UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 24, 2006March 25, 2007

or

For the transition period from            to            

Commission File Number: 0-21154

CREE, INC.

(Exact name of registrant as specified in its charter)

(919) 313-5300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

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

The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of January 5,April 9, 2007, was 76,602,056.84,260,011.

CREE, INC.

FORM 10-Q

For the Three and SixNine Months Ended December 24, 2006March 25, 2007

INDEX

PART I - FINANCIAL INFORMATION

Item 1. Financial StatementsCREE, INC.

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

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

CREE, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

(Unaudited)

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

CREE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

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

CREE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 24, 2006March 25, 2007

(Unaudited)

1. Basis of Presentation

The consolidated balance sheet at December 24, 2006,March 25, 2007, the consolidated statements of income for the three and sixnine months ended December 24,March 25, 2007 and March 26, 2006, and December 25, 2005, and the consolidated statements of cash flow for the sixnine months ended December 24,March 25, 2007 and March 26, 2006 and December 25, 2005 have been prepared by Cree, Inc. (collectively with its subsidiaries, the “Company”) and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to present fairly the consolidated financial position, results of operations and cash flows at December 24, 2006,March 25, 2007, and for all periods presented, have been made. The consolidated balance sheet at June 25, 2006 has been derived from the audited financial statements as of that date.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 2006 Annual Report on Form 10-K. The results of operations for the period ended December 24, 2006March 25, 2007 are not necessarily indicative of the operating results that may be attained for the entire fiscal year.

2. Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.

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 2007 fiscal year extends from June 26, 2006 through June 24, 2007 and is a 52-week fiscal year. The Company’s 2006 fiscal year extended from June 27, 2005 through June 25, 2006 and was also a 52-week fiscal year.

Reclassifications

Certain fiscal 2006 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2007 presentation. These reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.

Estimates

The preparation of 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 December 24, 2006March 25, 2007 and June 25, 2006, and the reported amounts of revenues and expenses during the three and sixnine months ended December 24, 2006March 25, 2007 and December 25, 2005.March 26, 2006. Actual amounts could differ from those estimates.

Revenue Recognition

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

The Company estimates its allowance in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”). Specifically, the Company reviews historical sales returns and other relevant data and matches returns or other credits to the quarter when the sales were originally recorded. Based on historical return percentages and other relevant factors, the Company estimates its potential future exposure on product sales that have been recorded. The allowance for sales returns at December 24, 2006March 25, 2007 and June 25, 2006 was $5.7$4.3 million and $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. As of December 24, 2006March 25, 2007 and June 25, 2006, the Company estimated the cost of future product returns at $1.1$1.2 million and $1.7 million, respectively, which is recorded in prepaid expenses and 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 and its wholly owned subsidiary (“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, areis included in the consolidated financial statements of the Company from the date of acquisition.

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

The purchase price has been allocated based on estimated fair values of assets acquired and liabilities assumed. The Company’s purchase price allocation is as follows (amounts in thousands):

In accordance with the criteria set forth in Emerging Issues Task Force 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination,” and in connection with the merger, the Company began to formulate a restructuring plan for the integration of INTRINSIC. During the third quarter of fiscal 2007, the Company completed its assessment of the Dulles, Virginia facility and as of March 25, 2007, ceased business operations at the location. Employees and certain machinery and equipment were relocated to the Durham, North Carolina operations.

As a result of ceasing business operations at this location, the Company recorded a $1.9 million disposal of property, plant and equipment, a $1.1 million charge for facility lease obligations, a $158,000 inventory write-off charge, and $46,000 in employee-related costs. The resulting charges increased goodwill by $3.2 million during the third quarter of fiscal 2007. The $1.1 million lease obligation was included in accrued expenses in the consolidated balance sheet as of March 25, 2007.

The Company remains liable for the operating lease of the Dulles facility through March 2009. In accordance with the provisions of SFAS No. 146, “Accounting for the Costs Associated with Exit or Disposal Activities,” the Company has recorded a liability of $1.1 million for ongoing lease obligations. This liability represents the fair value of the remaining lease liability based on

an estimate of the present value of the remaining lease obligations reduced by an estimate of sublease rental income that may be obtained for the property through the expiration of the lease term. The Company believes that significant write-downs related to ceasing operations at the Dulles facility have been completed.

The following table summarizes the changes in accrued liabilities during the third quarter of fiscal 2007 attributable to costs incurred related to ceasing operations of the Dulles facility:

4. 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 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 and sixnine months ended December 24,March 25, 2007 and March 26, 2006, and December 25, 2005, and the assets and liabilities of CMI on the consolidated balance sheet at December 24, 2006March 25, 2007 and June 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 estimated accrual of future lease obligations. During the second quarter of fiscal 2007, the Company entered into a sublease agreement for its Sunnyvale facility. As a result of entering into this agreement, the Company has adjusted its accrual for future lease obligations by $394,000 to reflect the actual payments agreed to under the terms of the sublease. The lease for the Sunnyvale facility expires in November 2011 and the Company does not intend to extend the term. The sublease also expires in November 2011.

The following table summarizes the changes

attributable to costs incurred and charged to expense 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 income (losses)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 to sell the inventory for its intended purpose, the inventory’s value is determined to be less than cost or it is determined to be obsolete. The charge for the inventory reserves is recorded in cost of revenue in the consolidated statements of income. Reserves are adjusted quarterly to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management.

The following is a summary of the components of inventory:

		($ in 000s)
		March 25, 2007				June 25, 2006
Raw materials		$	10,625			$	6,425
Work-in-process			21,088				12,532
Finished goods			19,941				11,668
			51,654				30,625
Inventory reserve			(1,352	)			(631	)
Total inventories, net		$	50,302			$	29,994

6. Investments

The Company currently holds 864,385 shares of Color Kinetics, Incorporated (“Color Kinetics”) common stock. During the second quarter of fiscal 2007, the Company sold 931,275 shares of Color Kinetics common stock for $16.7 million and recognized aan $11.4 million gain. During the first quarter of fiscal 2006, the Company sold 63,782 shares of Color Kinetics common stock for $954,000 and recognized a $587,000 gain. As of December 24, 2006March 25, 2007 and June 25, 2006, the Company had recorded cumulative unrealized holding gains on its investment in Color Kinetics of $13.1$11.5 million and $18.7 million, or $8.2$7.2 million and $11.8 million, net of tax, respectively. The calculation of the unrealized gains was based on the closing share price of Color Kinetics common stock as of December 22, 2006March 23, 2007 and June 23, 2006 was used to determine the fair market value of the Company’s investment of $18.1$16.5 million and $29.1 million, respectively.

7. Intangible Assets

The following table reflects the components of intangible assets:

Customer relationships are amortized over ten years. Developed technology is amortized over seven years. Patent and license rights are amortized over twenty years.

8. Earnings Per Share

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

Potential common shares that would have the effect of increasing diluted earnings per share are considered to be antidilutive. In accordance with SFAS No. 128, “Earnings per Share,” these shares were not included in calculating diluted earnings per share. For the three and sixnine months ended December 24, 2006,March 25, 2007, there were 89.5 million and 8.7 million shares, in both periods that wererespectively, not included in calculating diluted earnings per share because their effect was antidilutive. For the three and sixnine months ended December 25, 2005,March 26, 2006, there were 6.35.1 million and 5.4 million shares, respectively, not included in 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 sixnine months ended December 24, 2006March 25, 2007 (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 $2.7 million and $6.4$9.2 million in the three and sixnine months ended December 24, 2006,March 25, 2007, respectively. The Company recorded stock-based compensation of $3.5 million and $6.3$9.8 million in the three and sixnine months ended December 25, 2005,March 26, 2006, respectively. Approximately $368,000$663,000 and $713,000$618,000 of stock-based compensation was allocated towere recorded in inventory in the Company’s consolidated balance sheets as of December 24,March 25, 2007 and June 25, 2006, and December 25, 2005, respectively.

The fair value of each award is estimated on the date of grant using the Black-Scholes-Merton option-pricing model using the following assumptions:

The following table summarizes option activity as of December 24, 2006,March 25, 2007, and changes during the sixnine months then ended:

As of December 24, 2006,March 25, 2007, there was approximately $23.6$24.2 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 six months ended December 24, 2006 was $18.94. The total intrinsic value of options exercised during the sixnine months ended December 24, 2006March 25, 2007 was $1.9$2.1 million.

A summary of nonvested shares of restricted stock awards outstanding under the Company’s 2004 Long-Term Incentive Compensation Plan as of December 24, 2006,March 25, 2007, and changes during the sixnine months then ended, follows:

As of December 24, 2006,March 25, 2007, there was approximately $4.1$3.7 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

For the three and six months ended December 24, 2006, the Company’s effective tax rate, including discrete items, was 12% and 24%, respectively. The variation between income taxes and income tax expense and pretax accounting incomeat the statutory rate of 35% is primarily due to the retroactive reenactment of the research and experimentationdevelopment tax credit, the release of $5.2 million of contingency reserves associated with the completion of the Company’s research and development tax credit study, the release of $9.3 million due to the expected resolution of Internal Revenue Service audits of the Company’s fiscal 2003, 2004 and 2005 federal income tax returns, the release of $1.5 million of valuation allowances on deferred tax assets related to Federalfederal capital loss carryforwardscarry forwards, and state taxes.

For the three and six months ended December 25, 2005, the Company recorded reductions in income tax expenseprovision adjustments of $132,000 and $2.3$4.4 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 such benefits would expire unused byfiling of our fiscal 2006 federal tax returns and the Company. Based on SFAS No. 109, “Accounting for Income Taxes,” the valuation allowance should be adjusted for any new realizableamendment of our fiscal 2004 and 2005 federal capital gains or losses. The 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 this reason, a portion of the valuation allowance associated with the prior year capital loss was reversed initially and has been adjusted in each subsequent quarter as the market value of the Company’s investment in Color Kinetics changed.tax returns.

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.

12. Recent Accounting Pronouncements

In September 2006,The Company continues to assess the impact that Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), will have on its consolidated financial statements. Issued by FASB in June 2006, FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal 2008.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”) 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 2009.

Also in September 2006,In February 2007, the SecuritiesFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Exchange CommissionFinancial Liabilities – Including an amendment of FASB Statement No. 115” (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”SFAS 159”). SAB 108 requires using both an incomeSFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value at specified election dates. The statement approachalso establishes presentation and a balance sheet approach in assessing materialitydisclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of misstatementsassets and liabilities. The statement is effective for the Company beginning in fiscal 2007.2009. The Company has not yet determined the impact, if any, of the adoption of SAB 108 is not expected to have a material impact onSFAS 159.

13. Subsequent Event

On March 30, 2007, the Company acquired all of the outstanding share capital of COTCO Luminant Device Ltd. (“COTCO”) in exchange for consideration consisting of 7,604,785 shares of the Company’s common stock and $70 million in cash. The cash portion of the purchase price is subject to a working capital adjustment after the closing of the transaction. Additional consideration of up to $125 million may be payable to the seller or its designees in the event COTCO achieves specific financial position or results of operations.

targets over the next two fiscal years. The Company continuesmay elect to assesspay the impact that FASB Interpretationadditional consideration, if any, in cash, shares of its common stock, or a combination of cash and stock, as long as the total number of shares of the Company’s common stock issued to the seller relating to the transaction is less than 9.99% of the Company’s then outstanding common stock. The acquisition will be accounted for under the purchase method of accounting as prescribed by SFAS No. 48, “Accounting141, “Business Combinations,” and all related goodwill and other intangible assets will be accounted for Uncertainty in Income Taxes – an interpretation of FASB Statementaccordance with SFAS No. 109” (“FIN 48”), will have on its consolidated financial statements. Issued by the FASB in June 2006, FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold142, “Goodwill and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal 2008.Other Intangible Assets.”

13.14. Commitments and Contingencies

On September 11, 2006, the Company, 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 the Company, and No. 5,686,738, entitled “Highly Insulating Monocrystalline Gallium Nitride Thin Films,” which the Company has licensed from the University on an exclusive basis. The suit was filed in the U.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 filed a complaint against the Company 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. On December 11, 2006, the Company filed an answer to this complaint in which the Company denied any infringement. Together with Boston University, the Company also asserted counterclaims against BridgeLux for infringement of the ‘236 and ‘738 patents originally asserted in the North Carolina case. In addition, the Company counterclaimed against BridgeLux for infringement of U.S. Patent Nos. 6,614,056 and 6,885,036 both entitled “Scalable LED With Improved Current Spreading Structures.” The Company’s counterclaims seek monetary damages and injunctive relief to prohibit BridgeLux from infringing these four patents. The Company also requested declaratory judgments that BridgeLux’s ‘812 patent is not infringed, is invalid based in part on our earlier ‘056 and ‘036 patents, and is unenforceable due to fraud and/or inequitable conduct committed before the U.S. Patent Office. BridgeLux has moved to sever and either dismiss or stay the proceedings on the infringement counterclaims.

On October 17, 2006, BridgeLux filed a complaint against the Company and Boston University in the U.S. District Court for the Northern District of California. The complaint seeks a declaratory judgment of non-infringement and invalidity with respect to the ‘236 and ‘738 patents and of non infringement with respect to U.S. Patent No. 6,600,175, entitled “Solid State White Light Emitter and Display Using Same,” which the Company owns, and U.S. Patent No. 6,953,703, entitled “Method of Making a Semiconductor Device with Exposure of Sapphire Substrate to Activated Nitrogen,” which we license from the University on an exclusive basis. After the Company filed its counterclaims in the Texas actionasserting the ‘056 and ‘036 patents, BridgeLux amended its complaint in the California action to add a request for a declaratory judgment of non-infringement with respect to these. The Company has moved to dismiss BridgeLux’s declatory judgment claims regarding the ‘236, ‘738, ‘056 and ‘036 patents on its prior filings in North Carolina and Texas and to dismiss the claims regarding the ‘175 and ‘703 patents for lack of subject matter jurisdiction.

Please refer to Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 25, 2006 for a description of other material legal proceedings.proceedings, including descriptions of the proceedings discussed below under the captions “In re Cree, Inc. Securities Litigation” and “Neumark v. Cree, Inc.” Please also refer to Part II, Item 1 of the Quarterly Report on Form 10-Q for the quarter ended December 24, 2006 for a description of the proceedings discussed below under the caption “BridgeLux Patent Litigation.”

In re Cree, Inc. Securities Litigation

As described in Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 25, 2006, the U.S. District Court for the Middle District of North Carolina, in August 2005, dismissed the plaintiffs’ amended complaint in these consolidated cases and the plaintiff appealed the dismissal to the U.S. Court of Appeal for the Fourth Circuit. In a published opinion issued in February 2007, the appellate court affirmed the dismissal of the amended complaint. The plaintiffs petitioned for rehearing by the entire appellate court. The petition was denied in April 2007.

Neumark v. Cree, Inc.

As described in Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 25, 2006, this patent infringement case is pending before the U.S. District Court for the Southern District of New York. In March 2007, the court conducted a hearing, in accordance with the procedure laid out in the U.S. Supreme Court’s 1996 decision in Markman et al. v. Westview Instruments, Inc., for the purpose of determining the interpretation of disputed terms used in the claims of the patents at issue in the lawsuit.

BridgeLux Patent Litigation

As described in Part II, Item 1 of the Quarterly Report on Form 10-Q for the quarter ended December 24, 2006, the Company initiated this litigation by filing a patent infringement action against BridgeLux, Inc., in federal court in North Carolina, and BridgeLux subsequently filed related actions in federal court in California and in Texas. In the California case, the Company’s motion to dismiss BridgeLux’s declaratory judgment claims remains pending. In the Texas case, BridgeLux alleged infringement of U.S. Patent No. 6,869,812. The Company denied any infringement in its answer and has moved for summary judgment of invalidity on certain claims of the ‘812 patent on the ground that the claims were anticipated by prior art. The Company also asserted counterclaims against BridgeLux in the Texas case for infringement of U.S. Patent Nos. 6,657,236 and 5,686,738. The Company had first alleged that BridgeLux infringed the ‘236 and ‘738 patents in its complaint filed in the North Carolina case, which BridgeLux has moved to dismiss. In February 2007, the court in Texas ordered that the claims on the ‘236 and ‘738 patents be severed and dismissed without prejudice on the ground that claims under these patents are the subject of prior pending litigation. BridgeLux had also moved to sever and to dismiss or stay proceedings on additional counterclaims the Company had asserted against BridgeLux for infringement of U.S. Patent Nos. 6,614,056 and 6,885,036. The court denied the motion by BridgeLux to sever the claims under the ‘056 and ‘036 patents, with the result that these claims remain pending in Texas.

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 the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All information contained in this 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,” 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 do not intend to update them if our views later change. These forward- looking statements should not be relied upon as representing our views as of any date subsequent to the date of this quarterly report. To review risk factors that could cause actual results to 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 fiscal 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 arewere manufactured at our main production facilities in Durham and Research Triangle Park, 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:

Industry Dynamics

Our business is primarily selling high-brightness LED products, which is affected by a number of industry factors, including design trends in mobile products, overall demand in products using high-brightness LEDs, an intense and constantly evolving competitive environment, and intellectual property issues. Currently, the most significant market for our LED chips is for illumination purposes in mobile products, including LCD backlighting, keypad illumination and flash units for camera phones. LED unit sales for mobile products are impacted by the number of LEDs used in a product, which varies depending on design trends and the brightness of the LEDs used in an application. Average LED sales prices generally decline each year as market players implement pricing strategies to gain or protect market share. To remain competitive, LED producers generally must increase product performance and reduce costs to support lower average sales prices. The mobile phoneLED high-brightness segment has become more competitive over the last several quarters which has caused companies to lower prices at a faster rate than was previously estimated. 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 of the SecondThird Quarter of Fiscal 2007

The following is a summary of our financial results infor the three months ended December 24, 2006:March 25, 2007:

Outlook for Fiscal 2007

We target that the LED chip market will continue to be challenged inremain highly competitive during the second halfremainder of fiscal 2007. We plan to continue to expand our global sales, marketing, and distribution capabilities to support increased sales of our new LED components, including those from our acquisition of COTCO and high-power products.

For the remainder of fiscal 2007, we plan to work on increasing the brightness of our LED chips and packaged LED products. We plan to continue cost reduction initiatives for both our LED and SiC-based high-power products by converting some production to four-inch wafer production and transferring more of our production to our subcontractors in Asia. In addition, we target to invest $90a total of $80 million to $100$90 million in capital expenditures primarily at our North Carolina sites.during fiscal 2007. This will support unit volume growth and is a critical part of our overall product cost reduction initiatives.

We plan to continue 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, 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 Part 2,II, Item 8 of our Annual Report on Form 10-K for the fiscal 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. 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 From Assumptions 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 at the time of sale, which is recorded as a reduction of product revenue and accounts receivable.   In connection with the allowance for sales returns, we also record an asset for the value of product returns that we believe will be returned to inventory.		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.		As of December 24, 2006March 25, 2007 and June 25, 2006, the amount of our sales return allowance was $5.7$4.3 million and $5.4 million, respectively.   As of December 24, 2006March 25, 2007 and June 25, 2006, we estimated the value of future product returns that would be returned to inventory to be $1.1$1.2 million and $1.7 million, respectively.   A 10% increase or decrease in our sales return estimates and deferred product costs asset at December 24, 2006March 25, 2007 would have affected net income by approximately $315,000$216,000 for the sixnine months ended December 24, 2006.March 25, 2007.
Accounting for Stock-Based Compensation:
We account for stock-based compensation arrangements in accordance with the provisions of SFAS No. 123(R), “Shared-Based Payment.” Under SFAS 123(R), compensation cost is calculated on the date of the grant using the 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 key assumptions, we may be required to adjust compensation expense, which could be material to our results of operations.
Valuation of Long-Lived Assets:
We review long-lived assets such as property, equipment, goodwill, intangible assets and patents for impairment on a routine basis and when events and circumstances indicate that the carrying value of the assets recorded in our financial statements may not be recoverable. For example, a portion of our equipment may be scrapped; 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		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 no long-lived asset impairment charges during the three and sixnine months ended December 24, 2006.March 25, 2007 and $581,000 during the nine months ended March 26, 2006 for building improvements no longer being used at our Durham, North Carolina facility.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and AdjustmentsRecordedAdjustments Recorded
carrying value of our assets to the estimated future cash flows of the assets (undiscounted and without interest charges). If the estimated undiscounted 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 discounted 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.   For goodwill, we evaluate impairment in a two-step process. The first step compares the fair value of the reporting unit with its carrying value. If the fair value of the reporting unit exceeds its carrying value, no impairment is recorded. If the carrying amount of the reporting unit exceeds its fair value, the second step of the impairment analysis is performed. The second step is used to measure the amount of the impairment loss and compares the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill. If the carrying amount exceeds the implied fair value of the goodwill, an impairment loss is recognized for the excess. However, it should be noted that the loss recognized shall not be in excess of the carrying amount. Once a goodwill impairment loss is recognized, the adjusted carrying value shall be its new accounting basis.   We do not restore a previously recognized impairment loss if the asset’s carrying value decreases below its estimated fair value.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
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 carryforwards and unrealized losses on certain securities where 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 might 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. For example, in the third quarter of fiscal 2007 we recorded a tax benefit of $17.9 million for the release of contingency reserves associated with the completion of our research and development tax credit study and the expected resolution of Internal Revenue Service audits of our fiscal 2003, 2004 and 2005 federal income tax returns. As of December 24, 2006,March 25, 2007, we had established tax reserves of $20.1$3.3 million and a valuation allowance of $6.0$6.5 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 on 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 twelve 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 December 24, 2006March 25, 2007 would have affected net income by approximately $83,000$96,000 for the sixnine months ended December 24, 2006.March 25, 2007.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
		eliminate demand for a product. When inventory is physically destroyed, we remove the inventory and the associated reserve from our financial records.
Accruals for Self-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 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 expressed as a percentage of total revenue from continuing operations for the periods indicated: