UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 28,September 26, 2004

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,share; as of April 16,October 18, 2004 was 74,210,059.73,872,433.

CREE, INC.

FORM 10-Q

For the Quarter Ended March 28,September 26, 2004

INDEX

PART I - FINANCIAL INFORMATION

Item 1 - Financial Statements

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

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

CREE, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

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

CREE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

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

CREE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Basis of Presentation

The consolidated balance sheet as of March 28,September 26, 2004, the consolidated statements of income for the three and nine months ended March 28,September 26, 2004 and March 30,September 28, 2003, and the consolidated statements of cash flow for the ninethree months ended March 28,September 26, 2004 and March 30,September 28, 2003 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 March 28,September 26, 2004, and for all periods presented, have been made. The consolidated balance sheet at June 29, 200327, 2004 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. TheseIt is suggested that these condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 20032004 Annual Report on Form 10-K. The results of operations for the period ended March 28,September 26, 2004 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., Cree Japan, Inc, Cree International Holdings Inc. and Cree Japan, Inc.Asia-Pacific Limited. Cree Funding was merged into the Company effective June 27, 2004. 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 LEDlight emitting diode (“LED”) displays and other lighting applications as well as microwave and power applications. The Cree segment also sells SiC and GaN material products to corporate, government and university research laboratories and generates revenue from contracts with agencies of the U.S. Federal government.government and other parties.

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.applications as well as products serving military and aeronautics markets.

Summarized financial information concerning the reportable segments as of and for the three and nine months ended March 28,September 26, 2004 and March 30,September 28, 2003 areis shown in the following tables.table. 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. TheIn 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.

Reclassifications

Certain fiscal 20032004 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 20042005 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- or52-or 53-week period ending on the last Sunday in the month of June. The Company’s 2005 fiscal year extends from June 28, 2004 through June 26, 2005 and is a 52-week fiscal year. The Company’s 2004 fiscal year extendsextended from June 30, 2003 through June 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 March 28,September 26, 2004 and June 29, 200327, 2004 and the reported amounts of revenues and expenses during the three and nine months ended March 28,September 26, 2004 and March 30,September 28, 2003. Actual amounts could differ from those estimates.

Earnings per 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 Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” these shares were not included in calculating diluted earnings per share. For the three months ending September 26, 2004 and September 28, 2003, there were 4.4 million and 8.0 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive.

Business Combination

The Company acquired the GaN substrate and epitaxy business of Advanced Technology Materials, Inc. (“ATMI”) effective March 31, 2004. The Company signed a definitive agreement to purchase the intellectual property, fixed assets and inventory of this business for $10.3 million in cash. The Company accounted for this transaction under the purchase method and there was no resulting goodwill. The operating results of the assets acquired from ATMI are included in the accompanying consolidated statements of income from the date of acquisition.

As part of the acquisition, the Company planned and is in the process of relocating the acquired GaN substrate and epitaxy business into its North Carolina operations. The Company originally established a $315,000 liability to cover relocation costs of employees and equipment in its quarter ended June 27, 2004. For the quarter ended September 26, 2004, the Company has increased the liability by $256,000 to provide for costs to be incurred in vacating the business’s former location. The following table summarizes the changes in the Company’s relocation liability for the three-months ended September 26, 2004:

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 FOBfree on board (“FOB”) or FCAfree carrier alongside (“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 itsthe Company’s 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 CIF.products cost insurance freight (“CIF”). Under this arrangement, revenue is recognized under FOB shipping point shipping terms;terms, however, the Company is responsible for the cost of insurance during shipmentto transport the product 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 threethree-month period ended September 26, 2004 and nine months ended MarchSeptember 28, 2004, amounts2003, the Company recognized $42,000 and $26,000, respectively, as revenue for shipping and handling costs were $27,400 and $79,500, 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.costs. If inventory is maintained at a consigned location, revenue is recognized when the Company’s customer pulls product for its use.

use and the title of the goods is transferred to the customer. The Company provides its customers with limited rights of return for non-conforming shipments and warranty claims. The Company accrues estimated warranty expense as a cost of revenue.claims for up to 36 months for Cree Microwave products and for lesser periods for Cree products. 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 customersales arrangements provide for limited product exchanges and reimbursement of certain sales costs. For two customers, with these arrangements,Sumitomo Corporation (“Sumitomo”) and OSRAM Opto Semiconductors GmbH (“OSRAM”), the Company defers revenue equal to the levellevels specified in these contractual arrangements and recognizes the related revenue less any claims made against the reserves when the customer’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 distributorour sales agreement with Sumitomo, Corporation (“Sumitomo”), such deferred revenue amounted to $6.5$6.6 million and $5.3$7.9 million as of March 28,September 26, 2004 and June 29, 2003,27, 2004, respectively. In connection with the Company’s purchaseour agreement with OSRAM, Opto Semiconductors Gmbh (“Osram”), such deferred revenue amounted to $365,000$531,000 and $0$471,000 as of March 28,September 26, 2004 and June 29, 2003,27, 2004, 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 March 28,September 26, 2004 and June 29, 200327, 2004 was $824,000$737,000 and $644,000,$798,000, respectively.

Revenue from government contracts and certain private entities is recorded on the proportional performance method as contract expenses are incurred. Contract revenue represents contracts withreimbursement by various U.S. Government entities and certain private entitiesother parties to perform research and development work related toaid in the development of new technology. The applicable contracts generally provide that the Company’s technologies.Company may elect to retain ownership of inventions made in performing the work, subject to a non-exclusive license retained by the government to practice the inventions for government purposes. 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 applicableFor the cost-share contracts, generally provide thatthe actual costs relating to the activities to be performed by the Company may elect to retain ownership of inventions made in performingunder the work, subject to a non-exclusive license retained bycontract are divided between the

government or funding entity to practice U.S. Government and the inventions for limited purposes. Contract revenue includes funding of direct research and development costs and a portionCompany based on the terms of the Company’s generalcontract. The government’s cost share is then paid to the Company. Activities performed under these arrangements include research regarding SiC and administrative expensesGaN materials and other operating expensesdevices. The contracts typically require the submission of a written report that documents 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 under whichwhere the Company anticipates that funding is expected towill exceed direct costs over the life of the contract. The specific reimbursement provisionscontract, funding is reported as contract revenue and all direct costs are reported as costs of the contracts, including the portion of the Company’s general and administrative expenses and other reimbursable operating expenses vary by contract. Such reimbursements are recorded as contract revenue. For contracts under which the Company anticipates that direct costs of the activities subject to the contract will exceed amounts to be funded over the life of the contract, (i.e., certain cost share arrangements), the Company reports direct costs are reported as research and development expenses withand related reimbursements recordedfunding is reported as an offset toof 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, investments held to maturity accounts and interest receivable, accounts payable and other liabilities approximate fair values at March 28,September 26, 2004 and June 29, 2003.27, 2004.

Investments

Investments are accounted for using the specific identification method and in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”).Securities.” This statement requires certain securities to be classified into three categories:

At March 28,As of September 26, 2004 and June 27, 2004, the Company held no marketable securities. Duringa long-term equity investment in the second quartercommon stock of fiscal 2003, the Company sold its remaining position in two publicly traded companies. The first company was Microvision, Inc.Color Kinetics, Incorporated (“Microvision”) and the second one was Emcore Corporation (“Emcore”Color Kinetics”). Prior to the sales, the Company owned 356,000 common shares of Microvision at a total cost of $14.3 millionIn fiscal 2001 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 expensepurchased an aggregate of 2,202,442 shares of Color Kinetics stock in private investment rounds for an aggregate of $12.7 million. On June 22, 2004, the shares of Color Kinetics’ stock were approved for quotation 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.Nasdaq National Market. The Company recorded a charge through non-operating expense on the consolidated statements of operationsaccounts for its shares 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 valueColor Kinetics 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”available-for-sale securities under SFAS 115. The Company carried these investments at fair value, based on quoted market prices, andAccordingly, unrealized gains or losses on Color Kinetics’ shares are excluded from earnings and losses, net of taxes, were includedare recorded in accumulated other comprehensive income, (loss), which is reflectednet of tax. Management classifies the shares as a separate componentlong-term investment as the Company has the intent and the ability to hold these shares. As of shareholders’ equity. Realized gainsSeptember 26, 2004 and losses are recognized upon sale or when declinesJune 27, 2004, the Company had recorded a cumulative unrealized holding gain on its investment in value are deemed to be “other than temporary”Color Kinetics of $20.5 million and $9.3 million, respectively, (or $12.4 million and $5.6 million, net of tax, respectively). This unrealized gain was based on the consolidated statementsmost recent closing stock price as of income.September 26, 2004 and June 27, 2004, to determine the fair market value of the Company’s investment of $33.2 million and $22.0 million, respectively. The Company reviews equity holdings onis restricted from selling its shares in Color Kinetics for a regular basis to evaluate whether or not each security has experienced an “other-than-temporary” declineperiod of 180 days from June 22, 2004, the date of Color Kinetics’ initial public offering and considers its investment in fair value. This policy requires, among other things, the review of each of the companies’ cash position, 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 recordedColor Kinetics as a comprehensive loss in shareholders’ equity, as a non-operating loss on the Company’s 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.long-term investment.

As of March 28,September 26, 2004 and June 29, 2003,27, 2004, the Company had investments in the equity of privately held companies with carrying values of $15.6$2.9 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.

Comprehensive Income

Comprehensive income consists of the following:

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 processwork-in-progress 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 statements of income. The Company evaluates inventory levels at least quarterly against sales forecasts on a part-by-part basis, in addition to determining its overall inventory risk. Reserves are adjusted monthly to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management.

As of March 28,September 26, 2004, the Company maintained a $1.1 million$681,000 reserve for inventory. Of this total amount, $770,000$282,000 is attributable to the Cree Microwave segment and $318,000$399,000 is attributable to the Cree segment.

The majority of the inventory reserve 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 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.The Company destroyed a portion of the inventory previously reserved during the fiscal 2003 and 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 statements of income when these items were destroyed. The Company still maintains some inventory 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 this inventory. However, the Company plans to dispose of this remaining inventory when the “last time buy” rights expire. Therefore, with the exception of certain inventory covered under “last time buy” obligations, all items previously reserved 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 nine months ended March 30, 2003 include a $784,000 additional reserve for LED and wafer inventories as management assessed the inventory to be slow moving or obsolete. The Company also 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 during the nine months ended March 30, 2003. These adjustments were recorded to cost of revenue. During the first nine months of fiscal 2003, the Company also wrote off $1.0 million of the initial XBright^® chips that were developed during fiscal 2002. An improved chip had 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):

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.the consolidated statements of income.

Impairment of Long-Lived Assets

In accordance with SFASStatement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company reviewsrecords long-lived assets for impairment based on changes in circumstances that indicate their carrying amounts may not be recoverable. The Company reviews an undiscountedthe discounted cash flow analysis for the Cree Microwave

segment to test for impairment of its assets on a quarterly basis. During the three and nine months ended March 28,September 26, 2004 and March 30,September 28, 2003, 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 second quarter of fiscal 2004, 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 was reflected as an impairment of property and equipment in the consolidated statement of income. In the third quarter of fiscal 2004, the Company determined that this equipment was not salable and wrote off the remaining value of $30,000 as an impairment of property and equipment. The Company also wrote off $50,000 of equipment that was disposed of at the Cree segment’s facility.

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 the remaining life of the patent or over the license period. The related amortization expense was $215,000$406,000 and $602,000$183,000 for the three and nine months ended MarchSeptember 26, 2004 and September 28, 2004, respectively. The related amortization expense was $78,000 and $233,000 for the three and nine months ended March 30, 2003, respectively.

Research and Development

The U.S. Government and certain private entities providehave provided 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 funding party’sgovernment’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 typically require the submission of a written report documentingthat documents 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 nine months ended March 28,September 26, 2004 and March 30,September 28, 2003, there were no contracts for which direct expenses exceeded funding.

Company funded researchProduct Warranty Costs

Accrued expenses include amounts accrued for product warranty expenses at both the Cree, Inc. and development is expensedCree Microwave segments. Cree Microwave accrues 0.5% of product revenue as incurred. Customers did not contribute funds towarda warranty liability each month and maintains the reserve for 36 months after the date of sale pursuant to our warranty terms with our customers. The Cree segment records warranty expense up to 21 months based on an experience factor for product researchreturns and development activities during fiscal 2004. Customers contributed $500,000pursuant to warranty terms with its customers. The following table summarizes the changes in the Company’s product warranty

liability for the nine monthsthree-month periods ended March 30,September 26, 2004 and September 28, 2003 toward product research and development activities. This amount was recorded as an offset to research and development expense. As of March28, 2004, there was no product research and development commitment recorded as a reduction to research and development expenses to fund future research and development activities for the Company.(in thousands):

Income Taxes

The Company has established an estimated tax provision based upon an effective rate of 31%32.5% for the three and nine months ended March 28,September 26, 2004. The Company’s effective tax rate was 26%31% for the three and nine months ended March 30,September 28, 2003. 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 SFASStatement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”.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 basedstock-based employee compensation under APBAccounting Principles Board 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 SFASStatement 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 and net income per share if the Company had applied the fair value recognition provisions of SFAS 123, as amended (in thousands, except per share amounts):

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 became vested on April 13, 2004. After this date, 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 4.0 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. In February 2004, the Board of Directors extended the repurchase program through February 2005. 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. There were no repurchases made during the third quarter of fiscal 2004. 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

Shareholder LawsuitsIn re Cree, Inc. Securities Litigation

As reported in ourthe Company’s Annual Report on Form 10-K for the fiscal 2003 and in our Quarterly Report on Form 10-Q for the second quarter of fiscalyear ended June 27, 2004, there is pending in the U.S. District Court for the Middle District of North Carolina a consolidated class action seeking damages for alleged violations of securities laws by the Company and certain of our officers and current and former directors. In February 2004, wethe Company moved that the court dismiss the consolidated amended complaint on the grounds that it failsfailed to state a claim upon which relief can be granted and doesdid not satisfy the pleading requirements under applicable law. The motion is currently pending.

As also reported in our Quarterly Report on Form 10-Q for the second quarter of fiscal 2004, there was pending before the same court a purported derivative action that named certain of our directors as defendants and named the Company as a nominal defendant. In FebruaryOn August 30, 2004, the individual defendants moved that the court dismiss the derivative complaint on the ground that it failed to state a claim upon which relief can be granted. The plaintiff subsequently filed a motion, which the defendants did not oppose, requesting that the court allow the plaintiff to dismiss the action voluntarily without prejudice. The court entered an order granting the motion to dismiss without prejudice and dismissingallotting 45 days for the derivative actionplaintiffs to file an amended consolidated complaint. The plaintiffs filed a First Amended Consolidated Class Action Complaint on October 14, 2004, asserting essentially the same claims and seeking the same relief as in Marchtheir prior complaint. The Company expects to file a motion to dismiss the Amended Complaint on or before November 15, 2004.

The Company believes that the claims set forth in the amended consolidated complaint are without merit. However, the Company is unable to predict the final outcome of these matters with certainty. The Company’s failure to successfully defend against these allegations could have a material adverse effect on its business, financial condition and results of operations.

Trustees of Boston University and Cree Lighting Company v. AXT, Inc.

As reported in our Annual Report on Form 10-K for fiscal 2003, in June 2003 Boston University and our subsidiary, Cree Lighting Company (which later merged into Cree, Inc.), commenced a

patent infringement lawsuit against AXT, Inc. in the U.S. District Court for the Northern District of California. In March 2004, Boston University and the Company reached a settlement with AXT in which the parties agreed to the dismissal of all claims and counterclaims. The resolution of the disputes is reflected in the Company’s consolidated financial statements for the third quarter of fiscal 2004.

Other Legal Proceedings

During the third quarter of fiscalthree months ended September 26, 2004, there were no other material developments in the legal proceedings previously reported in our Annual Report on Form 10-K for fiscal 2003 and our Quarterly Reports on Form 10-Q for the first two quarters of fiscal 2004. Please refer to Part I, Item 3 of theCompany’s Annual Report on Form 10-K for the fiscal year ended June 29, 2003 and Part II,27, 2004. Please refer to Item 13 of the Quarterly Reports on Form 10-Q for the quarterly periods ended September 28, 2003 and December 28, 2003, respectively,10-K for a description of other material legal proceedings.

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

Earnings Per 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 nine months ended March 28, 2004, there were 4.6 million and 8.4 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive. For the three and nine months ended March 30, 2003, there were 9.5 million and 10.1 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 SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146, which 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 the adoption of SFAS 146 did not have a material impact on the Company’s consolidated results of operations, financial position or cash flows.

In December 2002, the Emerging Issues Task Force (“EITF”) issued EITF Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 provides guidance to determine whether revenue arrangements contain multiple deliverable items and if so, requires that revenue be allocated amongst the different items based on fair value. EITF 00-21 also requires that revenue on any item in a revenue arrangement with multiple deliverables not delivered completely must be deferred until delivery of the items is completed. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s consolidated results of operations, financial position or cash flows.

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 has determined that it does not have any investments or other interests in VIEs, therefore, there are no VIEs that would be 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 companies and does not have any variable interests in any entitites after January 31, 2003.

In 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 of certain financial instruments that have the characteristics of both liabilities and equity. The provisions of this statement require that any financial instruments that are 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 No. 150 did not have a material effect on the Company’s consolidated results of operations, financial position or cash flows.

Subsequent Event

On April 6, 2004, we announced the completion of our acquisition of the gallium nitride substrate and epitaxy business of ATMI, Inc. The acquisition will be accounted for under the purchase method of accounting. Under the terms of the agreement, we acquired the assets of the business including 17 U.S. patents and additional patent applications, fixed assets and inventory in exchange for $10,250,000 in cash. The excess of the fair market value over the purchase price of the assets will be allocated as a pro rata reduction to the value of the long-term assets in accordance with SFAS No. 141 “Business Combinations”.

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

Information set forth in this Quarterly Report on Form 10-Q contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended, (Exchange Act). All information contained in 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

Factors that could cause or contribute to such differences include: our actual operating resultsability to differ materially from those forward-looking statements. These factors include, but are not limited to, risks associated with our pending securitiescomplete development and other litigation,commercialization of products under development, such as the considerable management time and attention required and substantial expenses incurred regardlessour pipeline 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 (“SEC”) has requested that we provide information in responsebrighter light emitting diodes (LEDs); our ability to an informal inquiry. Furthermore, our actual operating results could differ materially due to a number of additional factors, includinglower costs; potential changes in demand; the risk that price stability, improved operational efficiencies, and the favorable product mix we have recently experienced will not continue; the risk that, due to the complexity of our manufacturing process,processes, 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-upramp up of our production for our new products; risks resulting from the concentration of our business among few customers, including the risk that customers may reduce or cancel orders or fail to honor purchase commitments,commitments; the rapid development of new technology and competing products that may impair demand or render our products obsolete; the potential lack of customer acceptance for our products; and the risks associated with our product supply chain .securities litigation. See Exhibit 99.1“Certain Business Risks and Uncertainties” below, as well as other risks and uncertainties referenced in this report, for further discussion ofadditional risk factors that could cause our actual results to differ.

Business Overview

Business Overview

We develop and manufacture compound semiconductor materials and electronic devices made from SiC, GaN, silicon carbide, or SiC, and Group III nitrides, or GaN.related compounds. The majority of our products are currently produced in our factory in Durham, North Carolina. We derive the largest portion of our revenue from the sale of blue, green and near ultraviolet or UV light emitting diodes or LEDs.LED chips. We currently offer LEDsLED chips at three brightness levels: high brightness blue and

Our LED deviceschips are packaged by our customers and used by manufacturers as a lighting source for mobile appliances such as cell phones, automotive dashboard lighting, indicator lamps, miniature white lights, indoor and outdoor full color displays, and signs, traffic signals and other lighting applications. Some of our customers package our blue LEDs with a phosphor coating to create white LEDs. In July 2004, we released a family of new high power packaged LEDs called our XLamp^™ products, that are designed to compete with conventional lighting technology for certain specialty lighting applications. We currently are marketing these products for use in architectural lighting, appliance lighting, channel letters and reading lamps and target that future versions of XLamp will be used in emerging applications such as automotive headlamps and backlighting for large format liquid crystal display (LCD) screens. LED products represented 80%82% and 78%76% of our revenue for the three and nine months ended MarchSeptember 26, 2004 and September 28, 2004, respectively. LED products represented 76% and 74% of our revenue for the three and nine months ended March 30, 2003, respectively.

We also derive revenue from the sale of semiconductor wafers and epitaxy products made from SiC and GaN 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 and GaN wafer and epitaxy products represented 6%7% and 8% of our revenue for the three and nine months ended MarchSeptember 26, 2004 and September 28, 2004, respectively. Sales of SiC wafer products represented 8% of our revenue for the three and nine months ended March 30, 2003, respectively. We also sell SiC materials in bulk crystal form for use in gemstones to Charles & Colvard, Ltd. (“C&C”).(C&C) for use in gemstones. Sales of SiC crystals for gemstones represented 2% of our revenue for each of the threethree-month periods ended September 26, 2004 and nine months ended MarchSeptember 28, 2004, respectively. Sales of SiC crystals for gemstones represented 3% and 4% of our revenue for the three and nine months ended March 30, 2003, respectively. Our other products include SiC-based power and radio frequency, or RF devices. We received 2% and 1% of totalour revenue from sales of power devices and SiC-based RF devices combined for the three and nine months ended MarchSeptember 26, 2004 and September 28, 2004, respectively. We received 1% of total revenue from sales of power devices and SiC-based RF devices combined for the three and nine months ended March 30, 2003, respectively.

Through our Cree Microwave segment, based in Sunnyvale, California, we also 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. Wetechnology. During the three months ended September 26, 2004 and September 28, 2003, we received 3%1% and 2% of totalour revenue from sales from theour Cree Microwave segment, for the three and nine months ended March 28, 2004, respectively. We received 1% of total revenue from sales from the Cree Microwave segment for the three and nine months ended March 30, 2003, respectively.

The balance of our revenue was derived primarily from contract research funding under government contracts, which amounted to 7%6% and 9%11% for the three and nine months ended MarchSeptember 26, 2004 and September 28, 2004, respectively. For the three and nine months ended March 30, 2003, revenue from contract research funding was approximately 11% and 12%, 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 nine months ended March 28,September 26, 2004 and March 30,September 28, 2003, respectively, we did not have any contracts for which we anticipated direct costs to exceed funding over the life of the contract.

Product Overview

Our LED revenue and units sold increased 36%56% and 62%51%, respectively, in the thirdfirst quarter of fiscal 20042005 over the prior year comparative period of the prior year.period. Overall, we experienced sequentialcontinued to experience revenue growth in our standard, midmid-brightness, high-brightness and high brightnesspower packaged LEDs. Our most significant increase in product categories fromsales was in our high-brightness LED chips, which was driven by success in a combination of LED applications, including white keypads and LCD backlights in mobile phones, automotive, display and gaming products. Sales of high-brightness LEDs represented 55% of our LED revenue for the second to the thirdfirst quarter of fiscal 2004. X-class2005. Sales of mid-brightness products were the fastest growing partmade up 39% of our high brightness segment, while salesLED revenue in the first quarter of mid-brightness chips forfiscal 2005. During the blue keypad backlight market also increased over the prior sequential quarter. Based on feedback from our customers, the increase in salesfirst quarter of our X-class chips was driven by white LED applications, with success in mobile phones for white keypads, camera flashes and LCD backlights for several major phone manufacturers. In addition, thefiscal 2005, we experienced growth in this product category also benefited from new Japanese automotive designs and LED display signs. We continue to see strong demand for our high brightness products that are being used by our customers to make white LEDs for LCD backlights, camera flashes, keypad backlights, solid state illumination, outdoor displays and automotive dashboards.

During the third quarter of fiscal 2004, we continued to work with our customers to develop and expand our X-class products for specific markets and packaging appliances. The X-class of LED products include XBrightRazerThin^™® blue and green, XBright^® Plus blue and XThin^® blue and green. The X-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, but has presented packaging challenges for our customers. Our customers began having more success during the third quarter of fiscal 2004. As a result, our X-class products represented almost 20% of our fiscal 2004 third quarter LED revenue versus 2% in the second quarter of fiscal 2004. During the second quarter of fiscal 2004, we introduced our brighter XT-15^™ and XT-18^™ chips. During the third quarter of fiscal 2004, we extended our LED brightness capabilities with the development of our XT-21^™ chip that we have recently started shipping to several of our major customers in sample quantities. We target increased business for our high brightness products for the fourth quarter of fiscal 2004.

For the high volume, price sensitive keypad market, we target to release the UT230^™ deviceLED products, which are thinner and offer a lower voltage for use in our fourth quartera variety of fiscal 2004. Shipmentsapplications including blue keypads for mobile phones. Sales of our standard brightness devices remained stable inproducts made up 6% of our LED sales during the thirdfirst quarter of fiscal 2005.

We are focused on expanding our high-brightness product family with brighter products to enable us to increase use of our products for mobile appliance LCD backlight applications, which our customers have identified as a growth opportunity. Recently, we released our XT24^™-Investment chip and have started to sample customers with our XT27^™-Investment chip for white LCD backlights and

other high performance applications. We target other markets for our high-brightness LED applications, such as specialty lighting, displays, automotive, gaming and other applications, to continue to grow in fiscal 2005.

During the first quarter of fiscal 2005, we began the conversion of our LED production process from two-inch to three-inch SiC wafers. As we exited the first quarter, approximately 10% of our LED production was manufactured on three-inch wafers. As a result of the targeted cost savings from the three-inch migration and other benefits, we aim to implement a more aggressive pricing strategy to drive additional market share for our products.

In the first quarter of fiscal 2005, we released our XLamp 7090 series, which were the first products in our high power packaged LED family. In October of 2004, due towe announced the release of the XLamp 4550 series for smaller form factor applications. The XLamp products are being designed into several specialty lighting applications including architectural lighting, appliance lighting and channel letters. As automotive headlight and indicator light designs from a number of customers. In order to reduce our overall costs, we have undertaken an initiative to convertlarge screen LED applications emerge over the next year many ofseveral years, we target to position our XLamp products to be produced from 3-inch wafers. During the third quarter of fiscal 2004, our standard brightness, mid-brightness and high brightness parts made up 7%, 42% and 51% of our LED revenue, respectively.serve these markets as well.

During the three months ended March 28,September 26, 2004, SiC and GaN materials revenue decreased 5%increased 25% over the prior year comparative period due to a 33% decreasesignificant increase in the number of wafers sold. The lower volume resulted from reduced sales of epitaxal wafers, with SiC or GaN epitaxy for research customers and other changes in customer and product mix.which carry higher average selling prices. Revenue from salessale of SiC materials for useused in gemstones was 45% lower15% greater in the thirdfirst quarter of fiscal 20042005 as compared to the prior year period due to reduced demand and lowerimproved yields.

Revenue from silicon-based microwave products increased 238%38% in the thirdfirst quarter of fiscal 20042005 as compared to the prior year period. During the third quarter of fiscal 2004, we realized growth in both our Bi-polar and Laterally Diffused Metal Oxide Semiconductors (“LDMOS”) products. Much of the new business was derived from new customers, including the military and aeronautics markets. We received 2% and 1% of total revenue from sales of power devices and SiC-based RF devices combined for the three and nine months ended March 28, 2004, respectively. We received 1% of total revenue from sales of power devices and SiC-based RF devices combined for the three and nine months ended March 30, 2003, respectively. Government contract revenue decreased 11% for the three months ended March 28, 2004 over the prior year period as we experienced growth in sales of our Laterally Diffused Metal Oxide Semiconductors (LDMOS).

Contract revenue decreased 19% for the three months ended September 26, 2004 over the prior year period due largely to a shift to more cost share programs whereslow down of spending on contracts nearing completion. The first quarter of fiscal 2004 included $529,000 of additional funding on a formerly completed contract line item. In the first quarter of fiscal 2005, we absorbalso recorded a greater portion$337,000 license fee from a third party for the use of the overall cost.