UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended SeptemberDecember 28, 2003

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)

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.    x  Yes    ¨  No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    x  Yes    ¨  No

The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of October 20, 2003January 16, 2004 was 74,208,423.73,739,495.

CREE, INC.

FORM 10-Q

For the Quarter Ended SeptemberDecember 28, 2003

INDEX

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PART I—I – FINANCIAL INFORMATION

Item 1—1 – Financial Statements

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)data

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

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CREE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONSINCOME

(In thousands, except per share data)

(Unaudited)

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

4

CREE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

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

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CREE, INC.

CREE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Basis of Presentation

The consolidated balance sheet as of SeptemberDecember 28, 2003, the consolidated statements of operationsincome for the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002, and the consolidated statements of cash flow for the threesix months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002 have been prepared by the Company and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to present fairly the consolidated financial position, results of operations and cash flow at SeptemberDecember 28, 2003, and for all periods presented, have been made. The consolidated balance sheet at June 29, 2003 has been derived from the audited financial statements as of that date.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. It is suggested that theseThese condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 2003 Annual Report on Form 10-K. The results of operations for the period ended SeptemberDecember 28, 2003 are not necessarily indicative of the operating results that may be attained for the entire fiscal year.

Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Cree, Inc., and its wholly-owned subsidiaries, Cree Microwave, Inc. (“Cree Microwave”), Cree Research FSC, Inc. (“FSC”), Cree Funding, LLC (“Cree Funding”), Cree Employee Services Corporation, Cree Technologies, Inc., CI Holdings, Limited, Cree Asia-Pacific, Inc. and Cree Japan, Inc. All material intercompany accounts and transactions have been eliminated in consolidation.

Business Segments

The Company operates in two business segments, Cree and Cree Microwave. The Cree segment incorporates its proprietary technology to produce wide bandgap compound semiconductors using silicon carbide, or SiC, and group III nitrides, or GaN, technology. Products from this segment are used in mobile appliances, automotive backlighting, indicator lamps, full color LED displays and other lighting applications as well as microwave and power applications. The Cree segment also sells SiC material products to corporate, government and university research laboratories and generates revenue from contracts with agencies of the U.S. Federal government.

The Cree Microwave segment designs, manufactures and markets a line of silicon-based laterally diffused metal oxide semiconductors (“LDMOS”) and bipolar radio frequency power semiconductors and modules, a critical component utilized in building power amplifiers for wireless infrastructure applications.

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Summarized financial information concerning the reportable segments as of and for the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002 isare shown in the following table.tables. There were no intercompany sales between the Cree segment and the Cree Microwave segment during the comparative periods. The “Other” column represents amounts excluded from specific segments such as interest income, write-downs for investments made in marketable equity securities or long-term investments held to maturity and gains or losses on the sale of marketable securities. In addition, the “Other” column also includes corporate assets such as cash and cash equivalents, short-term investments held to maturity, marketable securities, interest receivable and long-term investments held to maturity which have not been allocated to a specific segment.

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Reclassifications

Certain fiscal 2003 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2004 presentation. These reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.

Fiscal Year

The Company’s fiscal year is a 52-or 53-week period ending on the last Sunday in the month of June. The Company’s 2004 fiscal year extends from June 30, 2003 through June 28,27, 2004 and is a 52-week fiscal year. The Company’s 2003 fiscal year extended from July 1, 2002 through June 29, 2003 and was a 52-week fiscal year.

Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at SeptemberDecember 28, 2003 and June 29, 2003, and the reported amounts of revenues and expenses during the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002. Actual amounts could differ from those estimates.

Revenue Recognition

Revenue on product sales is recognized when persuasive evidence of a contract exists, such as when a purchase order or contract is received from the customer, the price is fixed, title of the goods has transferred and there is a reasonable assurance of collection of the sales proceeds. The Company obtains written purchase authorizations from its customers for a specified amount of product at a specified price and considers delivery to have occurred at the time of shipment. The

majority of the Company’s products have shipping terms that are FOB or FCA shipping point, which means that the Company fulfills the obligation to deliver when the goods are handed over and into the charge of the carrier at its shipping dock. This means that the buyer bears all costs and risks of loss or damage to the goods from that point. The difference between FOB and FCA is that under FCA terms the customer designates a shipping carrier of choice to be used. In certain cases, the Company ships its product Cost Insurance Freight (“CIF”).CIF. Under this arrangement, revenue is recognized under FOB shipping point shipping terms; however, the

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Company is responsible for the cost of insurance during shipment as well as the cost to ship the product.

For all of its sales other than those with CIF terms, the Company invoices its customers only for shipping costs necessary to physically move the product from its place of business to the customer’s location. The costs primarily consist of overnight shipping charges. The Company incurs the direct shipping costs on behalf of the customer and invoices the customer to obtain direct reimbursement for such costs. The Company accounts for its shipping costs by recording the amount of freight that is invoiced to its customers as revenue, with the corresponding cost recorded as cost of revenue. For the three and six months ended December 28, 2003, amounts recognized as revenue for shipping and handling costs were $26,000 and $52,000, respectively. In fiscal 2003, shipping costs were not material and the Company accounted for such costs as a cost of revenue with the reimbursement of these costs reflected as a direct offset and reduction of cost of revenue. If inventory is maintained at a consigned location, revenue is recognized when the Company’s customer pulls product for its use.

The Company provides its customers with limited rights of return for non-conforming shipments and warranty claims for up to 36 months for Cree Microwave products and for lesser periods for Cree products.claims. The Company accrues estimated warranty expense as a cost of revenue. The Company records a reserve for estimated sales returns, which is reflected as a reduction of revenue at the time of revenue recognition. Certain of the Company’s distributorcustomer arrangements provide for limited product exchanges and reimbursement of certain sales costs. For one distributor,two customers, with these arrangements, the Company defers revenue equal to the level specified in these contractual arrangements and recognizes the related revenue less any claims made against the reserves when the distributor’scustomer’s exchange rights expire and the deferred revenue reserves are released. The reserve expires no later than two quarters from the date of the original sale. In connection with the Company’s distributor agreement with Sumitomo Corporation (“Sumitomo”), such deferred revenue amounted to $6.8$7.9 million and $5.3 million as of SeptemberDecember 28, 2003 and June 29, 2003, respectively. In connection with the Company’s purchase agreement with OSRAM Opto Semiconductors Gmbh (“Osram”), such deferred revenue amounted to $0.2 million and $0 as of December 28, 2003 and June 29, 2003, respectively.

Historically, the Company has experienced only nominal credit losses from customers’ inability to pay. Any uncollectibility of receivables is primarily due to returned products. Therefore, the Company records an allowance for sales returns at the time of sale. Significant judgments and estimates made by management are used in connection with establishing the allowance for sales returns. Material differences may result in the actual amount and timing of the Company’s revenue for any period in which management made different judgments or utilized different estimates. The allowance for sales returns at SeptemberDecember 28, 2003 and June 29, 2003 was $696,000$970,000 and $644,000, respectively.

Revenue from government contracts and certain private entities is recorded on the percentage-of-completionproportional performance method as contract expenses are incurred. Contract revenue represents contracts

with various U.S. Government entities and certain private entities to perform research and development work related to the development of the Company’s technologies. The contract funding may be based on either a cost-plus or a cost-share arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set percentage margin. The applicable contracts generally provide that the Company may elect to retain ownership of inventions made in performing the work, subject to a non-exclusive license retained by the government or funding entity to practice the inventions for governmentlimited purposes. Contract revenue includes funding of direct research and development costs and a portion of the Company’s general and administrative expenses and other operating expenses for contracts under which funding is expected to exceed direct costs over the life of the contract. The specific reimbursement provisions of the contracts, including the portion of the Company’s general and administrative expenses and other reimbursable operating expenses vary by contract. Such

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reimbursements are recorded as contract revenue. For contracts under which the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract (i.e., certain cost share arrangements), the Company reports direct costs as research and development expenses with related reimbursements recorded as an offset to those expenses.

Cash and Cash Equivalents

Cash and cash equivalents consist of unrestricted cash accounts and liquid investments with an original maturity of three months or less when purchased.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, accounts and interest receivable, accounts payable and other liabilities approximate fair values at SeptemberDecember 28, 2003 and June 29, 2003.

Investments

Investments are accounted for using the specific identification method and in accordance with Statement of Financial Accounting Standards (“SFAS”) 115 “Accounting for Certain Investments in Debt and Equity Securities”. This statement requires certain securities to be classified into three categories:

At December 28, 2003, the Company held no marketable securities. During the second quarter of fiscal 2003, the Company sold its remaining position in two publicly traded companies. The first company was Microvision, Inc. (“Microvision”) and the second one was Emcore Corporation (“Emcore”). Prior to the sales, the Company owned 356,000 common shares of Microvision at a total cost of $14.3 million and 691,000 shares of Emcore at a total cost of $13.8 million. In June 2002, the Company recorded a charge through non-operating expense on the consolidated statement of operations for an “other than temporary” decline in value which reduced the value of the Microvision investment to $1.9 million, which was the market value as of June 28, 2002. These shares were sold during the three months ended December 29, 2002 for $1.9 million, with a net loss on the sale recognized for $36,000.

During the second quarter of fiscal 2003, the Company also sold 691,000 common shares of Emcore. These shares were purchased between June 2001 and October 2001. The Company recorded a charge through non-operating expense on the consolidated statements of operations in June 2002 for an “other than temporary” decline in value that reduced the value of this investment to $4.1 million, which was the market value as of June 28, 2002. These shares were sold during the three months ended December 29, 2002 for $2.1 million, with a net loss on the sale recognized for $2.0 million during the second quarter of fiscal 2003.

Management viewed these investments as strategic in nature and therefore the shares were accounted for as “available-for-sale” securities under SFAS 115. The Company carried these investments at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, were included in accumulated other comprehensive income (loss), which is reflected as a separate component of shareholders’ equity. Realized gains and losses are recognized upon sale or when declines in value are deemed to be “other than temporary” on the consolidated statements of income. The Company reviews equity holdings on a regular basis to evaluate whether or not each security has experienced an “other-than-temporary” decline in fair value. This policy requires, among other things, to review each of the companies’ cash position, earnings\revenue outlook, stock price performance, liquidity, ability to raise capital and management\ownership. Based on this review, if the Company determined that an “other-than-temporary” decline existed in the value of marketable equity securities, it is the Company’s policy to write-down these equity investments to the respective market value. Any related write-down would then be recorded as an investment loss on the Company’s consolidated statements of income. In the fourth quarter of fiscal 2002, the Company determined that an “other-than-temporary” decline in market value had occurred in both of these marketable equity investments. Accordingly, the Company wrote down these equity investments to their market values at June 30, 2002 and recorded the unrealized losses, previously recorded as a comprehensive loss in shareholders’ equity, as a non-operating loss on our consolidated statements of operations for the year then ended. The total amount of the charge to non-operating expenses in the consolidated statements of operations for the year ended June 30, 2002 relating to these investments was $22.0 million.

As of SeptemberDecember 28, 2003 and June 29, 2003, the Company had investments in the equity of privately held companies with carrying values of $15.6 million for each period. These privately held investments are accounted for under the cost method and are included in “other assets” in the consolidated balance sheets.

Inventories

Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out (“FIFO”) method for finished goods and work in process accounts. The Company uses the average cost method for raw materials for the Cree segment. The Cree Microwave segment uses a standard cost method to value its inventory. It is the Company’s policy to record a reserve against inventory once it has been determined that conditions exist which may not allow the Company to sell the inventory for its intended purpose, the inventory’s value is determined to be less than cost, or it is determined to be obsolete. The charge for the inventory reserves is recorded in cost of revenue on the consolidated statement of operations.income. The Company evaluates

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inventory levels quarterly against sales forecasts on a part-by-part basis, in addition to determining its overall inventory risk. Reserves are adjusted to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management.

As of SeptemberDecember 28, 2003, the Company maintained a $1.7$1.1 million reserve for inventory. Of this total amount, $1.4 million$837,000 is attributable to the Cree Microwave segment and $339,000$290,000 is attributable to the Cree segment.

The majority of the allowance at Cree Microwave was recorded during the second quarter of fiscal 2003 resulting from the termination of the supply agreement with Spectrian Corporation (“Spectrian”). In exchange for a one-time payment of $5.0 million recorded as “other operating income” on the consolidated statements of operations,income, the Company relieved Spectrian of further obligations to purchase product under the supply agreement that was originally signed in December 2000. For the three months ended December 29, 2002, Cree Microwave recorded an additional reserve of $1.3 million for inventory targeted for sale to Spectrian, which included some customized parts. Additional reserves of $5.1 million were recorded in the third quarter of fiscal 2002, as contract negotiations at the time with Spectrian indicated that several parts on hand would not be salable.saleable. During these contract negotiations, Spectrian indicated that it would only purchase new generation LDMOS8 and certain types of LDMOS7 devices from Cree Microwave after the fourth quarter of fiscal 2002. As a result, the Company fully reserved for inventories of non-LDMOS and other older devices maintained for Spectrian. The Company destroyed the majority of this inventory previously reserved during the fourth quarter of fiscal 2002, and fiscal 2003 and the second quarter of fiscal 2004, and as a result, the related items were taken out of inventory and the related reserve. There was no financial impact to the statement of operationsincome when these items were destroyed. The Company still maintains some packaging materials originallyinventory included in the reserve that are no longer available from third party suppliers or are available only with lengthy lead timeframes. The Company also has “last time buy” contracts with Remec, Inc. (which purchased Spectrian) for devices that use these packages.this inventory. However, the Company plans to dispose of thesethis remaining packagesinventory when the “last time buy” rights expire. Therefore, with the exception of certain package materialsinventory covered under “last time buy” obligations, all items previously reserved atin the March 2002 and December 2002 quarters have now been scrapped and removed from inventory and the related reserve account. These reserves were recorded as a cost of revenue when they were established. In addition, $417,000 of LDMOS8 product was also written off as a research and development expenditure during the first quarter of fiscal 2003 as it related to prototype devices that were initially accepted by Spectrian and later rejected. These parts were never sold.

Cree segment results for the three months ended December 29, 2002 include a $784,000 additional reserve for LED and wafer inventories as management assessed the inventory to be slow moving or obsolete. During the first quarter of fiscal 2003, the Company recorded a $185,000 lower of cost or market adjustment to certain LED products based on management’s estimate of an average sales price for the products. This adjustment was recorded to cost of revenue. During the first quarter of fiscal 2003, the Company wrote-off $1.0 million of the initial XBright chips that were developed during fiscal 2002. An improved chip has replaced these devices and this write down was recorded as a research and development expense as the initial devices were prematurely launched and not commercially viable. In addition, customers had returned the entire product line that was initially shipped after determining that the chips did not meet their specifications.

The following is a summary of inventory (in thousands):

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Property and Equipment

Property and equipment are recorded at cost and depreciated on a straight-line basis over the estimated useful lives of the assets, which range from three to forty years. Leasehold improvements are amortized over the lesser of the asset life or the life of the related lease. Expenditures for repairs and maintenance are charged to expense as incurred. The costs for major renewals and improvements are capitalized and depreciated over their estimated useful lives. The cost and related accumulated depreciation of the assets are removed from the accounts upon disposition and any resulting gain or loss is reflected in operations.

Impairment of Long-Lived Assets

In accordance with SFAS 144, the Company reviews long-lived assets for impairment based on changes in circumstances that indicate their carrying amounts may not be recoverable. The Company reviews the discountedan undiscounted cash flow analysis for the Cree Microwave segment to test for impairment of its assets on a quarterly basis. During the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002, there was no impairment recorded on these assets. There can be no assurance that future analysis of Cree Microwave’s discounted cash flow will not result in a charge to earnings.

During the three months ended December 28, 2003, the Company’s Cree Microwave segment identified certain equipment to be sold, which had a carrying value in excess of its fair market value. The Company recorded a charge of $143,000 as of December 28, 2003, which has been reflected within the impairment of property and equipment in the consolidated statement of income.

Patent and License Rights

Patent rights reflect costs incurred to enhance and maintain the Company’s intellectual property position. License rights reflect costs incurred to use the intellectual property of others. Both are amortized on a straight-line basis over the lesser of 20 years from the date of patent application or over the license period. The related amortization expense was $183,000$204,000 and $45,000$387,000 for the three and six months ended SeptemberDecember 28, 2003, respectively. The related amortization expense was $110,000 and September$155,000 for the three and six months ended December 29, 2002, respectively.

Research and Development

The U.S. Government providesand certain private entities provide funding through research contracts for several of the Company’s current research and development efforts. The contract funding may be based on either a cost-plus or a cost-share arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set percentage margin. For the cost-share contracts, the actual costs are divided between the U.S. Government or other funding entity and the Company based on the terms of the contract. The government’sfunding party’s cost share is then paid to the Company. Activities performed under these arrangements include research regarding SiC and GaN materials and devices. The contracts

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typically require the submission of a written report documenting the results of such research, as well as some material deliverables.

The revenue and expense classification for contract activities is based on the nature of the contract. For contracts where the Company anticipates that funding will exceed direct costs over the life of the contract, funding is reported as contract revenue and all direct costs are reported as costs of contract revenue. For contracts under which the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding as an offset of those expenses. For the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002, there were no contracts for which direct expenses exceeded funding.

Non-government contract relatedCompany funded research and development is expensed as incurred. Customers did not contribute funds toward product research and development activities during fiscal 2004. Customers contributed $0 and $500,000 for the threesix months ended September 28, 2003 and SeptemberDecember 29, 2002, toward product research and development activities. These amounts wereThis amount was recorded as an offset to research and development expense. As of September 28,December 29, 2003, there werewas no non-government customerproduct research and development commitments recorded as a reduction to research and development expenses to fund future research and development activities for the Company.

Income Taxes

The Company has established an estimated tax provision based upon an effective rate of 31% for the three and six months ended SeptemberDecember 28, 2003. The Company’s effective tax rate was 26% for the three and six months ended SeptemberDecember 29, 2002. The estimated effective rate was based upon estimates of income for the fiscal year and the Company’s ability to use remaining net operating loss carryforwards and other tax credits. However, the actual effective rate may vary

depending upon actual pre-tax book income for the year and other factors. Income taxes have been accounted for using the liability method in accordance with SFAS 109 “Accounting for Income Taxes”. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts.

Stock Options

The Company accounts for stock based employee compensation under APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and does not intend to adopt the fair value method of accounting for stock based employee compensation defined by Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”). The Company has adopted stock plans under which options for the purchase of common stock have been granted to employees and directors of the Company. The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS 123, as amended (in thousands, except per share amounts):

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On March 17, 2003, the Company made an offer to exchange options to purchase an aggregate of 3,482,128 shares of the Company’s common stock held by eligible employees (the “Offer”). Directors and executive officers were not eligible to participate in the Offer. The options subject to the Offer were granted under the Company’s Equity Compensation Plan and 2001 Stock Option Bonus Plan at exercise prices greater than $30.00 per share. The Offer, including all withdrawal rights, expired at 12:00 midnight Eastern Time on Friday, April 11, 2003. On April 12, 2003, the Company accepted for cancellation options to purchase 1,663,600 shares of its common stock, tendered by 91 eligible employees, representing approximately 48% of the options that were eligible to be tendered in the Offer. Subject to the terms and conditions of the Offer, the Company granted new options to purchase approximately 562,852 shares of its common stock on October 13, 2003 in exchange for the options tendered and accepted. The new options were granted under the Company’s Equity Compensation Plan with an exercise price equal to the last sale price of the Company’s common stock reported by the Nasdaq National Market on the new option grant date or $19.88 per share. The new options will not vest for six months after the new option grant date after which the vesting schedule of each new option will be the same as the corresponding canceled option in percentage terms.

Shareholders’ Equity

On January 18, 2001, Cree announced that its Board of Directors had authorized the repurchase of up to four million shares of its outstanding common stock through January 2002. Additionally, on March 22, 2001, Cree announced that its Board of Directors had increased the repurchase limits under the stock repurchase program announced in January 2001 to include an additional three million shares. During the second quarter of fiscal 2004, the Company repurchased 664,000 shares at an average price of $17.35 per share with an aggregate value of approximately $11.5 million. Since the inception of the stock repurchase program, Cree has repurchased 4.0 million shares of its common stock at an average price of $15.61 per share, with an aggregate value of $62.5 million.

The Company intends to use available cash to finance purchases under the program. At the discretion of the Company’s management, the repurchase program can be implemented through open market or privately negotiated transactions. The Company will determine the time and extent of repurchases based on its evaluation of market conditions and other factors.

Contingencies

Eric Hunter and Jocelyn Hunter v. Cree, Inc. and F. Neal Hunter

As reported in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003, on June 12, 2003, Eric Hunter, and his wife Jocelyn Hunter filed a lawsuit in United StatesU.S. District Court for the Middle District of North Carolina naming as defendants the CompanyCree and Neal Hunter, Eric Hunter’s brother and our current chairman. The court on November 25, 2003 entered a final judgement and order dismissing the lawsuit against all

defendants pursuant to a settlement agreement between Eric and Jocelyn Hunter and Cree. The agreement did not require any payments to the plaintiffs. In connection with the settlement, Cree accepted Eric Hunter’s resignation as an employee effective November 24, 2003. His remaining stock options were terminated, except that options were vested with respect to a portion of the shares, prorated to the date of his resignation, that were otherwise scheduled to vest in May 2004. Accordingly, Cree recognized $152,000 of additional compensation expense during the three months ended December 28, 2003 in connection with the vesting of these stock options.

Shareholder Lawsuits

As reported in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003, between June 16 and August 18, 2003, nineteen complaints claiming violations of securities laws were filed in the U.S. District Court for the Middle District of North Carolina against Cree and certain of our officers and current and former directors. On October 9,December 17, 2003, the plaintiffs stated,court entered an order consolidating these actions for pre-trial purposes and appointing a lead plaintiff and lead counsel for the consolidated cases. The lead plaintiff filed a consolidated amended complaint on January 16, 2004. The amended complaint asserts, among other claims, violations of federal securities laws, including violations of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5, and violations of Section 20(a) and Section 18 of the Exchange Act against the individual defendants and also asserts claims against certain of our officers under Section 304 of the Sarbanes-Oxley Act of 2002. The amended complaint alleges that we made false and misleading statements concerning our investments in certain public and privately held companies, our acquisition of the UltraRF division of Spectrian Corporation (“Spectrian”), our supply agreement with Spectrian, our agreements with C&C, and our employment relationship with Eric Hunter and that our financial statements did not comply with the requirements of the securities laws during the class period. The amended complaint requests certification of a court filing opposingplaintiff class consisting of purchasers of Cree stock between August 12, 1998 and June 13, 2003 and seeks, among other relief, unspecified damages and disgorgement of profits by the individual defendants, plus costs and expenses, including attorneys’, accountants’ and experts’ fees. We intend to defend these cases vigorously.

On November 4, 2003, an individual claiming to be a shareholder of Cree filed a purported derivative complaint in the U.S. District Court for the Middle District of North Carolina naming as defendants members of our motion to dismiss theboard of directors and naming Cree as a nominal defendant. The derivative complaint that they had decided to dismiss without prejudice theasserts claims against the Companyindividual defendants, nominally on Cree’s behalf, for breach of fiduciary duty, abuse of control, waste of corporate assets and Neal Hunter alleging federal securities fraud and unfair or deceptive trade practices. On October 15, 2003, the Hunters filed a notice of voluntary dismissal without prejudiceindemnification. The factual allegations of the federal securities fraud claims against the Companyderivative complaint allege and Neal Hunter and a voluntary dismissal without prejudice of all claims against all other defendants. As to the remaining claims of the complaint the plaintiffs opposed our motion to dismiss, which is pending before the court. We will continue to vigorously defend the litigation.

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As a result of the commencement of the litigation, on June 14, 2003, our Board of Directors established a special committee, comprised of independent directors Dr. Robert J. Potter and Mr. William J. O’Meara, to investigaterepeat, in large part, the allegations of corporate wrongdoing madethe shareholder securities lawsuits filed between June and August 2003, which have now been consolidated as set forth above. The derivative complaint seeks, among other relief, unspecified damages from the individual defendants, including statutory treble damages, and an order requiring defendants to repay their salaries and other compensation received for the periods when they allegedly breached their fiduciary duties. At a hearing held November 25, 2003, the court directed that discovery in the complaintderivative action would follow the same schedule as in the consolidated securities lawsuits.

Other Legal Proceedings

During the three months ended December 28, 2003, there were no other material developments in the legal proceedings previously reported in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003 and in certain pre-litigation correspondence. On October 10, 2003, we announced thatour Quarterly Report on Form 10-Q for the special committee had completed its investigation. The special committee’s report indicated that it did not discover any evidencethree-month period ended September 28, 2003. Please refer to support anyItem 3 of the allegationsForm 10-K for the fiscal year ended June 29, 2003 and concluded based upon its investigation that allItem 1 of the allegations lack merit.10-Q for the quarterly period ended September 28, 2003 for a description of other material legal proceedings pending through December 28, 2003.

The Company is also involved in various other legal proceedings.proceedings not described in this report or in the reports noted above. Although the final resolution of these other matters cannot be determined,predicted with certainty, management’s opinionpresent judgment is that the final outcome of these other matters will not likely have a material adverse effect on the Company’s consolidated financial positioncondition or results of operations. If an unfavorable resolution occurs in these legal proceedings, our businessfinancial condition and results of operations and financial condition could be materially adversely affected.

Earnings (loss) per sharePer Share

The following computation reconciles the differences between the basic and diluted earnings per share presentations:

Potential common shares that would have the effect of increasing diluted earnings per share are considered to be antidilutive. In accordance with SFAS 128, “Earnings Per Share”, these shares were not included in calculating diluted earnings per share. For the three and six months ending SeptemberDecember 28, 2003, there were 9.0 million and September8.4 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive. For the three and six months ending December 29, 2002, there were 8.09.8 million and 10.910.2 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive.

Recent Accounting Pronouncements

In July 2002, the FASB issued Statement of Financial Accounting Standards 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146, which

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nullified EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”, requires that a liability for a cost associated with an exit or disposal activity be recognized when

the liability is incurred. Under EITF Issue 94-3, a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Company has adopted SFAS 146 for fiscal 2004 and does not expect the adoption of SFAS 146 todid not have a material impact on the Company’s consolidated results of operations or financial position or cash flows.

In December 2002, the FASBEmerging Issues Task Force, (“EITF”), issued Statement of Financial Accounting Standards No. 148,EITF Issue 00-21, “Accounting for Stock-Based Compensation, TransitionRevenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 provides guidance to determine whether revenue arrangements contains multiple deliverable items and Disclosure” (“SFAS 148”). SFAS 148 provides alternative methods of transition for a voluntary change toif so, requires that revenue be allocated amongst the different items based on fair value based method of accounting for stock-based employee compensation. SFAS 148value. EIFT 00-21 also requires that disclosuresrevenue on any item in a revenue arrangement with multiple deliverables not delivered completely must be deferred until delivery of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently anditems is completed. The guidance in a tabular format. Additionally, SFAS 148 requires disclosure of the pro forma effect in interim financial statements. The transition disclosure requirements of SFAS 148 areEITF 00-21 is effective for revenue arrangements entered into in fiscal year 2004. The interim and annual disclosure requirements were effective for the third quarter ofperiods beginning after June 15, 2003. The adoption of SFAS 148 did not have a material effect on the Company’s financial condition, results of operations or cash flows.

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees” (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation it has undertaken in issuing the guarantee. The Company will apply FIN 45 to guarantees, if any, issued after December 28, 2002. At adoption, FIN 45EITF 00-21 did not have a material impact on the Company’s consolidated financial position or results of operations or financial position.operations.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 requires an investor with a majority of the variable interests in a variable interest entity (“VIE”) to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A VIE is an entity in which the equity investors do not have a controlling interest, or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. For arrangements entered into with VIEs created prior to January 31, 2003, the provisions of FIN 46 are required to be adopted at the beginning of the first interim or annual period beginning after December 15, 2003. The Company is currently reviewing its investments and other arrangements to determine whether any of its investee companies are VIEs. The Companyhas determined that it does not expect to identifyhave any significantinvestments in VIEs, therefore, there are no VIEs that would be consolidated, but may be required to make additional disclosures.consolidated. The provisions of FIN 46 are effective immediately for all arrangements entered into with new VIEs created after January 31, 2003. The Company has not invested in any new VIEs createdcompanies after January 31, 2003.

16In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liability and Equity” (“SFAS 150”). This statement established standards for classifying and measuring liabilities certain financial instruments that have the characteristics of both liabilities and equity. The provisions of this statement require that any financial instruments that are mandatorily redeemed on a fixed or determinable date or upon an event certain to occur be classified as liabilities. This statement was effective immediately for instruments entered into or modified after May 31, 2003 and for all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15, 2003. The Company adopted SFAS No. 150 during the three months ended September 28, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s consolidated financial condition or results of operations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

All information contained in the following discussion 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. We caution that such forward-looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those forward-looking statements. These factors include, but are not limited to, risks associated with our pending securities and other litigation, such as the considerable management time and attention required and substantial expenses incurred regardless of its outcome and the potential impact of an adverse result of the lawsuits filed against us and certain named executives and directors. In addition, the Securities and Exchange Commission or SEC,(“SEC”), has requested that we provide information in response to an informal inquiry. Furthermore, our actual operating results could differ materially due to a number of additional factors, including potential changes in demand; the risk that price stability, improved operational efficiencies, and the favorable product mix we are subjecthave recently experienced will not continue; the risk that, due to the complexity of our manufacturing process, 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 our production ramp-up for our new products; the risk that we will be unable to manufacture products with sufficiently low cost to offer them at competitive prices or with acceptable margins; and the rapid development of new technology and competing products that may impair demand or render our products obsolete; and the potential lack of customer acceptance for theour products. See Exhibit 99.1 for further discussion of factors that could cause our actual results to differ.

Business Overview

We develop and manufacture compound semiconductor materials and electronic devices made from silicon carbide, or SiC and Group III nitrides, or GaN. We derive the largest portion of our revenue from the sale of blue, green and near ultraviolet or UV light emitting diodes or LEDs. We currently offer LEDs at three brightness levels:

Our LED devices are used by manufacturers as a lighting source for mobile appliances, automotive dashboard lighting, indicator lamps, miniature white lights, indoor and outdoor full color displays and signs, traffic signals and other lighting applications. LED products represented 76%78% and 73%77% of our revenue for the three and six months ended SeptemberDecember 28, 2003, respectively. LED products represented 74% of our revenue for the three and Septembersix months ended December 29, 2002, respectively.

We also derive revenue from the sale of SiC materials products. We sell semiconductor wafers made from SiC that our customers use for manufacturing LEDs and power devices or for research and development. Sales of SiC wafer products represented 8% of our revenue for the

three and six months ended SeptemberDecember 28, 2003, respectively. Sales of SiC wafer products represented 7% and September8% of our revenue for the three and six months ended December 29, 2002, respectively. We also sell SiC materials in bulk crystal form for use in gemstones to Charles & Colvard, Ltd., or (“C&C.&C”). Sales of SiC crystals for gemstones represented 2%1% and 3%2% of our revenue for the three and six months ended

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September December 28, 2003, respectively. Sales of SiC crystals for gemstones represented 4% of our revenue for the three and Septembersix months ended December 29, 2002, respectively. Our other products include SiC-based power and radio frequency, or RF devices. We received 2% of total revenue from sales of power devices and SiC-based RF devices combined for the three and six months ended December 28, 2003, respectively. We received less than 1% of total revenue from sales of power devices and SiC basedSiC-based RF devices combined for the three and six months ended September 28, 2003 and SeptemberDecember 29, 2002.2002, respectively.

Through our Cree Microwave segment, we develop and manufacture RF power transistors and modules using silicon technologies. These RF power transistors are a key semiconductor component for power amplifiers that are used in base stations for wireless networks. We received 3% and 2% of total revenue from sales from the Cree Microwave segment for the three and six months ended December 28, 2003, respectively. We received 1% of total revenue from sales from the Cree Microwave segment for the three and six months ended September 28, 2003 and SeptemberDecember 29, 2002, respectively.

The balance of our revenue, 11%8% and 14%9% for the three and six months ended SeptemberDecember 28, 2003, and September 29, 2002, respectively, was derived primarily from contract research funding. For the three and six months ended December 29, 2002, revenue from contract research funding was approximately 14% and 13%, respectively. Under various programs, U.S. Government entities and certain private entities assist us in the development of new technology by funding our research and development efforts. Contract revenue includes funding for direct research and development costs and a portion of our general and administrative expenses and other operating expenses for contracts under which we expect funding to exceed direct costs over the life of the contract. For contracts under which we anticipate that direct costs will exceed amounts to be funded over the life of the contract, we report direct costs as research and development expenses with related reimbursements recorded as an offset to those expenses. For the three and six months ended SeptemberDecember 28, 2003 and SeptemberDecember 29, 2002, we did not have any contracts for which we anticipated direct costs to exceed funding over the life of the contract.

On September 26, 2003, we entered into a purchase agreement with OSRAM Opto Semiconductors GmbH, or Osram, for the purchase of a minimum of 500 million LEDs over a 21-month period commencing October 2003 and extending through June 2005. The agreement also provides for the purchase of a specified number of silicon carbide wafers during this 21-month period. Osram may decrease or terminate its minimum purchase commitments if product prices offered by Cree in future periods exceed a specified range and the parties are unable to mutually agree on pricing. The agreement provides for liquidated damages in the event that we fail to timely ship products ordered by Osram.

The Osram agreement also requires us to establish a rolling reserve based upon a percentage of the total purchase price of all LED products purchased under the agreement. This reserve would be used to reimburse Osram for certain warranty-related expenses incurred in connection with our products. If Osram makes a valid claim against this reserve, we would write off the amount of the claim against the reserve. Except to the extent that Osram would make a valid claim against the reserve, amounts added to these reserve during a fiscal quarter will expire on a rolling basis by the end of the fifth calendar month following the calendar month in which the LED products were shipped. We would recognize revenue equal to the expired amount at that time.

Product Overview

Our LED revenue and units sold increased 42%34% and 76%66%, respectively, in the firstsecond quarter of fiscal 2004 respectively, over the comparative period of the prior year comparative period. We saw the most significant increaseyear. Overall, we experienced sequential revenue growth in both our mid and high brightness product sales in our mid-brightness LEDs, which our customers estimate were to be used mostly in the keypads and displays of handheld mobile appliances. Mid-brightness products made up 87% of our LED revenue incategories from the first to the second quarter of fiscal 2004. DuringWe succeeded in the firstsecond quarter of fiscal

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2004, we also ramped up production ofgrowing revenues from our RazerThin^™, MegaBright^® green and MegaBright^® Plus LEDblue products. Based on conversations with our customers, we believe that many of our blue products which contributedare being used by our customers to our increased revenue in the quarter asmake white LEDs for LCD backlights, camera flashes and keypad backlights for several major phone manufacturers. Our sales of these products made up more than 7% of our LED salesmid brightness product for the low cost blue keypad backlight market also remained strong during the first quarter of fiscal 2004.second quarter.

We have continued to work with our customers toward gaining design wins usingto develop and expand our XBright LEDs.X-class products for specific markets and packaging appliances. The X-class of LED products includes XBright^®

blue and green, XBright^® Plus blue and XThin^® blue and green. The X-class product family targets applications that include miniature white lights, traffic signals, video screens and video screens.backlighting for mobile appliances. The XBrightX-class LED technology incorporates a junction down design and utilizes the optical benefits of SiC, while maintaining the advantages of our vertical structure with a single top contact. This design allows for a standard size chip similar to our other LED devices, however, it presents significantpresented packaging challenges for many of our traditional customers. We have made progress working withcustomers over the past year. Recently, our customers to address die attachment issues in the packaging process they encounteredare having more success using our X-class products as we target increased business for both our XBright products. As a result, XBright LEDs comprised 4% of LED revenue during firstand XThin products for the third quarter of fiscal year 2004. With the recent introduction of our new brighter XT-15 and XT-18 chips, we expect the XThin product family to become a larger part of our business, especially for use in white LEDs for mobile appliances. These products build on the XThin platform and deliver brightness up to 22mW with the low forward voltage and thin design of our other XThin products. Overall, we have continued to see strong demand for our high brightness products and look to expand this category in future quarters.

For the high volume, price sensitive keypad market we are developing a new lower cost product called the UT230, which we have recently started sampling to select customers. We are workingaim to develop a lower temperature die attach compatiblerelease this mid-brightness product to address someproduction in the third quarter of our customer’s needs. Consequently, we are targeting that sales of XBright products will increase in fiscal 2004.

Shipments of our standard brightness devices remained stable in the firstsecond quarter of fiscal 2004 and were supported by automotive and indicator light designs from a number of customers. ForDuring the firstsecond quarter of fiscal 2004, our standard brightness, products were approximately 9%mid-brightness and high brightness parts made up 8%, 46% and 46% of our LED revenue.revenue, respectively.

During the three months ended SeptemberDecember 28, 2003, SiC materials revenue increased 33%50% over the prior year comparative period due to a 65%71% increase in the number of wafers sold. The higher volume resulted from increased sales to volume customersOSRAM Opto Semiconductors Gmbh (“Osram”) who useuses our products for commercial applications, and a higher demand for SiC from customers using our wafers for research.epi wafers. Revenue from sales of SiC materials for use in gemstones was 20%50% lower in the firstsecond quarter of fiscal 2004 as compared to the prior year period due to lower yields of usable material per crystal which reduced our average sales price received from C&C. Materials sold for use in gemstones were 2% of our overall revenue for the three months ended September 28, 2003.yields.

Revenue from silicon-based microwave products increased 79%163% in the firstsecond quarter of fiscal 2004 as compared to the prior year period as we gained new design winssaw increased demand for our newer Laterally Diffused Metal Oxide Semiconductors or LDMOS,(“LDMOS”) from several customers. The new business is coming from both the cellular infrastructure amplifier market and module products.the Military and Aeronautics (“Mil/Aero”) markets. We received 2% of total revenue from sales of power devices and SiC-based RF devices combined for the three and six months ended December 28, 2003, respectively. We received less than 1% of total revenue from sales of power devices and SiC-based RF devices combined for the three and six months ended December 29, 2002, respectively. We have recently increased our sales of SiC power semiconductors to a large power supply customer and have increased sales of SiC RF devices and foundry services

Government contract revenue increased 6%decreased 19% for the three months ended SeptemberDecember 28, 2003 over the prior year period as additional funding was awarded onwe experienced a formerly completed contract line item. This adjustmentshift to revenue totaled $529,000 and was recorded inmore cost share programs where we absorb a greater portion of the first quarteroverall cost.

During the remainder of fiscal 2004, while the associated expenses were incurred in a prior year.

During fiscal 2004,based on current order patterns and industry trends, we believe that one of our best growth opportunities will be for blue LEDschips that our customers would convert toare packaged in white LEDs for mobile applianceapplications. We believe these order patterns and other applications. Based onindustry trends in the industry, we believealso indicate

that there will be an increase in the use of white LEDs as a backlight for the keypad and for full color screens in mobile phones and other handheld electronics.appliances. We recently have introduced our MegaBright^® Plus, XBright^® Plus, XThin^™ and RazerThin products to target these and other applications.

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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. 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. Critical accounting policies include those policies that are reflective of significant judgments and uncertainties, which potentially could produce materially different results under different assumptions and conditions. We believe that our critical accounting policies are limited to those described below.

The following listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in its application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003 which contained a discussion of our accounting policies and other disclosures required by accounting principles generally accepted in the United States.

Valuation of Long-Lived Assets Intangible Assets and Goodwill. We have approximately $358.6$366.6 million of long-lived assets as of SeptemberDecember 28, 2003, including approximately $267.5$274.3 million related to fixed assets and capitalized patents, $58.0$62.9 million in long-termlong term investments held to maturity and $33.1$29.4 million of other long termlong-term assets, thatwhich includes net investments in privately held companies of $15.6 million and deferred taxes of $17.0$13.5 million. In addition to the original cost of these assets, their recorded value is impacted by a number of management estimates that are determined based on our judgment, including estimated useful lives and salvage values. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of”, or SFAS 144, we record impairment charges on long-lived assets used in operations when events and circumstances indicate that the assets have been impaired. In making these determinations, we utilize certain assumptions, including, but not limited to: (i) estimations of the fair market value of the assets, and (ii) estimations of future cash flows expected to be generated by these assets, which are based on additional assumptions such as asset utilization, length of service the asset will be used in our operations and estimated salvage values.

During the second quarter of fiscal 2004, Cree Microwave identified certain equipment, which was written down and recorded at fair market value. The amount of the write-down was $143,000. We hope to sell this equipment prior to the end of fiscal 2004.

Based on estimations of the fair market value of our Cree Microwave assets, and estimations of future cash flows, we determined that the estimated undiscounted cash flow exceeded the amount of the book value of the other long-term tangible assets. As a result, no other Cree Microwave

assets were impaired or written down during the firstsecond quarter of fiscal 2004.2004 other than the assets held for sale that was described above.

Accounting for Marketable and Non-Marketable Equity Securities. From time to time, we evaluate strategic opportunities and potential investments in complementary businesses and as a result may invest in marketable equity securities. At SeptemberDecember 28, 2003, we held no marketable equity securities. We classify marketable securities that are not trading or “held-to-maturity” securities as “available-for-sale”. We carry these investments at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income, which is reflected as a separate component of shareholders’ equity. Realized gains and losses are recognized when realized upon sale or disposition. Declines in value that are deemed to be other than temporary in accordance with SFAS 115, “Accounting for Certain Debt and Equity Securities” are also recorded in the statement of operations. We have a policy in place to review our equity holdingsinvestments on a periodic basis to evaluate whether or not each security has experienced an “other-than-temporary” decline in fair value. Our policy requires, among other things, a review of each company’s cash position, earnings and revenue outlook,

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stock price performance, liquidity, ability to raise capital and management and ownership changes. Based on this review, if we believe that an “other-than-temporary” decline exists in the value of one of our marketable equity securities, it is our policy to write down these equityimpaired investments to the market value. In addition, we generally record a write-down for investments in publicly held companies for an “other than temporary” impairment any time the market price of the security has remained below the Company’sour average cost for two consecutive fiscal quarters, unless strong positive evidence exists that makes it clear that an “other than temporary”“other-than-temporary” write-down would be inappropriate under the guidance of SFAS 115. The related write-down will then be recorded as an investment loss on our consolidated statements of operations.income.

We also make strategic investments in equity securities of privately held companies from time to time. Since we do not have the ability to exercise significant influence over the operations of these companies, these investment balances are carried at cost and accounted for using the cost method of accounting. The shares of stock we received in these investments are not presently publicly traded and there is no other established market value for these securities. We have a policy in place to review the fair value of these investments on a regular basis to evaluate the carrying value of such investments. This policy includes, but is not limited to, reviewing each of the companies’ cash position, financing needs, earnings and revenue outlook, operational performance, management or ownership changes, and competition. The evaluation process is based on information that we are provided by these privately held companies. Since these companies are not subject to the same disclosure regulations as U.S. public companies, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. If the carrying value of an investment is at an amount in excess of our estimate of fair value, and we have determined that the decline is “other than temporary”“other-than-temporary”, it is our policy to record a write-down of the investment. This write-down is estimated based on the information described above, and it is recorded as an investment loss on our consolidated statements of operations.income. Estimating the fair value of non-marketable investments in early-stage technology companies is inherently subjective and may contribute to significant volatility in our reported results of operations. There were no adjustments made to investment lossesour investments in privately held company investments on our consolidated statements of operationsincome during firstthe three and six months ended December 28, 2003.

During the second quarter of fiscal 2004 relating to2003, we sold our investmentsentire position in privately heldtwo publicly traded companies. We sold 356,000 common shares in the first company for $1,826,000, with a net loss on the sale recognized for $36,000 during the second quarter of fiscal 2003. We also sold 691,000 common shares in the second publicly traded company for $2,115,000, with a net loss on the sale recognized for $2,031,000 during the second quarter of fiscal 2003.

Inventories. Inventories are stated at the lower of cost or market, cost being determined using the first-in, first-out method for finished goods and work in process accounts and using the average cost method for raw materials for the Cree segment. The Cree Microwave segment uses a standard cost inventory costing method.method to value its inventory. We evaluate our ending inventories for excess quantities, impairment of value and obsolescence. This evaluation includes analysis of sales levels by product and projections of future demand based upon input received from our customers, sales team and management estimates. We reserve for inventories on hand that are greater than twelve months old, unless there is an identified need for the inventory. In addition, we write off inventories that are considered obsolete based upon changes in customer demand, manufacturing process changes that result in existing inventory obsolescence or new product introductions, which eliminates demand for existing products. Remaining inventory balances are adjusted to approximate the lower of our manufacturing cost or market value. If future demand or market conditions are less favorable than our estimates, additional inventory write-downs may be required and would increase cost of revenue in the period the revision is made. We evaluate the adequacy of these reserves quarterly.

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During the first quarter of fiscal 2004,three and six months ended December 28, 2003, we wrote down LED inventory by $531,000 to an estimated market value calculation. Some of these products were also sold during the first quarter. We also reduced our reserve for certain wafer material products by $165,000$49,000 and $214,000, respectively, as products previously reserved for were selling more rapidly than anticipated. During the three months ended December 28, 2003, Cree Microwave scrapped $576,000 of previously reserved products. We tookreduced the respective inventory reserves totalingaccordingly as of December 28, 2003.

As a result of the termination of the supply agreement with Spectrian in the second quarter of fiscal 2003, Cree Microwave recorded a $1.3 million reserve for inventory that was slow moving or specifically identified to be sold to Spectrian, including customized parts. We also reserved an additional $522,000 at Cree Microwave during the first quarter of fiscal 2003. This inventory charge was taken because of a change in demand from Spectrian Corporation, or Spectrian. Spectrian, initially, indicated that it would have strong demand for this type of transistor, but later determined that the demand had significantly weakened. During the three months ended December 29, 2002, we reserved $784,000 in the Cree segment for slow moving LED and wafer inventory. In addition, during the first quarter of fiscal 2003, we wrote down $185,000 of certain LEDs to an estimated market value calculation. All these adjustments were recorded through cost of revenue.

In addition, we also wrote off $1.0 million of costs associated with initial XBright products and $417,000 of costs associated with LDMOS8 devices as research and development expenses in the first quarter of fiscal 2003. The $1.0 million write down was attributable to early generation XBright devices that were later determined to be non-saleable because of design deficiencies. The $417,000 write-down was associated with LDMOS8 products on hand that we determined not to be saleable for similar reasons. In both cases, our customers had initially accepted the devices and we produced initial amounts of the product. Based on history with our customers, once products are accepted, they are ultimately qualified. Thus we concluded that capitalizing the cost of these items, as inventory was appropriate. However, in both cases, our customers

later rejected the products. Therefore, we wrote off the entire amount of inventory as research and development expenses, because the materials never qualified as completed devices or ultimately sold to customers. In the case of the LED devices, our customers returned all products shipped of that technology.

Revenue Recognition and Accounts Receivable. Revenue on product sales is recognized when persuasive evidence of a contract exists, such as when a purchase order or contract is received from the customer, the price is fixed, title of the goods has transferred and there is a reasonable assurance of collection of the sales proceeds. We obtain written purchase authorizations from ourits customers for a specified amount of product at a specified price and consider delivery to occurhave occurred at the time of shipment. The majority of itsour products have shipping terms that are FOB or FCA shipping point, which means that we fulfill the obligation to deliver when the goods are handed over and into the charge of the carrier at its shipping dock. This means that the buyer bears all costs and risks of loss or damage to the goods from that point. The difference between FOB and FCA is that under FCA terms the customer designates a shipping carrier of choice to be used. In certain cases, we ship our product Cost Insurance Freight (“CIF”).CIF. Under this arrangement, revenue is recognized under FOB shipping point shipping terms; however, we are responsible for the cost of insurance during shipment as well as the cost to ship the product. For all of its sales other than those with CIF terms, we invoice our customers only for shipping costs necessary to physically move the product from its place of business to the customer’s location. The costs primarily consist of overnight shipping charges. We incur the direct shipping costs on behalf of the customer and invoice the customer to obtain direct reimbursement for such costs. We account for our shipping costs by recording the amount of freight that is invoiced to itsour customers as revenue, with the corresponding cost recorded as cost of revenue. For the three and six months ended December 28, 2003, amounts recognized as revenue for shipping and handling costs were $26,000 and $52,000, respectively. In fiscal 2003, shipping costs were not material and we accounted for such costs as a cost of revenue with the reimbursement of these costs reflected as a direct offset and reduction of cost of revenue. If inventory is maintained at a consigned location, revenue is recognized when itsour customer pulls product for its use. We provide our customers with limited rights of return for non-conforming shipments and warranty claims for up to 36 months for Cree Microwave products and for lesser periods for Cree products.claims. We accrue estimated warranty expense as a cost of revenue. We record a reserve for estimated sales returns, which is reflected as a

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reduction of revenue at the time of revenue recognition. Certain of our distributorcustomer arrangements provide for limited product exchanges and reimbursement of certain sales costs. For one distributor,two customers, with these arrangements, we defer revenue equal to the level specified within these contractual arrangements and recognizes the related revenue less any claims made against the reserves when the distributor’scustomer’s exchange rights expire and the deferred revenue reserves are released. The reserve expires no later than two quarters from the date of the original sale. In connection with our distributor agreement with Sumitomo, Corporation (“Sumitomo”), such deferred revenue amounted to $6.8$7.9 million and $5.3 million as of SeptemberDecember 28, 2003 and June 29, 2003, respectively. In connection with our purchase agreement with Osram, such deferred revenue amounted to $200,000 and $0 as of December 28, 2003 and June 29, 2003, respectively.

Historically, we have experienced only nominal credit losses from customers’ inability to pay. Any uncollectibility of receivablesOur accounts receivable reserve is primarily due to returned products. Therefore, we record an allowance for sales returns at the time of sale. Significant judgments and estimates made by management are used in connection with establishing the allowance for sales returns. Material differences may result in the actual amount and timing of our revenue for any period in which

management made different judgments or utilized different estimates. The allowance for sales returns at SeptemberDecember 28, 2003 and June 29, 2003 was $696,000$970,000 and $644,000, respectively.

Revenue from government contracts and private agencies is recorded on the percentage-of-completionproportional performance method as contract expenses are incurred. Contract revenue represents contracts with various U.S. Government entities and certain private entities to perform research and development work related to the development of the Company’sour technologies. The contract funding may be based on either a cost-plus or a cost-share arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set percentage margin. 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 government or funding entity to practice the inventions for governmentlimited purposes. Contract revenue includes funding of direct research and development costs and a portion of the Company’sour general and administrative expenses and other operating expenses for contracts under which funding is expected to exceed direct costs over the life of the contract. The specific reimbursement provisions of the contracts, including the portion of our general and administrative expenses and other reimbursable operating expenses vary by contract. Such reimbursements are recorded as contract revenue. For contracts under which we anticipate that direct costs will exceed amounts to be funded over the life of the contract (i.e., certain cost share arrangements), we reportsreport direct costs as research and development expenses with related reimbursements recorded as an offset to those expenses.

Accruals for Liabilities and Warranties.We make estimates for the amount of costs that have been incurred but not yet billed for general services, including legal and accounting fees, costs pertaining to our self-funded medical insurance, warranty costs and other expenses. Many of these expenses are estimated based on historical experience or information gained directly from the service providers. During the second quarter of fiscal 2004, we increased our overall warranty cost reserve by $391,000.

Valuation of Deferred Tax Assets.As of SeptemberDecember 28, 2003, we had $18.9$15.4 million recorded as a short and long-term deferred tax asset. These assets wereThis asset was recorded as a result of a tax benefitsbenefit associated with the $143.9 million of significant charges taken in fiscal 2002. These charges were recorded for the write-off of property and equipment, the impairment of goodwill and

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intangible assets at Cree Microwave and other charges resulting from the downturn in Cree Microwave’s business and the “other than temporary”“other-than-temporary” charges taken on our investments.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in its application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 29, 2003 which contained a discussion of our accounting policies and other disclosures required by accounting principles generally accepted in the United States.

Results of Operations

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