UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 23,December 30, 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’sRegistrant'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.    Yes  x    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 Act).    Yes  ¨    No  x

The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of October 5, 2007,January 15, 2008, was 85,278,370.85,610,550.

CREE, INC.

FORM 10-Q

For the Three and Six Months Ended September 23,December 30, 2007

INDEX

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

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 FLOWINCOME

(In thousands)thousands, except per share amounts)

(Unaudited)

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

September 23,December 30, 2007

(Unaudited)

The consolidated balance sheet at September 23,December 30, 2007 and the consolidated statements of income for the three and six months ended December 30, 2007 and December 24, 2006, and the consolidated statements of cash flows for the threesix months ended September 23,December 30, 2007 and SeptemberDecember 24, 2006 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 September 23,December 30, 2007, and for all periods presented, have been made. The consolidated balance sheet at June 24, 2007 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 Annual Report on Form 10-K for the fiscal year ended June 24, 2007. The results of operations for the period ended September 23,December 30, 2007 are not necessarily indicative of the operating results that may be attained for the entire fiscal year.

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 2008 fiscal year extends from June 25, 2007 through June 29, 2008 and is a 53-week fiscal year.year, with the additional week included in the Company’s fiscal second quarter. The Company’s 2007 fiscal year extended from June 26, 2006 through June 24, 2007 and was a 52-week fiscal year.

Reclassifications

Certain fiscal 2007 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2008 presentation. These reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.

Accounting Changes

In the first quarter of fiscal 2008, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109,” (“FIN 48”). See Note 10 “Income Taxes” below for further discussion on the Company’s adoption of FIN 48.

Reclassifications

Certain fiscal 2007 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2008 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 September 23,December 30, 2007 and June 24, 2007, and the reported amounts of revenues and expenses during the three and six months ended September 23,December 30, 2007 and SeptemberDecember 24, 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 September 23,December 30, 2007 and June 24, 2007 was $5.5$4.8 million and $4.6 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 September 23,December 30, 2007 and June 24, 2007, the Company estimated the cost of future product returns at $1.8$1.6 million and $1.3 million, respectively, which is recorded in prepaid expenses and other current assets in the consolidated balance sheets.

On March 30, 2007, Cree, Inc., acquired COTCO Luminant Device Limited, a Hong Kong company (“COTCO”), from COTCO Holdings Limited, a Hong Kong company (“Holdings”). The Company acquired all of the outstanding share capital of COTCO in exchange for consideration consisting of 7,604,785 shares of the Company’s common stock and $77 million cash. Additional consideration of up to $125 million may be payable to Holdings or its designees in the event COTCO achieves specific EBITDA targets over the Company’s next two fiscal years. The Company may elect to pay the additional consideration, if any, in cash, shares of the Company’s common stock or a combination of cash and stock, so long as the total number of shares of the Company’s common stock issued to Holdings relating to the transaction is less than 9.99% of the Company���sCompany’s then outstanding common stock.

This acquisition has been accounted for under the purchase method of accounting as prescribed by SFAS 141, “Business Combinations”. All related goodwill and other intangible assets have been accounted for in accordance with SFAS 142, “Goodwill and Other Intangible Assets.” The goodwill associated with the acquisition of COTCO is not expected to be tax deductible.

The total purchase price for this acquisition is as follows (amounts in 000’s):

The purchase price for this acquisition has been preliminarily allocated based on estimated fair values of assets acquired and liabilities assumed. The allocation of the purchase price will be finalized within one year of the date of the acquisition. The Company’s preliminary purchase price allocation is as follows (amounts in 000’s):

The following unaudited pro forma information presents a summary of the Company’s consolidated results of operations as if the COTCO transaction occurred at the beginning of the fiscal year for the period presented (amounts in 000’s, except per share data):

4.	Inventories

Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out (“FIFO”) method for finished goods and work-in-progress accounts. The Company uses the average cost method 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 inventory:

During the fourth quarter of fiscal 2007, Color Kinetics Incorporated (“Color Kinetics”) announced that it had been acquired. The transaction closed during the fiscal quarter ended September 23, 2007, and as a result the Company liquidated its remaining 500,000 shares of Color Kinetics stock. The Company no longer holds an equity investment in Color Kinetics. The Company received proceeds of $17.0 million and recognized a pre-tax gain of $14.1 million from this transaction in the consolidated statement of income during the quarter.

The following table reflects the components of intangible assets:

Amortization expense recognized during the three and six months ended September 23,December 30, 2007 and SeptemberDecember 24, 2006 was $4.8$4.9 million and $600,000,$9.7 million and $1.0 million and $1.7 million, respectively.

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

7.	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 six months ended September 23,December 30, 2007 there were 4.6 million and September4.2 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive. For the three and six months ended December 24, 2006 there were 3.8 million and 8.28.0 million shares respectively,in both periods that were not included in calculating diluted earnings per share because their effect was antidilutive.

8.	Shareholders’ Equity

The following presents a summary of activity in shareholders’ equity for the threesix months ended September 23,December 30, 2007 (dollars and shares in thousands):

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 expense of $3.2$3.9 million and $3.7$7.2 million infor the three and six months ended September 23,December 30, 2007, respectively. The Company recorded stock-based compensation of $2.7 million and September$6.4 million for the three and six months ended December 24, 2006, respectively. Approximately $518,000$429,000 and $699,000 of stock-based compensation has been recorded in inventory in the Company’s consolidated balance sheets as of September 23,December 30, 2007 and June 24, 2007, 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:

		Three Months Ended						Six Months Ended
		December 30, 2007			December 24, 2006			December 30, 2007			December 24, 2006
Stock Option Grants:
Risk-free interest rate		3.87	%		4.55	%		4.23	%		4.69	%
Expected life, in years		4.5			4.5			4.5			4.5
Expected volatility		45.4	%		51.2	%		45.4	%		51.2	%
Dividend yield		0	%		0	%		0	%		0	%
Employee Stock Purchase Plan:
Risk-free interest rate		3.95	%		5.10	%		3.95	%		5.10	%
Expected life, in years		0.5			0.5			0.5			0.5
Expected volatility		45.4	%		51.2	%		45.4	%		51.2	%
Dividend yield		0	%		0	%		0	%		0	%

The following table summarizes option activity as of September 23,December 30, 2007, and changes during the threesix months then ended:

A summary of nonvested shares of restricted stock awards outstanding under the Company’s 2004 Long-Term Incentive Compensation Plan as of September 23,December 30, 2007, and changes during the threesix months then ended, follows:

The variation between income taxes and income tax expense at the statutory rate of 35% is primarily due to the consolidation of our foreign operations, which are subject to income taxes at lower statutory rates.

Effective with the beginning of the first quarter of 2008, the Company adopted the provisions of FIN 48. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109, “Accounting for Income Taxes.” The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is cumulatively more than 50% likely to be realized upon ultimate settlement.

As a result of the implementation of FIN 48, the Company recognized an increase in total unrecognized tax benefits of $2.7 million, and accounted for the increase as a cumulative effect of a change in accounting principle that resulted in a decrease to retained earnings of $37,000$36,000 and an increase to the goodwill associated with the acquisition of COTCO of $2.7 million. The total amount of gross unrecognized tax benefits as of the date of adoption was $8.4 million. The Company has historically classified all unrecognized tax benefits as long-term deferred tax liabilities. As a result of the adoption of FIN 48, unrecognized tax benefits have been reclassified to long-term contingent tax reserves. The total amount of gross unrecognized tax benefits remains unchanged at December 30, 2007. Of the $8.4 million total unrecognized tax benefits, $5.2 million represents tax positions that, if recognized, would impact the effective tax rate. TheAlthough timing of the resolution and/or closure on audits is highly uncertain, the Company does not believebelieves it is reasonably possible that the balance of gross unrecognized tax benefits will materially change in the next twelve12 months.

The Company’s policy is to include interest and penalties related to unrecognized tax benefits within the income tax expense line item in the consolidated statements of income. This classification has not changed as a result of implementing the provisions of FIN 48. As of the date of adoption, the Company has accrued $96,000 for the payment of interest related to unrecognized tax benefits. The Company has accrued additional interest related to uncertain tax positions of $40,000 through the second quarter.

The Company files U.S. federal, U.S. state, and foreign tax returns. For federal and foreignU.S. Federal purposes, the Company is generally no longer subject to tax examinations for fiscal years ended June 26, 2005 and prior. For foreign purposes, the Company is no longer subject to examination for tax periods 2000 and prior. Certain carryforward tax attributes generated in years prior remain subject to 2004.examination and adjustment. For U.S. state tax returns the Company is generally no longer subject to tax examinations for fiscal years prior to 1997.

Subsequent to the end of the first quarter of fiscal 2008, the Internal Revenue Service issued Coordinated Issue Paper (“CIP”) LMSB-04-090762 dated September 27, 2007. The Company is currently in the process of evaluating the impact the issuance of this CIP will have on its consolidated financial statements.

In December 2006, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations,” (“SFAS 141R”) to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. This Statement applies to all transactions or other events in which an entity obtains control of one or more businesses, and combinations achieved without the transfer of consideration. The standard is effective for the Company beginning in fiscal 2010. Earlier adoption is not permitted. The issuance of this Statement has no current impact on the Company.

In December 2006, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51, (“SFAS 160”) to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements. This Statement applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. This Statement is effective for the Company beginning in fiscal 2010. Earlier adoption is prohibited. The issuance of this Statements has no current impact on the Company.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value at specified election dates. The statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The statement is effective for the Company beginning in fiscal 2009. The Company has not yet determined the impact, if any, of the adoption of SFAS 159.

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 standard is effective for the Company beginning in fiscal 2009. The Company is currently evaluating the impact SFAS 157 will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value at specified election dates. The statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The statement is effective for the Company beginning in fiscal 2009. The Company has not yet determined the impact, if any, of the adoption of SFAS 159.

Please refer to Part I, Item 3 of the Company’s Annual Report on Form 10-K for the fiscal year ended June 24, 2007 and Part II, Item 1 of the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 23, 2007 for a description of material legal proceedings, includingin addition to the proceedings discussed below.

BridgeLux PatentHoneywell Litigation

In theOn October 19, 2007, Honeywell International, Inc. and Honeywell Intellectual Properties Inc. commenced a patent infringement lawsuit that the Companyagainst us and Boston University commenced against BridgeLux, Inc.a third party by filing a complaint in the U.S. District Court for the MiddleEastern District of North Carolina for infringement of U.S. Patent Nos. 6,657,236 and 5,686,738, the court on August 21, 2007 adopted the recommendation of the magistrate judge and dismissedTexas. In the complaint, for lack of personal jurisdiction. The Company’s claims against BridgeLux for infringement of these patents remain part of the lawsuit pending in the U.S. District Court for the Northern District of California, in which the Company and Boston University have also asserted a claim against BridgeLux for infringement ofplaintiffs allege that we are infringing U.S. Patent No. 7,235,819. In6,373,188, entitled “Efficient Solid-State Light Emitting Device with Excited Phosphors for Producing a Visible Light Output.” The complaint seeks damages in an unspecified amount, an injunction against future infringements, attorneys’ fees and costs. We have answered, denying any infringement and seeking declaratory judgment that the California case, the court on August 17, 2007 entered a case managementpatent is invalid, unenforceable and pretrial order that sets a trial date in May 2009 and addresses other case management matters. The case is in the discovery phase.not infringed.

Other Matters

The Company is currently a party to other legal proceedings incidental to its business. Although the resolution of these matters cannot be predicted with certainty, management’s present judgment is that the final outcome will not likely have a material adverse effect on the Company’s consolidated financial condition or results of operations. If an unfavorable resolution occurs, the Company’s business, results of operations and financial condition could be materially adversely affected.

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.

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 primarily made from silicon carbide, or SiC, gallium nitride, or GaN, and related compounds. The majority of our products are manufactured at our main production facilities in Durham and Research Triangle Park, North Carolina and in our facility in Huizhou, China. We also use contract manufacturers in Asia to perform some of our manufacturing steps for certain light emitting diode, or LED, and power products. We generate revenues from the following product lines:

Industry Dynamics

Our business is primarily focused on selling high-brightness and high-power LED products. Industry factors affecting our business include overall demand in products using high-brightness LEDs, an intense and constantly evolving competitive environment, and intellectual property issues. 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.

Highlights of the FirstSecond Quarter of Fiscal 2008

The following is a summary of our financial results for the three months ended September 23,December 30, 2007:

Outlook for Fiscal 2008

We project that the LED chip market will remain highly competitive during the remainder of fiscal 2008. 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.

For the remainder of fiscal 2008, weWe plan to work on increasing the brightness of our LED chips and packaged LED products. We plan to continue our work on the integration of COTCO by expanding our product offerings and customer base. We plan to continue cost reduction initiatives for both our LED and SiC-based high-power products by converting some production to four-inch waferwafers and transferring more of our LED production to our contract manufacturersmanufacturer in Asia and our production facility in Huizhou, China. In addition, we target to invest a total of $25$45 million to $35$50 million in capital expenditures during the remainder of fiscal 2008. This will support unit volume growth in our new product lines 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 II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended June 24, 2007. Management believes 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
Valuation of Long-Lived Assets:
We review long-lived assets such as property, equipment, goodwill, definite lived 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 property, equipment and definite lived intangiblesintangible 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 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, on at least an annual basis, 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		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 $759,000$307,000 of impairments of long-lived assets during the three months ended September 23,December 30, 2007, and $1,000$1.1 million during the six months ended December 30, 2007. We recorded no long-lived asset impairment charges during the three or six months ended SeptemberDecember 24, 2006.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
For goodwill, on at least an annual basis, 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 more likely than not. 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 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.   As of September 23,December 30, 2007, we had established tax reserves of $5.8 million and a valuation allowance of $2.8 millionmillion.

Description of Policy		Judgments and Uncertainties		Effect If Actual Results Differ From Assumptions and Adjustments Recorded
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.   As of September 23,December 30, 2007 the amount of our inventory reserve was $3.2$4.7 million.   A 10% increase or decrease in our actual inventory reserve at September 23,December 30, 2007 would have affected net income by approximately $240,000$359,000 for the three months ended September 23,December 30, 2007.
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:

Comparison of Three Months Ended September 23,December 30, 2007 and SeptemberDecember 24, 2006

Revenue. Revenue from continuing operations increased 9%34.0% to $113.4$119.0 million in the firstsecond quarter of fiscal 2008 from $103.9$88.8 million in the firstsecond quarter of fiscal 2007. Product revenue increased 9%36.6% to $106.0$111.3 million from $97.4$81.5 million. The increase in product revenue primarily resulted from an increase in our high-brightness and high-powered packaged products, which was offset by a decline in revenue from material and high-power products.

LED revenue increased 50.9% to $98.9 million in the second quarter of fiscal 2008 from $65.5 million in the second quarter of fiscal 2007, making up 83% of our total revenue from continuing operations. Unit shipments of our LED products increased 9.8% over the second quarter of fiscal 2007 and our blended average LED sales price increased 26.8%. The increase in unit shipments is due to higher demand and the increase in blended average sales price is attributable to a shift in product mix.

Materials revenue decreased 28.9% in the second quarter of fiscal 2008 to $7.5 million from $10.6 million in the second quarter of fiscal 2007 making up 6% of our revenue from continuing operations. The decrease in materials revenue was attributable to a 18.5% decrease in the number of units sold and a 15.9% decrease in the average sales price, which were primarily due to changes in the mix of product sold and a decrease in the amount of revenue generated from sales to Charles & Colvard, Ltd. during the quarter.

Revenue from our high-power devices decreased 10.6% to $4.8 million in the second quarter of fiscal 2008 from $5.3 million in the second quarter of fiscal 2007. A 73.0% increase in the number of units sold was offset by a 48.3% decrease in the average sales price due to changes in the mix of product that were sold, as there was a higher concentration of Schottky diode products sold in the quarter-to-quarter comparison. Revenue from high-power devices was 4% of revenue from continuing operations in the second quarter of fiscal 2008.

Contract revenue increased 5.4% to $7.7 million in the second quarter of fiscal 2008 from $7.3 million in the second quarter of fiscal 2007, making up 6% of revenue from continuing operations. The increase in revenue was primarily due to new contract awards.

Gross Margin. Gross margin from continuing operations in the second quarter of fiscal 2008 increased 37.6% to $41.8 million from $30.4 million in the second quarter of fiscal 2007. Our gross margin percentage increased from 34% to 35% of revenue from continuing operations in the quarter-to-quarter comparison. The increase was caused primarily from increased utilization by our factories, the initial contribution from our high-power packaged products being produced in our factory in China, manufacturing yield improvements and the transition of our high power devices to four-inch wafers.

Contract gross margin increased to 22.2% in the second quarter of fiscal 2008 from 20.3% in the second quarter of fiscal 2007. The increase in gross margin is primarily related to a larger number of cost-plus contracts in the comparable periods.

Research and Development.Research and development expenses from continuing operations increased 4.3% in the second quarter of fiscal 2008 to $14.9 million from $14.3 million in the second quarter of fiscal 2007. The increase in research and development spending is primarily related to the continued investment in the development of higher brightness LED chips, higher brightness and high power packaged LEDs, larger wafer process development and the ongoing development of high-power devices.

Sales, General and Administrative.Sales, general and administrative, or SG&A expenses, from continuing operations increased 49.1% in the second quarter of fiscal 2008 to $18.2 million compared to $12.6 million in the second quarter of fiscal 2007. During the second quarter of fiscal 2008, SG&A expenses reflected increased stock based compensation expense as we continue to comply with the provision of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payments” (“SFAS 123R”), higher costs incurred in connection with patent litigation, increased spending on sales and marketing to support the growth of our global sales force and additional expenses related to the acquisition of COTCO.

Amortization of Acquisition Related Intangibles.Amortization of acquisition related intangibles was $4.0 million in the second quarter of fiscal 2008 compared to $341,000 in the second quarter of fiscal 2007. During fiscal 2007, we acquired INTRINSIC Semiconductor Corporation, or INTRINSIC, and COTCO, resulting in $63.7 million of acquisition related intangibles required to be amortized.

Loss on Disposal or Impairment of Long-Lived Assets. We recorded $474,000 of losses on the disposal of long-lived assets in the second quarter of fiscal 2008 compared to a loss of $85,000 in the second quarter of fiscal 2007 as a result of the long-lived assets disposed of or impaired in each comparative quarter.

Gain (Loss) on Sale of Investments, Net. During the second quarter of fiscal 2007, we sold 931,275 shares of Color Kinetics Incorporated, or Color Kinetics, common stock for $16.7 million in proceeds and recognized a gain of $11.4 million.

Interest and Other Non-Operating Income, Net. Net interest and other non-operating income increased 13.5% to $4.6 million in the second quarter of fiscal 2008 from $4.0 million in the second quarter of fiscal 2007. The increase is primarily due to the higher levels of cash and investments and due to the second quarter including an additional week as fiscal 2008 is a 53 week year.

Income Tax Benefit or Expense. We recorded income tax expense of $2.1 million from continuing operations in the second quarter of fiscal 2008 as compared to income tax expense of $2.2 million in the second quarter of fiscal 2007. The decrease is attributable to lower levels of taxable income in the comparable periods and the consolidation of our foreign operations that are subject to lower statutory tax rates. We currently estimate our effective tax rate for fiscal 2008 will be approximately 24%.

(Loss) income from Discontinued Operations, Net of Related Income Tax Benefit. During the second quarter of fiscal 2008, we recorded an after-tax loss of $20,000 versus $216,000 after-tax income recorded in the second quarter of fiscal 2007. The after-tax loss from discontinued operations is attributable to the continued expenses arising from the Sunnyvale facility operating lease.

Comparison of Six Months Ended December 30, 2007 and December 24, 2006

Revenue. Revenue from continuing operations increased 20.6% to $232.4 million in the first six months of fiscal 2008 from $192.7 million in the first six months of fiscal 2007. Product revenue increased 21.4% to $217.3 million from $178.9 million. The increase in product revenue resulted from an increase in our high-brightness packaged products, which was offset by a decline in revenue from LED chipmaterial and materialadvance device products.

LED revenue increased 13%29.7% to $93.4$192.3 million in the first quartersix months of fiscal 2008 from $82.8$148.3 million in the first six months of fiscal 2007, making up 82%83% of our total revenue from continuing operations. While unitUnit shipments of our LED products decreased 2%increased 3.1% over the first quartersix months of fiscal 2007 and our blended average LED sales price increased 16%25.7%. The decreaseincrease in unit shipments is due to higher demand and the increase in the blended average sales price areis attributable to a shift in product mix and end customer demand during the quarter. There was a decrease in the number of LED chips sold and an increase in the number of high-brightness packaged products sold in the quarter to quarter comparison, which lead to the increased blended average sales price of our LED products.mix.

Materials revenue decreased 16%22.6% in the first quartersix months of fiscal 2008 to $8.5$16.0 million from $10.1$20.7 million in the first quartersix months of fiscal 2007 making up 7%7.0% of our revenue from continuing operations. The decrease in materials revenue was attributable to a 1%8.6% decrease in the number of units sold and a 16%15.9% decrease in the average sales price, which were primarily due to changes in the mix of product sold and a decrease in the amount of revenue generated from sales to Charles & Colvard, Ltd. during the quarter.comparable periods.