We also generate revenue under contracts funded by government agencies. Government entities assist us in the development of new technology by funding a portion of our research and development efforts. Revenue from contract research funding represented 7% and 6% of our revenue in each offrom continuing operations for the quartersthree and six months ended SeptemberDecember 25, 2005, respectively. Revenue from contract research funding represented 6% of our revenue from continuing operations for the three and Septembersix months ended December 26, 2004, respectively.
Our business is affected by a number of industry factors, including: trends in mobile product designs and sales, our LED brightness and technology, competitive LED pricing pressures, technology and the relative strength of each supplier’s intellectual property. The most significant market currently for our blue and green LED chips is for illumination purposes in mobile products, including LCD backlighting, keypad illumination and flash units for cameras. LED sales for mobile products are impacted by the number of LEDs used in an application, which may vary depending on trends in the features of the application and the brightness of the LEDs used. Average LED sales prices decline each year as market players implement pricing strategies to strengthen or protect market share. To remain competitive, LED producers generally must increase product performance and reduce the average sales price at or above the market rate.price. Finally, vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. Customers’ purchasing decisions can be influenced by whether a product may infringe valid intellectual property rights.
We continue to expand our product offerings of our XLamp family of high-power packaged LED products. We are aiming to increase sales of XLamp products in the specialty lighting markets (such as lighting for pools and spas), including architectural lighting, appliance lights, flashlights and reading lights.
In order to expand our factory output and improve our yields, we plan to invest $90.0 million to $110.0 million during fiscal 2006 in capital equipment additions.additions, which includes the build out of the fabrication facility in Research Triangle Park, North Carolina that we purchased in the third quarter of fiscal 2005. We also plan to expand our production at a subcontractor facility in Asia. During the third quarter of fiscal 2006, we need to expand our XLamp production capacity in order to meet targeted demand and reach our financial goals for the third quarter of fiscal 2006. We also may increase our research and development and sales and marketing spending as a percentage of revenue over our fiscal 2005 level.
Gross Profit. Gross profit decreased 4%from continuing operations increased 3% to $50.9$52.2 million in the firstsecond quarter of fiscal 2006 from $53.3$50.5 million in the firstsecond quarter of fiscal 2005. Compared to the prior year period, gross margin decreased from 55.5%52.6% to 48.9%49.4% of revenue. During the second quarter of fiscal 2006, we recorded a $1.2 million expense to cost of sales for stock compensation resulting from the adoption of SFAS 123R at the beginning of our 2006 fiscal year, which had a negative effect on our gross margin of 1.2% on revenue from continuing operations. This decrease was also driven by lower gross margin on sales of LED chips, for which blended average selling prices were 24%13% lower and costs were reduced by only 8%9% over the same period of fiscal 2005. Our average sales price declined due to our pricing strategyincreasing price competition in the marketplace for high brightness chipsmid-brightness and a shift in product mixhigh-brightness devices. Our costs were reduced as we began to low priced UT230 products. As partmanufacture more of our strategy to increaseproducts from three-inch wafers. Approximately 80% of our market share in white LED chips, we had to increase our performance specifications to support new design wins. The higher brightness requirements for our products resulted in lower overall yields, which offset the benefit of manufacturing more chips per wafer that was gained from our conversion to three-inch wafers. More thanor approximately 60% of our LED chipswafers were produced from three-inch wafers during the firstsecond quarter of fiscal 2006. We targetGross profit was impacted by a $1.3 million decrease in our sales return allowance, which increased revenue, as we estimate that we have experienced a trend of lower customer returns over the majority of our LED chips to be fabricated from three-inch wafers during fiscal 2006. During the first quarter of fiscal 2006, we alsopast few quarters. We recorded a $200,000 write downcorresponding reduction in our estimate for product returns of inventory related to$184,000, which increased cost of sales. Overall, the silicon-based Cree Microwave business and a $628,000 expense for stock compensation resulting from the adoption of SFAS 123R in that quarter.
Our silicon-based Cree Microwave business reported negativeadjustment increased gross profit of $1.3 million for both the three months ended September 25, 2005 and September 26, 2004. With the previously announced winding down of our silicon-based business in December 2005, we target gross profit to improve by approximately $1.3 million beginning in the third quarter of fiscal 2006.$1.1 million.
Wafer costs per unit for our materials sales were 18%24% higher in the firstsecond quarter of fiscal 2006 compared to the firstsecond quarter of fiscal 2005 due to a different mix of products sold in the first quarter of fiscal 2006.current quarter. Contract margin improved to 33%28% in the firstsecond quarter of fiscal 2006 compared to 25% the first quarter of fiscal 2005 as we began work under several new contracts.
During16% in the second quarter of fiscal 2006, we target stock compensation expense2005 due to increase our costthe mix of product sales from $628,000 recordednew contracts that were awarded to us in the first quarter of fiscal 2006 to $1.2 million, as approximately $725,000 of stock compensation expense was allocated as inventory in the first quarter of fiscal2005 and 2006.
Research and Development. Research and development expenses increased 21%44% in the firstsecond quarter of fiscal 2006 to $12.8$14.8 million from $10.6$10.3 million in the firstsecond quarter of fiscal 2005. During the firstsecond quarter of fiscal 2006, research and development costs included $1.1$1.0 million in stock compensation expense resulting from our adoption of SFAS 123R.123R at the beginning of fiscal 2006. The remaining increase in research and development spending supported our three-inchcontinued development of higher brightness LED wafer process development,chips and high power LED components, our thin chip products, X-class and power chip LEDs, our XLamp high power packaged LEDs, and other high brightnessthree-inch and four-inch LED research programs.wafer process development. In addition, we funded ongoing development for higher power and higher linearity RF and microwave devices, near ultraviolet laser diodes and higher power diodes and switches. We target that research and development spending will increase in future quarters in line with our revenue.
Sales, General and Administrative. Sales, general and administrative, or SG&A expenses increased 44%52% in the firstsecond quarter of fiscal 2006 to $11.1$10.8 million from $7.7$7.1 million in the firstsecond quarter of fiscal 2005. During the firstsecond quarter of fiscal 2006, sales, general and administrativeSG&A costs included $1.2$1.1 million in stock compensation expense resulting from our adoption of SFAS 123 R. Sales, general and administrative123R at the beginning of fiscal 2006. During the second quarter of fiscal 2005, SG&A expense levels were reduced by a $1.1 million for an insurance reimbursement for certain legal fees related to our securities litigation. SG&A expenses in the second quarter of fiscal 2006 also increased over the prior year quarter due to higher costs associated with our continued compliance with the Sarbanes-Oxley Act of 2002 and higher overall costs associated
with our growth. In addition, we increased spending on sales and marketing in our high power packaged LED and power semiconductor products, and we target to increase these expenses in future quarters.products.
Impairment or Loss on Disposal of Long-Lived Assets. Impairment or loss on the disposal of long-lived assets increased 896%decreased 47% to $777,000$132,000 in the firstsecond quarter of fiscal 2006 as compared to $78,000$248,000 in the first quarter of fiscal 2005. During the first quarter of fiscal 2006, we recorded an impairment of $581,000 for building improvements that are no longer being used at our Durham facility and other disposals. During the three months ended September 25, 2005, the silicon-based Cree Microwave business also recorded a $196,000 impairment charge for patents as we are winding down this business.
Severance Charges. In the first quarter of fiscal 2006, we incurred $391,000 in severance charges for employees at our Cree Microwave-Sunnyvale facility. Severance costs are accrued ratably over the period between the communication date in the fourthsecond quarter of fiscal 2005 andas a result of the actual termination datelong-lived assets disposed of these employees. We currently estimate that we will incur additional severance costs of approximately $300,000 duringin each comparative quarter.
Loss on Long-term Investments. For the second quarter of fiscal 2006, associated with the closure of the Sunnyvale facility. We anticipate that all remaining employees at the Sunnyvale facility will be terminated as of December 2005.
Gainthere was no loss recorded on Investments in Marketable Securities. Gainlong-term investments. The $2.0 million loss on investments in marketable securities was $587,000 in the firstsecond quarter of fiscal 2006, compared2005 was due to $118,000an other-than-temporary impairment in the first quarter of fiscal 2005. In the first quarter of fiscal 2006, we sold a small portion of our investment in Color Kinetics, Incorporated (Color Kinetics) for a realized gainprivate company. The write-down was based on our evaluation of $587,000.the company’s financial results and a third party proposal to purchase our investment.
Interest Income, Net. Interest income, net increased 102%161% to $2.3$3.0 million in the firstsecond quarter of fiscal 2006 from $1.1 million in the firstsecond quarter of fiscal 2005 due to a combination of our greater cash balance of invested assets and higher interest rates on our investments arisingresulting from rate increases that have occurred over the past 12twelve months.
Income Tax Expense. Income tax expense from continuing operations for the firstsecond quarter of fiscal 2006 was $7.0$9.4 million compared to $11.8$4.9 million in the firstsecond quarter of fiscal 2005. During the firstsecond quarter of fiscal 2006, our income tax expense decreased by $2.2 million$132,000 for tax related adjustments to the valuation allowance previously established to offset our federal capital loss carryover deferred tax asset. We currently target that our effective tax rate for the remainder of fiscal 2006 will be approximately 32.1%, which does not reflect changes in the market price of shares of Color Kinetics’ common stock, which we treat as a discrete item each quarter. As of December 26, 2004, we had a federal capital loss carryover of $39.8 million. The related deferred tax asset of $13.9 million was previously offset by a valuation allowance since it was more likely than not that we could not utilize the capital loss carryover. Based on Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," the valuation allowance should be adjusted for any new realizable federal capital gains or losses. The contractual trading restrictions applicable to our investment in Color Kinetics expired on December 22, 2004. As a result, the $16.0$22.5 million unrealized federal capital gain, as well as the $587,000 realized federal capital gain related to our investment in Color Kinetics required a $2.2$7.9 million reversal of the valuation allowance, which decreased income tax expense for the three months ended SeptemberDecember 26, 2004. Also, we increased the valuation allowance related to privately held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005. Additionally, we increased income tax expense during the second quarter of fiscal 2005 by $1.8 million for a settlement of state income taxes, estimated state tax rate changes and other adjustments.
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 have reflected 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 for the second quarter of fiscal 2006 increased 13% from $2.1 million to $2.3 million as compared to the second quarter of fiscal 2005. During the second quarter of fiscal 2006, we recorded $3.9 million of pre-tax charges, or $2.7 million of after-tax charges related to the closure of the business. These charges included $232,000 for severance expenses, a $468,000 write-down of inventory that was scrapped, a $93,000 fixed asset impairment and a $3.1 million charge for an accrual relating to the remaining lease contract obligation for the Sunnyvale facility. The net loss from discontinued operations also included pre-tax stock compensation expenses of $126,000 for the three months ended December 25, 2005. WithoutDuring the tax adjustment forsecond quarter of fiscal 2006, our investmentsilicon microwave business generated $3.2 million in Color Kinetics,revenue from last time buy orders that produced pre-tax income of $408,000, or $277,000 after-tax from operations. In the second quarter of fiscal 2005, our effective income tax ratesilicon microwave business generated a pre-tax operating loss of $3.1 million, or $2.1 million after-tax, as we produced revenue of $1.5 million offset by heavy fixed costs incurred to operate the Sunnyvale facility.
Six Months Ended December 25, 2005 and December 26, 2004
Revenue. Revenue from continuing operations increased 9% to $208.5 million in the first six months of fiscal 2006 from $190.5 million in the first six months of fiscal 2005. Higher revenue was 32.2%attributable to greater product revenue, which increased 9% to $195.0 million in the first half of fiscal 2006 from $178.8 million in the first half of fiscal 2005. Much of the increase in revenue resulted from significantly higher unit shipments of our LED products, which increased 33% in the first six months of fiscal 2006 as compared to the same period of the prior year. LED revenue was $171.1 million and $157.8 million, for the first six months of fiscal 2006 and 2005, respectively. Our blended average LED sales price decreased 18% in the first six months of fiscal 2006 as compared to the first six months of fiscal 2005. This decrease was due to increasing price competition in the marketplace for high-brightness and mid-brightness devices.
Our LED revenue increased 8% in the first six months of fiscal 2006 as compared to the first six months of fiscal 2005 and made up 82% of our total revenue from continuing operations for the six months ended December 25, 2005. Revenue from our sales of high-brightness products increased to 40% of LED revenue as compared to 12% of LED revenues for the six months ended December 25, 2005 and December 26, 2004, respectively. Revenue from sales of our mid-brightness products declined as a percentage of total LED revenue to 60% as of December 25, 2005 from 88% as of December 26, 2004. The primary drivers of the increase in revenue from sales of high-brightness products and the related decrease in revenue from sales of our mid-brightness products are increased high-brightness chip sales for mobile products requiring white LEDs in keypads, backlights for LCD displays and camera flashes. During the second quarter of fiscal 2006, revenue increased by $1.3 million due to the reduction of our estimated sales return reserve, as we experienced a trend of lower customer returns over the past few quarters. Revenues from sales of our high-brightness products have also increased as a percentage of our LED revenue due to our success in selling our XLamp packaged products. Our XLamp revenue increased in the first six months of fiscal 2006 as compared to the first six months of fiscal 2005 as we have added several new customers for our XLamp products. The XLamp product was released to production in early fiscal 2005.
Wafer product revenue was $10.6 million and $13.8 million for the first six months of fiscal 2006 and 2005, respectively. The average sales price increased 50% while units sold declined 49% during the first six months of fiscal 2006 as compared to the prior year period. The increase in the average sales price for our wafers and the reduction in the units sold were due mostly to a change in our product mix as we sold more high-grade and custom wafers used by our customers for research and development projects and we sold fewer standard wafers that we previously sold in high volume. Wafer revenue made up 5% of our revenue from continuing operations in the first six months of fiscal 2006. SiC materials revenue for gemstone use was $6.8 million and $3.3 million for the six months of fiscal 2006 and 2005, respectively. Revenue from sales of our SiC materials for use in gemstones increased 105% during the first six months of fiscal 2006 as compared to the prior year period due to higher customer demand from our sole customer for these products, Charles & Colvard. Revenue from gemstone materials was 3% of our total revenue from continuing operations for the six months ended December 25, 2005.
Revenue from our high-power devices increased 70% to $6.3 million for the first six months of fiscal 2006 from $3.7 million for the prior year comparative period. Much of the increase in revenue resulted from the growth of our MMIC foundry sales. Revenue from high-power devices was 3% of our revenue from continuing operations for the six months ended December 25, 2005.
Contract revenue was 6% of revenue from continuing operations for the first six months of fiscal 2006. Contract revenue increased 16% during the first six months of fiscal 2006 compared to the same period of fiscal 2005 due to the start of new contracts that were awarded to us during fiscal 2005 and 2006.
Gross Profit. Gross profit from continuing operations decreased 1% to $104.4 million in the first six months of fiscal 2006 from $105.1 million in the comparative period in fiscal 2005. Compared to the prior year period, gross margin decreased from 55.2% to 50.1% of revenue. During the six months ended December 25, 2005, we recorded a $1.8 million expense to cost of sales for stock compensation resulting from the adoption of SFAS 123R at the beginning of fiscal year 2006, which had a negative effect on our gross margin of 0.8% of revenue from continuing operations. This decrease was also driven by lower gross margin on sales of LED chips, for which blended average selling prices were 18% lower and costs were reduced by only 9% over the same period of fiscal 2005. Our average sales price declined due to increasing price competition in the marketplace for mid-brightness and high-brightness devices. Our costs were reduced as we began to manufacture more of our products from three-inch wafers. Approximately 70% of our LED chips were produced from three-inch wafers during the first half of fiscal 2006. Gross profit was impacted by a $1.3 million decrease in our sales return allowance, which increased revenue from continuing operations, as we have experienced a trend of lower customer returns over the past few quarters. We recorded a corresponding reduction in our estimate for product returns of $184,000, which increased cost of sales. Overall, the adjustment increased gross profit by $1.1 million.
Wafer costs per unit for our materials sales were 19% higher in the first six months of fiscal 2006 compared to the first six months of fiscal 2005 due to a different mix of products sold in the current quarter. Contract margin improved to 30% in the first six months of fiscal 2006 compared to 20% in the first six months of fiscal 2005 due to the start of new contracts that were awarded to us during fiscal 2005 and 2006.
Research and Development. Research and development expenses increased 39% in the first six months of fiscal 2006 to $27.6 million from $19.9 million in the first six months of fiscal 2005. During the first six months of fiscal 2006, research and development costs included $2.1 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 and high-power LED components, our XLamp high-power packaged LEDs, three-inch and four-inch LED wafer process development and other high-brightness LED research programs. In addition, we funded ongoing development for higher power and higher linearity RF and microwave devices, near ultraviolet laser diodes and higher power diodes and switches.
Sales, General and Administrative. Sales, general and administrative, or SG&A expenses increased 55% in the first six months of fiscal 2006 to $21.6 million from $14.0 million in the first six months of fiscal 2005. During the six months ended December 25, 2005, SG&A costs included $2.3 million in stock compensation expense resulting from our adoption of SFAS 123R at the beginning of fiscal 2006. During the first six months of fiscal 2005, SG&A expense levels were reduced by a $1.1 million insurance reimbursement for certain legal fees related to our securities litigation. SG&A expenses in the first six months of fiscal 2006 also increased over the first six months of fiscal 2005 due to higher costs associated with our continued compliance with the Sarbanes-Oxley Act of 2002 and higher overall costs associated with our growth. In addition, we increased spending on sales and marketing in our high power packaged LED and power semiconductor products.
Impairment or Loss on Disposal of Long-Lived Assets. Impairment or loss on the disposal of long-lived assets increased 114% to $700,000 in the first six months of fiscal 2006 as compared to $326,000 in the first six months of fiscal 2005. During the first six months of fiscal 2006, we recorded an impairment of $581,000 for building improvements that are no longer being used at our Durham facility.
Gain on Investments in Securities. Gain on investments in securities was $587,000 in the first six months of fiscal 2006, compared to a 32.5% rate during$1.9 million loss in the comparative period infirst six months of fiscal 2005. We currently target that our effective tax rate forIn the remainderfirst six months of fiscal 2006, will be approximately 32.2%.we sold a small portion of our investment in Color Kinetics for a realized gain of $587,000. The fiscal 2005 loss was 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 a third party proposal to purchase our investment.
Interest Income, Net. Interest income, net increased 131% to $5.3 million in the first six months of fiscal 2006 from $2.3 million in the first six months of fiscal 2005, due to a combination of our greater balance of invested assets and higher interest rates resulting from rate increases that have occurred over the past twelve months.
Income Tax Expense. Income tax expense for the first six months of fiscal 2006 was $17.0 million compared to $17.7 million in the first six months of fiscal 2005. During the first six months of fiscal 2006, our income tax expense decreased by $2.3 million for tax related adjustments to the valuation allowance previously established to offset our federal capital loss carryover deferred tax asset. During the first six months of fiscal 2005, our income tax expense was reduced by an aggregate of $5.4 million of adjustments. As of December 26, 2004, we had a federal capital loss carryover of $39.8 million. The related deferred tax asset of $13.9 million was previously offset by a valuation allowance since it was more likely than not that we could not utilize the capital loss carryover. Based on Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," the valuation allowance should be adjusted for any new realizable federal capital gains or losses. The contractual trading restrictions applicable to our investment in Color Kinetics expired on December 22, 2004. As a result, the $22.5 million unrealized federal capital gain related to our investment in Color Kinetics required a $7.9 million reversal of the valuation allowance, which decreased income tax expense for the six months ended December 26, 2004. Also, we increased the valuation allowance related to privately held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005. Additionally, we increased income tax expense by $1.8 million during the first six months of fiscal 2005 for a settlement on state income taxes, estimated state tax rate changes and other adjustments.
Loss from discontinued operations, net of tax. In accordance with SFAS 144, effective December 25, 2005, we reflected our silicon RF and microwave business as a discontinued operation in the consolidated financial statements. The net loss from discontinued operations for the first six months of fiscal 2006 decreased 9% from $4.2 million to $3.9 million in the first six months of fiscal 2005. During the first six months of fiscal 2006, we recorded $4.7 million of pre-tax charges, or $3.2 million of after-tax charges related to the closure of the business. These charges included $623,000 for severance expenses, a $668,000 write-down of inventory that was scrapped, a $289,000 fixed asset and patent impairment and a $3.1 million charge for an accrual relating to the remaining lease contract obligation for the Sunnyvale facility. During the six months ended December 25, 2006, our silicon microwave business generated $4.3 million in revenue from last time buy orders that produced a $1.0 million pre-tax loss, or $700,000 after-tax from operations. The net loss from discontinued operations also included pre-tax stock compensation expense of $202,000 for the six months ended December 25, 2005. In the first six months of fiscal 2005, our silicon microwave business generated a pre-tax operating loss of $6.3 million, or $4.2 million after-tax, as we produced revenue of $2.9 million offset by heavy fixed costs incurred to operate the Sunnyvale facility.
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 the first quarter forsix months of fiscal 2006, our operations provided $31.0$87.7 million of cash as compared to $53.8$92.6 million of cash provided in the first quartersix months of fiscal 2005. This $4.9 million decrease was primarily attributabledue to a $12.6 million declinereduction in cashthe amount of working capital provided by working capitaloperations of $11.9 million and a decrease in the first quarter of fiscal 2006 compared to a $13.1 million increase in cash provided by working capital in the first quarter of fiscal 2005. In addition, results from the first quarter of fiscal 2006 included lower profits as net income decreased 11%, or $2.7of $10.0 million to $21.7 million. Depreciationbeing partly offset by increased non-cash expenses which include, higher depreciation and amortization increased by $2.8of property, equipment and patents of $3.8 million, ina $3.8 million charge for the first three monthsimpairment of fiscal 2006 compared to the first three months of fiscal 2005long-lived assets due to the purchaseclosure of new equipment to support our silicon microwave business, growth and patents being amortized. In addition, we also recorded a number of non-cash charges including $2.9$6.3 million ofexpense for stock based compensation expense as a result of adopting the provisions of SFAS 123R and a $777,000 impairment or loss on the disposal of long-lived assets in the three months ended September 25, 2005.123R.
During the first quartersix months of fiscal 2006, we used $12.6$1.0 million for servicing our working capital mostly due to higher accounts receivable, and lower accounts payable balances, which werewas partly offset by lower inventory, prepaid expense and other current assets and higher accrued expenses. As of SeptemberDecember 25, 2005, our inventory remained below our industry average at 5046 days on hand. The decrease in inventory is primarily due to higher sales and our continued efforts to manage the levels of in stock inventory.inventory levels. We normally target our accounts receivable balances to average between 45 and 60 days outstanding; however,outstanding. However, due to focused collections, our days sales outstanding was 3937 days and 32 days for the periods ended SeptemberDecember 25, 2005 and June 26, 2005, respectively, based on our monthly revenue profile calculation. Additionally, our accounts payable and accrued expenses increased by $1.2$1.7 million during the first quartersix months of fiscal 2006 primarily due to the timing of payments made to vendors.
Investing Activities:
In the first quartersix months of fiscal 2006, we used $47.2$100.1 million for investing primarily reflecting netactivities. The majority of this was attributable to $111.6 million used for the purchase of investments of $36.2 million made in securities held to maturity and $13.5$33.8 million in property and equipment and patent and licensing rights. The majority of the increase in our spendingwas related to the $44.0 million reinvestment of operating cash in marketable investments to optimize investment yield and the addition of new equipment to increase manufacturing capacity in our manufacturing facilities.
Financing Activities:
In the first quartersix months of fiscal 2006, we generated $1.2$8.5 million from financing activities. The entire amount represents proceeds that were received from the exercise of stock options during the first quarter.
As of SeptemberDecember 25, 2005, there remained approximately 5.5 million shares of our common stock approved for repurchase under a repurchase program authorized by the Board of Directors that extends through June 2006. Since the inception of our stock repurchase programs 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 purchase 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.
Fiscal 2006 Outlook:
We plan to meet the cash needs for the business for fiscal 2006 through cash from operations and cash on hand. We also plantarget 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 targetanticipate that we will needcontinue to make additional cash outlays for severance costs and possibly to buy out ouroperating lease that extendspayments on the Sunnyvale facility through November 2011. Unless we successfully negotiate a buy out of our existing lease or sublease the facility in Sunnyvale, California we may incur cash out flows of approximately $6.3 million over the next six years to satisfy those obligations.our obligation. During the second quarter of fiscal 2006, we recorded a $3.1 million charge related to an accrual for lease commitments on the Sunnyvale facility. This liability represents the fair value of the remaining lease liability based on an estimate of the present value of the remaining lease rentals reduced by an estimate of sublease rental income that may be obtained for the property through the expiration of the lease term. The expenses related to the Cree Microwave-Sunnyvale facility will continue to be presented as discontinued operations in the Company’s consolidated financial statements.
As of SeptemberDecember 25, 2005, our cash and cash equivalents and short-term investments combined increased $7.7$69.6 million, or 4%40%, over balances reported as of June 25, 2005. Our long-term investments held to maturity also increaseddecreased by $11.0$8.5 million, or 11%8%, over balances reported as of June 25, 2005. The combined $18.7net $61.1 million increase to net cash and investments resulted from profits in the first quartersix months of fiscal 2006. Our net property and equipment has decreased by $6.0$5.1 million or 2%1% since June 25, 2005 as depreciation expense more than offset investments made to expand production capacity. During the first quartersix months of fiscal 2006, we spent $12.5$31.7 million on capital additions. We target capital spending in fiscal 2006 to be in a range of $90.0 million to $110.0 million. 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. 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.
As of December 25, 2005, we held a long-term investment in the equity of Color Kinetics, which is treated for accounting purposes under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Business RisksInvestments in Debt and UncertaintiesEquity Securities” (“SFAS 115”) as an available-for-sale security. This investment is carried at fair market value based upon the quoted market price of that investment as of December 25, 2005, 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 operations if we believe that an other-than-temporary decline existed in our marketable equity securities. As of December 25, 2005, 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 December 25, 2005, using the closing sale price as of December 23, 2005, was $26.7 million, compared to the fair market value as of June 26, 2005, using the closing sale price as of June 24, 2005, which was $20.9 million.
As of December 25, 2005, we held warrants to purchase the capital stock 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. 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 the footnote, “Investments,” in the consolidated financial statements included in Part 1 Item 1 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 December 25, 2005, we had $271.2 million invested in these securities, compared to $206.3 million at June 26, 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. 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. The potential loss in fair value resulting from a hypothetical 10% decrease in quoted market price was approximately $27.1 million at December 25, 2005.
Under certain of our customer agreements, foreign currency exchange rates can affect our sales price. These contracts represent our main risk with respect to foreign currency. We have no commodity risk.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures are effective in that they provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission’s rules and forms. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate.
We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. There have been no changes to our internal control over financial reporting as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the second quarter of fiscal 2006 that we believe materially affected, or will be reasonably likely to materially affect, our internal control over financial reporting.
During the three months ended December 25, 2005, there were no material developments in the legal proceedings previously reported in our Annual Report on Form 10-K for the fiscal year ended June 26, 2005 and our Quarterly Report on Form 10-Q for the quarterly period ended September 25, 2005. Please refer to Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 26, 2005 and Part II, Item 1 of the Quarterly Report on Form 10-Q for the quarterly period ended September 25, 2005 respectively, for a description of our material legal proceedings.
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:
| · | our ability to develop, manufacture and deliver products in a timely and cost-effective manner; |
| · | variations in the amount of usable product produced during manufacturing (our “yield”); |
| · | our ability to improve yields and reduce costs in order to allow lower product pricing without margin reductions; |
| · | our ability to ramp up our subcontractor in Asia; |
| · | our ability to ramp up production for our new products; |
| · | our ability to convert our substrates used in our volume manufacturing to larger diameters; |
| · | our ability to produce higher brightness and more efficient LED products that satisfy customer design requirements; |
| · | our ability to develop new products to specifications that meet the evolving needs of our customers; |
| · | changes in demand for our products and our customers’ products; |
| · | effects of an economic slow down on consumer spending on such items as cell phones, electronic devices and automobiles; |
| · | changes in the competitive landscape, such as availability of higher brightness LED products, higher volume production and lower pricing from Asian competitors; |
| · | average sales prices for our products declining at a greater rate than anticipated; |
| · | changes in the mix of products we sell, which may vary significantly; |
| · | other companies’ inventions of new technology that may make our products obsolete; |
| · | product returns or exchanges that could impact our short-term results; |
| · | changes in purchase commitments permitted under our contracts with large customers; |
| · | changes in production capacity and variations in the utilization of that capacity; |
| · | disruptions of manufacturing that could result from damage to our manufacturing facilities from causes such as fire, flood or other casualties, particularly in the case of our single site for SiC wafer and LED production; |
| · | changes in accounting rules, such as recording expenses for stock option grants; |
| · | our policy to fully reserve for all accounts receivable balances that are more than 90 days past due, which could impact our short-term results; and |
| · | changes in Federal budget priorities could adversely affect our contract revenue. |
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 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 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 LED products and high power packaged LEDs. The successful development and introduction of these products depends on a number of factors, including the following:
| · | achievement of technology breakthroughs required to make commercially viable devices; |
| · | the accuracy of our predictions of market requirements and evolving standards; |
| · | acceptance of our new product designs; |
| · | acceptance of new technology in certain markets; |
| · | the availability of qualified development personnel; |
| · | our timely completion of product designs and development; |
| · | our ability to develop repeatable processes to manufacture new products in sufficient quantities for commercial sales; |
| · | our customers’ ability to develop applications incorporating our products; and |
| · | acceptance of our customers’ products by the market. |
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 arewere unable to growbalance customer demand and revenue to utilize our expanded capacity.
We are currently 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 from operations could be adversely impacted. For example, we are currently expanding our productionmanufacturing capacity, by adding new equipment and facilities and transitioningincluding the productionbuild out of our LED productsthe fabrication facility in Research Triangle Park, North Carolina, that we acquired from two-inch to three-inch wafers. We have committed substantial resources to these efforts. For example,a third party in the third quarter of fiscal 2005,2005. If our expansion initiative is delayed, costs more than we purchased an existing wafer fabrication facility in Research Triangle
Park, North Carolina.anticipate or requires long transition or qualification periods, our business and financial results could be harmed. If weour business does not grow fast enough to use this new capacity, our financial results could decline. We are unable to generate sufficient customer demandalso expanding capacity for our XLamp products and qualifying a subcontractor. If there are delays or unforeseen costs associated with this expansion, we wouldmay not be able to utilizeachieve 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.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 for thein sales of our high brightnesshigh-brightness LED chips used in white light applications is dependantdependent upon our customers’ ability to produce competitivedevelop efficient white LED products using our chips. Nichia Corporation, or Nichia, currently has the majority of the market share for white LEDs.LEDs and other companies, such as Toyoda Gosei Co. Ltd., have started to offer competitive blue chips and white products to compete with Nichia. The phosphor solutionspackage design that our customers have used in their products generally havehas not been as efficient as the phosphor solutiondesign that Nichia has used in its products. As a result, 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 more competitive white LED products, 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 efficient white LED products using our chips.
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 byif we experience reduced customer demand for LED products for use in mobile products. For the first half of fiscal 2005,2006, we derived nearlyapproximately one-half of our LED revenue from sales of our products into mobile appliance applications.products. In the first quarter of fiscal 2006 more than one-half of our LED revenue represented sales of our products into mobile product 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 and market trends. For example, the adoption of full color screens has driven growth in the market for LEDs for use in mobile appliances in the past. As full color screens have penetrated the mobile product market, the growth rate of demand for LEDs has slowed, thereby increasing competition among LED suppliers and putting pressure on pricing. Also, designDesign cycles in the handset 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, 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:
| · | variability in our process repeatability and control; |
| · | impurities in the materials used; |
| · | contamination of the manufacturing environment; |
| · | equipment failure, power outages or variations in the manufacturing process; |
| · | lack of adequate quality and quantity of piece parts and other raw materials; |
| · | losses from broken wafers or human errors; and |
| · | defects in packaging either within our control or at our subcontractors. |
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. 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, 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.
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 increasedincrease market share in key applications such as mobile phones.products. One major supplier dominates this market and we anticipate that the competition for these designs will be intense and may result in 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 and our ability to produce our products 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:
| · | pay substantial damages; |
| · | indemnify our customers; |
| · | stop the manufacture, use and sale of products found to be infringing; |
| · | discontinue the use of processes found to be infringing; |
| · | expend significant resources to develop non-infringing products and processes; and/or |
| · | obtain a license to use third party technology. |
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 intellectual property violations.infringement claims directed to the products we supply. Under this indemnification obligation we may be responsible for future payments to them to resolve infringement claims.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. We have grown from 680 employees on June 25, 2000 to 1,332 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:
| · | implement and improve operating systems; |
| · | maintain adequate manufacturing facilities and equipment to meet customer demand; |
| · | maintain a sufficient supply of raw materials to support our growth; |
| · | improve the skills and capabilities of our current management team; |
| · | add experienced senior level managers; |
| · | attract and retain qualified people with experience in engineering, design and technical marketing support; and |
| · | recruit and retain qualified manufacturing employees. |
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 and development and application support employees for our power, solid-state lightingLED and backlightinghigh-power businesses. If we are not successful in recruiting personnel, our projectedactual 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 greater capacity that has been added recently which would not be used.
Performance of our investments in other companies could affect our financial condition.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 conditionresults 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 materialan adverse effect on our reported net income. We currently hold an interest in one public company. We do not currently hold any interests in private companies that have a net carrying value other than a $37,000 value relating to certain 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. 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. For example, during the first quarterand second quarters of fiscal 2006, we recorded a $2.0 decrease in our income tax expense related to an unrealized capital gain on the Color Kinetics investment of $2.0 million and $132,000, respectively, which we offset against a prior year tax carry forward. In the fourth quarter of fiscal 2005, we recorded an $814,000 decrease in our tax expense related to an increase in value of our Color Kinetics investment. 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 demandIf delays occur in bringing the RTP facility on line, our financial results could suffer..
AlthoughIn the third quarter of fiscal 2005, we are taking steps to address our manufacturing capacity needs, if we are not able to increase our capacity to respond to customer demand, our business results from operations could be impacted.purchased an existing wafer fabrication facility in Research Triangle Park, North Carolina. We are exploring ways to expand our manufacturing capacity and plan to make certain expenditurescomplete our build out of the RTP facility and bring capacity for the production of high-power products online in the fourth quarter of fiscal 2006 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 impact2006. If delays are incurred, our ability to meet our customers’ demandsfuture demand for high power products and affect our operating results.contract revenue targets could be impacted.
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:
| · | incur increased costs, such as warranty expense and costs associated with customer support; |
| · | experience delays, cancellations or rescheduling of orders for our products; |
| · | write down existing inventory; or |
| · | experience product returns. |
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. For example, in fiscal 2004 we acquired the gallium nitride substrate and epitaxy business of ATMI, Inc. 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 could adversely affect our business, results of operations and financial condition.
The process of winding down our Cree Microwave business could adversely affect our results of operation.
In June 2005, we announced plans to close Cree Microwave, our silicon RF and microwave semiconductor business 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 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 longer than expected, our business could suffer.
We are actively seeking a new Chief Financial Officer in response to the August 2005 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 we secure a qualified successor but not later than mid-FebruaryMay 5, 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 a replacement, our business could also be harmed.
Litigation could adversely affect our operating results and financial condition.
We are defendants in pending litigation (as described in “Part II, Item 1. Legal Proceedings” of thisour quarterly report on Form 10-Q for the quarterly period ended September 25, 2005 and “Part II, Item 3. Legal Proceedings” of our annual report on Form 10-K for the fiscal year ended June 26, 2005) 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.
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, 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 compliance 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 have required, and we expect such efforts to continue to require, the commitment of significant financial and managerial resources. We cannot assure you that we will not discover a material weakness or significant deficiency in our internal control over financial reporting. If we discover a material weakness or significant deficiency, corrective action may be time-consuming, costly and further divert the attention of management. The disclosure of a material weakness or significant deficiency may cause our stock price to fluctuate significantly.
As of September 25, 2005, we held a long-term investment in the equity 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” (“SFAS 115”) as an available-for-sale security. This investment is carried at fair market value based upon the quoted market price of that investment as of September 25, 2005, 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 operations if we believe that an other-than-temporary decline existed in our marketable equity securities. As of September 25, 2005, 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 September 25, 2005, using the closing sale price as of September 23, 2005, was $26.3 million, compared to the fair market value as of June 26, 2005, using the closing sale price as of June 24, 2005, which was $20.9 million.
As of September 25, 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 the footnote, “Investments,” in the consolidated financial statements included in Part 1 Item 1 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 September 25, 2005, we had $240.1 million invested in these securities, compared to $206.3 million at June 26, 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 $24.0 million at September 25, 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 and Euro exchange rates against the U.S. dollar are not maintained. During the first quarter of fiscal 2006, we recognized zero 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. We have no commodity risk.
Our management,Annual Meeting of Shareholders was held on November 3, 2005. The following matters were submitted to a vote of the shareholders with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures are effective in that they provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission’s rules and forms. The officers noted that during the period covered by this Form 10-Q, as a result of human error, we were late in filing a Form 8-K pursuant to Item 1.01 (Entry into a Material Definitive Agreement) relating to the renewal of our annual management incentive plan by the compensation committee of our board of directors, but that the fact that the filing had not been made was identified through our disclosure controls and procedures. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate. results shown below:
We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. There have been no changes to our internal control over financial reporting as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the first quarter of fiscal 2006 that we believe materially affected, or will be reasonably likely to materially affect, our internal control over financial reporting. | (a) | Election of six directors, each elected to serve until the later of the next Annual Meeting of Shareholders or until such time as his successor has been duly elected and qualified. |
| Name | | Votes For | | Votes Withheld |
| Charles M. Swoboda | | 62,028,416 | | 5,541,591 |
| John W. Palmour, Ph. D. | | 62,077,136 | | 5,492,871 |
| Dolph W. von Arx | | 61,921,989 | | 5,648,018 |
| James E. Dykes | | 60,153,479 | | 7,416,528 |
| Robert J. Potter, Ph. D | | 60,164,968 | | 7,405,039 |
| Harvey A. Wagner | | 61,986,086 | | 5,583,921 |
Item 1. Legal Proceedings| (b) | Approval of the adoption of the 2005 Employee Stock Purchase Plan which replaces our 1999 Employee Stock Purchase Plan. |
In re Cree, Inc. Securities Litigation| Votes For | | Votes Against | | Abstained |
| 31,376,536 | | 9,155,079 | | 238,856 |
As reported| (c) | Approval of the amendments to the 2004 Long-Term Incentive Compensation Plan. |
| Votes For | | Votes Against | | Abstained |
| 29,359,001 | | 11,053,508 | | 357,961 |
| (d) | Ratification of the appointment of Ernst & Young LLP as independent auditors for the fiscal year ended June 25, 2006. |
| Votes For | | Votes Against | | Abstained |
| 66,439,098 | | 1,031,959 | | 98,949 |
The matters listed above are described in detail in our Annual Report on Form 10-Kdefinitive proxy statement dated September 26, 2005 for the fiscal year ended June 26, 2005, a consolidated class action was pending in the U.S. District Court for the Middle DistrictAnnual Meeting of North
Carolina seeking damages for alleged violations of securities laws by us and certain of our current and former officers and directors. In February 2004, the defendants moved that the court dismiss the consolidated amended complaintShareholders held on the grounds that it failed to state a claim upon which relief can be granted and did not satisfy the pleading requirements under applicable law. On August 30, 2004, the court entered an order granting the 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. The defendants filed a motion to dismiss this further amended complaint. On August 2, 2005, the court entered an order granting the motion to dismiss the plaintiffs’ amended complaint in its entirety with prejudice. On August 31, 2005, the plaintiffs filed an appeal of the dismissal to the U.S. Court of Appeals for the Fourth Circuit. The appeal currently is pending.
Neumark v. Cree, Inc.
We also reported in our most recent Annual Report on Form 10-K that a patent infringement action is pending against us in the U.S. District Court for the Southern District of New York. The complaint alleges that we are infringing two U.S. patents relating to wide band gap semiconductors by manufacturing, importing, using, selling and/or offering for sale LEDs and/or laser diodes created using processes claimed in the patents. On September 30, 2005, we filed an answer and counterclaims in which we deny any infringement and assert, among other defenses, that the patents are invalid and are unenforceable under the doctrine of inequitable conduct. Our counterclaims seek a declaratory judgment that we have not infringed the patents and that the patents are invalid and unenforceable.
We believe 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 a material adverse effect on our business, financial condition and results of operations.November 3, 2005.
The following exhibits are being filed herewith and are numbered in accordance with Item 601 of Regulation S-K:
| 10.1 | | Form of Master Restricted Stock Award AgreementDirector’s Deferred Compensation Plan, as amended
|
| 10.2 | | FiscalTrust Agreement between the Company and Fidelity Management Trust Company, as amended, effective as of February 1, 2006 Management
|
| 10.3 | | 2004 Long-Term Incentive Compensation Plan, as amended (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on October 21,November 8, 2005) |
10.310.4 | | Amendment dated January 18, 2006, to Letter Agreement, dated August 10, 2005, between Cynthia B. Merrell and the Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on August 12, 2005)January 18, 2006). |
| 31.1 | | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1 | | Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2 | | Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | CREE, INC. |
| | |
| | |
| Date: October 26, 2005January 31, 2006 |
| | |
| | /s/ /s/ Cynthia B. Merrell |
| | Cynthia B. Merrell |
| Chief Financial Officer and Treasurer |
| (Authorized Officer and Chief Financial and Accounting Officer) |
EXHIBIT INDEX
Exhibit No. | Description |
| 10.1 | | Form of Master Restricted Stock Award AgreementDirector’s Deferred Compensation Plan, as amended
|
| 10.2 | | FiscalTrust Agreement between the Company and Fidelity Management Trust Company, as amended, effective as of February 1, 2006 Management
|
| 10.3 | | 2004 Long-Term Incentive Compensation Plan, as amended (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on October 21,November 8, 2005) |
10.310.4 | | Amendment dated January 18, 2006, to Letter Agreement, dated August 10, 2005, between Cynthia B. Merrell and the Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on August 12, 2005) January 18, 2006). |
| 31.1 | | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2 | | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1 | | Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2 | | Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |