UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DCD.C. 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 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; as of October 18, 2004January 13, 2005 was 73,872,433.76,522,889.

CREE, INC.

FORM 10-Q

For the Quarter Ended SeptemberDecember 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 SeptemberDecember 26, 2004, the consolidated statements of income for the three and six months ended SeptemberDecember 26, 2004 and SeptemberDecember 28, 2003, and the consolidated statements of cash flow for the threesix months ended SeptemberDecember 26, 2004 and SeptemberDecember 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 SeptemberDecember 26, 2004, and for all periods presented, have been made. The consolidated balance sheet at June 27, 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. It is suggested that these condensed financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 2004 Annual Report on Form 10-K. The results of operations for the period ended SeptemberDecember 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-ownedwholly owned subsidiaries, Cree Microwave, Inc. (“Cree Microwave”), 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 Asia-Pacific Limited. Cree Funding was merged into the CompanyCree, Inc. effective June 27, 2004.2004 and is no longer a stand-alone entity. Cree Technologies, Inc. merged into Cree, Inc. effective December 26, 2004 and is no longer a stand-alone entity. 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,(“SiC”) and group III nitrides or GaN,(“GaN”) technology. Products from this segment are used in mobile appliances, automotive backlighting, indicator lamps, full color light 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 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 as well as products serving military and aeronautics markets.

Summarized financial information concerning the reportable segments as of and for the three and six months ended SeptemberDecember 26, 2004 and SeptemberDecember 28, 2003 is shown in the following 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 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.

As of and for the three months ended December 28, 2003 (in thousands)		Cree			Cree Microwave				Other			Total
Highlights from the Consolidated Statement of Income:
Product revenue, net		$	64,602		$	1,983			$	—		$	66,585
Contract revenue, net			6,099			—				—			6,099
Total revenue			70,701			1,983				—			72,684
Cost of revenue			36,050			2,789				—			38,839
Gross profit (loss)			34,651			(806	)			—			33,845
Research and development			7,343			993				—			8,336
Selling, general and administrative			7,191			677				—			7,868
Impairment of property and equipment			—			143				—			143
Other non-operating income			378			29				—			407
Income (loss) before income taxes			20,495			(2,590	)			945			18,850
Depreciation and amortization		$	12,623		$	673				—		$	13,296
Other Consolidated Financial Information:
Inventories, net		$	16,043		$	713			$	—		$	16,756
Property and equipment, net			252,639			10,590				—			263,229
Additions to property and equipment			19,113			143				—			19,256
Total assets		$	335,200		$	13,225			$	235,097		$	583,522
As of and for the six months ended December 26, 2004 (in thousands)		Cree			Cree Microwave				Other			Total
Highlights from the Consolidated Statement of Income:
Product revenue		$	178,683		$	2,949			$	—		$	181,632
Contract revenue			11,716			—				—			11,716
Total revenue			190,399			2,949				—			193,348
Cost of revenue			84,642			5,913				—			90,555
Gross profit (loss)			105,757			(2,964	)			—			102,793
Research and development			20,683			1,760				—			22,443
Sales, general and administrative			13,957			1,530				—			15,487
Other expense			326			—				—			326
Other non operating income			128			—				—			128
Write-down of long-term investment			—			—				1,992			1,992
Income (loss) before income taxes			70,919			(6,254	)			414			65,079
Depreciation and amortization		$	31,724		$	1,301			$	—		$	33,025
Other Consolidated Financial Information:
Additions to property and equipment		$	81,693		$	832			$	—		$	82,525

As of and for the six months ended December 28, 2003 (in thousands)		Cree			Cree Microwave				Other			Total
Highlights from the Consolidated Statement of Income:
Product revenue		$	122,714		$	3,034			$	—		$	125,748
Contract revenue			13,147			—				—			13,147
Total revenue			135,861			3,034				—			138,895
Cost of revenue			71,251			5,583				—			76,834
Gross profit (loss)			64,610			(2,549	)			—			62,061
Research and development			14,672			1,990				—			16,662
Sales, general and administrative			14,442			1,339				—			15,781
Impairment of property & equipment			3			143				—			146
Other non operating income			381			29				—			410
Income (loss) before income taxes			35,874			(5,992	)			1,837			31,719
Depreciation and amortization		$	24,638		$	1,300			$	—		$	25,938
Other Consolidated Financial Information:
Additions to property and equipment		$	37,200		$	200			$	—		$	37,400

Reclassifications

Certain fiscal 2004 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2005 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 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 extended from June 30, 2003 through June 27, 2004 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 26, 2004 and June 27, 2004 and the reported amounts of revenues and expenses during the three and six months ended SeptemberDecember 26, 2004 and SeptemberDecember 28, 2003. Actual amounts could differ from those estimates.

Earnings per shareShare

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 and six months ending SeptemberDecember 26, 2004, there were 1.8 million and September3.5 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive. For the three and six months ending December 28, 2003, there were 4.49.0 million and 8.08.4 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 relocatinghas relocated 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 quartersix months ended SeptemberDecember 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-monthssix months ended SeptemberDecember 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 free on board (“FOB”) or free 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 the 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 products cost insurance freight (“CIF”). Under this arrangement, revenue is recognized under FOB shipping point terms, however, the Company is responsible for the cost of insurance to 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 three-month periodthree and six-month periods ended SeptemberDecember 26, 2004, the Company recognized $47,000 and September$89,000, respectively, as revenue for shipping and handling costs. For the three and six-month periods ended December 28, 2003, the Company recognized $42,000$26,000 and $26,000,$52,000, respectively, as revenue for shipping and handling costs. If inventory is maintained at a consigned location, revenue is recognized when the Company’s customer pulls product for its 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 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 sales arrangements provide for limited product exchanges and reimbursement of certain sales costs. For two customers, Sumitomo Corporation (“Sumitomo”) and OSRAM Opto Semiconductors GmbH (“OSRAM”), the Company defers revenue equal to the levels specified in 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 ourthe Company’s sales agreement with Sumitomo, such deferred revenue amounted to $6.6$7.4 million and $7.9 million as of SeptemberDecember 26, 2004 and June 27, 2004, respectively. In connection with ourthe Company’s agreement with OSRAM, such deferred revenue amounted to $531,000$519,000 and $471,000 as of SeptemberDecember 26, 2004 and June 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 SeptemberDecember 26, 2004 and June 27, 2004 was $737,000$1,085,000 and $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 reimbursement by various U.S. Government entities and other parties to aid in the development of new technology. 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 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 fundingrevenue recognized 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 fundingrevenue is determined based on actual costs plus a set percentage margin. For the cost-share contracts, the actual costs relating to the activities to be performed by the Company under the contract are divided between the U.S. Government and the Company based on the terms of the contract. The government’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 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 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 of the activities subject to the contract will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding is reported as an offset of 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 SeptemberDecember 26, 2004 and June 27, 2004.

Investments

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

(b)	Trading Securities-Debt and equity securities that are bought and held principally for the purpose of selling in the near term are reported at fair value, with unrealized gains and losses included in earnings.

Trading Securities: Debt and equity securities that are bought and held principally for the purpose of selling in the near term are reported at fair value, with unrealized gains and losses included in earnings.

Securities Available-for-Sale: Debt and equity securities not classified as either securities held-to-maturity or trading securities are reported at fair value with unrealized gains or losses excluded from earnings and reported as a separate component of shareholders’ equity.

As of SeptemberDecember 26, 2004 and June 27, 2004, the Company held a long-term equity investment in the common stock of Color Kinetics, Incorporated (“Color Kinetics”). In fiscal 2001 and 2002, the Company purchased 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 Nasdaq National Market. The Company accounts for its shares in Color Kinetics as available-for-sale securities under SFAS 115. Accordingly, unrealized gains or losses on Color Kinetics’ shares are excluded from earnings and are recorded in other comprehensive income, net of tax. Management classifies the shares as a long-term investment as the Company has the intent and the ability to hold these shares. As of SeptemberDecember 26, 2004 and June 27, 2004, the Company had recorded a cumulative unrealized holdingcapital gain on its investment in Color Kinetics of $20.5$22.5 million and $9.3 million, respectively, (or $12.4$13.6 million and $5.6 million, net of tax, respectively). ThisThe unrealized capital gain was based on the most recent closing stock price as of SeptemberDecember 26, 2004 and June 27, 2004 to determine the fair market value of the Company’s investment of $33.2$35.2 million and $22.0 million, respectively. The Company iswas restricted from selling its shares in Color Kinetics for a period of 180 days from June 22, 2004, the date of Color Kinetics’ initial public offering and considersoffering. This restriction was lifted on December 22, 2004.

For the three months ended December 26, 2004, the Company has recorded a $7.9 million reduction in its income tax expense related to the unrealized capital gains on the Color Kinetics investment. In fiscal 2002, the Company recorded a capital loss associated with certain other marketable securities that was carried forward for tax purposes. However, the Company fully reserved the tax benefits associated with the loss because the benefits were required to be offset against a like kind unrealized capital gain. The increase in the market value of the Company’s investment in Color Kinetics was a like kind unrealized capital gain that the Company could offset against the fiscal 2002 loss carryforward, once the Company’s ability to transfer the stock was no longer contractually restricted. Therefore, a portion of the valuation allowance associated with the prior year capital loss was reversed in the second quarter of fiscal 2005. In future periods, the Company will be required to adjust its deferred tax asset valuation allowance in connection with any increase or decrease in the value of its investment in Color Kinetics, as a long-term investment.which could increase or decrease the income tax expense for the period.

As of SeptemberDecember 26, 2004 and June 27, 2004, the Company had investments in the equity of privately held companies with carrying values of $933,000 and $2.9 million, respectively, for each period. These privately held investments arewere accounted for under the cost method and are included in “other assets” in the consolidated balance sheets. Since the Company does not have the ability to exercise significant influence over the operations of these companies, the investment balances are carried at cost and accounted for using the cost method of accounting. Because the shares of stock and stock warrants the Company has received in these investments are not publicly traded, there is no established market for these securities. The Company reviews the fair value of these investments on a regular basis to evaluate the carrying value of the investments. This review includes, but is not limited to, an analysis of the companies’ cash position, financing needs, earnings and revenue outlook, and operational performance. The evaluation process is based on information requested from the privately held companies by the Company. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. If the Company determines that the carrying value of an investment is at an amount in excess of fair value, it is the Company’s 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 the Company’s consolidated statement of income. During the second quarter of fiscal 2005, the Company recorded a write-down of $2.0 million on one of its investments, representing the Company’s best estimate of other-than-temporary declines in value. This impairment charge was the “loss on long-term investments” included on the consolidated statements of income.

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-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 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 SeptemberDecember 26, 2004, the Company maintained a $681,000$487,000 reserve for inventory. Of this total amount, $282,000$168,000 is attributable to the Cree Microwave segment and $399,000$319,000 is attributable to the Cree segment. During the three months ended December 26, 2004, Cree Microwave scrapped $114,000 of previously reserved products. The Company reduced the respective inventory reserves accordingly as of December 26, 2004.

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 the consolidated statements of income.

Impairment of Long-Lived Assets

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

segment to test for impairment of its assets on a quarterly basis. DuringFor the three and six months ended SeptemberDecember 26, 2004, the Company recorded write-downs equal to $248,000 and September 28, 2003, there was no impairment recorded on these assets. There can be no assurance$326,000, respectively, for certain equipment that future analysis of Cree Microwave’s discounted cash flow will not result in a charge to earnings.the Company disposed of.

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 $406,000$397,000 and $183,000$803,000 for the three and six months ended SeptemberDecember 26, 2004, respectively. The related amortization expense was $204,000 and September$387,000 for the three and six months ended December 28, 2003, respectively.

Research and Development

The U.S. Government and certain private entities have 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 and the Company based on the terms of the contract. The government’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 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 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 26, 2004 and SeptemberDecember 28, 2003, there were no contracts for which direct expenses exceeded funding.

Product Warranty Costs

Accrued expenses include amounts accrued for product warranty expenses at both the Cree, Inc. and Cree Microwave segments. Cree Microwave accrues 0.5% of product revenue as a 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 returns and pursuant to warranty terms with its customers. The following table summarizes the changes in the Company’s product warranty

liability for the three-monththree and six-month periods ended SeptemberDecember 26, 2004 and SeptemberDecember 28, 2003 (in thousands):

Income Taxes

The Company has established an estimated tax provision based upon an effective rate of 32.5%13.4% and 24.0% for the three and six months ended SeptemberDecember 26, 2004. The Company’s effective tax rate was 31% for the three and six months ended SeptemberDecember 28, 2003. The estimated effective rate was based upon estimates of income for the fiscal year and projected differences between book and taxable income for the Company’s ability to use remaining net operating loss carryforwards and other tax credits.year. However, the actual effective rate may vary depending upon actual results compared to projected pre-tax book income for the year and other factors. Income taxes have been accounted for using the liability method in accordance with Statement of Financial Accounting Standards No. 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.

During the second quarter of fiscal 2005, the Company’s income tax expense was reduced by an aggregate of $5.4 million of adjustments. As of December 26, 2004, the Company has a federal capital loss carryover of $39.8 million. The related deferred tax asset of $13.9 million was previously offset by a valuation allowance, since it was more likely than not that the Company could not utilize the capital loss carryover. Based on Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes,” the valuation allowance should be adjusted for any new realizable federal capital gains or losses. The contractual trading restrictions applicable to the Company’s investment in Color Kinetics expired on December 22, 2004. As a result, the $22.5 million unrealized federal capital gain related to the Company’s investment in Color Kinetics required a $7.9 million reversal of the valuation allowance, which decreased income tax expense for the three and six months ended December 26, 2004. Also, the Company increased the valuation allowance related to privately held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005. Additionally, the Company increased income tax expense by $1.8 million for a settlement on state income taxes, estimated state tax rate changes and other adjustments.

Stock Options

The Company accounts for stock-based employee compensation under Accounting 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 Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”)Employees”. 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 the revised Statement of Financial Accounting Standards No. 123, “Share-Based Payment” (“SFAS 123, as amended123”) (in thousands, except per share amounts):

		Three Months Ended December 28, 2003				Six Months Ended December 28, 2003
Net income, as reported		$	13,007			$	21,886
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects			69				140
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects			(9,255	)			(16,397	)
Pro forma net income		$	3,821			$	5,629
Basic earnings per share, as reported		$	0.18			$	0.30
Pro forma basic net income per share		$	0.05			$	0.08
Diluted earnings per share, as reported		$	0.17			$	0.29
Pro forma diluted net income per share		$	0.05			$	0.07

Recent Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS 151 requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal.” In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company adopted SFAS 151 during the three months ended December 26, 2004. The adoption of SFAS 151 did not have a material effect on the Company’s consolidated financial condition or results of operations.

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (“Statement 123(R)”), (revised 2004), “Share-Based Payment,” which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

Statement 123(R) must be adopted no later than the first interim or annual period beginning after June 15, 2005, irrespective of the entity’s fiscal year. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt Statement 123(R) on June 27, 2005, the beginning of its first quarter of fiscal 2006 using the modified-prospective method.

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future and other factors. However, had the Company adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to our consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $3.1 million, $5.2 million, and $2.7 million in the fiscal years ended 2004, 2003 and 2002, respectively.

Contingencies

In re Cree, Inc. Securities Litigation

As reported in the Company’s Annual Report on Form 10-K for the fiscal year 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 ourits officers and current and former directors. In February 2004, the Company moved that the court dismiss the consolidated amended complaint on the grounds that it failed to state a claim upon which relief can be granted and did not satisfy the pleading requirements under applicable law. On August 30, 2004, the court entered an order granting the motion to dismiss without prejudice and allotting 45 days for the plaintiffs 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 their prior complaint. The Company expects to filehas filed a motion to dismiss the Amended Complaint, which currently is pending. The Company also filed an early motion for summary judgment based on or before November 15, 2004.the statute of limitations. The court denied the motion without prejudice to the Company’s ability to re-file the motion, if necessary, at a later point in the litigation.

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.

During the three months ended SeptemberDecember 26, 2004, there were no other material developments in the legal proceedings previously reported in the Company’s Annual Report on Form 10-K for the fiscal year ended June 27, 2004 and its Quarterly Report on Form 10-Q for the quarterly period ended September 26, 2004. Please refer to Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 27, 2004 and Part II, Item 1 of the Quarterly Report on Form 10-Q for the quarterly period ended September 26, 2004, respectively, for a description of other material legal proceedings.

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.

Factors that could cause or contribute to such differences include: our ability to complete development and commercialization of products under development, such as our pipeline of brighter light emitting diodes (LEDs); our ability to lower 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 processes and the transition of production to three-inch wafers, we may experience production delays that preclude us from shipping sufficient quantities to meet customer orders or that result in higher production costs and lower margins; risks associated with the ramp up of 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; 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; our ability to utilize tax loss carryforwards in future periods; and risks associated with our securities litigation. See “Certain Business Risks and Uncertainties” below, as well as other risks and uncertainties referenced in this report, for additional risk factors that could cause our actual results to differ.

Business Overview

We develop and manufacture semiconductor materials and electronic devices made from SiC, GaN, silicon and 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 UVgreen LED chips. We currently offer LED chips at three brightness levels:

Our LED chips are packaged by our customers and used by manufacturers as a lighting source for mobile appliances such as cellmobile phones, automotive dashboard lighting, indicator lamps, miniature white lights, indoor and outdoor full color displays, traffic signals and other lighting applications. Some of our customers package our blue LEDs in combination 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 and derivatives of XLamp products will be used in emerging applications such as automotive headlamps and backlighting for large format liquid crystal display (LCD) screens. LED products represented 82%81% and 76%82% of our revenue for the three and six months ended SeptemberDecember 26, 2004, respectively. LED products represented 78% and September77% of our revenue for the three and six months ended December 28, 2003, respectively.

We also derive revenue from the sale of semiconductor wafers and epitaxywafer products made from SiC and GaN that our customers use for manufacturing LEDs and power devices or for research and development. Sales of SiC and GaN wafer and epitaxythese products represented 7% of our revenue for the three and six months ended December 26, 2004, respectively. Sales of wafer products represented 8% of our revenue for the three and six months ended September 26, 2004 and SeptemberDecember 28, 2003, respectively. We also sell SiC materials in bulk crystal form to Charles & Colvard, Ltd. (C&C) for use in gemstones. Sales of SiC crystals for gemstones represented 2% of our revenue for each of the three-month periodsthree and six months ended SeptemberDecember 26, 2004, respectively. Sales of SiC crystals for gemstones represented 1% and September2% of our revenue for the three and six months ended December 28, 2003, respectively. Our other products include SiC-based power and RF devices. We received 2% and 1% of our revenue from sales of power devices and SiC-based RF devices combined for the three and six months ended SeptemberDecember 26, 2004, respectively. We received 2% of total revenue from sales of power devices and SeptemberSiC-based RF devices combined for the three and six months ended December 28, 2003, respectively.

Through our Cree Microwave segment, based in Sunnyvale, California, we also develop and manufacture RF power transistors and modules using silicon technology. During the three and six months ended SeptemberDecember 26, 2004, we received 2% and September1% of our revenue from sales from our Cree Microwave segment, respectively. During the three and six months ended December 28, 2003, we received 1%3% and 2% of our revenue from sales from our Cree Microwave segment, respectively.

The balance of our revenue was derived primarily from research funding under government contracts, which amounted to 6% and 11% for the three and six months ended SeptemberDecember 26, 2004, respectively. For the three and Septembersix months ended December 28, 2003, revenue from contracts

was approximately 8% and 9%, respectively. Under various programs, U.S. Government 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 26, 2004 and SeptemberDecember 28, 2003, 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 56%39% and 51%70%, respectively, in the firstsecond quarter of fiscal 2005 over the prior year comparative period. Overall, we continued to experience revenueDuring the second quarter of fiscal 2005, our growth inwas led by strong sales of our standard, mid-brightness, high-brightnessnewer products, including our UT230 and high power packaged LEDs. Our most significant increase in product sales 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.X-class products, as well as our MegaBright devices. Sales of high-brightness LEDs represented 55%52% of our LED revenue for the firstsecond quarter of fiscal 2005. Sales of mid-brightness products made up 39%42% of our LED revenue in the firstsecond quarter of fiscal 2005. During the firstsecond quarter of fiscal 2005, we experienced growth inmobile phone applications led the demand for our RazerThin^™®UT230^™ LED products, which are thinner and offer a lower voltage chips, for use in a variety of applications including blue keypads, and MegaBright and X-products, for mobile phones.use in white keypads and backlights for LCDs. Sales of our standard brightness products made up 6% of our LED sales during the firstsecond quarter of fiscal 2005.

We are focused on expanding our high-brightness product family with brighter blue and green products to enable us to increase use of our products forin mobile appliance LCD backlight applications, which our customers have identified as a large near-term growth opportunity. Recently,We believe that 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 growcurrently participate in fiscal 2005.

a small percentage of this market. During the firstsecond quarter of fiscal 2005, we begancontinued the conversion of our LED production process from two-inch to three-inch SiC wafers. As we exitedDuring the firstsecond quarter, approximately 10%15% of our LED production was manufactured on three-inch wafers. As a resultDuring the second quarter of fiscal 2005, the targetedprogression to three-inch wafer production increased our costs as we worked through transition issues. Longer-term, we target cost savings from the three-inch migrationbased products and other benefits, we aimtherefore plan to implement a morecontinue to be aggressive with our pricing strategy to driveseek additional market share for our products. During the second quarter of fiscal 2005, our customer demand slowed in December for certain products and we had difficulty increasing production of X-class products to meet a shift in product mix desired by our customers.

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 Octoberthe second quarter of 2004,fiscal 2005, we announced the release ofreleased the XLamp 4550 series for smaller form factor applications.applications and a brighter XLamp 7090 product. The XLamp products are being designed into several specialty lighting applications including architectural lighting, appliance lighting and channel letters. As automotive headlightheadlights, LED backlighting for large format LCD monitors and large screentelevisions, and other LED lighting applications emerge, over the next several years, we targetplan to position our XLamp productspackaged LED product family to serve these markets as well.

During the three months ended SeptemberDecember 26, 2004, SiC and GaN materialswafer product revenue increased 25%18% over the prior year period due to a significant increase in sales of epitaxal wafers, which carrycertain wafer products with higher average sellingsales prices. Revenue from the sale of SiC materials used in gemstones was 15%72% greater in the firstsecond quarter of fiscal 2005 as compared to the prior year period due to higher unit sales and improved yields. Revenue from silicon-based microwave products increased 38%decreased 24% in the firstsecond quarter of fiscal 2005 as compared to the prior year period as we experienced growth in sales of our Laterally Diffused Metal Oxide Semiconductors (LDMOS).

period. Contract revenue decreased 19%2% for the three months ended SeptemberDecember 26, 2004 over the prior year period due largely to a slow downthe timing 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 also recorded a $337,000 license fee from a third party for the use of certain technology owned by us but not part of our core technology.programs.

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 U.S. accounting principles. 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.

Valuation of Long-Lived Assets Intangible Assets and Goodwill. We have approximately $428.6$468.1 million of long-lived assets as of SeptemberDecember 26, 2004, including approximately $314.4$345.0 million related to fixed assets and capitalized patents $76.9and license rights, $85.7 million in long-term investments held to maturity, $33.2$35.2 million in long-term marketable securities available for sale and $4.1$2.2 million of other long term assets, including net investments in privately held companies of $2.9 million$900,000 and

long-term deposits of $1.2 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 or Disposal of Long-Lived Assets”, 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. For the three and six months ended SeptemberDecember 26, 2004, we recorded impairment chargeswrite-downs equal to $78,000$248,000 and $326,000, respectively, for the disposal of certain equipment that we identified as obsolete and disposed of and for patents that we abandoned.equipment.

We also review our capitalized patent portfolio and record impairment charges when circumstances warrant, such as when issued patents have been abandoned or patent applications are no longer being pursued.

Accounting for Marketable and Non-Marketable Equity Securities. From time to time, we make strategic investments in the equity securities of privately held companies. Since we do not have the ability to exercise significant influence over the operations of these companies, thesethe investment balances are carried at cost and accounted for using the cost method of accounting. TheBecause the shares of stock that we receivedreceive 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 estimatereview the fair value of these investments on a regular basis in order to evaluate the carrying value of suchthe investments. This policyreview includes, but is not limited to, reviewing each company’san analysis of the companies’ cash position, estimates of the company’s market capitalization based on recent financing transactions, itsneeds, earnings and revenue outlook, and operational performance, management or ownership changes and competition.performance. The evaluation process is based on information that we are provided byrequested from the privately held companies. Since these companies areby us. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. If we determine that the carrying value of an investment is determined to beat an amount in excess of our estimate of fair value, and we have determined that the decline is 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 statement of income. During the second quarter of fiscal 2005, we recorded a write-down on our investment in a privately held company of $2.0 million pre-tax, representing our best estimate of other-than-temporary declines in value. This impairment charge was included as an “other non-operating loss” on the consolidated statements of income. EstimatingOur investment in this company was written down to reflect the fair value based on our evaluation of non-marketable investments in early-stage technology companies is inherently subjectivethe company’s financial results and may contributea third party proposal to significant volatility inpurchase our reported results of operations.investment. There were no adjustments made to investment losses on our consolidated statements of income during the three and six months ended September 26, 2004 and SeptemberDecember 28, 2003 relating to our investments in privately held companies.

From time to time, we evaluate strategic opportunities and potential investments in complementary businesses, and as a result we may invest in 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 on the consolidated balance sheets.

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 No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115), are recorded as an investment loss on our consolidated statements of income. We have a policy in place to review our equity holdings 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, stock price performance, liquidity, ability to raise capital and any management 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 equity investments to the market value. In addition, we 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 our average cost for two consecutive fiscal quarters, unless strong positive evidence exists that makes it clear that an other-than-temporary write-down would be inappropriate under the guidance of SFAS 115. Any related write-down would then be recorded as an investment loss on our consolidated statements of income.

As of June 27, 2004, we began accounting for our investment in the common stock of Color Kinetics as a marketable security that is available-for-sale under SFAS 115. Our investment in Color Kinetics is valued at $33.2$35.2 million, which represents the $12.7 million cost, plus a $20.5$22.5 million unrealized gain in the security based on the closing share price on SeptemberDecember 24, 2004. As an available-for-sale security, any unrealized gain or loss is accounted for as a comprehensive income item in the equity section of the consolidated balance sheet and on the consolidated

statement of shareholders’ equity and is not recorded through earnings. At SeptemberDecember 28, 2003, we held no marketable equity securities. For the three months ended December 26, 2004, we recorded a $7.9 million reduction in our income tax expense related to the unrealized gains on our Color Kinetics investment. In fiscal 2002, we recorded a capital loss associated with certain other marketable securities that was carried forward for tax purposes. However, we fully reserved the tax benefits associated with the loss because the benefits were required to be offset with a like kind capital gain. The increase in the market value of our investment in Color Kinetics was a like kind unrealized gain that we could offset against the fiscal 2002 loss carryforward, once our ability to transfer the stock was no longer contractually restricted. Therefore, a portion of the valuation allowance associated with the prior year capital loss was reversed in the second quarter of fiscal 2005, following expiration of the lock-up. In future periods, we will be required to adjust our deferred tax asset valuation allowance in connection with any increase or decrease in the value of our investment in Color Kinetics, which could increase or decrease the income tax expense recorded for each quarter.

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-progress 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. We evaluate our ending inventories for excess quantities, impairment of value and obsolescence on a monthly basis. This evaluation includes analysis of sales levels by product and projections of future demand based upon input received from our customers, sales teama review of orders, forecasts and management estimates.customer purchase trends. 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 eliminate 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. During the three months ended December 26, 2004, Cree Microwave scrapped $114,000 of previously reserved products. We reduced the respective inventory reserves accordingly as of December 26, 2004.

During the three and six months ended December 28, 2003, we reduced our reserve for certain wafer material products by $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 reduced the respective inventory reserves accordingly as of December 28, 2003.

During the first quarter of fiscal 2004, we wrote down LED inventory by $531,000 to an estimated market value calculation. Some of these products were subsequently sold during the same quarter.value. We also reduced our reserve by $165,000 for certain wafer material products by $165,000 as the products previously reserved for were selling more rapidly than anticipated.

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 our customers for a specified amount of product at a specified price and consider delivery to have occurred at the time of shipment. The majority of our products have shipping terms that are free

on board (FOB) or free carrier alongside (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 our 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 products cost insurance freight (CIF). Under this arrangement, revenue is recognized under FOB shipping point terms, however, we are responsible for the cost of insurance to transport the product as well as the cost to ship the product. For all of our sales other than those with CIF terms, we invoice our customers only for shipping costs necessary to physically move the product from our 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 our customers as revenue, with the corresponding cost recorded as cost of revenue. For the three-monththree and six month periods ended SeptemberDecember 26, 2004, and September 28, 2003, we recognized $42,000$47,000 and $26,000,$89,000, respectively, as revenue for shipping and handling costs. If inventory is maintained at a consigned location, revenue is recognized when our customer pulls product for its use and the title of the goods is transferred to the customer. 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. We record a reserve for estimated sales returns, which is reflected as a reduction of revenue at the time of revenue recognition.

Certain of our sales arrangements provide for limited product exchanges and reimbursement of certain sales costs. For two customers, Sumitomo and OSRAM, we defer revenue equal to the levels specified in contractual arrangements and recognize 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 our sales agreement with Sumitomo, such deferred revenue amounted to $6.6$7.4 million and $7.9 million as of SeptemberDecember 26, 2004 and June 27, 2004, respectively. In connection with our agreement with OSRAM, such deferred revenue amounted to $531,000$519,000 and $471,000 as of SeptemberDecember 26, 2004 and June 27, 2004, respectively.

Historically, we have experienced only nominal credit losses from customers’ inability to pay. Any uncollectibilitypay as the majority of past due receivables is primarily due toresult from 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 26, 2004 and June 27, 2004 was $737,000$1,085,000 and $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 reimbursement by various U.S. Government entities and other parties to aid in the development of new technology. The applicable contracts generally provide that we may elect to retain ownership of inventions made in performing the work, subject to a non-exclusive license retained by the 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 fundingrevenue recognized under each contract is determined based on cost estimates that include direct costs, plus an

estimated allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus fundingcontract revenue is determined based on actual costs plus a set percentage margin. For the cost-share contracts, the actual costs relating to the activities to be performed by us under the contract are divided between the U.S. Government and us based on the terms of the contract. The government’s cost share is then paid to us. Activities performed under these arrangements include research regarding SiC and GaN materials and devices. 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 where we anticipate 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 we anticipate that direct costs of the activities subject to the contract will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding is reported as an offset of 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.

Valuation of Deferred Tax Assets and Liabilities.As of SeptemberDecember 26, 2004, we had $2.6 million recorded as a short-term deferred tax asset and $8.3$1.9 million as a long-term deferred tax liability. This asset was recorded as a result of tax benefits associated with write-downs and reserves recorded for accounts receivable and inventory reserves that are deferred for tax purposes. The liability provides for amounts due as a result of the timing difference for depreciation between book and tax purposes being offset by deferred tax benefits associated with write-downs taken for goodwill and other intangible assets, other-than-temporary charges taken on our investments and other write-downs taken in prior fiscal years. We have a reserve for taxes that may become payable in the future included in deferred tax liabilities. A valuation allowance has been established on capital loss carryforwards and unrealized losses on certain securities as we believe that it is more likely than not that the tax benefits of the items will not be realized. As of December 26, 2004, we have a federal capital loss carryover of $39.8 million. The related deferred tax asset of $13.9 million was previously offset by a valuation allowance since it was more likely than not that we could not utilize the capital loss carryover. Based on Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes”, the valuation allowance should be adjusted for any new realizable federal capital gains or losses. The contractual trading restrictions applicable to our investment in Color Kinetics expired on December 22, 2004. As a result, the $22.5 million unrealized federal capital gain related to our investment in Color Kinetics required a $7.9 million reversal of the valuation allowance, which decreased income tax expense for the three and six months ended December 26, 2004. Also, we increased the valuation allowance related to privately held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005.

It is our policy to establish reservesa reserve for taxes that may become payable in future years, and we currently have a reserve of $8.5$7.3 million for such deferred tax liabilities. The tax reserve decreased by

$1.2 million in the three-month period ended December 26, 2004 as we settled a state tax adjustment during the quarter and we no longer are required to maintain a reserve relating to that matter. We establishestablished the reserves based upon management’s assessment of exposure associated with the tax return deduction. We analyze the tax reserves at least annuallyquarterly and makemakes adjustments as events occur that warrant adjustment to the reserve. For example, if the statutory period for assessing tax on a given tax return lapses, we reduce the reserve associated with that period. Similarly, if tax

authorities provide administrative guidance or a decision is rendered in the courts, we make appropriate adjustments to our tax reserve. The tax reserve was unchanged in the three month period ended September 26, 2004.

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. SeePlease refer to our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 27, 2004, 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 income data expressed as a percentage of total revenue for the periods indicated: