties, both known and unknown, including ones that we currently deem immaterial or that are similar to those faced by other companies in our industry or business in general, may also affect our business. If any of the risks described below actually occur, our business, financial condition or results of operations could be materially and adversely affected.

Our operating results and margins may fluctuate significantly.

Although we experienced significant revenue and earnings growth in the past year, we may not be able to sustain such growth or maintain our margins, and we may experience significant fluctuations in our revenue, earnings and margins in the future. Historically, the prices of our LEDs have declined based on market trends. We attempt to maintain our margins by constantly developing improved or new products, which provide greater value and result in higher prices, or by lowering the cost of our LEDs. If we are unable

to do so, our margins will decline. Our operating results and margins may vary significantly in the future due to many factors, including the following:

These or other factors could adversely affect our future operating results and margins. If our future operating results or margins are below the expectations of stock market analysts or our investors, our stock price will likely decline.

If we are unable to produce and sell adequate quantities of our high-brightness and mid-brightness LED chip products and improve our yields, our operating results may suffer.

We believe that our ability to gain customer acceptance of our high-brightness and mid-brightness LED chip products and to achieve higher volume production and lower production costs for those products will be important to our future operating results. We must reduce costs of these products to avoid margin reductions from the lower selling prices we may offer due to our competitive environment and/or to satisfy prior contractual commitments. Achieving greater volumes and lower costs requires improved production yields for these products. We may encounter manufacturing difficulties as we ramp up our capacity to make our newest products.Our failure to produce adequate quantities and improve the yields of any of these products

could have a material adverse effect on our business, results of operations and financial condition. Some of our customers may encounter difficulties with their manufacturing processes using our XBright and XThin devices due to the non-standard die attachment processes required, which could increase product returns and impact customer demand, each of which would have a material adverse effect on our business, results of operations and financial condition. We are continuing to work with our customers to develop and expand our X-class products to help meet their market and packaging requirements.

Our operating results are substantially dependent on the development of new products based on our SiC and GaN technology.

Our future success will depend on our ability to develop new SiC and GaN solutions for existing and new markets. We must introduce new products in a timely and cost-effective manner, and we must secure production orders from our customers. The development of new SiC and GaN products is a highly complex process, and we historically have experienced delays in completing the development and introduction of new products. Products currently under development include larger, higher quality substrates and epitaxy, wide bandgap RF and microwave products based on SiC and GaN, SiC power devices, near UV laser diodes, higher brightness, thinner LED products and high power packaged LEDs. The successful development and introduction of these products depends on a number of factors, including the following:

If any of these or other factors become problematic, we may not be able to develop and introduce these new products in a timely or cost-efficient manner.

Our results of operations, financial condition and business would be harmed if we are unable to grow customer demand and revenue to utilize our expanded capacity.

We are currently in the process of expanding our production capacity by adding new equipment and facilities and transitioning the production of our LED products from two-inch to three-inch wafers.We have committed substantial resources to these efforts. For example, in the third quarter of fiscal 2005, we purchased an existing wafer fabrication facility in Research Triangle Park, North Carolina. If we are unable to generate sufficient customer demand for our products, we would not be able to utilize our expanded capacity and our margins would decrease, due in part to higher fixed costs associated with additional capacity, and our results could decline. In addition, if we are unable to grow our revenues, which are affected by product mix as well as demand, our margins would decrease and our results could decline.

Our LED revenues are highly dependent on our customers’ ability to source or develop efficient phosphor solutions to enable them to use our LED chips to produce competitive white LED products.

Some of our customers package our blue LEDs in combination with phosphors to create white LEDs. Nichia currently has the majority of the market share for white LEDs. The phosphor solutions that our

customers have used in their products generally have not been as efficient as the phosphor solution that Nichia has used in its products. As a result, the white LEDs that our customers produce historically have not been as bright as Nichia’s white LEDs.We are assisting our customers in their efforts to develop or gain access to more competitive phosphor solutions.Even if our customers are able to develop or secure more competitive phosphor solutions, there can be no assurance that they will be able to compete with Nichia, which has an established market presence. Growth in sales of our high-brightness LED chips used in white light applications is dependent upon our customers’ ability to develop, secure and implement more competitive phosphor solutions.

We are highly dependent on trends in mobile phones to drive a substantial percentage of LED demand.

Our results of operations could be adversely affected by reduced customer demand for LED products for use in mobile appliances. For fiscal 2005, we derived nearly one-half of our LED revenue from sales of our products for use in mobile phone applications. Our design wins are spread over numerous models and customers. Our ability to maintain or increase our LED product revenue depends in part on the number of models into which our customers design our products and the overall demand for these products, which is impacted by seasonal fluctuations. Also, design cycles in the handset industry are short and demand is volatile, which makes production planning difficult to forecast.

If we experience poor production yields, our margins could decline and our operating results may suffer.

Our materials products and our LED, power and RF device products are manufactured using technologies that are highly complex. We manufacture our SiC wafer products from bulk SiC crystals, and we use these SiC wafers to manufacture our LED products and our SiC-based RF and power semiconductors. During our manufacturing process, each wafer is processed to contain numerous die, which are the individual semiconductor devices. The RF and power devices and XLamp products then are further processed by incorporating them into packages for sale as packaged components. The number of usable crystals, wafers, dies and packaged components that result from our production processes can fluctuate as a result of many factors, including but not limited to the following:

We refer to the proportion of usable product produced at each manufacturing step relative to the gross number that could be constructed from the materials used as our manufacturing yield.

If our yields decrease, our margins could decline and our operating results would be adversely affected. In the past, we have experienced difficulties in achieving acceptable yields on new products, which has adversely affected our operating results.We may experience similar problems in the future, and we cannot predict when they may occur or their severity. In some instances, we may offer products for future delivery at prices based on planned yield improvements. Reduced yields or failure to achieve planned yield improvements could significantly affect our future margins and operating results.

We depend on a few large customers, and our revenues can be affected by their contract terms.

Historically, a substantial portion of our revenue has come from large purchases by a small number of customers. Accordingly, our future operating results depend on the success of our largest customers and on our success in selling large quantities of our products to them. The concentration of our revenues with a few large customers makes us particularly susceptible to factors affecting those customers. For example, if demand for their products decreases, they may limit or stop purchasing our products and our operating results could suffer. We are unable to predict whether such a change would be positive or negative for our business. For example, Sumitomo’s inventory of our products can vary materially each quarter based on fluctuations in their customer demand. The Sumitomo contract provides that Sumitomo may decrease its purchase commitment or terminate the contract if its inventory of our products reaches a specified level. In general, the success of our relationships with our customers is subject to a number of factors, including the dynamics of the overall market. For example, if some of our competitors were to license technology or form alliances with other parties, our business may be impacted.

Our traditional LED chip customers may reduce orders as a result of our entry into the packaged LED markets.

We began shipping packaged LED devices in fiscal 2005. Some of our customers may reduce their orders for our chips as a result of us competing with them in the packaged LED business. This reduction in orders could occur faster than our packaged LED business can grow in the near term. This could reduce our overall revenue and profitability.

The markets in which we operate are highly competitive and have evolving technology standards.

The markets for our LED, RF and microwave and power semiconductor products are highly competitive. In the LED market, we compete with companies that manufacture or sell nitride-based LED chips as well as those that sell packaged LEDs. Competitors are offering new blue, green and white LEDs with aggressive prices and improved performance. These competitors may reduce average sales prices faster than our cost reduction. The market for SiC wafers is also becoming competitive as other firms in recent years have begun offering SiC wafer products or announced plans to do so.

We expect competition to increase. In order to achieve our revenue growth objectives in fiscal 2006, we need to continue to develop new products that enable our customers to win new designs and increased market share in key applications such as mobile phones. One major supplier dominates this market and we anticipate that the competition for these designs will be intense. Therefore, our ability to provide higher performance LEDs at lower costs will be critical to our success. Competitors may also try to align with some of our strategic customers. This could mean lower prices for our products, reduced demand for our products and a corresponding reduction in our ability to recover development, engineering and manufacturing costs. Competitors also could invent new technologies that may make our products obsolete. Any of these developments could have an adverse effect on our business, results of operations and financial condition.

Our business and our ability to produce our products may be impaired by claims that we infringe intellectual property rights of others.

Vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. These traits have resulted in significant and often protracted and expensive litigation. Litigation to determine the validity of patents or claims by third parties of infringement of patents or other intellectual property rights could result in significant expense and divert the efforts of our technical personnel and management, even if the litigation results in a determination favorable to us. In the event of an adverse result in such litigation, we could be required to:

There can be no assurance that third parties will not attempt to assert infringement claims against us with respect to our current or future products. We have also indemnified certain of our customers that we will protect them in the event that they are sued by our competitors for intellectual property violations. Under these indemnifications we may be responsible for future payments to them to settle royalty claims with our competitors. From time to time we receive correspondence asserting that our products or processes are or may be infringing patents or other intellectual property rights of others. Our practice is to investigate such claims to determine whether the assertions have merit and, if so, we take appropriate steps to seek to obtain a license or to avoid the infringement. However, we cannot predict whether a license will be available or that we would find the terms of any license offered acceptable or commercially reasonable. Failure to obtain a necessary license could cause us to incur substantial liabilities and costs and to suspend the manufacture of products.

There are limitations on our ability to protect our intellectual property.

Our intellectual property position is based in part on patents owned by us and patents exclusively licensed to us by North Carolina State University, Boston University and others. The licensed patents include patents relating to the SiC crystal growth process that is central to our SiC materials and device business. We intend to continue to file patent applications in the future, where appropriate, and to pursue such applications with U.S. and foreign patent authorities.

However, we cannot be sure that patents will be issued on such applications or that our existing or future patents will not be successfully contested by third parties. Also, since issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, we cannot be sure that any of our patents (or patents issued to others and licensed to us) will provide significant commercial protection, especially as new competitors enter the market.

In addition to patent protection, we also rely on trade secrets and other non-patented proprietary information relating to our product development and manufacturing activities. We try to protect this information through appropriate efforts to maintain its secrecy, including requiring employees and third parties to sign confidentiality agreements. We cannot be sure that these efforts will be successful or that the confidentiality agreements will not be breached. We also cannot be sure that we would have adequate remedies for any breach of such agreements or other misappropriation of our trade secrets, or that our trade secrets and proprietary know-how will not otherwise become known or be independently discovered by others.

Where necessary, we may initiate litigation to enforce our patent or other intellectual property rights. Any such litigation may require us to spend a substantial amount of time and money and could distract management from our day-to-day operations. Moreover, there is no assurance that we will be successful in any such litigation.

We face significant challenges managing our growth.

We have experienced a period of significant growth that has challenged our management and other resources. We have grown from 680 employees on June 25, 2000 to 1,322 employees on June 26, 2005 and from revenues of $108.6 million for the fiscal year ended June 25, 2000 to $389.1 million for the fiscal year ended June 26, 2005. To manage our growth effectively, we must continue to:

We will spend substantial amounts of money in supporting our growth and may have additional unexpected costs. We may not be able to expand quickly enough to exploit potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development and administrative support. If we cannot attract qualified people or manage growth effectively, our business, operating results and financial condition could be adversely affected. For example, we are currently trying to build a worldwide team of sales and marketing employees for our solid-state lighting and power businesses. If we are not successful in recruiting personnel, our projected growth may be lower than our forecasts. Conversely, if the product demand from our customers does not expand as we anticipate, our margins may decrease in part due to higher costs associated with our recent increase in capacity that which would not be used.

Performance of our investments in other companies could affect our financial condition.

From time to time, we have made investments in public and private companies that engage in complementary businesses. Should the value of any such investments we hold decline, the related write-down in value could have a material adverse effect on our financial condition as reflected in our consolidated balance sheets. In addition, if the decline in value is determined to be other-than-temporary, the related write-down could have a material adverse effect on our reported net income. We currently hold an interest in one public company. In the third quarter of fiscal 2005, we sold our investment in Lighthouse Technologies, Inc. at its carrying value and no longer have investments in privately held companies with a net carrying value on our financial statements other than a $37,000 value for warrants held in a private company.

An investment in another company is subject to the risks inherent in the business of the company in which we have invested and to trends affecting the equity markets as a whole. Private company investments are subject to additional risks relating to the limitations on transferability of our interests due to the lack of a public market and to other transfer restrictions. Investments in publicly held companies are subject to market risks and may not be liquidated easily. As a result, we may not be able to reduce the size of our positions or liquidate our investments when we deem appropriate to limit our downside risk.

Our investments in public and private companies also may cause fluctuations to our earnings results. For example, during the fourth quarter of fiscal 2005, we recorded an $814,000 decrease to our tax expense related to an increase in the value of our Color Kinetics investment and in the third quarter of fiscal 2005, we recorded a $4.1 million increase in our income tax expense related to an unrealized capital gain on the Color Kinetics investment, which we offset against a prior year tax carryforward.In future periods, we will be required to continue to adjust our deferred tax asset valuation allowance in connection with any increase or decrease in the value of our investment in Color Kinetics, which could increase or decrease our income tax expense for the period. This may cause fluctuations in our earnings results that do not accurately reflect our results from operations.

Our manufacturing capacity may not be aligned with customer demand.

Although we are taking steps to balance our manufacturing capacity needs, if we are not able to adjust our capacity to respond to customer demand, our business results from operations could be impacted. We are

exploring ways to expand our manufacturing capacity and plan to make certain expenditures in the coming fiscal year to acquire new equipment. Any potential expansion projects may be delayed, cost more than we anticipate or require long transition periods, any of which could impact our ability to meet our customers’ demands and affect our operating results.

We also are in the process of transitioning our production process in several ways. First, over the course of fiscal 2005, we began shifting production of our LED products from two-inch wafers to three-inch wafers. This process involves qualifying our production processes for each product on systems designed to accommodate the larger wafer size. In the past we have experienced lower yields for a period of time following a transition to a larger wafer size until use of the larger wafer is fully integrated in production and we begin to achieve production efficiency. We have experienced similar short-term yield challenges during the first part of the transition to the three-inch wafers.If we experience delays in the qualification process, the transition phase takes longer than we expect, or if we are unable to attain expected yield improvements, our operating results may be adversely affected.

We rely on a few key suppliers.

We depend on a limited number of suppliers for certain raw materials, components, services and equipment used in manufacturing our products, including key materials and equipment used in critical stages of our manufacturing processes. We generally purchase these limited source items with purchase orders, and we have no guaranteed supply arrangements with such suppliers. If we were to lose key suppliers or suppliers are unable to support our demand, our manufacturing operations could be interrupted or hampered significantly.

If government agencies discontinue or curtail their funding for our research and development programs, our business may suffer.

Changes in Federal budget priorities could adversely affect our contract revenue. Historically, government agencies have funded a significant portion of our research and development activities. When the government makes budget priorities, such as in times of war, our funding has the risk of being redirected to other programs. Government contracts are also subject to the risk that the government agency may not appropriate and allocate all funding contemplated by the contract. In addition, our government contracts generally permit the contracting authority to terminate the contracts for the convenience of the government, and the full value of the contracts would not be realized if they were prematurely terminated. Furthermore, we may be unable to incur sufficient allowable costs to generate the full estimated contract values, and there is some risk that any technologies developed under these contracts may not have commercial value. If government funding is discontinued or reduced, our ability to develop or enhance products could be limited, and our business; results of operations and financial condition could be adversely affected.

If our products fail to perform or meet customer requirements, we could incur significant additional costs.

The manufacture of our products involves highly complex processes. Our customers specify quality, performance and reliability standards that we must meet. If our products do not meet these standards, we may be required to replace or rework the products. In some cases our products may contain undetected defects or flaws that only become evident after shipment. We have experienced product quality, performance or reliability problems from time to time. Defects or failures may occur in the future. If failures or defects occur, we could:

We are subject to risks from international sales.

Sales to customers located outside the U.S. accounted for approximately 87%, 83% and 80% of our revenue in fiscal 2005, 2004 and 2003, respectively. We expect that revenue from international sales will continue to be the majority of our total revenue. International sales are subject to a variety of risks, including risks arising from currency fluctuations, trading restrictions, tariffs, trade barriers and taxes. Also, U.S. Government export controls could restrict or prohibit the exportation of products with defense applications. Because all of our foreign sales are denominated in U.S. dollars, our sales are subject to variability as prices become less competitive in countries with currencies that are low or are declining in value against the U.S. dollar and more competitive in countries with currencies that are high or increasing in value against the U.S. dollar.

If we fail to evaluate and implement strategic opportunities successfully, our business may suffer.

From time to time we evaluate strategic opportunities available to us for product, technology or business acquisitions, investments or other relationships. For example, in fiscal 2004 we acquired the gallium nitride substrate and epitaxy business of ATMI. If we choose to make an acquisition, we face certain risks, such as failure of the acquired business in meeting our performance expectations, diversion of management attention, retention of existing customers of the acquired business and difficulty in integrating the acquired business’s operations, personnel and financial and operating systems into our current business. We may not be able to successfully address these risks or any other problems that arise from our recent or future acquisitions. Any failure to successfully evaluate strategic opportunities and address risks or other problems that arise related to any acquisition, investment or relationship could adversely affect our business, results of operations and financial condition.

The process of winding down the business of our Cree Microwave segment could adversely affect our results of operation.

In June 2005, we announced plans to close the silicon RF and microwave semiconductor business of our Cree Microwave segment in Sunnyvale, California. We accepted last-time buy orders from our customers through July 2005 and expect to wind-down operations by the end of calendar 2005. We have written down the assets and disclosed certain expenses we expect to incur in winding down the business and closing the Sunnyvale facility. We will continue to be obligated on our lease for that facility through November 2011. The amount of expense we expect to incur for lease obligations was calculated assuming that we can sublease the facility beginning in fiscal 2007. If our estimated expenditures related to the closure are higher than expected, we are unable to find a tenant to sublease the facility from us or we are unable to fulfill last-time buy orders and wind-down operations by the end of calendar 2005, our results of operation could be adversely affected.

If we are unable to attract and hire a new Chief Financial Officer or if the search process takes too long, our business could suffer.

We are actively seeking a new Chief Financial Officer in connection with the recent announcement that Cynthia B. Merrell, our current Chief Financial Officer, is resigning. Ms. Merrell has agreed to continue her service as Chief Financial Officer until such time as we secure a qualified successor, but not later than mid-February 2006. There is intense competition for qualified senior management, particularly those with the financial expertise needed for this position. If we are unable to attract and hire a new Chief Financial Officer in a timely manner, our business could suffer from the uncertainty caused by the continued management search process. If Ms. Merrell were to step down prior to our hiring of a replacement, our business also could be harmed.

Litigation could adversely affect our operating results and financial condition.

We are defendants in pending litigation (as described in Part I, Item 3, entitled “Legal Proceedings,” of this report) that alleges, among other things, violations of federal securities laws.Defending against existing and potential securities and class action litigation will likely require significant attention and resources and, regardless of the outcome, result in significant legal expenses, which will adversely affect our results unless covered by insurance or recovered from third parties. If our defenses are ultimately unsuccessful, or if we are unable to achieve a favorable resolution, we could be liable for damage awards that could materially adversely affect our results of operations and financial condition.

Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new regulations from the Securities and Exchange Commission (SEC), are creating uncertainty for public companies such as ours. These laws, regulations and standards are subject to varying interpretations in many cases, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased sales, general and administrative expenses and a diversion of management time and attention. In particular, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal control over financial reporting and our independent accountants’ audit of that assessment for fiscal 2005 have required, and we expect such efforts to continue to require, the commitment of significant financial and managerial resources.

Item 8.Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Cree, Inc.

We have audited the accompanying consolidated balance sheets of Cree, Inc. as of June 26, 200525, 2006, and June 27, 2004,26, 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended June 26, 2005.25, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cree, Inc. at June 26, 200525, 2006 and June 27, 2004,26, 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 26, 2005,25, 2006, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Cree, Inc.’s internal control over financial reporting as of June 26, 2005,25, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 10, 200521, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

The accompanying notes are an integral part of the consolidated financial statements.

CREE, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)