In accordance with the provisions of SFAS 144, the following table summarizes the amounts of revenue and pre-tax losses reported in discontinued operations for the respective income statement periods presented (in thousands):

Business Segments

As a result of the closure of the Cree Microwave silicon business, the Company now has one reportable segment.year.

Reclassifications

Certain fiscal 20052006 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 20062007 presentation. These reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.

Fiscal Year

The Company’s fiscal year is a 52-or 53-week period ending on the last Sunday in the month of June. The Company’s 2006 fiscal year extends from June 27, 2005 through June 25, 2006 and is a 52-week fiscal year. The Company’s 2005 fiscal year extended from June 28, 2004 through June 26, 2005 and was a 52-week fiscal year.

Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at March 26,September 24, 2006 and June 26, 200525, 2006 and the reported amounts of revenues and expenses during the three and nine months ended March 26,September 24, 2006 and March 27,September 25, 2005. Actual amounts could differ from those estimates.

Earnings Per Share

The following computation reconciles the differences between the basic and diluted earnings per share presentations (in thousands, except per share amounts):

Potential common shares that would have the effect of increasing diluted earnings per share are considered to be antidilutive. In accordance with SFAS No. 128, “Earnings per Share,” (“SFAS 128”) these shares were not included in calculating diluted earnings per share. For the three and nine months ended March 26, 2006, there were 5.1 million and 5.4 million shares, respectively, not included in calculating diluted earnings per share because their effect was considered to be antidilutive. For the three and nine months ended March 27, 2005, there were 4.5 million and 3.8 million shares, respectively, not included in calculating diluted earnings per share because their effect was considered to be antidilutive.

Revenue Recognition

The Company provides its customers with limited rights of return for non-conforming shipments and certain of the Company’s contractual sales arrangements provide for limited product exchanges and the potential for reimbursementreimbursements of certain sales costs. As a result, the Company records an allowance for sales returns at the time of sale, which is recorded as a reduction of product revenue onin the consolidated statements of income and as a reduction to accounts receivable onin the consolidated balance sheets.

During fiscal 2005, theThe Company determined that sufficient historical sales return information was available to enable the Company to reasonably estimateestimates sales returns in accordance with the criteria in SFASprovisions of Statement of Financial Accounting Standards (SFAS) No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”).Exists.” Specifically, the Company reviews historical quarterly sales returns as a percentage of total sales. The returns are matched to the quarter when the sales were originally recorded. Based on historical return percentages and other relevant factors, the Company estimates its sales returns that have not yet occurred for product sales that have been recorded. During the three months ended March 26,September 24, 2006, the Company reduced its allowance for sales returns by $1.7$1.3 million primarily due to actual customer returns, adjustments to the Company’s estimated future sales returns and for the reimbursement to one of the Company’s customers for certain sales costs in accordance with its contract with the Company. The amount of this reimbursement was previously accrued in the Company’s allowance for sales returns. During the nine months ended March 26, 2006, the Company reduced its allowance for sales returns by $3.1 million due to actual customer returns, adjustments to the Company’s estimated future sales returns and for the reimbursement to one of the Company’s customers for certain sales costs in accordance with its contract with the Company. The allowance for sales returns at March 26,September 24, 2006 and June 26, 200525, 2006 was $6.5$4.1 million and $9.6$5.4 million, respectively.

In accordance with SFAS 48, the Company also records an estimate for the value of product returns that it believes will be returned to inventory in the future and resold. During the third quarter of fiscal 2006, the Company recorded a $434,000 increase in its estimate for the value of product returns. During the nine months ended March 26, 2006, the Company recorded a net $250,000 increase in its estimate for the value of product returns that it believed would be returned to inventory. As of March 26,September 24, 2006 and June 26, 2005,25, 2006, the Company estimated the cost of future product returns at $1.9$1.4 million and $1.7 million, respectively, which iswas recorded as a reduction in the costs of product revenue in the consolidated statements of incomeprepaid expenses and reflected in other current assets in the consolidated balance sheets.

3. Acquisition

Through a wholly owned subsidiary, the Company acquired all of the outstanding capital stock and options of INTRINSIC Semiconductor Corporation (“INTRINSIC”) on July 10, 2006. The acquisition has been accounted for under the purchase method of accounting as prescribed by SFAS No. 141, “Business Combinations.” All related goodwill and other intangible assets have been accounted for in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.”

The Company changed the name of INTRINSIC to Cree Dulles, Inc., effective July 10, 2006. All financial information of Cree Dulles, Inc., and its wholly owned subsidiary are included in the consolidated financial statements of the Company from the date of acquisition.

The total estimated purchase price is as follows (amounts in thousands):

The estimated purchase price has been allocated based on estimated fair values of assets acquired and liabilities assumed. The final valuation of net assets acquired is expected to be completed by the end of December 2006, but no later than one year from the acquisition date in accordance with generally accepted accounting principles. The Company’s preliminary estimate of the purchase price allocation is as follows (amounts in thousands):

Investments4. Discontinued Operations

During fiscal 2006, the Company discontinued the operations of its silicon-based radio frequency and microwave semiconductor business conducted by its Cree Microwave subsidiary (“CMI”). As of March 26,December 25, 2005, the Company completed production of all last time buy orders for CMI’s silicon products and terminated its remaining employees. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has reported the operating results of CMI for the three months ended September 24, 2006 and September 25, 2005, and the assets and liabilities of CMI on the balance sheet at September 24, 2006 and June 26, 2005,25, 2006, as a discontinued operation.

The Company believes the significant write-downs related to the closure of CMI’s business have been completed; however, there may be future adjustments to the estimate for the accrual of the lease contract obligations. The following table summarizes the changes attributable to costs incurred and charged to expense and costs paid for the three months ended September 24, 2006 related to the exit activities for CMI, which are reflected in liabilities of discontinued operations in the consolidated balance sheets:

The following table summarizes the amounts of revenue and pre-tax losses reported in discontinued operations for the respective income statement periods presented:

5. Inventories

Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out (“FIFO”) method for finished goods and work in process accounts. The Company uses the average cost method to value raw materials. The Company records a reserve against inventory once it has been determined that conditions exist which may not allow the Company held a long-term equity investmentto sell the inventory for its intended purpose, the inventory’s value is determined to be less than cost, or it is determined to be obsolete. The charge for the inventory reserves is recorded in cost of revenue in the common stockconsolidated statements of Color Kinetics, Incorporated (“Color Kinetics”). income. Reserves are adjusted quarterly to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management.

The Company accounts for its sharesfollowing is a summary of Color Kinetics common stock as available-for-sale securities under SFAS No. 115, “Accounting for Certainthe components of inventory:

6. Investments in Debt and Equity Securities” (“SFAS 115”). Accordingly, unrealized gains or losses on Color Kinetics’ shares are excluded from earnings and are recorded as other comprehensive income, net of tax. Management classifies the shares as a long-term investment as the Company has the intent and the ability to hold these shares.

During the first quarter of fiscal 2006, the Company sold 63,782 shares of Color Kinetics, Incorporated (“Color Kinetics”) common stock for $954,000, and recognized a $587,000 gain. During the third quarter of fiscal 2005, the Company sold 343,000 shares of Color Kinetics common stock for $4.8 million and recognized a gain of $2.8 million. The Company heldcurrently holds 1,795,660 shares of Color Kinetics common stock as of March 26, 2006.stock. As of March 26,September 24, 2006 and June 26, 2005,25, 2006, the Company had recorded a cumulative unrealized gainholding gains on its investment in Color Kinetics of $22.3$18.9 million and $10.2$18.7 million, respectively, (or $14.0or $11.9 million and $6.2$11.8 million, net of tax, respectively).respectively. The calculation of the unrealized gaingains was based on the closing share price of theColor Kinetics common stock as of March 26,September 22, 2006 and June 26, 200523, 2006 to determine the fair market value forof the Company’s investment of $32.7$29.3 million and $20.9$29.1 million, respectively.

As of March 26, 2006 and June 27, 2005, the Company held warrants to purchase stock in a privately-held company with a carrying value of $37,000 for each period. During the second quarter of fiscal 2005, the Company recorded a write-down of $2.0 million on its investment in a privately-held company called Lighthouse Technologies Limited (“Lighthouse”), representing the Company’s best estimate of an other-than-temporary decline in the value of the investment. This impairment charge was recorded as a loss on long-term investments on the consolidated statements of income. During the third quarter of fiscal 2005, the Company sold its investment in Lighthouse for $896,000, which was the carrying value of the investment. Since the Company does not have the ability to exercise significant influence over the operations of such privately-held companies, the investment balances are carried at cost, accounted for using the cost method of accounting and are included in other non-current assets in the consolidated balance sheets. Because the shares of stock and stock warrants the Company received in these investments are not publicly traded, there is no established market for these securities.

Inventories7. Intangible Assets

The following is a summarytable reflects the components of inventory (in thousands):intangible assets:

As8. Earnings Per Share

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

Potential common shares that would have the effect of March 26, 2006, the Company maintained a $673,000 reserve for inventory. Duringincreasing diluted earnings per share are considered to be antidilutive. In accordance with SFAS No. 128, “Earnings per Share,” these shares were not included in calculating diluted earnings per share. For the three and nine months ended March 26,September 24, 2006 the Company scrapped $65,000 and $1.0September 25, 2005, there were 8.2 million and 5.3 million shares, respectively, of previously reserved products as they could no longer be usednot included in production or sold. The Company reduced the respective inventory reserves accordingly as of March 26, 2006.calculating diluted earnings per share because their effect was antidilutive.

9. Shareholders’ Equity

The following presents a summary of activity in shareholders’ equity for the ninethree months ended March 26,September 24, 2006 (in(dollars and shares in thousands):

10. Stock-Based Compensation

The Company currently has one equity-based compensation plan from which stock-based compensation awards can be granted to employees and directors. In addition, the Company has five plans that have been terminated as to future grants, but under which options are currently outstanding. The Company also has an Employee Stock Purchase Plan (“ESPP”) that provides employees with the opportunity to purchase common stock at 85% of the fair market value of the common stock at two designated times each year.

The Company recorded stock-based compensation of $3.7 million and $2.9 million in the three months ended September 24, 2006 and September 25, 2005, respectively. Approximately $673,000 and $795,000 of stock-based compensation was allocated to inventory in the Company’s consolidated balance sheets as of September 24, 2006 and September 25, 2005, respectively.

Research and Development

Revenue and expense classifications for U.S. Government and non-governmental contracts are basedThe fair value of each award is estimated on the naturedate of grant using the contract. For contracts whereBlack-Scholes-Merton option-pricing model using the Company anticipates that funding will exceed direct costs over the life of the contract, funding is reported as contract revenue and all direct costs are reported as costs of contract revenue. For contracts where the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding as an offset of those expenses. following assumptions:

The following table details information about contracts for which direct expenses exceeded funding by periodsummarizes option activity as included in researchof September 24, 2006, and development expenses forchanges during the three and nine-month periodsmonths then ended:

As of September 24, 2006, there was approximately $25.2 million of total unrecognized compensation costs related to stock-based compensation arrangements. The unrecognized compensation cost is expected to be recognized over a weighted-average period of two years. The weighted-average grant-date fair value of options granted during the three months ended March 26,September 24, 2006 was $18.70. The total intrinsic value of options exercised during the three months ended September 24, 2006 was $512,000.

A summary of nonvested shares of restricted stock awards outstanding under the Company’s 2004 Long-Term Incentive Compensation Plan as of September 24, 2006, and March 27, 2005, respectively:changes during the quarter then ended, follows:

As of September 24, 2006, there was approximately $3.9 million of total unrecognized compensation costs related to nonvested restricted stock share-based compensation arrangements. The unrecognized compensation cost is expected to be recognized over a weighted-average period of four years.

11. Income Taxes

ForThere were no significant variations in the threerelationship between income tax expense and nine months ended March 26,pretax accounting income in the first quarter of fiscal 2007.

In the first quarter of fiscal 2006, the Company recorded reductionsa $2.2 million reduction in its income tax expense of approximately $2.3 million and $4.7 million, respectively, related to realized and unrealized capital gains on its investment in Color Kinetics. In fiscal 2002, the Company recorded a capital loss associated with certain other marketable securities that was carried forward for tax purposes. However, the Company fully reserved the tax benefits associated with the loss because it was more likely than not that such benefitbenefits would expire unused by the Company. Based on SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”) the valuation allowance should be adjusted for any new realizable federal capital gains or losses. Therefore, once the Company’s ability to transfer its shares of Color Kinetics stock was no longer contractually restricted in December 2004, theThe increase in the market value of the Company’s investment in Color Kinetics was an unrealized capital gain that the Company could offset against the fiscal 2002 loss carry forward for tax purposes.forward. For this reason, a portion of the valuation allowance associated with the prior year capital loss was reversed beginning in the second quarter of fiscal 2005initially and has been adjusted in each subsequent quarter. quarter as the market value of the Company’s investment in Color Kinetics changed.

In future periods, the Company will continue to adjust its deferred tax asset valuation allowance in connection with any increase or decrease in the value of its investment in Color Kinetics, which could increase or decrease the income tax expense for such period. For the three and nine months ended March 26, 2006, the Company also recorded an additional $1.4 million tax benefit related to a prior year tax return that was filed in March 2006.

For the three and nine months ended March 27, 2005, the Company recorded an increase of $3.2 million and a $3.8 million decrease, respectively, related to realized and unrealized capital gains on its investment in Color Kinetics. Also, during the third quarter of fiscal 2005, the Company determined that its effective tax provision rate had declined from 32.20% to 31.11%, and, as a result recorded a $716,000 reduction in income tax expense. During the second quarter of fiscal 2005, the Company increased the valuation allowance related to privately-held investments by $697,000 resulting from the tax effect of the $2.0 million reserve that was recorded in the second quarter of fiscal 2005. Additionally, the Company increased income tax expense by $1.8 million for a settlement on state income taxes, estimated state tax rate changes and other adjustments. The net effect of the adjustments recorded for income taxes was a $2.1 million increase to net income for the nine months ended March 27, 2005.

Stock-Based Compensation

At March 26, 2006, the Company has one equity-based compensation plan from which stock-based compensation awards can be granted to employees and directors. In addition, the Company has five plans that have been terminated as to future grants, but under which options are currently outstanding. The Company’s plans are as follows:

Long-Term Incentive Compensation Plan - This plan provides for awards in the form of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, stock units and performance units. Currently, this is the only plan under which awards are authorized to be granted. As approved by the shareholders in November 2004, the plan authorized issuance of up to 1,200,000 shares plus the number of shares then authorized for issuance under the Equity Compensation Plan, which were not thereafter used for awards under the Equity Compensation Plan. On November 3, 2005, the Company’s shareholders approved an amendment to the Long-Term Incentive Compensation Plan, which increased the shares authorized for issuance under the plan by 2,000,000 shares. Awards issued under the plan to date include only nonqualified stock options and restricted stock.

Equity Compensation Plan - This plan provided for grants in both the form of incentive stock options and nonqualified stock options. The plan was terminated as to future grants in November 2004.

Stock Option Plan for Non-Employee Directors - This plan provided for fixed annual non-qualified option grants to the Company’s non-employee directors. The plan was terminated as to future grants in 1997.

2001 Nonqualified Stock Option Plan - This plan provided for non-qualified option grants to eligible employees. The plan was terminated as to future grants in 2003.

Fiscal 2001 Stock Option Bonus Plan - This plan provided for non-qualified option grants to eligible employees for each quarter of fiscal 2001. The plan expired as to future grants in September 2001.

Fiscal 2002 Stock Option Bonus Plan - This plan provided for non-qualified option grants to eligible employees for each quarter of fiscal 2002. This plan expired as to future grants in September 2002.

The Company also has an Employee Stock Purchase Plan (the “ESPP”) that provides employees of the Company and designated subsidiaries the opportunity to purchase common stock through payroll deductions. The Company established the original ESPP in 1999 and terminated it on October 31, 2005. The Company’s shareholders approved the new 2005 ESPP on November 3, 2005 and it became effective November 3, 2005. Under the 1999 ESPP, the purchase price was set at the lower of 85% of the fair market value of common stock at the beginning of the participation period or 85% of the fair market value on the purchase date. Under the 2005 ESPP, the purchase price is set at 85% of the fair market value of common stock at the purchase date. Under the 1999 ESPP, the Company’s board of directors had reserved a total of 1,350,000 shares of common stock for issuance. Under the 2005 ESPP, the Company’s board of directors has reserved a total of 600,000 shares of common stock for issuance. The 2005 ESPP also limits employee contributions to 15% of each employee’s compensation, and participation periods have a 6-month duration, beginning in May and November of each year.

Prior to June 27, 2005, the Company accounted for its equity-based compensation plans under the recognition and measurement provision of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). The Company did not recognize stock-based compensation cost in its Consolidated Statements of Income prior to June 27, 2005, as all options granted under its equity-based compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective June 27, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified-prospective-transition method. Under this transition method, compensation cost recognized includes compensation costs for all share-based payments granted prior to, but not yet vested as of June 26, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and compensation cost for all share-based payments granted subsequent to June 26, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option-pricing model, which uses the assumptions noted in the following table. Expected volatility is based on implied volatilities from options traded on the Company’s common stock. The Company uses historical data among other factors to estimate forfeiture rates used in the model. In addition, separate groups of employees that have similar historical exercise behavior are considered separately. The expected term of options granted is derived using the “simplified” method as allowed under the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 (“SAB 107”) and represents the period of time that options granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

		Three Months Ended						Nine Months Ended
		March 26, 2006			March 27, 2005			March 26, 2006			March 27, 2005
Stock Option Grants:
Risk-free interest rate		4.53	%		3.60	%		3.96	%		3.26	%
Expected life, in years		4.5			4.0			4.5			4.1
Expected volatility		42.0	%		70.0	%		42.0	%		70.0	%
Dividend yield		0	%		0	%		0	%		0	%
Employee Stock Purchase Plan:
Risk-free interest rate		4.27	%		2.27	%		3.77	%		2.05	%
Expected life, in years		0.5			0.8			0.5			0.8
Expected volatility		42.0	%		70.0	%		42.0	%		70.0	%
Dividend yield		0	%		0	%		0	%		0	%

Prior to June 27, 2005 and the adoption of SFAS 123R, the Company’s expected volatility on shares of its common stock was based on a weighted average of the implied volatility of publicly traded call options on its stock and the historical volatility of the Company’s stock price. However, as a result of adopting SFAS 123R and in accordance with SAB 107, the Company determined that the implied volatility relating to the call options represents its best estimate of future expected volatility.

As a result of adopting SFAS 123R, the Company’s income from continuing operations before income taxes for the three and nine months ended March 26, 2006 was $3.5 million and $9.8 million lower, respectively, than if the Company had continued to account for share-based compensation under APB 25. As a result of adopting SFAS 123R, the Company’s net income for the three and nine months ended March 26, 2006 was $2.4 million and $6.7 million lower, respectively, than if the Company had continued to account for share-based compensation under APB 25. Basic earnings per share for the three and nine months ended March 26, 2006 would have been $0.34 and $0.92, respectively, if the Company had not adopted SFAS 123R, compared to reported basic earnings per share of $0.31 and $0.83, respectively. Diluted earnings per share for the three and nine months ended March 26, 2006 would have been $0.34 and $0.90, respectively, if the Company had not adopted SFAS 123R, compared to reported diluted earnings per share of $0.31 and $0.81, respectively. Net cash provided by financing activities was unchanged for the nine months ended March 26, 2006 since there were no excess tax benefits from equity-based compensation plans.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock option plans for the three and nine months ended March 27, 2005. For purposes of this pro forma disclosure, the value of the options is estimated using the Black-Scholes-Merton option-pricing model and amortized to expense over the options’ vesting periods.

		Three Months Ended March 27, 2005				Nine Months Ended March 27, 2005
		(in thousands, except per share amounts)
Net income, as reported		$	20,683			$	70,132
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax			(6,361	)			(17,528	)
Pro forma net income		$	14,322			$	52,604
Earnings per share:
Basic, as reported		$	0.27			$	0.94
Basic, pro forma		$	0.19			$	0.70
Diluted, as reported		$	0.27			$	0.91
Diluted, pro forma		$	0.19			$	0.68

12. Recent Accounting Pronouncements

In November 2004,September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” to provide enhanced guidance when using fair value to measure assets and liabilities. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value and, while not requiring new fair value measurements, may change current practices. The Company is currently evaluating the impact SFAS 157 will have on its consolidated financial statements. The standard is effective for the Company beginning in fiscal year 2009.

The Company continues to assess the impact that FASB Interpretation No. 151, “Inventory Costs”48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“SFAS 151”FIN 48”). SFAS 151, will have on its consolidated financial statements. Issued by the FASB in June 2006, FIN 48 clarifies the accounting for abnormal amountsuncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of idle facility expense, freight, handling costs,a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on derecognition, classification, interest and wasted material (spoilage). SFAS 151penalties, accounting in interim periods, and disclosure. FIN 48 is effective for inventory costs incurred during fiscal years beginning after JuneDecember 15, 2005. The adoption of SFAS 151 did not have a material effect on2006, and is required to be adopted by the Company’s consolidated financial position, results of operations or cash flows.

Contingencies

During the three months ended March 26, 2006, there were no material developmentsCompany in the legal proceedings previously reportedfirst quarter of fiscal 2008.

13. Commitments and Contingencies

On September 11, 2006, we, together with the Trustees of Boston University as co-plaintiffs, filed a complaint against BridgeLux, Inc. (formerly eLite Optoelectronics) for infringement of two U.S. patents. The two patents are No. 6,657,236, entitled “Enhanced Light Extraction in LEDs through the Use of Internal and External Optical Elements,” which is owned by us, and No. 5,686,738, entitled “Highly Insulating Monocrystalline Gallium Nitride Thin Films,” which we have licensed from the University on an exclusive basis. The suit was filed in the Company’sU.S. District Court for the Middle District of North Carolina and seeks monetary damages and injunctive relief to prohibit BridgeLux from infringing these patents. BridgeLux has filed a motion to dismiss the complaint contending that it is not subject to personal jurisdiction of the court and that venue is improper. On October 17, 2006, BridgeLux also filed a complaint against us and the University in the U.S. District Court for the Northern District of California seeking a declaratory judgment of non-infringement and invalidity with respect to the two patents on which we sued BridgeLux and of non-infringement with respect to two additional U.S. patents. The two additional patents are No. 6,600,175, entitled “Solid State White Light Emitter and Display Using Same,” which we own, and U.S. Patent No. 6,953,703, entitled “Method of Making a Semiconductor Device with Exposure of Sapphire Substrate to Activated Nitrogen,” which is owned by the University subject to an exclusive license to us. On October 17, 2006, BridgeLux also filed a complaint against us in the U.S. District Court for the Eastern District of Texas alleging infringement of U.S. Patent No. 6,869,812, entitled “High Power AlInGaN Based Multi-Chip Light Emitting Diode,” and seeking unspecified monetary damages and injunctive relief. Please refer to Part I, Item 3, “Legal Proceedings,” of our Annual Report on Form 10-K for the fiscal year ended June 26, 2005 and the Company’s Quarterly Report on Form 10-Q25, 2006 for the quarterly period ended September 25, 2005. Please refer to Part I, Item 3descriptions of the Annual Report on Form 10-K for the fiscal year ended June 26, 2005 and Part II, Item 1 of the Quarterly Report on Form 10-Q for the quarterly period ended September 25, 2005 for a description of ourother material legal proceedings.

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

Information set forth in this Quarterly Report on Form 10-Q contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (or Securities(Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (or Exchange(Exchange Act). All information contained in the following discussionthis report relative to future markets for our products and trends in and anticipated levels of revenue, gross margins and expenses, as well as other statements containing words such as “may,” “will,” “anticipate,” “target,” “plan,” “estimate,” “expect,” and “intend”“intend,” and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business, economic, and other risks and uncertainties, both known and unknown, and actual results may differ materially from those contained in the forward-looking statements. Any forward-looking statements we make are as of the date made and we have no dutydo not intend to update them if our views later change.

Factors that could cause or contribute to such differences include: These forward- looking statements should not be relied upon as representing our ability to complete development and commercializationviews as of products under development, such as our pipeline of brighter light emitting diodes or LEDs; our ability to lower costs; potential changes in demand; increasing price competition in key markets; the risk that dueany date subsequent to the complexitydate of our manufacturing processes, the transition of production to three-inch wafers and the transition of advanced device wafer fabrication to our new facility, we may experience production delays that preclude us from shipping sufficient quantities to meet customer orders or that result in higher production costs and lower margins; risks associated with the ramp up of production for our new products; risks resulting from the concentration of our business among few customers, including the risk that customers may reduce or cancel orders or fail to honor purchase commitments; the rapid development of new technology and competing products that may impair demand or render our products obsolete; the potential lack of customer acceptance for our products; the ability of Cree Microwave, LLC, or Cree Microwave to sublease its facility in Sunnyvale California; and risks associated with our ongoing litigation. See “Risk Factors” below, as well as other risks and uncertainties referenced in this report, for additionalquarterly report. To review risk factors that could cause actual results to differ.differ, see “Risk Factors” in Part II, Item 1A, of this report and in Part I, Item 1A, of our Annual Report on Form 10-K for the year ended June 25, 2006.

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, our consolidated financial statements, including the notes thereto.

Overview

We develop and manufacture semiconductor materials and electronic devices made from silicon carbide, or SiC, gallium nitride, or GaN, and related compounds. The majority of our products are manufactured at our main production facilityfacilities in Durham and RTP, North Carolina. We also use subcontractors in Asia to perform some of our manufacturing steps for certain LED and power products. We generate revenues from the following product lines:

lighting for pools and spas), architectural lighting, appliance lighting, flashlights and reading lamps. Sales of LED products represented 80% and 81% of our revenue from continuing operations for the three and nine months ended March 26, 2006, respectively. Sales of LED products represented 84% and 83% of our revenue from continuing operations for the three and nine months ended March 27, 2005, respectively.

In the second quarter of fiscal 2006, we discontinued the operations of our silicon-based RF and microwave semiconductor business, previously known as our Cree Microwave segment. All historical financial periods presented herein have been reclassified to reflect the Cree Microwave silicon-based RF and microwave business as a discontinued operation. This business produced silicon-based semiconductor components for power amplifiers used for analog and digital base stations. As of the end of the second quarter of fiscal 2006, we completed the production of all last time buy orders for our silicon products and terminated the employment of the remaining employees of our Cree Microwave subsidiary. Sales of silicon-based RF and microwave devices at Cree Microwave were $4.3 million for the nine months ended March 26, 2006. Sales of silicon-based RF and microwave devices at Cree Microwave were $957,000 and $3.9 million in the three and nine months ended March 27, 2005, respectively. These sales are reflected in the loss from discontinued operations in the consolidated statements income.

We also generate revenue under contracts funded by government agencies or other customers. Government entities assist us in the development of new technology by funding a portion of our research and development efforts. Revenue from contract research funding represented 7% of our revenue from continuing operations for the three and nine months ended March 26, 2006, respectively. Revenue from contract research funding represented 6% of our revenue from continuing operations for the three and nine months ended March 27, 2005, respectively.

Industry Dynamics

Our business is primarily selling high-brightness LED products, which is affected by a number of industry factors, including:including design trends in mobile product designsproducts, overall demand in products using high-brightness LEDs, a constantly changing competitive environment and sales, LED brightness, competitive LED pricing pressures, technology andintellectual property issues. Currently, 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 liquid crystal display, or LCD backlighting, keypad illumination and flash units for cameras.camera phones. LED sales for mobile products are impacted by the number of LEDs used in an application,a product, which may varyvaries depending on design trends in the features of the application and the brightness of the LEDs used.used in an application. Average LED sales prices generally decline each year as market players implement pricing strategies to strengthengain or protect market share. To remain competitive, LED producers generally must increase product performance and reduce thecosts to support lower average sales price.prices. Competition has increased in the mobile phone segment over the last several quarters as companies continue to position for increased market share. 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.

Highlights and Outlookof the First Quarter of Fiscal 2007

Financial highlights from the third quarterThe following is a summary of fiscal 2006

We reported our highest quarterly revenuefinancial results in the third quarter of fiscal 2006 primarily due to growth in XLamp high-power packaged LEDs, materials products and high-power devices.three months ended September 24, 2006:

In the third quarter of fiscal 2006,

Outlook for the Fourth Quarter of Fiscal 20062007

InFor the last quarterremainder of fiscal 2006,2007, we are workingplan to increasework on increasing the brightness of our LED chips and find ways to increase our customers’ ratio of blue conversion to white in LED packages for white backlight applications. If we are successful in achieving these goals, we believe that we will have an opportunity to gain market share in the LCD backlight and camera flash markets for mobile products that use white LEDs. We also plan to work through the qualification process with our customers for our new EZ Bright LED chips and target the first high volume shipments of this product in the first quarter of fiscal 2007.

We continue to expand our product offerings of our XLamp family of high-power packaged LED products. We are aimingplan to continue cost reduction initiatives for both our LED and SiC-based high-power products by converting to four-inch wafer production and increasing production at our subcontractors. In addition, we target to invest $100 million to $115 million in capital expenditures to expand our manufacturing capacity, primarily at our North Carolina sites. This expansion will support unit volume growth and reduce overall product costs in our LED and high-power product lines.

We plan to increase sales of XLampour XLamp® high power packaged LED products in the specialty lighting markets (such as lighting for pools and spas), including architectural lighting, appliance lights, and flashlights and reading lights.

In order to expand our factory output and improve our yields, we plan on investing $80.0 million to $85.0 million during fiscal 2006 in capital equipment additions, which includes the initial build out of the fabrication facility in Research Triangle Park, or RTP, North Carolina that we purchased in the third quarter of fiscal 2005. Our estimated capital expenditures for fiscal 2006 are slightly lower than our previous forecast as some of our planned expenditures for the fourth quarter of fiscal 2006 are now targeted for the first quarter of fiscal 2007. We also plan to continue the expansion of our production at our subcontractor facilities in Asia. During the fourth quarter of fiscal 2006, it will be important to continue to expand our XLamp production capacity in order to meet targeted demand and to reach our financial goals for the final quarter of fiscal 2006 and transfer wafer production of our high-power products to our new wafer fabrication facility in RTP.Schottky diode products. We will also need additional capacitybe expanding our sales, marketing and distribution teams to support projected growtha global components customer base. Also, our investment in fiscal 2007.research and development efforts will continue for LEDs, low-defect larger diameter wafers and improved high-power devices.

We plan to evaluate strategic investments to expand and strengthen our technology and product portfolio as well as to increase access to our targeted markets.

Critical Accounting Policies

The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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. We 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, and assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and we may be exposed to gains or losses that could be material.

Our significant accounting policies are discussed in Note 2, “Summary of Significant Accounting Policies and Other Matters,” of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of our Annual Report on Form 10-K.10-K for the year ended June 25, 2006. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results, and theyresults. These policies require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ Differ From Assumptions and and Adjustments Recorded
Revenue Recognition:
We provide our customers with limited rights of return for non-conforming shipments and product warranty claims. In addition, certain of our sales arrangements provide for limited product exchanges and the reimbursement of certain sales costs incurred by our customers. 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.		InAs of September 24, 2006 and June 25, 2006, the third quarteramount of fiscal 2006 we recorded a $1.7 million decrease in our sales return allowance for actual returns, adjustments towas $4.1 million and $5.4 million, respectively. During the first quarter of fiscal 2007, we decreased our estimated future sales return reserve allowance by $1.3 million primarily due to actual product returns.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and forAdjustments Recorded
sales returns at the reimbursement to onetime of our customers for certain sales costs in accordancesale, which is recorded as a reduction of product revenue and accounts receivable. In connection with its contract with us. The amount of this reimbursement was previously accrued in ourthe allowance for sales returns. In addition,returns, we recordedalso record an increase in our estimateasset for the value of product returns which decreased costthat we believe will be returned to inventory.				As of sales by $434,000. September 24, 2006 and June 25, 2006, we estimated the value of future product returns that would be returned to inventory to be $1.4 million and $1.7 million, respectively. A 10% increase or decrease in our sales return estimates and estimates of products to be returned to inventorydeferred product costs asset at March 26,September 24, 2006 would have affected net income by approximately $444,000 and $131,000, respectively,$182,000 for the three and nine months ended March 26, 2006.first quarter of fiscal 2007.
Accounting for Stock BasedStock-Based Compensation:
We account for stock-based employee compensation arrangements in accordance with the provisions of SFAS 123R, Shared-Based Payments (Revised).Payments. Under SFAS 123R, compensation cost is calculated on the date of the grant using the Black Scholes-Merton method.Black-Scholes-Merton model. 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 additionaladjust compensation or income tax expense, which could be material to our results of operations.

Valuation of Long-Lived Assets:
We review long-lived assets such as property, and equipment, acquired intangible assets, and patents for impairment on a routine basis and when events and circumstances indicate that the carrying value of the assets containedrecorded in our financial statements may not be recoverable. For example, piecesa portion of our equipment may be scrapped orscrapped; 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 $639,000 in$1,000 during the first nine monthsquarter of fiscal 2006 and $5.5 million during fiscal 2005. These impairment charges were primarily related to the planned and subsequent closure of our Cree Microwave-Sunnyvale facility and the disposal of certain assets.2007.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
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.
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 forwardscarryforwards 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 wouldmight 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 March 26,September 24, 2006, we had established tax reserves of $17.3 million and a valuation allowance of $6.5$8.1 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 uponon 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 our sales team. To mitigate uncertainties, we reserve for all inventory greater than 12 twelve		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

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
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.		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. When inventory is physically destroyed, we remove the inventory and the associated reserve from our financial records.		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 March 26,September 24, 2006 would have affected net earningsincome by approximately $46,000$56,000 for the three and nine months ended March 26, 2006.first quarter of fiscal 2007.
Accruals for Self InsuredSelf-Insured and Other Liabilities:
We make estimates for the amount of costs that have been incurred but not yet billed for our self-funded medical insurance, general services, including legal fees, 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.

Results of Operations

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

		Three Months Ended
		September 24, 2006			September 25, 2005
Revenue:
Product revenue, net		93.8	%		93.6	%
Contract revenue, net		6.2			6.4
Total revenue		100.0			100.0
Cost of revenue:
Product revenue		53.8			45.0
Contract revenue		4.9			4.3
Total cost of revenue		58.7			49.3
Gross profit		41.3			50.7
Operating expenses:
Research and development		13.8			12.4
Sales, general and administrative		11.5			10.4
Impairment or loss on disposal of long-lived assets		0.1			0.6
Total operating expenses		25.4			23.4
Income from operations		15.9			27.3
Non-operating income:
Gain on investments in securities, net		—			0.6
Other non-operating income		—			—
Interest income, net		3.7			2.3
Income from continuing operations before income taxes		19.6			30.2
Income tax expense		6.7			7.5
Income from continuing operations		12.9			22.7
Loss from discontinued operations, net of related income tax benefit		(0.1	)		(1.5	)
Net income		12.8	%		21.2	%