| · | LED chips and packaged products. We derive the largest portion of our revenue from the sale of blue, and green LED chips. We currently offer LED chips at three brightness levels:high-brightness blue, traffic green and true green products, which include our
MegaBright®, XBright® and XThin® chips and our XB900™ and XB500™ power chip devices;
| • | | mid-brightness blue, traffic green and truenear ultraviolet (“UV”) LED chips. Some of our customers package our blue LEDs in combination with phosphors to create white LEDs. Our LED chips are packaged by our customers and used by manufacturers as a light source for mobile products, entertainment devices, indoor and outdoor full color displays, automotive interior lighting, miniature white lights, and other lighting applications. In fiscal 2005, we released a family of high power packaged LEDs called our XLamp™ products that are designed to compete with conventional lighting technology for certain specialty lighting applications. We sell packaged LED products in blue, green, white, amber and red colors. We currently are marketing these products which include UltraBright®for use in specialty lighting applications, architectural lighting, appliance lighting, flashlights and UT230™ devices;reading lamps. Sales of LED products represented 82% of our revenue each of the quarters ended September 25, 2005 and September 26, 2004, respectively. |
standard brightness blue products.
| · | Materials products. Our customers purchase our SiC and GaN wafers for use in manufacturing LEDs and power devices or for research and development. Sales of SiC and GaN wafers represented 5% and 7% of our revenue for the three months ended September 25, 2005 and September 26, 2004, respectively. We also sell SiC materials in bulk crystal form for use in gemstone applications. Sales of SiC crystals for use in gemstone applications represented 3% and 2% of our revenue for the three months ended September 25, 2005 and September 26, 2004, respectively. |
| · | High power products. These products include SiC power devices, wide bandgap radio frequency (“RF”) and microwave devices and silicon-based RF products. Our customers currently purchase Schottky diode products for use in power factor correction circuits for power supplies in computer servers and other applications. We also provide discrete SiC RF transistors, as well as a foundry service for wide bandgap MMICs, for use in communication applications, high power radar amplifiers, electronic warfare and wireless infrastructure. Sales of power devices and SiC-based RF devices represented --3% and 2% of our revenue for the three months ended September 25, 2005 and September 26, 2004, respectively. In June 2005, we announced plans to close our silicon-based RF and microwave business previously known as our Cree Microwave segment. This business produces semiconductor components for power amplifiers used for analog and digital base stations. This business, which is located in Sunnyvale, California, is expected to complete production for last-time buy orders in December 2005, and we expect to close the factory in the third quarter of fiscal 2006. Sales of RF devices from our Cree Microwave-Sunnyvale business represented 1% of our revenue for the three months ended September 25, 2005 and September 26, 2004, respectively. |
Our LED chips are packaged by our customers and used by manufacturers as a lighting source for mobile appliances such as mobile phones, lighting for entertainment products such as pachinko machines, automotive dashboard lighting, indicator lamps, miniature white lights, indoor and outdoor full color displays, traffic signals and other lighting applications. SomeTable of our customers package our blue LEDs in combination with phosphors to create white LEDs. In July 2004, we released a family of new high power packaged LEDs called XLamp™Contents 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 and reading lamps. LED products represented 83% and 82% of our revenue for the three and nine months ended March 27, 2005, respectively. LED products represented 80% and 78% of our revenue for the three and nine months ended March 28, 2004, respectively.We also derivegenerate revenue from the sale of semiconductor wafer products that our customers use for manufacturing LEDs, power and radio frequency (“RF”) devices or for research and development. Sales of these products represented 6% and 7% of our revenue for the three and nine months ended March 27, 2005, respectively. Sales of wafer products represented 6% and 8% of our revenue for the three and nine months ended March 28, 2004, 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 the three and nine months ended March 27, 2005, respectively. Sales of SiC crystals for gemstones represented 2% of our revenue for the three and nine months ended March 28, 2004, respectively. Our other products include SiC-based power and RF devices. We received 2% of our revenue from sales of power devices and SiC-based RF devices combined for the three and nine months ended March 27, 2005, respectively. 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.Through our Cree Microwave segment, based in Sunnyvale, California, we also develop and manufacture RF power transistors and modules using silicon technology. During each of the three and nine months ended March 27, 2005, we received 1% of our revenue from sales from our Cree Microwave segment. During the three and nine months ended March 28, 2004, we received 3% and 2%, respectively, of our revenue from sales from our Cree Microwave segment.
The balance of our revenue was derived primarily from research funding under contracts funded by government contracts, which amounted to 6% for the three and nine months ended March 27, 2005, respectively. For the three and nine months ended March 28, 2004, revenue from contracts was
approximately 7% and 9%, respectively. Under various programs, U.S.agencies. Government and other entities assist us in the development of new technology by funding a portion of our research and development efforts. Contract revenue includesRevenue from contract research funding for direct research and development costs and a portionrepresented 6% of our general and administrative expenses and other operating expenses for contracts under which we expect funding to exceed direct costs over the liferevenue in each of the contract. For contracts underquarters ended September 25, 2005 and September 26, 2004, respectively.
Industry Dynamics
Our business is affected by a number of industry factors, including: trends in mobile product designs and sales, competitive LED pricing pressures and the relative strength of each supplier’s intellectual property. The most significant market currently for our blue and green LED chips is for illumination purposes in mobile products, including LCD backlighting, keypad illumination and flash for cameras. LED sales for mobile products are impacted by the number of LEDs used in an application, which we anticipate that direct costs will exceed amounts to be funded overmay vary depending on trends in the lifefeatures of the contract, we report direct costs as researchapplication and development expenses with related reimbursements recorded as an offset to those expenses. For the three and nine months ended March 27, 2005 and March 28, 2004, we did not have any contracts for which we anticipated direct costs to exceed funding over the lifebrightness of the contract.LEDs used. Average LED sales prices decline each year as market players implement pricing strategies to strengthen or protect market share. To remain competitive, LED producers generally must increase product performance and reduce the average sales price at or above the market rate. Finally, vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. Customers’ purchasing decisions can be influenced by whether a product may infringe valid intellectual property rights.
Product OverviewHighlights and OutlookOur
Financial highlights from the first quarter of fiscal 2006
We reported our highest quarterly revenue in the first quarter of fiscal 2006 primarily due to growth in LEDs, high power products and contract revenue.
For our first quarter of fiscal 2006, LED revenue and units sold increased 30% and 53%, respectively,grew $1.0 million over LED revenue recorded in the thirdfourth quarter of fiscal 2005, over the prior year comparative period. During the third quarter of fiscal 2005, our growth was generated by strongprimarily from increased sales of our high brightness products. These high brightnessLEDs, which increased from 65% to 68% of our LED revenue sequentially. We estimate that much of this LED revenue increase resulted from the use of our products are targetedin white backlighting for new designsLCDs in mobile phone applications for LCD backlighting, white keypads and camera flashes, and we experienced a strong seasonal demand for blue and greenproducts. Revenue from our mid-brightness LEDs for gaming machines, including pachinko, and other applications. Somedeclined from 32% of our high brightness successLED revenue in the thirdfourth quarter of fiscal 2005 resulted from salesto 28% of our newer families of products that have been introduced overLED revenue the past year. During the thirdfirst quarter of fiscal 2005 we noted2006. This decrease in mid-brightness LED revenue resulted from a declineshift in salesdemand toward our UT 230™ chip that is sold at a low average selling price and is used in blue keypad designs for mobile products. We estimate that more than 50% of our mid-brightnessoverall LED sales in the first quarter of fiscal 2006 were related to mobile product applications.
During the first quarter of fiscal 2006, revenue from our high power products as our customers’ demand for blue LEDs for keypad backlightingand contracts increased by $1.2 million and $2.1 million, respectively, over revenue from each category in mobile phones was lower due to the seasonal trend for these markets. Sales of high-brightness LEDs increased from 52% to 66% of our LED revenue, sequentially, during the thirdfourth quarter of fiscal 2005. SalesThe increase in high power products revenue resulted primarily from increased SiC MMIC foundry sales. Contract revenue increased due to new contract awards received from various government agencies.
Our gross margin was 49% of our LED revenue sequentially, in. For the thirdfirst quarter of fiscal 2005. During2006, our cost of product revenue increased over the third quarter of fiscal 2005, LEDs for mobile phones were still the largest demand from our customers, despite the decline in demand for blue keypad applications. Mobile phone applications typically use the UT230 chip to illuminate blue keypads and MegaBright and X-class products for use in white keypads, camera flashes and backlights for LCDs. Sales of products used in pachinko machines were also particularly strong in the thirdfourth quarter of fiscal 2005 due to seasonal increaseshigher product sales. Our first quarter cost of product revenue also included a $200,000 reserve for inventory for the silicon-based Cree Microwave business and a $628,000 charge resulting from stock compensation expense that we recorded for the first time as well as pent up demand for products because these markets experienced a delay in regulatory approval for some modelswe adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, “SFAS 123R”. Our LED product profitability declined in the last halffirst quarter of calendar year 2004 thatfiscal 2006 as our blended average sales price decreased 8% sequentially while average costs were resolved inunchanged compared to the thirdfourth quarter of fiscal 2005. These applications generally require MegaBright and X-classOur average sales price declined in part because of a strong product mix shift to our UT-230 chips to support a keypad application ramp up for mobile products. SalesWe also lowered our sales price on some of our standardhigh brightness products made up 3%and increased our performance specifications as part of our strategy to increase market share in white LEDs used for mobile products. The higher brightness specifications required to support the new design wins resulted in lower production yields for certain products. As we continued the migration of our production from two-inch wafers to three-inch wafers, more than 60% of our LED saleschips were made from three-inch wafers during the thirdfirst quarter of fiscal 2005.We are focused on continuing to expand our high-brightness product family with brighter blue2006. Three-inch wafers generally increase the number of chips made per wafer and green products. Our customers have identified mobile phone LCD backlights as a large near-term growth opportunity. We believe that we currently participate in a small percentagelower the overall cost. During the first quarter of fiscal 2006, the benefit of this market, as one Japanese competitor has a large market share. We anticipate thatmigration to three-inch wafers was offset by lower yields caused by the competition for these designs will be intense, which means that our ability to provide higher performance LEDs at lower costs will be criticalspecifications. As a result, the average cost of LED products remained unchanged from the fourth quarter of fiscal 2005. We plan to our success. We have continuedcontinue to drivemigrate more of our LED costs lower by converting our LED production process from two-inch to three-inch SiC wafers. Duringwafers during the thirdremainder of fiscal 2006, which we target will increase the number of LED chips per wafer and therefore lower our overall LED chip cost. Also, during the second quarter of fiscal 2005, approximately one third2006 we target LED price declines in a range of 3% to 5% based on our analysis of our LED chips were manufactured on three-inch wafers, and we improved our yield on these products, which lowered our cost per die. On a long-term basis, we target further cost savings from products made from three-inch waferscurrent backlog for the quarter as well as other yield and process improvements.
Intargeted LED price declines of approximately 25% to 30% for the entire fiscal year.
We achieved cash flow from operations of $31.0 million in the first quarter of fiscal 2005, we released our XLamp 7090 series, which were2006.
Cash and short and long-term investments increased from $277.3 million in the first products in our high power packaged LED family. In the secondfourth quarter of fiscal 2005 we released the XLamp 4550 series for smaller form factor applications and a brighter XLamp 7090 product. The XLamp products are being designed into several specialty lighting applications including architectural and appliance lighting. During the three months ended March 27, 2005, wafer revenue increased 14% over the prior year period due to a significant increase in sales of certain wafer products with higher average sales prices. Revenue from the sale of SiC materials used in gemstones was 79% greater$295.9 million in the thirdfirst quarter of fiscal 2005 as compared to the prior year period2006 due to greater customer demand and improved yields. Revenue from silicon-based microwave products decreased 56%higher profits, which was somewhat offset by capital expenditures of $12.5 million.
Outlook for Fiscal 2006
In fiscal 2006, we are working to increase the brightness of our LED products. If we are successful in developing brighter LEDs, we believe that we will have an opportunity to gain market share in the third quarterLCD backlight and camera flash markets for mobile products that use white LEDs. In addition to mobile products, we believe our new products can enable us to gain new customer designs for other high-brightness LED applications, such as specialty lighting, gaming machine designs, and displays.
We continue to expand our product offerings of our XLamp family of high-power packaged LED products. We are aiming to increase sales of XLamp products in the specialty lighting markets, including architectural lighting, appliance lights, flashlights and reading lights.
In order to expand our factory output and improve our yields, we plan to invest $90.0 million to $110.0 million during fiscal 2006 in capital equipment additions. We also may increase our research and development spending as a percentage of revenue over our fiscal 2005 as compared to the prior year period due to changes in our customer base and other factors. Contract revenue decreased 4% for the three months ended March 27, 2005 over the prior year period due to the winding downlevel.
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.principles generally accepted in the United States. In preparing our financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosure of contingent assets and liabilities at the date of our financial statements. CriticalWe base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. On a regular basis, management reviews our accounting policies include those policiesand assumptions, estimates and judgments to ensure that our financial statements are reflective of significant judgmentspresented fairly and uncertainties, which potentiallyin accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could produce materially different results under differentdiffer from our assumptions and conditions. We believeestimates, and we may be exposed to gains or losses that our criticalcould be material.
Our significant accounting policies are limited to those described below.Valuationdiscussed in Note 2, “Summary of Long-Lived Assets. We have approximately $477.8 million of long-lived assets as of March 27, 2005, including approximately $364.9 million related to fixed assetsSignificant Accounting Policies and capitalized patents and license rights, $87.0 million in long-term investments held to maturity, $18.6 million in long-term marketable securities available-for-sale and $7.3 million of other long term assets, including $6.4 million in deferred license fees, net investments in privately held companies of $37,000 and long-term deposits of $916,000. 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) estimationsOther Matters,” of the fair market value of the assets, and (ii) estimations of future cash flows expectedNotes 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 nine months ended March 27, 2005, we recorded write-downs equal to $277,000 and $603,000, respectively, for the disposal of certain 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 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, areConsolidated Financial Statements, included in accumulated other comprehensive income, which is reflected as a separate componentItem 8, Financial Statements and Supplementary Data, of shareholders’ equity on the consolidated balance sheets. Realized gains and losses are recognized upon the sale or disposition of the investment. 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 statement 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 $18.6 million, which represents the $10.7 million cost, plus a $7.9 million unrealized gain in the security based on the closing share price on March 24, 2005, which was the last trading date in the third quarter of fiscal 2005. 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. During the third quarter of fiscal 2005, we sold 343,000 shares of our Color Kinetics investment, which resulted in a gain of $2.8 million. At March 28, 2004, we held no marketable equity securities.
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 an unrealized capital gain. The increase in the market value of our investment in Color Kinetics became an 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 fiscal 2005, following expiration of the lock-up. For the three months ended March 27, 2005, we recorded a $4.1 million increase in our income tax expense related to an adjustment to the unrealized gains on our Color Kinetics investment. 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.
From time to time, we have made 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, the investment balances are carried at cost and accounted for using the cost method of accounting. Because the shares of stock that we receive in these investments are not publicly traded, there is no established market for these securities. We review 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 we request from the privately-held companies. 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 at an amount in excess of fair value, 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 Lighthouse of $2.0 million pre-tax, representing our best estimate of an other-than-temporary decline in the value of the investment. This impairment charge was included in other non-operating loss on the consolidated statement of income. Our investment was written down to reflect the fair value based on our evaluation of the company’s financial results and a third party proposal to purchase our investment. During the third quarter of fiscal 2005, we sold our investment in Lighthouse for $896,000, which was the carrying value of the investment. We no longer hold any investments in privately-held companies where the investment has a carrying value on our financial statements except for a $37,000 investment representing the estimated value of warrants that we received from a privately-held company. There were no adjustments made to investment losses on our consolidated statements of income during the three and nine months ended March 28, 2004 relating to our investments in privately-held companies.
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 quarterly basis. This evaluation includes analysis of sales levels by product and projections of future demand based upon a review of orders, forecasts and 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. As of March 27, 2005 and June 27, 2004, our inventory reserve account balance was $513,000 and $695,000, respectively.
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 our 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 our 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 these 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 and nine-month periods ended March 27, 2005, we recognized $48,000 and $138,000, respectively, as revenue for shipping and handling costs. For the three and nine-month periods ended March 27, 2004, we recognized $27,400 and $79,500, 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 their 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. In addition, certain of our sales arrangements provide for limited product exchanges and reimbursement of certain sales costs. As a result, we record an allowance for sales returns at the time of sale, which is reflected as a contra account for accounts receivable and a reduction of product revenue.
Prior to the third quarter of fiscal 2005, we deferred revenue equal to specified levels under certain of our contracts and recognized the related revenue less any claims made against the reserves when the customer’s rights expired. We deferred revenue in this manner because we did not have sufficient historical information to provide a basis to estimate the amount of future claims under these contractual arrangements. In the third quarter of fiscal 2005, we determined that sufficient historical sales return information is available that enabled us to reasonably estimate sales returns in accordance with criteria in SFAS 48. As a result of this change, we increased our allowance for sales returns by $8.4 million and decreased deferred revenue by $8.0 million on our consolidated balance sheet in the third quarter of fiscal 2005. These changes also had an impact to product revenue by reducing it by $441,000 in the third quarter of fiscal 2005. The allowance for sales returns at March 27, 2005 and June 27, 2004 was $9.5 million and $798,000, respectively. The amount of deferred revenue at March 27, 2005 and June 27, 2004 was $0 and $8.4 million, respectively. Significant judgments and estimates made by us 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 we made different judgments or used different estimates.
In connection with the change in our accounting estimate for sales returns, we also recorded an estimate in accordance with SFAS 48 for the value of product returns that we believe will be returned to inventory in the future and resold. This includes an estimate for costs of inventory that may be returned in the future. In the third quarter of fiscal 2005, we estimated the value of future product returns to be returned to inventory and resold at $1.6 million, which was reflected in other current assets in our consolidated balance sheet and as a reduction of cost of product sales on our consolidated statement of income. We also reduced our warranty reserve by $683,000 in the third quarter of fiscal 2005, since our estimates for sales returns includes the cost of products that may be returned and replaced under warranty provisions. The net effect of the adjustments recorded for the change in accounting estimate for sales returns was a $1.9 million increase to pretax income for the third quarter of fiscal 2005. Net of income taxes, this
adjustment increased net income by $1.3 million or $0.02 per common share. We also estimated an allowance for bad debt of $106,000 in the third quarter of fiscal 2005 that was recorded as a contra asset account to accounts receivable on our consolidated balance sheet and as sales, general and administrative expenses on our statement of income.
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 revenue 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. Revenue under cost-plus arrangements 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.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 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 March 27, 2005, we had $2.3 million recorded as a short-term deferred tax asset and $9.5 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 March 27, 2005, we have a federal capital loss carryover of $45.7 million. The related deferred tax asset of $16.0 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. Since contractual trading restrictions applicable to our investment in Color Kinetics expired on December 22, 2004, the $7.9 million unrealized federal capital gain related to our investment in Color Kinetics required a $3.8 million decrease of the valuation allowance, which decreased income tax expense for the nine months ended March 27, 2005. In the second quarter of fiscal 2005, we recorded a $7.9 million reduction to our income tax expense as a result of the increase in the value of this investment as of December 26, 2004. In the third quarter of fiscal 2005, we recorded a $4.1 million increase to our income tax expense as a result of the decrease in the value of this investment as of March 27, 2005. Also, during the third quarter of fiscal 2005, we determined that our effective tax provision rate had declined from 32.20% to 31.11%, and as a result it recorded a $716,000 reduction in income tax expense, in addition to recording $230,000 in other tax benefits during the third quarter of fiscal 2005. During the second quarter of fiscal 2005, we increased the valuation allowance related to privately held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005. Additionally, we increased income tax expense by $1.8 million for a settlement on state income taxes, estimated state tax rate changes and other adjustments.
It is our policy to establish a reserve for taxes that may become payable in future years, and we currently have a reserve of $8.9 million for such tax liabilities. The tax reserve increased by $1.7 million in the three-month period ended March 27, 2005 for the true up of certain reserves from our fiscal 2004 tax year and increases for fiscal 2005 activity. During the second quarter of fiscal 2005, we decreased our tax reserve by $1.2 million 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 established the reserves based upon management’s assessment of exposure associated with the tax return deduction. We analyze the tax reserves at least quarterly and make 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 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. Please refer to our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for10-K. Management believes that the fiscal year ended June 27, 2004, which contained a discussionfollowing accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of ourmatters that are inherently uncertain. Management has reviewed these critical accounting policies and otherrelated disclosures required by accounting principles generally accepted inwith our independent auditor and the United States.
Audit Committee of our Board of Directors.
Description of Policy | Judgments and Uncertainties | Effect If Actual Results Differ From Assumptions and Adjustments Recorded | Revenue Recognition: | We provide our customers with limited rights of return for non-conforming shipments and warranty claims for up to 36 months for our Cree Microwave-Sunnyvale products and lesser periods for Cree products. In addition, certain of our sales arrangements provide for limited product exchanges. As a result, we record an allowance for sales returns at the time of sale, which is recorded as a reduction of product revenue and accounts receivable. In connection with the reserve for sales returns, we also record an estimate for the value of product returns that we believe will be returned to inventory in the future and resold. This includes an estimate for costs of inventory that may be returned in the future. This estimate is recorded as other current assets and as a reduction in the cost of product sales. | We apply judgment in estimating the amount of product that will be returned in the future. Our estimate of product returns and the amount of those returns that will be placed back in inventory is based primarily on historical transactional experience and judgment regarding market factors and trends. | A 10% increase or decrease in our sales return estimates and estimates of products to be returned to inventory at September 25, 2005 would have affected net earnings by approximately $645,000 and $114,000, respectively, for the quarter ended September 25, 2005. | Valuation of Long-Lived Assets: | We review long-lived assets such as property and equipment and patents for impairment when events and circumstances indicate that the carrying value of the assets contained in our financial statements may not be recoverable. For example, pieces of our equipment may be scrapped or certain of our patents or patent applications may be abandoned. In these cases, we would directly write-off these long-lived assets. In addition, we evaluate all of our long-lived assets for potential impairment by comparing the carrying value of our assets to the estimated future cash flows of the assets (undiscounted and without interest charges). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows. We recognize an impairment loss if the amount of the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable (amortized) long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. We do not restore a previously recognized impairment loss if the asset’s carrying value decreases below its estimated fair value. | Our impairment loss calculations require management to apply judgment in estimating future cash flows and asset fair values, including estimating useful lives of the assets. To make these judgments, we may use internal discounted cash flow estimates, quoted market prices when available and independent appraisals as appropriate to determine fair value. We derive the required cash flow estimates from our internal business plans. | If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be required to record additional impairment losses that could be material to our results of operations. Using this impairment review methodology, we recorded long-lived asset impairment charges of $196,000 in the first quarter of fiscal 2005 and $5.5 million during the fiscal year ended June 26, 2005 related to plans to close our Cree Microwave-Sunnyvale facility and dispose of certain assets. | Tax Contingencies: | | We are subject to periodic audits of our income tax returns by Federal, state and local agencies. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposures associated with our various tax filing positions, including state and local taxes, we record reserves for what we identify as probable exposures. A number of years may elapse before a particular matter for which we have established a reserve is audited and fully resolved. We have also established a valuation allowance for capital loss carry forwards and unrealized losses on certain securities, as we believe that it is more likely than not that the tax benefits of the items will not be realized. | The estimate of our tax contingencies reserve contains uncertainty because management must use judgment to estimate the exposures associated with various tax filing positions. To make these judgments, we make determinations about the likelihood that the specific taxing authority may challenge the tax deductions that we have taken on our tax return. Based on information about other tax settlements we estimate amounts that we may settle with taxing authorities in order to conclude audits. | To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would require use of our cash and result in an increase in our effective rate in the year of resolution. A favorable tax settlement would be recognized as a reduction in our effective tax rate in the year of resolution. When we establish or reduce the valuation allowance against our deferred tax assets, our income tax expense will increase or decrease, respectively; in the period such determination is made. As of September 25, 2005, we had established tax reserves of $16.7 million and a valuation allowance of $9.0 million. | Inventories: | We value our inventory at the lower of cost of the inventory or fair market value by establishing a write-down or an inventory loss reserve. We base our lower of cost or market write-down on the excess carrying value of the inventory, which is typically its cost, over the amount that we expect to realize from the ultimate sale of the inventory based upon our assumptions regarding the average sales price to be received for the product. | Our inventory reserve is based upon our analysis of sales levels by product and projections of future customer demand derived from historical order patterns and input received from our customers and sales team. To mitigate uncertainties, we reserve for all inventory greater than 12 months old, unless there is an identified need for the inventory. In addition, we reserve for items that are considered obsolete based on changes in customer demand, manufacturing process changes or new product introductions that may eliminate demand for a product. We remove inventory and the associated reserve from our financial records when the inventory is physically destroyed. | If our estimates regarding customer demand and physical inventory losses are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may be exposed to losses or gains in excess of our established reserves that could be material. A 10% increase or decrease in our actual inventory reserve at September 25, 2005 would have affected net earnings by approximately $81,000 for the quarter ended September 25, 2005. | Accruals for Self Insured and Other Liabilities: | We make estimates for the amount of costs that have been incurred but not yet billed for general services, including legal, accounting fees, costs pertaining to our self-funded medical insurance and other expenses. | Our liabilities contain uncertainties because we must make assumptions and apply judgment to estimate the ultimate cost to settle claims and claims incurred but not reported as of the balance sheet date. When estimating our liabilities, we consider a number of factors, including interviewing our service providers for bills that have not yet been received. For self-insured liabilities, we estimate our liabilities based on historical claims experience. | If actual costs billed to us are not consistent with our assumptions and judgments, our expenses could be understated or overstated and these adjustments could materially affect our net income. | Accounting for Stock Based Compensation: | | We account for stock-based employee compensation arrangements in accordance with the provisions of Statement of Financial Accounting Standards No. 123R, Shared-Based Payments (Revised). Under SFAS 123R, compensation cost is calculated on the date of the grant using the Black Scholes-Merton method. The compensation expense is then amortized over the vesting period. | We use the Black-Scholes-Merton model in determining fair value of our options at the grant date and apply judgment in estimating the key assumptions that are critical to the model such as the expected term, volatility and forfeiture rate of an option. Our estimate of these key assumptions is based on historical information and judgment regarding market factors and trends. | If actual results are not consistent with our assumptions and judgments used in estimating the key assumptions, we may be required to record additional compensation or income tax expense, which could be material to our results of operations. |
The following table shows our consolidated statements of incomeoperations data expressed as a percentage of total revenue for the periods indicated: | | | | | | | | | | | | | | | | Three Months Ended
| | | Nine Months Ended
| | | | | March 27, 2005
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| | | March 27, 2005
| | | March 28, 2004
| | Revenue: | | | | | | | | | | | | | Product revenue, net | | 94.3 | % | | 92.6 | % | | 94.1 | % | | 91.3 | % | Contract revenue, net | | 5.7 | | | 7.4 | | | 5.9 | | | 8.7 | | | | |
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| Total revenue | | 100.0 | | | 100.0 | | | 100.0 | | | 100.0 | | Cost of revenue: | | | | | | | | | | | | | Product revenue | | 42.6 | | | 44.0 | | | 42.5 | | | 46.6 | | Contract revenue | | 4.4 | | | 6.5 | | | 4.7 | | | 7.4 | | | | |
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| Total cost of revenue | | 47.0 | | | 50.5 | | | 47.2 | | | 54.0 | | | | |
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| Gross margin | | 53.0 | | | 49.5 | | | 52.8 | | | 46.0 | | Operating expenses: | | | | | | | | | | | | | Research and development | | 11.9 | | | 13.6 | | | 11.4 | | | 12.5 | | Sales, general and administrative | | 9.3 | | | 9.3 | | | 8.4 | | | 10.2 | | Other expense | | 0.3 | | | 0.1 | | | 0.2 | | | 0.1 | | | | |
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| Income from operations | | 31.5 | | | 26.5 | | | 32.8 | | | 23.2 | | | | | | | Non-operating income (loss): | | | | | | | | | | | | | Gain on investments in marketable securities | | 2.9 | | | — | | | 1.0 | | | — | | (Loss) on long-term investments | | — | | | — | | | (0.7 | ) | | — | | Other non-operating income | | — | | | 0.6 | | | — | | | 0.3 | | Interest income, net | | 1.4 | | | 1.2 | | | 1.3 | | | 1.3 | | | | |
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| Income before income taxes | | 35.8 | | | 28.3 | | | 34.4 | | | 24.8 | | Income tax expense | | 14.4 | | | 8.8 | | | 10.2 | | | 7.7 | | | | |
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| Net income | | 21.4 | % | | 19.5 | % | | 24.2 | % | | 17.1 | % |
| | | Three Months Ended September 25, 2005 | | Three Months Ended September 26, 2004 | | | Revenue: | | | | | | | Product revenue, net | | | 93.6 | % | | 94.0 | % | | Contract revenue, net | | | 6.4 | | | 6.0 | | | Total revenue | | | 100.0 | | | 100.0 | | | Cost of revenue: | | | | | | | | | Product revenue | | | 46.8 | | | 40.0 | | | Contract revenue | | | 4.3 | | | 4.5 | | | Total cost of revenue | | | 51.1 | | | 44.5 | | | Gross margin | | | 48.9 | | | 55.5 | | | Operating expenses: | | | | | | | | | Research and development | | | 12.3 | | | 11.0 | | | Sales, general and administrative | | | 10.6 | | | 8.0 | | | Impairment or loss on disposal of long-lived assets | | | 0.7 | | | 0.0 | | | Severance charges | | | 0.4 | | | 0.0 | | | Other expense | | | 0.0 | | | 0.1 | | | Income from operations | | | 24.9 | | | 36.4 | | | | | | | | | | | | Non-operating income: | | | | | | | | | Gain on investments in marketable securities | | | 0.6 | | | 0.1 | | | Interest income, net | | | 2.2 | | | 1.2 | | | Income before income taxes | | | 27.7 | | | 37.7 | | | Income tax expense | | | 6.8 | | | 12.2 | | | Net income | | | 20.9 | % | | 25.5 | % | | | | | | | | | |
Three Months Ended March 27,September 25, 2005 and March 28,September 26, 2004
Revenue. Revenue increased 25%8% to $96.7$103.9 million in the thirdfirst quarter of fiscal 20052006 from $77.2$95.9 million in the thirdfirst quarter of fiscal 2004.2005. Higher revenue was attributable to greater product revenue, which increased 28%8% to $91.2$97.3 million in the thirdfirst quarter of fiscal 20052006 from $71.5$90.2 million in the thirdfirst quarter of fiscal 2004.2005. Much of the increase in revenue resulted from significantly higher unit shipments of our LED products, which increased 53%42% in the thirdfirst quarter of fiscal 20052006 as compared to the same quarter of the prior year period. The greater LED shipments resulted from stronger demand from our customers for a variety of our high brightness products for mobile phones requiring white LEDs, pachinko machines and other applications.year. LED revenue was $80.6$84.6 million and $62.1$78.9 million, for the thirdfirst quarter of fiscal 2006 and 2005, respectively.
Our LED revenue increased 7% in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 and 2004, respectively.Our LED revenue increased 30% in the third quarter of fiscal 2005 as compared to the third quarter of fiscal 2004 and made up 83%82% of our total revenue for the three months ended March 27,September 25, 2005. The increase in LED revenue was primarily due to an increased number of high brightness chips being soldchip sales for markets that range from mobile phonesproducts requiring white LEDs in keypads, backlights for LCD displays and camera flashes, and blue and green LEDs used in gaming machines including pachinko, displays and other applications.flashes. Our high-brightness product sales were 66% and 51%54% of LED revenues for the three months ended March 27,September 25, 2005 and March 28,September 26, 2004, respectively. Our blended average LED sales price decreased 15% as compared to the third quarter of fiscal 2004. This decrease was due to normal price declines that we offered to our customers and our customers purchasing more of our UT230 blue LED products, which offer a lower average sales price than many of our other products. While sales of our mid-brightness LED products declined in the third quarter of fiscal 2005 compared to the prior year, we increased unit shipments of our new thinner and lower voltage chips, including the UT230 product, which sells for a lower average sales price. Our mid-brightness product sales declined as a percentage of total LED revenue to 31%28% as of March 27,September 25, 2005 from 42%40% as of March 28,
September 26, 2004. Shipments of our standard brightness products were downlower in the thirdfirst quarter of fiscal 20052006 in comparison to the prior year period as overall marketdue to reduced demand for automotive and indicator light applications. Our blended average LED sales moved to higher brightness products. Duringprice decreased 24% in the thirdfirst quarter of fiscal 2005, we changed our estimate for sales returns, which reduced revenue by $441,000 for2006 as compared to the period. For the fourthfirst quarter of fiscal 2005, we target our overall LED revenue2005. This decrease was due to be slightly higher thanincreasing price competitiveness in the third quarter of fiscal 2005 and that our blended average sales price decline will be in line with historical trends. We also target sales ofmarketplace for our high brightness products to increase for use in applications such as white LEDs for mobile phone backlighting.
and mid brightness devices.
Wafer product revenue was $5.5$5.1 million and $4.8$6.8 million, for the thirdfirst quarter of fiscal 2006 and 2005, and 2004, respectively; therefore, wafer revenue increased 14% over the prior year.respectively. The average sales price increased 37% andwhile units sold declined 17%45% during the thirdfirst quarter of fiscal 20052006 as compared to the prior year period. Therefore, wafer revenue decreased 24% as compared to the prior year period. The increase in the average sales price for our wafers was due mostly to a change in our product mix as we sold more high-grade wafers used by our customers for research and development projects. Wafer revenue made up 6%5% of our total revenue in the thirdfirst quarter of fiscal 2005.2006. SiC materials revenue for gemstone use was $2.1$3.2 million and $1.2$1.5 million, for the thirdfirst quarter of fiscal 20052006 and 2004,2005, respectively. Revenue from sales of our SiC materials for use in gemstones increased 79%110% during the thirdfirst quarter of fiscal 20052006 as compared to the prior year period due to higher customer demand and improved yields of usable materials.from our sole customer Charles & Colvard Ltd. Revenue from gemstone materials was 2%3% of our total sales for the thirdfirst quarter of fiscal 2005.2006.
Revenue from our high-power devices increased 118% to $3.3 million in the first quarter of fiscal 2006 from $1.5 million in the first quarter of fiscal 2005. Much of the increase in revenue resulted from the growth of our MMIC foundry sales. Revenue from high power devices was 3% of our total sales for the first quarter of fiscal 2006.
Revenue from silicon-based Cree Microwave products was $956,000$954,000 and $2.2$1.4 million, for the thirdfirst quarter of fiscal 2006 and 2005, and 2004, respectively. Silicon-based Cree Microwave revenue made up 1% of our total revenue for the thirdfirst quarter of fiscal 2005.2006. Revenue from these products decreased 56%34% in the thirdfirst quarter of fiscal 2005 over2006 compared to the comparableprior year period of fiscal 2004 due to a changing customer baseour announcement in June 2005 that we are winding down the silicon-based business in Sunnyvale, California and customer delays on design wins. Product sales mix for Cree Microwave products changed as LDMOS and modules made up 97% and 50% of revenue for the third quarter of fiscal 2005 and fiscal 2004, respectively. Revenue attributable to bipolar devices was 1% and 45% for the third quarter of fiscal 2005 and 2004, respectively. Approximately 2% of Cree Microwave’s revenue was from engineering and other services for the third quarter of fiscal 2005 as compared to 5% for the third quarter of fiscal 2004.that we would complete last-time buy orders in December 2005. Overall, our average sales price for silicon-based Cree Microwave products was 36% lower15% higher compared to the prior fiscal year period due to these changesa change in product mix. At this time we target that revenue from silicon microwave products under last-time buy arrangements will be approximately $2.8 million in the product mix and annual price decreases. We have been pursuing some strategic alternatives for the Cree Microwave business over the past several months and plan to complete our analysis in the fourthsecond quarter of fiscal 2005. As a result of the analysis for the Cree Microwave business, we may make decisions that could significantly reduce our revenue and increase our expenses in this segment2006 and we may incur future write-downs on some of our assets.target that such revenue will be zero thereafter.
Contract revenue was 6% of total revenue for the thirdfirst quarter of fiscal 2005.2006. Contract revenue decreased 5%increased 16% during the thirdfirst quarter of fiscal 20052006 compared to the same period of fiscal 2004 as certain older programs wound down2005 due to the start of new contracts that were awarded to us.
Gross Profit. Gross profit decreased 4% to $50.9 million in the thirdfirst quarter of fiscal 2005.Gross Profit. Gross profit increased 34% to $51.22006 from $53.3 million in the thirdfirst quarter of fiscal 2005 from $38.2 million in the prior year comparative period.2005. Compared to the prior year period, gross margins increasedmargin decreased from 49.5%55.5% to 53%48.9% of revenue. This increasedecrease was driven by lower gross margin on sales of LED chips, wherefor which blended average selling prices were 15%24% lower and costs were reduced by 21%only 8% over the same period of fiscal 2004. Cost reductions were greater than reductions in2005. Our average sales price declined due to yieldour pricing strategy for high brightness chips and other process improvements as well asa shift in product mix to low priced UT230 products. As part of our strategy to increase our market share in white LED chips, we had to increase our performance specifications to support new design wins. The higher factory throughput. In addition,brightness requirements for our products resulted in lower overall yields, which offset the benefit of manufacturing more chips per wafer that was gained from our conversion to three-inch wafers. More than 60% of our LED chips were produced from three-inch wafers during the thirdfirst quarter of fiscal 2005, approximately one third2006. We target the majority of our LED chip production was manufacturedchips to be fabricated from three-inch wafers.wafers during fiscal 2006. During the thirdfirst quarter of fiscal 2005, our2006, we also recorded a $200,000 write down of inventory related to the silicon-based Cree Microwave business and a $628,000 expense for stock compensation resulting from the adoption of SFAS 123R in that quarter.
Our silicon-based Cree Microwave business reported negative gross profit also benefited by $1.9of $1.3 million fromfor both the change inthree months ended September 25, 2005 and September 26, 2004. With the estimatepreviously announced winding down of our sales return reserve.Wafer costs for our materials sales were 44% lowersilicon-based business in December 2005, we target gross profit to improve by approximately $1.3 million beginning in the third quarter of fiscal 20052006.
Wafer costs per unit for our materials sales were 18% higher in the first quarter of fiscal 2006 compared to the third quarter of fiscal 2004 due to a change in mix for wafer products and a $36,000 increase in wafer inventory reserves recorded in the third quarter of fiscal 2004.Negative gross profits were $1.7 million for our Cree Microwave segment during the third quarter of fiscal 2005 as compared to negative gross profits of $370,000 recorded during the third quarter of fiscal 2004, primarily due to lower revenue and a change in product mix in the third quarter of fiscal 2005. Contract margins increased from 12% in the third quarter of fiscal 2004 to 22% in the thirdfirst quarter of fiscal 2005 due to lower required cost share on current contracts and a $115,000 downward rate adjustment duringdifferent mix of products sold in the thirdfirst quarter of fiscal 2004 that reduced revenue.
2006. Contract margin improved to 33% in the first quarter of fiscal 2006 compared to 25% the first quarter of fiscal 2005 as we began work under several new contracts.
During the second quarter of fiscal 2006, we target stock compensation expense to increase our cost of product sales from $628,000 recorded in the first quarter of fiscal 2006 to $1.2 million, as approximately $725,000 of stock compensation expense was allocated as inventory in the first quarter of fiscal 2006.
Research and Development.Research and development expenses increased 10%21% in the thirdfirst quarter of fiscal 20052006 to $11.5$12.8 million from $10.5$10.6 million in the thirdfirst quarter of fiscal 2004.2005. During the first quarter of fiscal 2006, research and development costs included $1.1 million in stock compensation expense resulting from our adoption of SFAS 123R. The remaining increase in research and development spending supported our three-inch LED wafer process development, our thin chip products, X-class and power chip LEDs, our XLamp high power packaged LEDs and other high brightness LED research programs. In addition, we funded ongoing development for higher power and higher linearity RF and microwave devices, near ultraviolet laser diodes and higher power diodes and switches. We target that research and development spending will increase in future quarters in line with our revenue.
Sales, General and Administrative. Sales, general and administrative expenses increased 25%44% in the thirdfirst quarter of fiscal 20052006 to $9.0$11.1 million from $7.2$7.7 million in the thirdfirst quarter of fiscal 2004. Increased2005. During the first quarter of fiscal 2006, sales, general and administrative costs included $1.2 million in stock compensation expense resulting from our adoption of SFAS 123 R. Sales, general and administrative expenses resulted fromalso increased due to higher costs associated with our continued compliance with the Sarbanes-Oxley Section 404 implementation, which approximated $801,000 in the third quarterAct of fiscal 2005,2002 and higher overall costs associated
with our growth. In addition, we increased spending on sales and marketing in our high power packaged LED and power semiconductor products, and we target to increase these expenses in future quarters.
Other Operating ExpenseImpairment or Loss on Disposal of Long-Lived Assets. Other operating expenseImpairment or loss on the disposal of long-lived assets increased 896% to $277,000$777,000 in the thirdfirst quarter of fiscal 2006 as compared to $78,000 in the first quarter of fiscal 2005. During the first quarter of fiscal 2006, we recorded an impairment of $581,000 for building improvements that are no longer being used at our Durham facility and other disposals. During the three months ended September 25, 2005, the silicon-based Cree Microwave business also recorded a $196,000 impairment charge for patents as we are winding down this business.
Severance Charges. In the first quarter of fiscal 2006, we incurred $391,000 in severance charges for employees at our Cree Microwave-Sunnyvale facility. Severance costs are accrued ratably over the period between the communication date in the fourth quarter of fiscal 2005 as compared to $80,000 inand the thirdactual termination date of these employees. We currently estimate that we will incur additional severance costs of approximately $300,000 during the second quarter of fiscal 2004. The third quarter2006 associated with the closure of fiscal 2005 results included net charges for the disposalsSunnyvale facility. We anticipate that all remaining employees at the Sunnyvale facility will be terminated as of equipment. During the third quarter of fiscal 2004, Cree Microwave recorded a $30,000 write-down to fair market value on certain equipment being held for sale.December 2005. Gain (Loss) on Investments in Marketable Securities.Gain on investments in marketable securities was $2.8 million$587,000 in the thirdfirst quarter of fiscal 2005,2006, compared to a $1,000 loss$118,000 in the thirdfirst quarter of fiscal 2004. The gain relates to our sale of 343,000 shares of our Color Kinetics investment during2005. In the thirdfirst quarter of fiscal 2005.Other Non-Operating Income.Other non-operating income decreased to $02006, we sold a small portion of our investment in the third quarter of fiscal 2005 from $488,000 in the third quarter of fiscal 2004. The income in the fiscal 2004 period relates to a gainColor Kinetics, Incorporated (Color Kinetics) for a one-time technology license fee.realized gain of $587,000.
Interest Income, Net. Interest income, net increased 49%102% to $1.4$2.3 million in the thirdfirst quarter of fiscal 2006 from $1.1 million in the first quarter of fiscal 2005, from $942,000 in the third quarterdue to a combination of fiscal 2004. The increase from the comparative period in the prior year resulted fromour greater cash balance and higher interest rates that we are now receiving on ourinvestments. Available cash has decreased to $229 million at investments arising from rate increases that have occurred over the end of the third quarter of fiscal 2005 from $241 million at the end of the third quarter of fiscal 2004 due to an increased use of cash for equipment purchases, our stock repurchases and our higher level of working capital items. Net interest income during the third quarter of fiscal 2005 was reduced by $136,000 in interest expense resulting from a settlement for income taxes.
past 12 months.
Income Tax Expense. Income tax expense for the thirdfirst quarter of fiscal 20052006 was $14.0$7.0 million compared to $6.8$11.8 million in the thirdfirst quarter of fiscal 2004, as we were more profitable in2005. During the thirdfirst quarter of fiscal 2005 than the comparative period. Our effective income tax rate was 31.11% for the third quarter of fiscal 2005 compared to a 31.0% rate during the comparative period in fiscal 2004. During the third quarter of fiscal 2005,2006, our income tax expense increaseddecreased by $3.2$2.2 million for tax related adjustments. As of March 27, 2005, we had aadjustments to the valuation allowance previously established to offset our federal capital loss carryover of $45.7 million. The related deferred tax asset of $16.0 million was previously offset by a valuation allowance since it was more likely than not that we could not utilize the capital loss carryover.asset. Based on Statement of Financial Accounting Standards No. 109, “Accounting"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 $7.9$16.0 million unrealized federal capital gain, as well as the $587,000 realized federal capital gain, related to our investment in Color Kinetics required a $4.1$2.2 million reversal of the valuation allowance, which increaseddecreased income tax expense for the three months ended March 27,September 25, 2005. Also duringWithout the thirdtax adjustment for our investment in Color Kinetics, our effective income tax rate was 32.2% for the first quarter of fiscal 2005, we determined that our effective tax provision2006 compared to a 32.5% rate had declined from 32.20% to 31.11%, and as a result, we recorded a $716,000 reductionduring the comparative period in income tax expense, in addition to recording $230,000 in other tax benefits. At this time, wefiscal 2005. We currently target that our effective tax rate for the remainder of fiscal 20052006 will be approximately 31.11%32.2%.Nine Months Ended March
Liquidity and March 28, 2004Capital ResourcesRevenue. Revenue increased 34%
Our strong cash generating capability and financial condition give us ready access to $290.2grow our business. Our principal source of liquidity is operating cash flows, which is derived from net income. This cash generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating, financing and investing needs.
Operating Activities:
In the first quarter for fiscal 2006, our operations provided $31.0 million of cash as compared to $53.8 million of cash provided in the first nine monthsquarter of fiscal 2005 from $216.52005. This decrease was primarily attributable to a $12.6 million decline in cash provided by working capital in the first nine months of fiscal 2004. The greater revenue was attributable to increased product revenue, which was up 38% to $273.0 million in the first nine months of fiscal 2005 from $197.6 million for the first nine months 2004. Our LED revenue increased 41% to $238.5 million in the first nine months of fiscal 2005 as compared to the first nine months of fiscal 2004 and made up 82% of our total revenue for the fiscal 2005 period. The most significant increase in revenue in the first nine months of fiscal 2005 came from sales to Sumitomo Corporation as a result of customer demand in Japan. This increase in LED revenue was a direct result of a greater number of high brightness chips being sold for markets that range from mobile phones requiring white LEDs in keypads, backlights for LCD displays and camera flashes, and blue and green LEDs used in gaming machines including pachinko, displays and other applications. For the first nine months of fiscal 2005, LED unit shipments increased 58% over units shipped in the comparative period. Our blended average LED sales price decreased 11% in the first nine months of fiscal 2005 as compared to the first nine months of fiscal 2004. On a product-by-product basis, our average sales prices were lower year-over-year due to normal price declines that we offer to our customers.Wafer product revenue was $19.4 million and $16.3 million, for the first nine months of fiscal 2005 and 2004, respectively. Wafer product revenue increased 19% over the prior year period. The average sales price increased 34% while unit sales declined 11%, during the first nine months of fiscal 2005 as compared to the prior year period. Wafer sales increased in the first nine months of fiscal 2005 over the year ago period due to changes in product and customer mix.
Wafer product revenue made up 7% of our total revenue in the first nine months of fiscal 2005. SiC material revenue for gemstones was $5.4 million and $3.5 million, for the first nine months of fiscal 2005 and 2004, respectively. Revenue from sales of our SiC materials for use in gemstones increased 53% during the first nine months of fiscal 2005 as compared to the prior year period due to higher unit volume and improved yields of usable materials in our production of gemstone material. Revenue from gemstone materials was 2% of our total sales for the first nine months of fiscal 2005.
Revenue from Cree Microwave products was $3.9 million and $5.2 million, for the first nine months of fiscal 2005 and 2004, respectively. Cree Microwave revenue made up 1% of our total revenue for the first nine months of fiscal 2005. Revenue from these products decreased 25% in the first nine months of fiscal 2005 over the comparable period of fiscal 2004 due to reduced order demand and other product mix changes. Product sales mix for Cree Microwave products changed as LDMOS and modules made up 86% and 51% of revenue for the first nine months of fiscal 2005 and fiscal 2004, respectively. Revenue attributable to bipolar devices was 10% and 45% for the first nine months of fiscal 2005 and 2004, respectively. Approximately 4% of Cree Microwave’s revenue was from engineering and other services for the first nine months of each of fiscal 2005 and fiscal 2004. Overall, our average sales price for Cree Microwave products was 51% lower in the first nine months of fiscal 2005 compared to the prior year period due to these changes in the product and customer mix and annual price decreases. Contract revenue was 6% of total revenue for the first nine months of fiscal 2005. Contract revenue decreased 11% during the first nine months of fiscal 2005 compared to the same period of fiscal 2004 as certain older programs wound down.
Gross Profit. Gross profit increased 54% to $153.4 million in the first nine months of fiscal 2005 from $99.5 million in the prior year comparative period. Compared to the prior year period, gross margins increased from 46% to 53% of revenue. The increase was driven by LED chips, where blended average selling prices were 11% lower and costs were reduced by 23% over the same period of fiscal 2004. As compared to the prior year comparative period, our costs declined faster than our average sales prices as we benefited from yield and other process improvements and higher factory throughput. During the third quarter of fiscal 2005, our gross profit also benefited by $1.9 million from the change in the estimate of our sales return reserve. In the first nine months of fiscal 2005, we also incurred $290,000 in non-budgeted payroll taxes in cost of sales due to stock option exercises by our manufacturing employees.
Our blended average wafer cost for our materials sales was 33% greater in the first nine months of fiscal 20052006 compared to the first nine months of fiscal 2004 due to a change in the mix of wafer products sold and a $179,000 reduction in wafer inventory reserves recorded in the third quarter of fiscal 2004. These higher costs were offset by a 34%$13.1 million increase in our average sales price during the same timeframe. The Cree Microwave segment had negative gross profits of $4.7 million during the first nine months of fiscal 2005 as compared to negative gross profits of $2.9 million recorded during the first nine months of fiscal 2004, primarily due to lower revenue resulting from changes in the product sales mix. Contract margins increased from 15% in the first nine months of fiscal 2004 to 21% in the first nine months of fiscal 2005 as we received $337,000 from a third party for a license fee for certain technology that we owncash provided by working capital in the first quarter of fiscal 2005. In addition, inresults from the first nine months of fiscal 2005 we have experienced a change in the mix of our contracts, which have a lower cost share requirement compared to the first nine months of fiscal 2004.
Research and Development.Research and development expenses increased 23% in the first nine months of fiscal 2005 to $33.1 million from $27.0 million in the first nine months of fiscal 2004. The increase in research and development spending resulted from our support for our three-inch process development, our thin chip products, X-class and power chip LEDs, our XLamp high power packaged LEDs and other high brightness LED research programs. In addition, we continue to fund ongoing development for higher power diodes and switches and wide bandgap RF devices. The first nine months of fiscal 2005 also included $346,000 of non-budgeted payroll taxes resulting from stock option exercises by our research and development employees.
Sales, General and Administrative. Sales, general and administrative expenses increased 11% in the first nine months of fiscal 2005 to $24.5 million from $22.0 million in the first nine months of fiscal 2004 due to the overall growth of our company. Our Sarbanes-Oxley Section 404 implementation of $1.6 million incurred in the first nine months of fiscal 2005 are primarily offset by a $1.1 million directors and officers insurance reimbursement received for certain legal fees related to the securities litigation for the nine months ended March 27, 2005. Additionally, we incurred $750,000 of non-budgeted payroll taxes resulting from stock option exercises by our sales, general and administrative employees. The first nine months of fiscal 2004 included legal expenses associated with the Hunter and class action litigation and related matters, including the cost of an investigation by a special committee of our Board of Directors.
Other Operating Expense. Other operating expense increased to $603,000 in the first nine months of fiscal 2005 as compared to $226,000 in the first nine months of fiscal 2004. The first nine months of fiscal 2005 included $508,000 relating to equipment being disposed of and $95,000 of impairments relating to certain patent applications being abandoned. During the first nine months of fiscal 2004, the impairments of fixed assets primarily related to Cree Microwave equipment write-downs of $173,000.
Gain on Investments in Marketable Securities.Gain on investments in marketable securities increased to $2.9 million in the first nine months of fiscal 2005 from zero in the first nine months of fiscal 2004. These gains resulted from the sale of a portion of our Color Kinetics investment in the third quarter of fiscal 2005.
Loss on Long-Term Investments.Loss on long-term investments increased to $2.0 million in the first nine months of fiscal 2005 from zero the first nine months of fiscal 2004. The loss is due to an other-than-temporary impairment on our investment in a private company that was taken in the second quarter of fiscal 2005. This write-down was based on our evaluation of the company’s financial results and a third party offer to purchase our investment. This investment was sold in the third quarter of fiscal 2005 at its then carrying value.
Other Non-Operating Income.Other non-operating2006 included lower profits as net income decreased 11%, or $2.7 million to $4,000 in the first nine months of fiscal 2005 from $518,000 in the first nine months of fiscal 2004. The income in the fiscal 2004 period primarily related to a gain recognized for a one-time technology license fee that was received from a third party.
Interest Income, Net. Interest income, net$21.7 million. Depreciation and amortization increased 33% to $3.7 million in the first nine months of fiscal 2005 fromby $2.8 million in the first ninethree months of fiscal 2004. This increase was a result of having a higher average invested balance during2006 compared to the first ninethree months of fiscal 2005 combined with higher interest rates available during fiscal 2005. Available cash has decreased to $229 million at the end of the third quarter of fiscal 2005 from $241 million at the end of the third quarter of fiscal 2004 due to an increased usethe purchase of cash for equipment purchases and our
stock repurchase program. The interest income recorded during the first nine months of fiscal 2005 was reduced by $403,000 in interest expense related to a settlement for federal and state income taxes.
Income Tax Expense. Income tax expense for the first nine months of fiscal 2005 was $29.6 million compared to $16.6 million recorded in the first nine months of fiscal 2004, as we were more profitable in the fiscal 2005 period than the comparative period. Our effective income tax rate was 31.11% for the first nine months of fiscal 2005 compared to a 31% rate during the comparative period in fiscal 2004. During the first nine months of fiscal 2005, our income tax expense was reduced by an aggregate of $2.1 million of adjustments. As of March 27, 2005, we had a federal capital loss carryover of $45.7 million. The related deferred tax asset of $16.0 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 current $7.9 million unrealized federal capital gain related to our investment in Color Kinetics required a $3.8 million reversal of the valuation allowance, which decreased income tax for the nine months ended March 27, 2005. Also, we increased the valuation allowance related to the federal capital loss carryover by $697,000 resulting from the tax effect of the $2.0 million loss on a private company investment that was impaired in the second quarter and sold in the third quarter of fiscal 2005. Additionally, we increased income tax expense by $1.6 million for settlement on state income taxes, and recorded estimated state tax rate changes and other adjustments.
Liquidity and Capital Resources
We have funded our operations, to date, through sales of equity, bank borrowings and from product and contract gross profits. As of March 27, 2005, we had working capital of $193.6 million, including $142.1 million in cash, cash equivalents and short-term investments held to maturity. As of March 27, 2005, we held investments of $87.0 million in long-term securities held to maturity in order to receive a higher interest rate on our cash and investments. Operating activities generated $109.3 million in the first nine months of fiscal 2005 compared with $101.4 million generated in the comparable period in fiscal 2004. This increase was primarily attributable to our operating results being more profitable in fiscal 2005 than fiscal 2004 as net income increased 90%, or $33.2 million to $70.1 million. Depreciation and amortization also increased by $10.9 million in the first nine months of fiscal 2005 over the first nine months of fiscal 2004 due to new equipment purchasedto support our business growth and patents being amortized. These increasesIn addition, we also recorded a number of non-cash charges including $2.9 million of stock based compensation expense as a result of adopting the provisions of SFAS 123R and a $777,000 impairment or loss on the disposal of long-lived assets in profitability were offset by changes in our deferred income taxes and working capital. the three months ended September 25, 2005.
During the first nine monthsquarter of fiscal 2006, we used $12.6 million for servicing our working capital mostly due to higher accounts receivable and lower accounts payable balances, which were partly offset by lower inventory and higher accrued expenses. As of September 25, 2005, our cash from operations was lower as compared to the prior year by $16.0 millioninventory remained below our industry average at 50 days on hand. The decrease in inventory is primarily due to changes in deferred income taxes and we also used a net of $19.0 million from overall changes in our working capital. Our working capital changes during the first nine months of fiscal 2005 include an accounts receivable increase of $11.2 million. This increase resulted from higher sales and our continued efforts to manage the fact that the majoritylevels of in stock inventory. We normally target our sales for the third quarter of fiscal 2005 were shipped in March 2005. As of March 27, 2005,accounts receivable balances to average between 45 and 60 days outstanding; however, due to focused collections, our days sales outstanding was 3839 days and 32 days for the periods ended September 25, 2005 and June 26, 2005, respectively, based on our calculation which is derived from our monthly revenue profile. Inventories increased by $9.9 million due to several factors including increased amounts to support our higher sales volume, the timing of our customer orders in the third quarter of fiscal 2005, our continued transition to three-inch wafers, which requires parallel platforms for our products, increased inventory to support the qualification of our contract manufacturer in Asia,greater raw materials to support new high brightness products and our ramp up of our new businesses for solid-state lighting and power products. Our prepaid expenses also increased by $5.2 million due to the timing of the payment of our insurance premiums and other deferred charges.profile calculation. Additionally, our accounts payable and accrued expenses increased by $13.8$1.2 million including a $4.3 million increase in our income taxes payable andduring the first quarter of fiscal 2006 primarily due to the timing of other payments.
Cash used by investing activities inpayments made to vendors.
Investing Activities:
In the first nine monthsquarter of fiscal 2005 was $143.4 million. Net2006, we used $47.2 million for investing, primarily reflecting net investments of $20.4$36.2 million were made in securities held to maturity $119.8and $13.5 million was invested in property and equipment and $6.3 million invested in other long-term assets.patent and licensing rights. The majority of the increase in property and equipmentour spending was related to the reinvestment of operating cash in marketable investments to optimize investment yield and the addition of new equipment additions to increase manufacturing capacity in our crystal growth, epitaxy, clean room and package and test areas and XLamp product manufacturing. We have received $5.7manufacturing facilities.
Financing Activities:
In the first quarter of fiscal 2006, we generated $1.2 million from the sale of investments and equipment. Finally, we invested $2.6 million in patents and patent applications, which are being amortized.Cash provided by financing activities was $13.6 million during the nine months ended March 27, 2005. Weactivities. The entire amount represents proceeds that were received $48.8 million forfrom the exercise of stock options and shares issued under our employee stock purchase plan during the first nine monthsquarter.
As of fiscalSeptember 25, 2005, when we repurchased 1,450,000there remained approximately 5.5 million shares of our common stock approved for repurchase under a repurchase program authorized by the Board of Directors that extends through June 2006. Since the inception of our stock repurchase programs in January 2001, we have repurchased 6.6 million shares of our common stock at an average price of $18.28 per share, with an aggregate costvalue of $35.3$121.0 million. We intend to use available cash to purchase additional shares under the program. At this time, we target approximately $135 to $145 million in capital spending in fiscal 2005, which is greater than fiscal 2004. The capital additions will be primarily for equipment to increase our LED chip production capacity. We continue to target spending at least $300 million in capital improvements over the next five years. We also may repurchase sharesdiscretion of our outstanding common stock under a company stockmanagement, the repurchase program that has been authorized bycan be implemented through open market or privately negotiated transactions. We will determine the time and extent of repurchases based on our boardevaluation of directors. market conditions and other factors.
Fiscal 2006 Outlook:
We anticipate that cash on hand will fund the majority of our expenditures, therefore; we plan to meet the cash needs for the business for fiscal 20052006 through cash from operations and cash on hand. We also anticipate that long termplan to meet long-term cash needs will be met with cash flow from operations or cash on hand over the next two fiscal years. Actual results may differ from our targets for a number of reasons as we discuss herein. From time to time, we evaluate potential acquisitionsaddressed in complementary businesses as strategic opportunities and anticipate continuing to make such evaluations.this report. We may also issue additional shares of common stock or use available cash on hand for the acquisition of complementary businesses or other significant assets. From time to time, we evaluate strategic opportunities and potential investments in complementary businesses and anticipate continuing to make such evaluations. As a result of our planned closure of the Cree Microwave-Sunnyvale facility, we target that we will need to make additional cash outlays for severance costs and possibly to buy out our lease that extends through November 2011. Unless we successfully negotiate a buy out of our existing lease in Sunnyvale, we may incur cash out flows of approximately $6.3 million over the next six years to satisfy those obligations.
As of March 27,September 25, 2005, our cash and cash equivalents and short-term investments held to maturity accounts combined decreased by $16.1increased $7.7 million, or 10%4%, over balances reported as of June 27, 2004 as we have shifted funds to25, 2005. Our long-term investments during fiscal 2005held to take advantage of higher interest rates available. Our accounts receivable balancematurity also increased by $2.5$11.0 million, as of March 27, 2005 compared toor 11%, over balances reported as of June 27, 2004 as our revenue25, 2005. The combined $18.7 million increase to net cash and investments resulted from profits in the thirdfirst quarter of fiscal 2005 was 6.6% higher at $96.7 million compared to revenue of $90.9 million in the fourth quarter of fiscal 2004. Our third quarter of fiscal 2005 also had heavier sales in the last month of the quarter. The impact of higher sales in the third quarter of fiscal 2005 compared to the fourth quarter of fiscal 2004 was mostly offset by a change in the estimate of our sales returns as well as the establishment of a bad debt reserve as of March 27, 2005. At March 27, 2005, our net accounts receivable balance was reduced by our sales return allowance of $9.5 million and an allowance for bad debt of $106,000. The June 27, 2004 net accounts receivable balance was reduced by an allowance for sales returns of $798,000. Our deferred revenue liability account also declined to $0 as of March 27, 2005, compared to $8.4 million at June 27, 2004, due to the change in our estimate for sales returns.2006. Our net property and equipment also increased at March27, 2005has decreased by $70.2$6.0 million or 26%2% since June 27, 2004 due to25, 2005 as depreciation expense more than offset investments made to expand production capacity. During the first quarter of fiscal 2006, we spent $12.5 million on capital additions. We target capital spending in fiscal 2006 to be in a range of $90.0 million to $110.0 million. These investments are intended to aid us in meeting current and what we view as increasing future customer product demands on a cost-effective basis. Our greaterWe target that these investments in additional equipment will allow us to meet increased demand for our products and thus may lead to higher revenue for us. The increased property investment will also result in higher depreciation expense. Net deferred income taxes changed by $5.9 million due to taxes on unrealized gains, a settlement on state income taxes and changes in our estimated state tax rates and other adjustments. Our income taxes payable grew $4.3 million due to our 31.1% tax provision on our pre-tax income of $99.7 million less estimated tax payments. Inventory increased by $9.9 million since June 27, 2004 due to several factors including increased amounts to support our higher sales volume, the timing of customer orders in the third quarter of fiscal 2005, our continued transition to three-inch wafers, which requires parallel platforms of our products, increased inventory to support the qualification of our contract manufacturer in Asia, greater raw materials to support new high brightness products and our ramp up of our new businesses for solid state lighting and power products. Marketable securities available for sale decreased by $3.4 million or 15% since the end of fiscal 2004 due to our sale of 343,000 shares of Color Kinetics Common Stock during the third quarter of fiscal 2005 and the decrease in the unrealized gain of our Color Kinetics investment, based on the closing stock prices as of March 27, 2005 and June 25, 2004. The cumulative unrealized holding gain is $7.9 million as of March 27, 2005.
Certain Business Risks and Uncertainties
Described below are various risks and uncertainties that may affect our business. These risks and uncertainties are not the only ones we face. Additional risks and uncertainties, both known and unknown, including ones that we currently deem immaterial or that are similar to those faced by other companies in our industry or business in general, may also affect our business. If any of the risks described below actually occur, our business, financial condition or results of operations could be materially and adversely affected.
Our operating results and margins may fluctuate significantly.
Although we experienced significant revenue and earnings growth in the past year, we may not be able to sustain such growth or maintain our margins, and we may experience significant fluctuations in our revenue, earnings and margins in the future. Historically, the prices of our LEDs have declined based on market trends. We attempt to maintain our margins by constantly developing improved or new products, which commandprovide greater value and result in higher prices, or by lowering the cost of our LEDs. If we are unable to do so, our margins will decline. Our operating results and margins may vary significantly in the future due to many factors, including the following: our ability to develop, manufacture and deliver products in a timely and cost-effective manner;
variations in the amount of usable product produced during manufacturing (our “yield”);| · | our ability to develop, manufacture and deliver products in a timely and cost-effective manner; |
our ability to improve yields and reduce costs in order to allow lower product pricing without margin reductions;| · | variations in the amount of usable product produced during manufacturing (our “yield”); |
our ability to ramp up production for our new products;| · | our ability to improve yields and reduce costs in order to allow lower product pricing without margin reductions; |
our ability to convert our substrates used in our volume manufacturing to larger diameters;| · | our ability to ramp up our subcontractor in Asia; |
our ability to produce higher brightness and more efficient LED products that satisfy customer design requirements;| · | our ability to ramp up production for our new products; |
our ability to develop new products to specifications that meet the evolving needs of our customers;| · | our ability to convert our substrates used in our volume manufacturing to larger diameters; |
our ability to generate customer demand for our LDMOS products and ramp up production of those products accordingly;| · | our ability to produce higher brightness and more efficient LED products that satisfy customer design requirements; |
changes in demand for our products and our customers’ products;| · | our ability to develop new products to specifications that meet the evolving needs of our customers; |
effects of an economic slow down on consumer spending on such items as cell phones, electronic devices and automobiles;| · | changes in demand for our products and our customers’ products; |
changes in the competitive landscape, such as higher brightness LED products, higher volume production and lower pricing from Asian competitors;| · | effects of an economic slow down on consumer spending on such items as cell phones, electronic devices and automobiles; |
average sales prices for our products declining at a greater rate than anticipated;| · | changes in the competitive landscape, such as higher brightness LED products, higher volume production and lower pricing from Asian competitors; |
changes in the mix of products we sell may vary significantly;| · | average sales prices for our products declining at a greater rate than anticipated; |
other companies’ inventions of new technology that may make our products obsolete;| · | changes in the mix of products we sell, which may vary significantly; |
product returns or exchanges that could impact our short-term results;| · | other companies’ inventions of new technology that may make our products obsolete; |
changes in purchase commitments permitted under our contracts with large customers;| · | product returns or exchanges that could impact our short-term results; |
changes in production capacity and variations in the utilization of that capacity;| · | changes in purchase commitments permitted under our contracts with large customers; |
disruptions of manufacturing that could result from damage to our manufacturing facilities from causes such as fire, flood or other casualties, particularly in the case of our single site for SiC wafer and LED production;| · | changes in production capacity and variations in the utilization of that capacity; |
our policy to fully reserve for all accounts receivable balances that are more than 90 days past due, which could impact our short-term results;| · | disruptions of manufacturing that could result fromdamage to our manufacturing facilities from causes such as fire, flood or other casualties, particularly in the case of our single site for SiC wafer and LED production; |
changes in Federal budget priorities could adversely affect our contract revenue.| · | changes in accounting rules, such as recording expenses for stock option grants; |
| · | our policy to fully reserve for all accounts receivable balances that are more than 90 days past due, which could impact our short-term results; and |
| · | changes in Federal budget priorities could adversely affect our contract revenue. |
These or other factors could adversely affect our future operating results and margins. If our future operating results or margins are below the expectations of stock market analysts or our investors, our stock price will likely decline.
If we are unable to produce and sell adequate quantities of our high-brightness and mid-brightness LED chip products and improve our yields, our operating results may suffer.
We believe that our ability to gain customer acceptance of our high-brightness and mid-brightness LED chip products and to achieve higher volume production and lower production costs for those products will be important to our future operating results. We must reduce costs of these products to avoid margin reductions from the lower selling prices we may offer due to our competitive environment and/or to satisfy prior contractual commitments. Achieving greater volumes and lower costs requires improved production yields for these products. We are continuing to work with our customers to develop and expand our X class products to help meet their market and packaging requirements. We may encounter manufacturing difficulties as we ramp up our capacity to make our newest high brightness products.Our failure to produce adequate quantities and improve the yields of any of these products could have a material adverse effect on our business, results of operations and financial condition. Some of our customers may encounter difficulties with their manufacturing processes using our XBright and XThin devices due to the non-standard die attachment processes required, which could increase product returns and impact customer demand, each of which would have a material adverse effect on our business, results of operations and financial condition.
Our operating results are substantially dependent on the development of new products based on our SiC and GaN technology.
Our future success will depend on our ability to develop new SiC and GaN solutions for existing and new markets. We must introduce new products in a timely and cost-effective manner, and we must secure production orders from our customers. The development of new SiC and GaNproducts is a highly complex process, and we historically have experienced delays in completing the development and introduction of new products. Products currently under development include larger, higher quality substrates and epitaxy, high powerwide bandgap RF and microwave devices in bothproducts based on SiC and GaN, SiC power devices, near UV laser diodes, higher brightness thinner LED products and high power packaged LEDs.The successful development and introduction of these products depends on a number of factors, including the following: achievement of technology breakthroughs required to make commercially viable devices;
the accuracy of our predictions of market requirements and evolving standards;| · | achievement of technology breakthroughs required to make commercially viable devices; |
acceptance of our new product designs;| · | the accuracy of our predictions of market requirements and evolving standards; |
the availability of qualified development personnel;| · | acceptance of our new product designs; |
our timely completion of product designs and development;| · | acceptance of new technology in certain markets; |
our ability to develop repeatable processes to manufacture new products in sufficient quantities for commercial sales;| · | the availability of qualified development personnel; |
our customers’ ability to develop applications incorporating our products;| · | our timely completion of product designs and development; |
acceptance of our customers’ products by the market.| · | our ability to develop repeatable processes to manufacture new products in sufficient quantities for commercial sales; |
| · | our customers’ ability to develop applications incorporating our products; and |
| · | acceptance of our customers’ products by the market. |
If any of these or other factors become problematic, we may not be able to develop and introduce these new products in a timely or cost-efficient manner.
Our results of operations, financial condition and business would be harmed if we are unable to grow customer demand and revenue to utilize our expanded capacity.
We are currently in the process of expanding our production capacity by adding new equipment and facilities and transitioning the production of the majority of our LED products from two-inch to three-inch wafers.We have committed substantial resources to these efforts. For example, in the third quarter of fiscal 2005, we purchased an existing wafer fabrication facility in Research Triangle
Park, North Carolina. If we are unable to generate sufficient customer demand for our products, we would not be able to utilize our expanded capacity and our margins would decrease, due in part to higher fixed costs associated with additional capacity, and our results could decline. In addition, if we are unable to grow our revenues, which are affected by product mix as well as demand, our margins would decrease and our results could decline.
Our LED revenues are highly dependent on our customers’ ability to source or develop efficient phosphor solutions to enable them to use our LED chips to produce competitive white LED products.products using our LED chips.
Some of our customers package our blue LEDs in combination with phosphorphosphors to create white LEDs. Growth for the sales of our high brightness chips is dependant upon our customers’ ability to produce competitive white LED products using our chips. Nichia Corporation, or Nichia, currently has the majority of the market share for white LEDs. The phosphor solutions that our customers have used in their products generally have not been as efficient as the phosphor solution that Nichia has used in its products. As a result, the white LEDs that our customers produce with our chips historically have not been as bright as Nichia’s white LEDs.We are assisting our customers in their efforts to develop or gain access to more competitive phosphor solutions.Even if our customers are able to develop or secure more competitive phosphor solutions,white LED products, there can be no assurance that they will be able to compete with Nichia, which has an established market presence. Growth in sales of our high-brightness LED chips used in white light applications is dependent upon our customers’ ability to develop secure and implement more competitive phosphor solutions.efficient white LED products using our chips.
We are highly dependent on trends in mobile appliancesproducts to drive a substantial percentage of LED demand.
Our results of operations could be adversely affected by reduced customer demand for LED products for use in mobile appliances. In the third quarter ofproducts. For fiscal 2005, we derived nearly one-half of our LED revenue from sales of our products into mobile appliance applications.In the first quarter of fiscal 2006 more than one-half of our LED revenue represented sales of our products into mobile product applications. Our design wins are spread over numerous models and customers. Our ability to maintain or increase our LED product revenue depends in part on the number of models into which our customers design our products and the overall demand for these products, which is impacted by seasonal fluctuations.fluctuations and market trends. For example, the adoption of full color screens has driven growth in the market for LEDs for use in mobile appliances in the past. As full color screens have penetrated the mobile product market, the growth rate of demand for LEDs has slowed, thereby increasing competition among LED suppliers and putting pressure on pricing. Also, design cycles in the handset industry are short and demand is volatile, which makes production planning difficult to forecast. Brightness performance, smaller size and price considerations are important factors in increasing our market share for mobile products.
If we experience poor production yields, our margins could decline and our operating results may suffer.
Our materials products and our LED, power and RF device products are manufactured using technologies that are highly complex. We manufacture our SiC wafer products from bulk SiC crystals, and we use these SiC wafers to manufacture our LED products and our SiC-based RF and power semiconductors. Our Cree Microwave subsidiary manufactures its RF semiconductors on silicon wafers purchased from others. During our manufacturing process, each wafer is processed to contain numerous die, which are the individual semiconductor devices. The RF and power devices and XLamp products then are further processed by incorporating them into packages for
sale as packaged components. The number of usable crystals, wafers, dies and packaged components that result from our production processes can fluctuate as a result of many factors, including but not limited to the following: variability in our process repeatability and control;
impurities in the materials used;| · | variability in our process repeatability and control; |
contamination of the manufacturing environment;| · | impurities in the materials used; |
equipment failure, power outages or variations in the manufacturing process;| · | contamination of the manufacturing environment; |
lack of adequate quality and quantity of piece parts and other raw materials;| · | equipment failure, power outages or variations in the manufacturing process; |
losses from broken wafers or human errors;| · | lack of adequate quality and quantity of piece parts and other raw materials; |
defects in packaging either within our control or at our subcontractors.| · | losses from broken wafers or human errors; and |
| · | defects in packaging either within our control or at our subcontractors. |
We refer to the proportion of usable product produced at each manufacturing step relative to the gross number that could be constructed from the materials used as our manufacturing yield.
If our yields decrease, our margins could decline and our operating results would be adversely affected. In the past, we have experienced difficulties in achieving acceptable yields on new products, which has adversely affected our operating results.We may experience similar problems in the future, and we cannot predict when they may occur or their severity. In some instances, we may offer products for future delivery at prices based on planned yield improvements. Reduced yields or failure to achieve planned yield improvements could significantly affect our future margins and operating results.
We depend on a few large customers, and our revenues can be affected by their contract terms.
Historically, a substantial portion of our revenue has come from large purchases by a small number of customers. Accordingly, our future operating results depend on the success of our largest customers and on our success in selling large quantities of our products to them. The concentration of our revenues with a few large customers makes us particularly susceptible to factors affecting those customers. For example, if demand for their products decreases, they may limit or stop purchasing our products and our operating results could suffer. For example, Sumitomo’s inventory of our products can vary materially each quarter based on fluctuations in their customer demand. The Sumitomo contract provides that Sumitomo may decrease its purchase commitment or terminate the contract if its inventory of our products reaches a specified level. In general, the success of our relationships with our customers is subject to a number of factors, including the dynamics of the overall market. For example, if some of our competitors were to license technology or form alliances with other parties, our business may be impacted.
Our traditional LED chip customers may reduce orders as a result of our entry into the packaged LED markets.
We began shipping packaged LED devices in fiscal 2005. Some of our customers may reduce their orders for our chips as a result of us competing with them in the packaged LED business. This reduction in orders could occur faster than our packaged LED business can grow in the near term. This could reduce our overall revenue and profitability.
The markets in which we operate are highly competitive and have evolving technology standards.
The markets for our LED, RF and microwave and power semiconductor products are highly competitive. In the LED market, we compete with companies that manufacture or sell nitride-based LED chips as well as those that sell packaged LEDs. Competitors are offering new blue, green and white LEDs with aggressive prices and improved performance. These competitors may reduce average sales prices faster than our cost reduction. Inreduction, and competitive pricing pressures may accelerate the RF power semiconductor field, the products manufactured by Cree Microwave compete with products offered by substantially larger competitors who have dominated the market to date based on product quality and pricing.rate of decline of our average sale prices. The market for SiC wafers is also becoming competitive as other firms in recent years have begun offering SiC wafer products or announced plans to do so. We also expect significant competition for our other products, such as those for use in microwave communications and power switching.
We expect competition to increase. In order to achieve our revenue growth objectives in calendar 2005,fiscal 2006, we need to continue to develop new products that enable our customers to win new designs and increased market share in key applications such as mobile phones. One major supplier dominates this market and we anticipate that the competition for these designs will be intense.intense and may result in lower sales prices of our products. Therefore, our ability to provide higher performance LEDs at lower costs will be critical to our success. Competitors may also try to align with some of our strategic customers. This could mean lower prices for our products, reduced demand for our products and a corresponding reduction in our ability to recover development, engineering and manufacturing costs. Competitors also could invent new technologies that may make our products obsolete. Any of these developments could have an adverse effect on our business, results of operations and financial condition.
Our business and our ability to produce our products may be impaired by claims that we infringe intellectual property rights of others.
Vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. These traits have resulted in significant and often protracted and expensive litigation. Litigation to determine the validity of patents or claims by third parties of infringement of patents or other intellectual property rights could result in significant expense and divert the efforts of our technical personnel and management, even if the litigation results in a determination favorable to us. In the event of an adverse result in such litigation, we could be required to: pay substantial damages;
indemnify our customers;| · | pay substantial damages; |
stop the manufacture, use and sale of products found to be infringing;| · | indemnify our customers; |
discontinue the use of processes| · | stop the manufacture, use and sale of products found to be infringing; |
expend significant resources to develop non-infringing products and processes; and/or| · | discontinue the use of processes found to be infringing; |
obtain a license to use third party technology.| · | expend significant resources to develop non-infringing products and processes; and/or |
| · | obtain a license to use third party technology. |
There can be no assurance that third parties will not attempt to assert infringement claims against us with respect to our current or future products. We have also promised certain of our customers that we will indemnify them in the event they are sued by our competitors for intellectual property violations. Under this indemnification obligation we may be responsible for future payments to them to resolve infringement claims. From time to time we receive correspondence asserting that our products or processes are or may be infringing patents or other intellectual
property rights of others. Our practice is to investigate such claims to determine whether the assertions have merit and, if so, we take appropriate steps to seek to obtain a license or to avoid the infringement. However, we cannot predict whether a license will be available or that we would find the terms of any license offered acceptable or commercially reasonable. Failure to obtain a necessary license could cause us to incur substantial liabilities and costs and to suspend the manufacture of products.
There are limitations on our ability to protect our intellectual property.
Our intellectual property position is based in part on patents owned by us and patents exclusively licensed to us by North Carolina State University, Boston University and others. The licensed patents include patents relating to the SiC crystal growth process that is central to our SiC materials and device business. We intend to continue to file patent applications in the future, where appropriate, and to pursue such applications with U.S. and foreign patent authorities.
However, we cannot be sure that patents will be issued on such applications or that our existing or future patents will not be successfully contested by third parties. Also, since issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, we cannot be sure that any of our patents (or patents issued to others and licensed to us) will provide significant commercial protection, especially as new competitors enter the market.
In addition to patent protection, we also rely on trade secrets and other non-patented proprietary information relating to our product development and manufacturing activities. We try to protect this information through appropriate efforts to maintain its secrecy, including requiring employees and third parties to sign confidentiality agreements. We cannot be sure that these efforts will be successful or that the confidentiality agreements will not be breached. We also cannot be sure that we would have adequate remedies for any breach of such agreements or other misappropriation of our trade secrets, or that our trade secrets and proprietary know-how will not otherwise become known or be independently discovered by others.
Where necessary, we may initiate litigation to enforce our patent or other intellectual property rights. Any such litigation may require us to spend a substantial amount of time and money and could distract management from our day-to-day operations. Moreover, there is no assurance that we will be successful in any such litigation.
We depend on a few large customers, and our revenues can be affected by their contract terms.Historically, a substantial portion of our revenue has come from large purchases by a small number of customers. Accordingly, our future operating results depend on the success of our largest customers and on our success in selling large quantities of our products to them. The concentration of our revenues with a few large customers makes us particularly susceptible to factors affecting those customers. For example, if demand for their products decreases, they may limit or stop purchasing our products and our operating results could suffer. Similarly, if they decide to purchase our products indirectly, through other packagers, our operating results could be affected. We are unable to predict whether such a change would be positive or negative for our business. In addition, our Sumitomo contract provides that Sumitomo may decrease its purchase commitment or terminate the contract if its inventory of our products reaches a specified level. In general, the success of our relationships with our customers is subject to a number of factors, including the dynamics of the overall market. For example, if some of our competitors were to license technology or form alliances with other parties, our business may be impacted.
We face significant challenges managing our growth.
We have experienced a period of significant growth that has challenged our management and other resources. We have grown from 390680 employees on June 27, 199925, 2000 to 1,2351,332 employees on June 27, 200426, 2005 and from revenues of $60.1$108.6 million for the fiscal year ended June 27, 199925, 2000 to $306.9$389.1 million for the fiscal year ended June 27, 2004.26, 2005. To manage our growth effectively, we must continue to: implement and improve operating systems;
maintain adequate manufacturing facilities and equipment to meet customer demand;maintain a sufficient supply of raw materials to support our growth;- 35 - improve the skills and capabilities of our current management team;
add experienced senior level managers;attract and retain qualified people with experience in engineering, design and technical marketing support; and
recruit and retain qualified manufacturing employees.| · | implement and improve operating systems; |
| · | maintain adequate manufacturing facilities and equipment to meet customer demand; |
| · | maintain a sufficient supply of raw materials to support our growth; |
| · | improve the skills and capabilities of our current management team; |
| · | add experienced senior level managers; |
| · | attract and retain qualified people with experience in engineering, design and technical marketing support; and |
| · | recruit and retain qualified manufacturing employees. |
We will spend substantial amounts of money in supporting our growth and may have additional unexpected costs. We may not be able to expand quickly enough to exploit potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development and administrative support. If we cannot attract qualified people or manage growth effectively, our business, operating results and financial condition could be adversely affected. For example, we are currently trying to build a worldwide team of sales, marketing and marketingdevelopment and application support employees for our power, solid-state lighting and powerbacklighting businesses. If we are not successful in recruiting personnel, our projected growth may be lower than our forecasts. Conversely, if the product demand from our customers does not expand as we anticipate, our margins may decrease in part due to higher costs associated with the greater capacity that has been added recently which would not be used.
Performance of our investments in other companies could affect our financial condition.
From time to time, we have made investments in public and private companies that engage in complementary businesses. Should the value of any such investments we hold decline, the related write-down in value could have a material adverse effect on our financial condition as reflected in our consolidated balance sheets. In addition, if the decline in value is determined to be other-than-temporary, the related write-down could have a material adverse effect on our reported net income. On March 27, 2005, we held interestsWe currently hold an interest in one public company. In the third quarter of fiscal 2005, we sold our investmentWe do not currently hold any interests in Lighthouse Technologies, Inc. at its carrying value and no longer have investments in privately heldprivate companies that have a net carrying value on our financial statements other than a $37,000 value forrelating to certain warrants held in a private company.
An investment in another company is subject to the risks inherent in the business of the company in which we have invested and to trends affecting the equity markets as a whole. OurInvestments in private company investmentscompanies are subject to additional risks relating to the limitations on transferability of ourthe interests due to the lack of a public market and to other transfer restrictions. Our investmentInvestments in a publicly held company exposes uscompanies are subject to market risks and may not be liquidated easily. As a result, we may not be able to reduce the size of our positions or liquidate our investments when we deem appropriate to limit our downside risk.
Our investments in public and privateother companies also may cause fluctuations toin our earnings results. For example, during the thirdfirst quarter of fiscal 2005,2006, we recorded a $4.1 million increase$2.0 decrease in our income tax expense related to a decline in the value of our Color Kinetics investment. On the other hand, in the second quarter of fiscal 2005, we recorded a $7.9 million increase in our income tax expense related toan unrealized capital gain on the Color Kinetics investment, which we offset against a prior year tax carry forward. In the fourth quarter of fiscal 2005, we recorded an $814,000 decrease in our fiscal 2002 loss carryforward.tax expense related to an increase in value of our Color Kinetics investment. In future periods, we will be required to continue to adjust our deferred tax asset valuation allowance in connection with any increase or decrease in the value of our investment in Color Kinetics, which could increase or decrease our income tax expense for the period. This may cause fluctuations in our earnings results that do not accurately reflect our results from operations.
Our manufacturing capacity may not be sufficient to keep upaligned with customer demand.demand.We experienced significant growth in fiscal 2004 and are operating near capacity for LED products.
Although we are taking steps to address our manufacturing capacity concerns,needs, if we are not able to increase our capacity quickly enough to respond to customer demand, if our business results from operations could be impacted. We are exploring ways to expand our manufacturing capacity and plan to make certain expenditures in fiscal 2006 to acquire new equipment. Any potential expansion plans are not adequate enough to address our capacity constraints or if ramping up new capacity costsprojects may be delayed, cost more than we anticipate or require long transition periods, any of which could impact our businessability to meet our customers’ demands and results of operation could be adversely affected.As part ofaffect our initiative to address these capacity concerns, weoperating results.
We also are in the process of transitioning our production process in several ways. First, over the course of fiscal 2005, we arebegan shifting production of the majority of our LED products from two-inch wafers to three-inch wafers over the course of fiscal 2005. We must first qualifywafers. This process involves qualifying our production processes for each product on systems designed to accommodate the larger wafer size, and some of our existing production equipment must be retooled for the larger wafer size. In the past we have experienced lower yields for a period of time following a transition to a larger wafer size until use of the larger wafer is fully integrated in production and we begin to achieve production efficiency. We have experienced similar short-term yield challenges during the first part of the transition to the three-inch wafers. If we experience delays in the qualification process, the transition phase takes longer than we expect, or if we are unable to attain expected yield improvements, our operating results may be adversely affected.
We also are in the process of qualifying production of Schottky diode products in our Sunnyvale, California location over the next several quarters. We may experience a transition period as we start to ramp up production in which our yields are low or our production costs do not meet our expectations. If we experience delays in qualifying this facility for production of SiC Schottky diodes, if this transition period extends longer than we expect, or if we are not able to achieve the production levels and margins we expect, our operating results could be adversely affected.We also are exploring ways to expand our manufacturing capacity and plan to make certain expenditures in the coming fiscal year to acquire new equipment. Any potential expansion projects may be delayed, cost more than we anticipate or require long transition periods, any of which could impact our ability to meet our customers’ demands and affect our operating results.
We rely on a few key suppliers.
We depend on a limited number of suppliers for certain raw materials, components, services and equipment used in manufacturing our products, including key materials and equipment used in critical stages of our manufacturing processes. We generally purchase these limited source items with purchase orders, and we have no guaranteed supply arrangements with such suppliers. If we were to lose key suppliers or suppliers are unable to support our demand, our manufacturing operations could be interrupted or hampered significantly.
If government agencies or other customers discontinue or curtail their funding for our research and development programs, our business may suffer.
Changes in Federal budget priorities could adversely affect our contract revenue. Historically, government agencies and other customers have funded a significant portion of our research and development activities. When the government makes budget priorities, such as in times of war, our funding has the risk of being redirected to other programs. Government contracts are also subject to the risk that the government agency may not appropriate and allocate all funding contemplated by the contract. In addition, our government contracts generally permit the contracting authority to terminate the contracts for the convenience of the government, and the full value of the contracts would not be realized if they arewere prematurely terminated. Furthermore, we may be unable to incur sufficient allowable costs to generate the full estimated contract values, and there is some risk that any technologies developed under these contracts may not have commercial value. If government and customer funding is discontinued or reduced, our ability to develop or enhance products could be limited, and our business, results of operations and financial condition could be adversely affected.
If our products fail to perform or meet customer requirements, we could incur significant additional costs.
The manufacture of our products involves highly complex processes. Our customers specify quality, performance and reliability standards that we must meet. If our products do not meet these standards, we may be required to replace or rework the products. In some cases our products may contain undetected defects or flaws that only become evident after shipment. We have experienced product quality, performance or reliability problems from time to time. Defects or failures may occur in the future. If failures or defects occur, we could: lose revenue;
incur increased costs, such as warranty expense and costs associated with customer support;experience delays, cancellations or rescheduling of orders for our products;| · | incur increased costs, such as warranty expense and costs associated with customer support; |
write down existing inventory;| · | experience delays, cancellations or rescheduling of orders for our products; |
experience product returns.| · | write down existing inventory; or |
| · | experience product returns. |
We are subject to risks from international sales.
Sales to customers located outside the U.S. accounted for approximately 83%87%, 80%83% and 65%80% of our revenue in fiscal 2005, 2004 2003 and 2002,2003, respectively. We expect that revenue from international sales will continue to be the majority of our total revenue. International sales are subject to a variety of risks, including risks arising from currency fluctuations, trading restrictions, tariffs, trade barriers and taxes. Also, U.S. Government export controls could restrict or prohibit the exportation of products with defense applications. Because all of our foreign sales are denominated in U.S. dollars, our sales are subject to variability as prices become less competitive in countries with currencies that are low or are declining in value against the U.S. dollar and more competitive in countries with currencies that are high or increasing in value against the U.S. dollar.
If we fail to evaluate and implement strategic opportunities successfully, our business may suffer.
From time to time we evaluate strategic opportunities available to us for product, technology or business acquisitions. For example, in fiscal 2004 we acquired the gallium nitride substrate and epitaxy business of ATMI, Inc. If we choose to make an acquisition, we face certain risks, such as failure of the acquired business in meeting our performance expectations, diversion of management attention, retention of existing customers of the acquired business and difficulty in integrating the acquired business’s operations, personnel and financial and operating systems into our current business. We may not be able to successfully address these risks or any other problems that arise from our recent or future acquisitions. Any failure to successfully evaluate strategic opportunities and address risks or other problems that arise related to any acquisition could adversely affect our business, results of operations and financial condition.
The process of winding down our Cree Microwave segmentbusiness could adversely affect our results of operation.
In June 2005, we announced plans to close Cree Microwave, our silicon RF and microwave semiconductor business in Sunnyvale, California. We accepted last-time buy orders from our customers through July 2005 and expect to wind-down operations by the end of calendar 2005. We have written down the assets and disclosed certain expenses we expect to incur in winding down the business and closing the Sunnyvale facility. We will continue to be obligated on our lease for that facility through November 2011. The amount of expense we expect to incur for lease obligations was calculated assuming that we sublease the facility beginning in fiscal 2007. If our estimated expenditures related to the closure are higher than expected, we are unable to find a tenant to sublease the facility from us or we are unable to fulfill last-time buy orders and wind-down operations by the end of calendar 2005, our results of operation could be adversely affected.
If we are unable to attract and hire a new Chief Financial Officer or if the search process takes longer than expected, our business could suffer.
We are actively seeking a new Chief Financial Officer in response to the August 2005 announcement that Cynthia B. Merrell, our current Chief Financial Officer, is resigning. Ms. Merrell has agreed to continue her service as Chief Financial Officer until we secure a qualified successor but not later than mid-February 2006. There is intense competition for qualified senior management, particularly those with the financial condition.Unless we develop sufficient new business for Cree Microwave’s products, our expensesexpertise needed for this segment will continue to exceed its revenues. As a result,position. If we are pursuing strategic alternatives for our Cree Microwave segmentunable to attract and expect to complete our analysis of an appropriate strategic approach in the fourth quarter of fiscal 2005. Actions we take ashire a result of this analysis could adversely impact our revenue and expenses and could resultnew Chief Financial Officer in a write-down of some oftimely manner, our Cree Microwave related assets. For example, we may decidebusiness could suffer from the uncertainty caused by the continued management search process. If Ms. Merrell were to discontinue the production and sale of certain or all of Cree Microwave’s products. Alternatively, we may pursuestep down prior to our hiring a sale of all or certain of the assets of the Cree Microwave segment, although we cannot predict whether we willreplacement, our business could also be able to enter into any suitable arrangement.
harmed.
Litigation and SEC matters could adversely affect our operating results and financial condition.
We and certain of our officers and current or former directors are defendants in pending litigation (as described in “Part II, Item 1. Legal Proceedings” of this report)quarterly report and “Part II, Item 3. Legal Proceedings” of our annual report on Form 10-K for the fiscal year ended June 26, 2005) that alleges, among other things, violations of federal securities laws.laws and patent infringement. Defending against existing and potential securities and class action litigation will likely require significant attention and resources and, regardless of the outcome, result in significant legal expenses, which will adversely affect our results unless covered by insurance or recovered from third parties. If our defenses are ultimately unsuccessful, or if we are unable to achieve a favorable resolution, we could be liable for damage awards that could materially adversely affect our results of operations and financial condition.In addition, the SEC in July 2003 initiated an informal inquiry of us and requested that we voluntarily provide certain information to the SEC staff. We have cooperated with the SEC in this informal inquiry. If the SEC elects to pursue a formal investigation of us, responding to any such investigation and any resulting enforcement action could require significant diversion of management’s attention and resources in the future as well as significant legal expense and exposure to possible penalties or fines that could materially adversely affect our results of operations.
Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC regulations from the Securities and Exchange Commission, are creating uncertainty for public companies such as ours. These laws, regulations and standards are subject to varying interpretations in many cases, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and
higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased sales, general and administrative expenses and a diversion of management time and attention. In particular, our efforts to complycompliance with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding our required assessment of our internal controlscontrol over financial reporting and our independent accountants’ audit of that assessment for fiscal 2005 have required, and we expect such efforts to continue to require, the commitment of significant financial and managerial resources. We cannot assure you that we will not discover a material weakness or significant deficiency in our internal controlscontrol over financial reporting or that we will complete the process of our evaluation and the auditors’ attestation on time.reporting. If we discover a material weakness or significant deficiency, corrective action may be time-consuming, costly and further divert the attention of management. The disclosure of a material weakness or significant deficiency may cause our stock price to fluctuate significantly.
Item 3.Quantitative and Qualitative Disclosures About Market Risk
As of March 27,September 25, 2005, we held a long-term investment in the equity of Color Kinetics, which is treated for accounting purposes under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115115”) as an available-for-sale security. This investment is carried at fair market value based upon the quoted market price of that investment as of March 27,September 25, 2005, with net unrealized gains or losses excluded from earnings and reported as a separate component of shareholders’ equity.
It is our policy to write down these types of equity investments to their market value and record the related write downwrite-down as an investment loss on our consolidated statements of operations if we believe that an other-than-temporary decline existed in our marketable equity securities. As of March 27,September 25, 2005, we do not believe that an other-than-temporary decline existed in our investment in Color Kinetics as the market value of the security was above our cost. This investment is subject to market risk of equity price changes. The fair market value of this investment as of March 27,September 25, 2005, using the closing sale price as of MarchSeptember 23, 2005, was $26.3 million, compared to the fair market value as of June 26, 2005, using the closing sale price as of June 24, 2005, which was $18.6$20.9 million.
As of March 27,September 25, 2005, other thanwe held warrants in the equity of a privately-heldprivate company valued at $37,000, we held no equity investments in private companies with a carrying value on our financial statements. During the quarter ending December 26, 2004, we recorded a $2.0 million other than temporary impairment on one of our private company investments. The write-down was based on our evaluation of the financial results of the private company. We sold our investment in this private company in the third quarter of fiscal 2005 at its carrying value. The remaining private company investments that we hold have been fully impaired in prior fiscal years for other than temporary impairments (other than a $37,000 value estimated for warrants held in a private company).$37,000. We hold and expect to continue to consider investments in minority interests in companies having operations or technology in areas within our strategic focus. We generally are not subject to material market risk with respect to our investments classified as marketable securities as such investments are readily marketable, liquid and do not fluctuate substantially from stated values. Many of our investments are in early stage companies or technology companies where operations are not yet sufficient to establish them as profitable concerns. However, anyOne of our investments we makeis in a publicly traded companies would becompany whose share prices are subject to market risk. Management continues to evaluate its investment positions on an ongoing basis. See the footnote, “Investments”“Investments,” in the consolidated financial statements included in Part 1 Item 1 of this report for further information on our policies regarding investments in private and public companies. We have invested some of the proceeds from our January 2000 public offeringcash from operations into high-grade corporate debt, commercial paper, government securities and other investments at fixed interest rates that
vary by security. These investments are A grade or better perin accordance with our cash management investment policy. At March 27,September 25, 2005, we had $168.2$240.1 million invested in these securities.securities, compared to $206.3 million at June 26, 2005. Although these securities generally earn interest at fixed rates, the historical fair values of such investments have not differed materially from the amounts reported on our consolidated balance sheets. Therefore, we believe that potential changes in future interest rates will not create material exposure for us from differences between the fair values and the amortized cost of these investments. The potential loss in fair value resulting from a hypothetical 10% decrease in quoted market price was approximately $24.0 million at September 25, 2005.
We currently have no debt outstanding.outstanding or off-balance sheet obligations, commitments or contingencies or guarantees and we do not use special purpose entities for any transactions. With two of our larger customers, we maintain a foreign currency adjustment to our sales price if Japanese and Euro exchange rates against the U.S. dollar are not maintained. During the first quarter of fiscal 2006, we recognized zero of revenue associated with proceeds received from one of these customers for foreign currency adjustments. These revenue adjustments represent our main risk with respect to foreign currency, since our contracts and purchase orders are denominated in U.S. dollars. We have no commodity risk.
Item 4. Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934), as amended (the “Exchange Act”) as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures are effective in that they provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission’s rules and forms. InThe officers noted that during the courseperiod covered by this Form 10-Q, as a result of human error, we were late in filing a Form 8-K pursuant to Item 1.01 (Entry into a Material Definitive Agreement) relating to the renewal of our ongoing preparations for making management’s report on internal controls over financial reporting atannual management incentive plan by the end of this fiscal year, as required by Section 404 of the Sarbanes-Oxley Act, we have identified areas in need of improvement and are taking remedial actions to strengthen the affected controls as appropriate. From time to time, we make these and other changes to our internal controls over financial reporting that are intended to enhance the effectivenesscompensation committee of our internalboard of directors, but that the fact that the filing had not been made was identified through our disclosure controls over financial reporting and which do not have a material effect on our overall internal controls.procedures. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal controlscontrol over financial reporting on an ongoing basis and will take action as appropriate.
We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. There have been no changes to our internal controlscontrol over financial reporting as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the thirdfirst quarter of fiscal 20052006 that we believe materially affected, or will be reasonably likely to materially affect, our internal controlscontrol over financial reporting. For further information about our internal controls over financial reporting, please see Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Certain Business Risks and Uncertainties” on page 47 of this report.
PART II - OTHER INFORMATION
Item 1. Legal ProceedingsDuring the three months ended March 27, 2005, there were no material developments in the legal proceedings previously
In re Cree, Inc. Securities Litigation
As reported in our Annual Report on Form 10-K for the fiscal year ended June 27, 2004, our Quarterly Report on Form 10-Q26, 2005, a consolidated class action was pending in the U.S. District Court for the quarterlyMiddle District of North
Carolina seeking damages for alleged violations of securities laws by us and certain of our current and former officers and directors. In February 2004, the defendants moved that the court dismiss the consolidated amended 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 allowing the plaintiffs a period ended September 26,of time in which to file an amended consolidated complaint. The plaintiffs filed a further amended complaint on October 14, 2004, asserting essentially the same claims and our Quarterly Report on Form 10-Qseeking the same relief as in their prior complaint. The defendants filed a motion to dismiss this further amended complaint. On August 2, 2005, the court entered an order granting the motion to dismiss the plaintiffs’ amended complaint in its entirety with prejudice. On August 31, 2005, the plaintiffs filed an appeal of the dismissal to the U.S. Court of Appeals for the quarterly period ended December 26, 2004. Please refer to Part I, Item 3 of theFourth Circuit. The appeal currently is pending.
Neumark v. Cree, Inc.
We also reported in our most recent Annual Report on Form 10-K that a patent infringement action is pending against us in the U.S. District Court for the fiscal year ended June 27, 2004, Part II, Item 1Southern District of New York. The complaint alleges that we are infringing two U.S. patents relating to wide band gap semiconductors by manufacturing, importing, using, selling and/or offering for sale LEDs and/or laser diodes created using processes claimed in the Quarterly Reportpatents. On September 30, 2005, we filed an answer and counterclaims in which we deny any infringement and assert, among other defenses, that the patents are invalid and are unenforceable under the doctrine of inequitable conduct. Our counterclaims seek a declaratory judgment that we have not infringed the patents and that the patents are invalid and unenforceable.
We believe that the claims in these actions are without merit. However, we are unable to predict the final outcome of these matters. Our failure to successfully defend against these allegations could have a material adverse effect on Form 10-Q for the quarterly period ended September 26, 2004our business, financial condition and Part II, Item 1results of the Quarterly Report on Form 10-Q for the quarterly period ended December 26, 2004 respectively, for a descriptionoperations.
The following exhibits are being filed herewith and are numbered in accordance with Item 601 of Regulation S-K:
| | | | 10.1 | | LetterForm of Master Restricted Stock Award Agreement dated February 9, 2005, between Charles & Colvard Ltd. and Cree, Inc. (asterisks located within | | 10.2 | | Fiscal 2006 Management Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 to the exhibit denote information that has been deleted pursuant to a request for confidential treatmentCompany’s Current Report filed on Form 8-K with the Securities and Exchange Commission)Commission on October 21, 2005) | | 10.3 | | Letter Agreement, dated August 10, 2005, between Cynthia B. Merrell and the Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on August 12, 2005) | | 31.1 | | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | | 31.2 | | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | | 32.1 | | Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | | 32.2 | | Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | CREE, INC. | | | | Date: May 5,October 26, 2005 | | | | /s/ Cynthia B. Merrell
| | Cynthia B. Merrell | Chief Financial Officer and Treasurer | (Authorized Officer and Chief Financial and Accounting Officer) |
| | | Exhibit No.
| | Description
| | 10.1 | | LetterForm of Master Restricted Stock Award Agreement dated February 9, 2005, between Charles & Colvard, Ltd. and Cree, Inc. (asterisks located within | | 10.2 | | Fiscal 2006 Management Incentive Compensation Plan (incorporated by reference to Exhibit 10.1 to the exhibit denote information that has been deleted pursuant to a request for confidential treatmentCompany’s Current Report filed on Form 8-K with the Securities and Exchange Commission)Commission on October 21, 2005) | | 10.3 | | Letter Agreement, dated August 10, 2005, between Cynthia B. Merrell and the Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report filed on Form 8-K with the Securities and Exchange Commission on August 12, 2005) | | 31.1 | | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | | 31.2 | | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | | | | 32.1 | | Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | | | | 32.2 | | Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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