Wolfspeed Inc (WOLF) 2005 Q2 法說會逐字稿

Good afternoon.

My name is April and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cree Incorporated second quarter 2005 fiscal year financial results conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

As a reminder, ladies and gentlemen this conference is being recorded today, Thursday, January 13, 2005.

Thank you.

I would now like to introduce Cynthia Merrell, Chief Financial Officer of Cree.

Ms. Merrell, you may begin your conference.

Thank you and good afternoon.

Welcome to Cree's second quarter of fiscal 2005 earnings conference call.

By now you should have all received a copy of the press release.

If you did not receive a copy, please call our office at 919-313-5300 and we will be pleased to assist you.

Today Chuck Swoboda, our President and CEO and I will report our results for the second quarter of fiscal year 2005.

Today's presentations include forward-looking statements about our business outlook, and we may be making other forward-looking statements during the call.

These may include comments concerning trends and revenue, gross margin and earnings, plans for new products and other forward-looking statements indicated by words like anticipate, expect, target and estimate.

Such forward-looking statements are subject to numerous risks and uncertainties.

Our press release today and the SEC filings noted in the release mention important factors that could cause actual results to differ materially.

Also we would like to note that as a result of SEC rules, we will be limiting our comments regarding Cree's second quarter of fiscal year 2005 to a discussion of the information included in our earnings release and the materials posted on our website, which you can find at www.cree.com by clicking on "Investor Information" and then click on "Financial Metrics."

We will not be able to answer any questions that would involve providing additional financial information about the quarter beyond the comments made in the prepared remarks.

This call is being recorded on behalf of the Company.

The presentations and the recording of this call are copyrighted property of the Company and no other recording or reproduction is permitted unless authorized by the Company in writing.

Consistent with our previous conference calls, we are requesting that only sell-side analysts ask questions during the Q&A session.

However, we recognize that other investors may have additional questions and we welcome you to contact us after the call by e-mail or phone at 919-313-5300.

We are also webcasting our conference call to allow more flexibility for our conference call attendees.

The webcast will be available through January 27, 2005.

Now I would like to turn the call over to Chuck.

Thank you, Cindy.

For the second quarter of fiscal 2005, revenue increased to a record $97.5 million while net income increased to $25 million, or 32 cents per share.

Our earning benefited from a non-operating adjustment of approximately $4 million related to our investments and taxes.

Overall gross margin decreased from the first quarter, but remained a healthy 50 percent of sales.

The change in margin was driven by a number of factors, including increased LED costs associated with the 3-inch conversion and X product ramp up; slightly lower than expected LED shipments in December; lower LED chip ASPs due to a shift in product mix and customer mix; and overall higher labor costs associated with employee stock option exercises.

We continue to make progress on our 3-inch conversions, although the benefit from more die and larger wafers was offset by the transition costs associated with the conversion.

Approximately 15 percent of our LED wafers were 3-inch in Q2, and we target this percentage to increase over the next 2 quarters in line with our plan.

We remain confident that as we move through the learning curve, we will recognize the cost benefits in future quarters.

Our R&D investment continued to yield good returns as our new LED products like the UT230 and our brighter XT18, 21 and 24 products have been key to our sales success at a time when overall LED chip demand has slowed.

This success is probably best highlighted when you compare our results over the last 6 months with many of our Asian competitors.

We continue to focus on R&D across our product lines, with a heavy emphasis on brighter blue and green LED chips, as well as further expansion of our XLamp product family.

As we move into Q3 we continue to face a number of challenges and opportunities.

We need to build on the sales momentum for our new LED chip products to generate new business in Q3 to offset lower overall market demand due to a variety of factors, such as the anticipated seasonal slow down in mobile phone production.

We have to quickly adapt from managing a steep ramp up and rapid capacity growth to ramping up select capacity for X class products, while balancing costs and driving productivity and yield improvements across the factory.

We need to continue to manage the challenges, risks and complexities associated with our conversion to 3-inch wafers as we convert more products over the next several quarters.

We need to continue to develop higher performance products to enable growth in both LED chips and the new product areas for high-power packaged LEDs and silicon carbide Schottky Diodes.

We need to continue to invest in building the sales, marketing and applications resources to provide the infrastructure to drive the growth for XLamp and Schottky products.

Although our business challenges continue to evolve, we have faced these types of challenges before and we are adapting our priorities to manage the near term challenges while staying focused on the issues which are critical to driving our long-term success.

For Q3 we are targeting Company revenue to be similar to Q2 in a range of $94 to $98 million.

LED chip demand is also targeted to be similar to Q2, although the range is wider than past quarters and will vary depending on our ability to increase market share in certain segments and ramp up our high-end X products to offset the forecasted softness in handset component demand.

As our business has grown, and the percentage of full-color handsets with LED backlights is increased, we are starting to see the effect of mobile phone build cycles on our chip demand.

We currently have approximately 75 percent of our target revenue booked or under contract for the third quarter, which is lower than last quarter but similar to our order level at this time last year.

Based on the strength of our current X product backlog and forecast, we target XT and other high brightness product demand to increase significantly in the third quarter.

We are targeting blended LED chip ASPs to decline approximately 2 to 3 percent in Q3, which is driven by normal price reductions and increased UT230 shipments, which should be somewhat offset by higher X product sales.

We continue to implement the aggressive pricing strategy that we announced last quarter, which is targeted to take advantage of our forecast cost savings from the 3-inch conversion in future quarters.

Although we expect fixed costs associated with our recent capacity investments to increase based on our forecast product mix, pricing trends, and target costs reduction, overall Company gross margin is targeted to remain at approximately 50 percent for the third quarter.

Operating expenses are targeted to increase slightly in Q3, as we keep R&D spending in line with revenue and expand our sales and marketing efforts to drive XLamp and Schocky Diode product sales.

Based on these assumptions, we are targeting Q3 earnings of 24 to 27 cents per share.

Although we have seen some near-term softness in market demand, we remain optimistic about the opportunities to expand our business for LED chips, XLamp and silicon carbide power devices.

Based on our confidence that we can develop new products for the key applications and increase market share for our high brightness LED products, we continue to invest in new capacity and factory expansion.

The expansion of our current facility for crystal growth through epi processes is on track and should be ready by early fall.

We recently purchased an existing semi-conductor fab located a few miles from our main campus in the Research Triangle Park which is intended to support a second wafer fab and test facility for LED products.

We are also in the process of evaluating an Asian subcontractor to provide additional capacity for our back-end die operations that could be on-line by midsummer depending on overall product demand.

Overall we are increasing our capital spending target range to between $110 and $130 million for this fiscal year and we will continue to refine this plan to adjust to changes in our business.

LED chip sales for Q2 were at the same level as Q1, which is slightly lower than what we had targeted at the beginning of the quarter.

Chip sales were led by strong growth in UT230 and our high brightness X products, which offset some softness in sales for our older mid-brightness and lower end high-brightness products.

The stronger than expected increase in X product orders challenged our ability to ramp up these products.

And although we made good strides, overall demand for this product family exceeded our capacity in the quarter.

Q2 demand was driven by a number of applications with mobile phones growing faster than the others and led by increased UT230s for blue key pads, and X products for white backlights.

Based on our current forecast for Q3, UT230 sales are targeted to remain strong, while X product sales are targeted to increase to more than 30 percent of overall chip sales in the quarter, as we target new design wins for LCD backlights and other high-brightness applications.

We are actively working to increase X product capacity to meet the targeted increase in demand.

From an R&D perspective, our development team continues to push to further raise the bar for blue chip performance, with a number of new chip designs to expand our high-brightness product line and build on our recent sales momentum for the mobile phone LCD backlight application.

As part of this effort, I am pleased to announce today that Cree has recently demonstrated several 30 milliwatt prototype blue chips operating at 2.9 volts and 20 milliamps.

We believe that these devices are the first blue LED chips that have been demonstrated to exceed 30 milliwatts and a wall plug efficiency of 50 percent, both of which are important technical milestones in our industry.

In the high power area, we have started sampling a brighter version of our XB-900 power chip that we believe raises the bar for white performance in the 1-watt power LED applications.

In addition to the blue brightness improvements, we are also increasing our focus on brighter green chips for RGB backlighting, as well as outdoor signs and signals.

Based on customer feedback, we continue to believe that IP is an important differentiator in the market, and we have continued to take steps to reinforce the value of our intellectual property.

Although the situation could change, at this time we believe that Nachia's licensing of 1 or more Taiwan chip manufacturers has actually helped to reinforce the importance of our IP with our customers.

We continued to expand our high power LED product line in the second quarter with the introduction of our XLamp 4550 series products and our new, brighter 7090 product.

The new higher bin 7090 product can deliver 40 to 60 lumines of white light at 350 milliamps, which we believe is the highest currently available in a 1-watt class power LED.

We have had some success in small volume specialty lighting applications, but are still working to win higher volume opportunities, as XLamp sales accounted for less than 1 percent of LED revenue in the quarter.

Although we have demonstrated excellent performance in our 4550 and 7090 products, we need to continue to improve these products for certain applications while increasing our sales, marketing and applications expertise to win the higher volume design.

We have refined our near-term XLamp product strategy to focus on the specialty and architectural lighting applications, while our R&D teams focus on trying to develop a winning solution for LED backlighting systems for LCD TVs and monitors.

Although we working on products and technology at Cree for a number of exciting applications, the market potential for LEDs in large-scale LCD backlighting is probably the single biggest business opportunities for our Company and our industry over the next few years, and could provide the catalyst for Company-changing growth.

Last week we demonstrated our LED backlighting technology in a 40-inch LCD TV demo at the Show Stoppers press event at the Consumer Electronics Show in Las Vegas and we are very encouraged by the response we received.

We expect that the next 6 to 9 months will be a critical time in the market and we are working to position Cree as a technology leader for this application.

The power device business continue to make progress in Q2 and we again increased sales from the previous quarter.

We are targeting continued incremental growth in our base Schocky Diode business over the next several quarters, driven by current power supply applications.

And we estimate that designs for motor controls could begin within the next year.

We have broadened the process for Schocky Diode fab and test in our Sunnyvale facility and currently target transferring production there by the end of Q3 subject to final qualifications.

Similar to our approach in the XLamp business, we plan to expand our sales, marketing and applications team over the next several quarters to work with our customers to leverage our initial design wins in the power factor correction circuit into additional models, as well as other stages of the power supply.

So look at microwave sales increased in Q2 as we were able to win some incremental new business for cellular applications.

We continue to work with our customers to win new designs for 1 GHz cellular applications, as well as a variety of milaero applications.

We are in the process of evaluating a couple of strategic alternatives for the silicon part of our microwave business, while we increase our emphasis on wide band gap microwave applications.

Silicon carbide MESFET product sales are growing rapidly for military applications and we are evaluating some new designs for commercial use.

Although the commercial opportunities for wide band gap RF products are probably a couple of years from being realized, we are becoming more confident that our technology can deliver a strong technical benefit in some of the emerging wireless applications.

In the laser area, we are transitioning most of our R&D efforts to our Santa Barbara technology center where we believe we can focus more resources on the project.

The market opportunity appears to be gaining some momentum, and despite the continued battle between standards, we believe it will be important to demonstrate certain reliability milestones over the next several quarters.

In Q2 we delivered record revenue of $97.5 million and earnings of $25 million or 32 cents per share.

We have been able to develop new products and expand overall capacity to offset the slowdown in the market and continue to deliver strong financial results.

Our outlook going forward remains positive as we strive to manage costs and improve yields, while we work through the challenges of ramping up our new products, converting LEDs to 3-inch, maintaining our new product momentum and winning the next design to drive demand for our products.

Although the costs are probably running ahead of the benefits on our 3-inch conversion in the short term, we believe this is a good investment in our future and enables us to continue to pursue our aggressive pricing strategy for LED chips in the second half of the year.

Our fundamentals remain solid and the balance sheet improved again as cash and investments increased to $287 million.

We are targeting a solid third quarter with revenue of $94 to $98 million and earnings of 24 to 27 cents per share.

We remain optimistic about the growth opportunities for our LED chips, XLamp, and silicon carbide power businesses over the next year and we are continuing to invest in the infrastructure and capacity to put us in a position to win in these markets.

I will now turn the call over to Cindy.

Thank you, Chuck.

Our second quarter revenue increased 2 percent sequentially to a record $97,451,000, which was slightly below the low end of the range we announced on the last conference call.

For the 6-month-period ended December 26, 2004, revenue was also a record at $193,348,000.

We also reported net income of $25,022,000 for the most recent 3-month period, which was a 2 percent increase over our first quarter results and included approximately $3.9 million of net non-operating and tax adjustments that improved our overall results by approximately 5 cents per share.

Also as a result of the recent increase in our stock price and stock option exercises for our employees, our fully diluted shares outstanding used to calculate earnings per share has increased by 2,696,000 shares sequentially.

This increase in shares outstanding had the impact of reducing our earnings per share by 1 cent in the December quarter.

Overall, earnings per share was 32 cents for the second quarter, which was even with our September results.

So for the 6-month period ended December 26, 2004, net income was $49,450,000, or 64 cents per share.

For the second quarter of fiscal 2005, LED revenue was nearly even with the first quarter at $78,806,000 and made up 81 percent of our overall sales.

Unit shipments grew 21 percent over the September quarter, but were offset by an 18 percent sequential drop in the LED blended average sales price.

We had originally targeted an approximate 10 percent average sales price decline for the second quarter due to an increase in UT230 sales.

However, blended average pricing declined faster due to product and customer mix changes from our original target.

Without the mix change towards UT230 chip, our blended average sales price would have declined 7 percent in the second quarter.

During the period we were successful in ramping up our new UT230 chip for the low cost blue keypad backlighting market, which was critical in order for Cree to maintain its position as the market leader in this segment of our business.

As a result of the increased sales of the UT230 product in the second quarter, our mid-brightness chip sales increased from 39 percent to 42 percent of our LED revenue; and high brightness products declined from 55 percent to 52 percent of LED revenues.

Our standard brightness chips remained even at 6 percent of LED revenue during this time.

During the second quarter we estimate that revenue from chips targeted for mobile phone applications increased over the September quarter and were approximately 1/2 of LED revenue or 40 percent of our total revenue.

In addition, we estimate that nearly 1/2 of our revenue relating to products used in mobile phones goes for white LED applications, mostly targeting keypads, but we did see some design wins for LCD backlighting as well.

In the month of December we noted a softer overall market for LED chips, which resulted in lower revenues than our original targets and increased our inventory.

During the second quarter, due to the timing of customer payments, we also recorded a $348,000 reserve on our accounts receivable balance which also lowered LED revenue.

Material sales were 9 percent of revenue for the December quarter, increasing 7 percent sequentially to $8,870,000.

Material sales include revenue for wafer and gem stone products.

Our wafer volume decreased 21 percent, while our average sales price for wafers grew 32 percent compared to the September quarter due to changes in our product and customer mix.

Our gem stone materials revenue increased 19 percent quarter-over-quarter to $1,815,000.

During the December quarter, revenue of Cree Microwave Sunnyvale increased 5 percent sequentially to $1,514,000.

While our advanced device products, which includes Schocky Diode and silicon carbide microwave sales, increased to $2,207,000 due to new designs combined with custom project work.

Contract revenue made up 6 percent of our overall sales in the second quarter of fiscal 2005 and grew 5 percent sequentially to $6,005,000.

Gross margin for the second quarter declined to 50.4 percent of revenue as compared to 56 percent reported in the September quarter.

This decrease was caused by a reduction in profitability on our LED products, as our blended average LED cost decreased by 4 percent sequentially, while our blended average sales price decreased by 18 percent over the first quarter.

During the second quarter, our overall factory spending was higher than our original plan as we encountered some production challenges with our 3-inch LED conversion, as well as the ramp up of our X class products.

As a result, we exited the quarter with higher overall costs than we had targeted.

During the second quarter we also incurred $242,000 in non-budgeted payroll taxes associated with cost of sales due to heavier than normal stock option exercises by our employees.

For the 3 months ended December 26, 2004, Cree Microwave lost $3.1 million pretax while revenue increased to $1.5 million.

We target that the Sunnyvale fab will be running at a significant portion of our power products by the end of our March quarter as we move production from Durham.

This should allow us to spend more of the fixed cost for this facility -- spread more of the fixed cost for this facility across product lines and improve the profitability of the Cree Microwave segment beginning in our fourth quarter.

Contract margins declined to 16 percent of revenue in the December quarter, which was down from 25 percent of revenue in September as our first quarter results include a one-time gain of $337,000 for a license granted to a third party.

We target our third quarter revenue in a similar range as our second quarter with margins approximating 20 percent of contract revenue.

Operating expenses remain even at 20 percent of revenue for the December quarter.

These expenses are comprised of research & development and SG&A costs and in the second quarter include a $248,000 charge for the disposal of fixed assets as compared to a $78,000 disposal charge in the first quarter.

During the second quarter, research & development expenses increased 4 percent sequentially to $11.4 million.

While SG&A costs increased by 2 percent to $7.8 million.

During the second quarter R&D and SG&A expenses were $501,000 and $578,000 higher respectively due to non-budgeted payroll taxes resulting from heavier than normal stock option exercises by our employees.

SG&A expenses were also higher as we incurred $424,000 of sequential incremental expenses in preparation for the Sarbanes-Oxley Section 404 implementation.

Heavier SG&A expenses were mostly offset in the second quarter by a $1,117,000 accrual for a reimbursement approved by our D&O insurance carrier of certain legal fees related to the Securities litigation.

During the second quarter of fiscal 2005, we recorded a $1,992,000 reserve on our investment in private company based on our evaluation of the company's financial results and its third party proposal to purchase our investment.

We also recorded a $123,000 gain as other non-operating income for favorable foreign currency adjustments per our contract with one of our large customers.

Net interest income remained at $1.1 million in the December quarter, as interest income was offset by an adjustment of $265,000 for interest expense resulting from a settlement that was made relating to state income taxes from a prior year.

Overall, interest income increased sequentially due to our greater cash balances being held by the Company at higher interest rates available on our cash investments.

During the second quarter of fiscal 2005, our income tax expense included a $6 million of adjustments that lower our overall expense.

Cree made a pre-IPO investment in Color Kinetics which went public in June, 2004.

And as of December 26, 2004, Cree had a $22.5 million unrealized gain recorded as comprehensive income.

Because Cree had a prior-year life time capital loss that was carried forward for tax purposes under Generally Accepted Accounting Principals we were required to reverse a portion of the tax reserve associated with the capital loss that was recorded in a prior year.

As a result, Cree reduced its income tax expense by $7.9 million in the second quarter of fiscal 2005.

Going forward, the Company will be required to record the tax effects of any increase or decrease to the value of its investment in Color Kinetics as an increase or reduction in its tax expense.

In the second quarter of fiscal 2005, we also recorded $1.9 million of increased tax expense relating to our settlement on state income taxes and other adjustments.

At this time we target our tax provision will be approximately 32.2 percent of revenue for the remainder of fiscal 2005.

In May, 2004, our Board of Directors authorized an additional 5.1 million shares to be repurchased under our stock repurchase program.

During the December quarter, we did not repurchase any shares authorized under this program.

Therefore as of December 26, 2004, we have 6.9 million shares remaining that have been authorized for repurchase.

As of the end of our second quarter, our balance sheet remains strong as cash and short-term investments increased from $253 million to $287 million.

During the second quarter, we received $43.9 million in proceeds from the issuance of common stock associated with our employee stock option program.

Our cash flow from operations decreased sequentially from $53.8 million to $38.9 million due to a $7.8 million increase in our accounts receivable balance resulting from the timing of payments from our customers, a $2.3 million increase in inventory and a $2.3 million increase in prepaid expenses.

As in the December quarter, our day sales outstanding was 41 days based on our trailing monthly revenue profile, while our inventory days on hand were calculated at 47 days.

Capital expenditures for the second quarter were $47.9 million to support the capacity increases for LED production.

The majority of expenses were for equipment in epi, wafer-fab and die test areas of the factory.

Year-to-date we have now spent $82.5 million in capital expenditures.

Despite this high level of investment, we generated free cash flow of $10.1 million for the 6 months ended December 26, 2004.

We calculate free cash flow as cash flow from operations less capital expenditures.

As we begin the third quarter of fiscal 2005, we target revenue in a range of $94 to $98 million.

This target is based on LED revenues remaining in a similar range to slightly higher than Q2 due to anticipated seasonal softness from mobile phone markets being offset with increased revenue of our newer X class products.

We also target our materials business may decline due to timing of customers orders while our other business areas maintain revenue in a similar range to slightly higher than Q2.

We also target gross margin to be approximately 50 percent of revenue plus or minus a few points as we continue to migrate to 3-inch wafers for LED products and target depreciation expense to again increase somewhat faster than revenues as we continue to bring some capital equipment on line.

Operating expenses, which include R&D and SG&A are targeted to be in the same range as the second quarter as a percent of revenue, but may be slightly higher due to greater administrative costs for Sarbanes-Oxley 404 implementation and higher sales and marketing expenses for our new business units.

Therefore, based on an estimated 78.7 million fully diluted shares outstanding, earnings per share is targeted in a range of 24 to 27 cents for the third quarter.

I want to note that during the December quarter our earnings per share was 32 cents, and as mentioned above included $3.9 million net in favorable non-operating and other tax adjustments which benefited earnings per share by approximately 5 cents per share.

In our second quarter, our new products provided sales success to offset the slow down in market demand and enabled us to deliver strong financial results.

And we are focused on meeting our near-term challenges while not losing sight of our longer term objectives.

Thank you.

I would now like to turn the discussion back to Chuck.

Thank you, Cindy.

We will now take analysts' questions.

Thank you. (Operator Instructions).

The first question comes from the line of Chris Montano with Wells Fargo Securities.

Thank you.

A question about the expansion and how that works with your inventory.

Given a slowing of demand, are you planning to continue with your aggressive expansion plans?

And, secondly, how does that impact your inventory levels, which were up again I did note.

So let me talk about the expansion and then I will get to inventory there, Chris.

On the expansion, you know, what the expansion was meant to address both near-term demand and our long-term outlook on what we think is possible with the high brightness LEDs, the XLamp and Schocky Diode products.

We are building buildings, we are planning for something that's much more than just next quarter.

So I think that, as I said earlier, we remain optimistic about all those markets and some of the opportunities for things like LCD backlighting that could really be tremendous opportunities.

So we are going to continue to invest in the infrastructure to support the growth in our business.

If I look at inventory it definitely came in a little higher, I think it was 2.3 million, and that was really spread across the factory.

I think if I have the numbers here correctly, it's about even between raw materials, WIP [ph] and with FGI.

And FGI is simply the revenue was a little softer in December as we said earlier, and then the other issue was is we were trying to ramp up X products, and frankly, we are not able to keep up with the demand at the end of the quarter.

So it's just a balancing there.

Definitely something we will manage going forward, but not something that given the amount of days we've got we are all that concerned about at this point.

Thanks a lot.

Sure.

Your next question comes from the line of Matthew Smith with CIBC World Markets.

I was hoping that you could go into a little more detail on exactly what sort of problems and issues you've been having with respect to the 3-inch fab.

Are these equipment issues?

Typical teething problems?

How was it worst than you were anticipating?

And can you give us some kind of time scale as to the rate of improvement here and how optimistic are you for the next couple of quarters on this transition.

Thank you.

Sure.

If I look back at what we've been talking about for the last couple of quarters, we've said that whenever we try to go to a larger wafer size you anticipate there is going to be some learning curve along the way.

And as we continue to move along this process we try to take different products, new products and start to convert them over.

Each time we do that, we are qualifying new processes and going through, I think, to use your words, teething pains and I think I would classify what we went through is simply things like that.

It's just a learning curve in each area as we bring up new products.

And I feel like we've worked those from the last set of products and we will move down the road.

And in terms of going forward, one of the nice things is as you bring more and more products you learn each time do you that.

We are relatively optimistic going forward.

At the same time we've got another couple of quarters of a lot of conversion.

We are also running a mixed fab.

So I'm cautiously optimistic at the same time, the reality is when do you this there's always challenges along the way.

So I don't have any worries in the midterm about where we are going to end up, but obviously there's challenges along the way.

Great.

May I ask a follow-up question?

I was just wondering, can you comment on yields?

I mean I'm guessing the yields so far haven't been that great, but what sort of yields are in your mind acceptable on this sort of aligning?

Are you looking for something in the 70 percent region or better?

And over what sort of time frame?

And what does that contribute ultimately towards the gross margin?

What sort of gross margins are you targeting here?

What's your model over the course of say the next 12 months?

If I look at yields, we don't get into the specifics, but as you're aware we have a pretty broad range ranging from our more mature products which are in the high double digits to our fairly new products, which can actually -- we will launch them with shoot yield that's in the low double digits.

So I don't see 3 inch as -- it's less of a -- it's much -- there's some yield issues, but there's also just a lot of learning curves.

It takes time to get the processes converted as process qualifications.

It's a lot more about -- we've got larger wafers running through certain processes and tools and how do we work through that before we get to the 2-inch.

So I would say that we would like them to be better than they are, but at the same time there is no -- there's been no significant -- other than normal issues of a conversion, I have not seen any major hurdles that I don't think over time we will overcome with the typical learning curve.

You asked a second question about gross margin and what we are saying is for this upcoming quarter in Q3 we are targeting approximately 50 percent and going forward it's really going to be a combination of factors.

Obviously we are excited about as we get more 3-inch on line, we should get the benefit on that side.

At the same time we've got a pretty aggressive pricing strategy that's designed to really take those cost reductions and drive the growth in our business especially for the high-end products.

We don't have guidance longer term.

I think you can look at our -- the last 4 to 8 quarters and get some idea of what the ranges we've been running in and it's going to kind of depend on where market demand is and how quickly 3-inch comes up and where exactly -- how fast we can drive some revenue growth from the market share gain.

It's just wait and see on the future quarters.

All right.

Thank you very much.

Sure.

Your next question comes from the line of John Lau with Banc of America.

Hi, Cindy.

Hi, Chuck.

I had a quick question.

ASPs were down more than expected last quarter.

I was wondering if you can give us some insight on what's happening with regards to competition from Taiwan, maybe, from the licensed LED manufacturers?

And what type of impact did that have on the ASPs or was it more of a mix issue?

Thank you.

If I look at ASPs, John, I would say they went down 18 percent, but 60 percent of that or 11 percent was simply mix shift.

It's just we ramped up the UT230.

It became the highest volume product that we're running in our factory and it is designed to compete at a much lower cost at a lower price point.

So that was the single largest driver and when you take that out you are looking at 6 to 7 percent and that's pretty much within a normal range in any given quarter.

I think that -- so from that standpoint, I don't think things were as out of line other than the 6 to 7 percent was mostly driven by a combination of just normal pricing trends in the customer mix that we saw.

As far as what's it coming from?

I would say at this point I would classify it as mix.

I think that at this point we have not seen the licensed Taiwan makers have a significant effect on our business.

In fact, as I commented earlier, I think if anything it's helped reinforce our value proposition in the market.

So at this point, though, we are still -- that's our outlook.

And so you -- do you anticipate that the license product will become a factor or is it -- is it still too early to tell.

I mean they've been out there talking about it for about 6 months now so I think, you know, we've seen the initial impact.

I don't know, I guess at this point if you look at how we compete, let's take the UT230, that product is competing at a very low price point already and we are able to do that successfully.

And I think the key there is is that we are able to sell at a premium, but at the end of the day that premium is relatively small to the end user and so what that says is the fact that Cree's IP or quality, reliability, other factors I think that at least with the customers that are buying that product with the big growth there, you are seeing that they are making -- they are probably giving you the best information about what they think about why they would by Cree's products and pay a premium.

Great.

Thank you.

Sure.

Your next question comes from the line of Harsh Kumar with Morgan Keegan.

Hi, Chuck and Hi, Cindy.

A couple of questions.

First of all, following up on earlier question, Chuck, maybe you can talk about the planned goal that you have for finishing up your 3-inch conversion.

Is it going to happen over the next 12 months or the next 18 months or more than that?

Yes, Harsh our plan that we've been working with for the last couple of quarters and we are still pretty much on track is that we want to get to have the majority of our LED wafers on 3-inch by the end of this fiscal year.

So as we exit June that means we want the majority of the wafers coming through the line to be 3-inch for LEDs.

And since, as you know, there's more than double the number of chips on a 3-inch wafer.

That means that we are looking at 75, 80 percent of the chips at that point in time.

At that point, decisions on what we convert going forward will really be based on, is it worth converting the last older products?

Is it easier just to make them on 2-inch until they go away?

And a variety of other, I would call them less high volume issues where it's more of a customer -- is a customer qualified it yet, things like that.

Got it.

Just a quick follow up.

You gave some clarification on the UT230 driving down margins, and you said that was about 60 percent of the drop in ASPs and some portion of the guidance decline is attributed to demand.

I'm wondering could you maybe give us the top 1 or 2 reasons as to what you saw as far as the demand and what you think is driving that.

Let me clarify.

You commented that UT230 drove down margins.

It had affected our blended ASP, but it did not necessarily -- it's not that that drove down the margins if you know what I mean there.

Okay, thanks.

In other words it is a lower price product.

It's also a much lower cost product.

As far as the demand picture I would say that what we are seeing is obviously we are having a lot of success with the new products, UT230 on the low end and our XT 18, 21 and 24 products on the high end.

We are definitely in the -- we have the strongest demand outlook for our high, high-end products that we've had in a long time.

So I think we are looking at I think, I said earlier, 30 percent of our demand or more next quarter could be from the X product line.

So I think on the opposite -- either end we are seeing good strength in the market and I think it's in the middle with what I would call our older products that tend to be some weakness.

And what I'm seeing is I think it's more market driven.

I would say that from what we can see it's not that we are losing any business we were winning before, as much as from our perspective it's more about the demand overall right now for some of those segments is lower.

So you are implying cell phones specifically, Chuck.

Actually, it's interesting.

I would say that definitely for our Q3 targets we are implying cell phones, but I would say that in some of the other product areas it's just general, the market just seems to be kind of soft right now.

Got it.

Thank you very much.

Sure.

(Operator Instructions).

Your next question comes from the line of Jed Dorsheimer with Adams, Harkness.

Chuck, just following up on the last question.

Is the gross margin of the UT230 greater than the corporate average?

We don't break out product line specific.

I can tell you though it's within the range of our other LED products right now.

Was there a significant shift in the end markets and specifically I guess with handsets greater than 50 percent?

You might have already said that, but I didn't hear you of the LED business.

No problem.

I would tell you that handsets is right around 50 percent, but it was definitely the fastest growing segment.

So I think before we said it was almost 50 and it definitely grew faster than the other segments last quarter.

Any chance of getting you to sort of rank the end markets?

You know, it would be pretty hard to do that.

I can tell you that once you get past handsets, there is a number of other, what I'd call relatively significant, but nothing close to handsets.

You've got displays, auto, I'd call it consumer type applications and then entertainment.

Those 4 I would kind of put in a category that quarter-to-quarter are -- probably make up the majority of the rest of it.

All right.

And then I guess as we look to fiscal third quarter, it sounds like you are really trying to ramp the X class production or the XThin, excuse me, to target the display portion of the handset.

And the UT230 to really come aggressively at the keypad market.

But yet there seems to be some -- or you are attributing seasonality or softness, I know you said it's general, I guess if you are looking at the display portion and the ASP is significantly higher than in the keypad, why wouldn't you guys be able to offset seasonality in that business?

Yes, so let me kind of walk you through that.

First of all it is actually X class, although XThin is a huge part for things like the LCD backlight.

We are actually seeing overall demand for the whole X class family, so that includes the X bright as well as XB-500 and 900 family.

So there is a general trend for the high-end products across the business.

But if you want to get into cell phones specifically, I would say that we are seeing an increase in -- we are seeing strength on the one side which is the keypad.

We are seeing the X class kind of for both the keypad, backlight, as well as the LCD backlight and what we are seeing is that those 2, while they are projected to grow, they have to do 2 things, right, they have to offset whatever seasonality there is, so they've got to grow that amount in terms of market share to try to keep the business even.

And then at the same time, I think the general slowness in our business for the older products as well, it's not as strong as it has been in past quarters right now.

All right.

Fair enough.

Moving to inventories, I'm curious, in the past you've talked about how fast Cree was making progress ramping to the next brighter product and how your customers were really asking for brighter product, clearly the XThin is an example of that as we've gotten to the XT-18, the 21, et cetera.

Is there a risk of write down I guess since revenues seem to be slowing and inventories seem to be growing with respect to what you have in inventory from a brightness perspective?

I don't know.

It's something we review on a pretty regular basis.

Our inventory generally if you still look at it, you are still looking at only about 47 days.

It's turning pretty darn fast.

It's a lot faster than most semiconductor companies.

And I would think that if I look at some of the different areas, you know, if I look at, for example, the WIP build, that is X class WIP that we have more orders than we have demand.

We had more demand than we could make at the end of the quarter.

That's an example of trying to ramp up and not being able to make it.

So obviously that's something we always got to watch, but we feel pretty comfortable with those inventory levels at this point.

And then just IP in the marketplace is sort of my final question.

We're starting to see phones sold in the U.S. here using some Asian die.

And I know you spoke about -- or what looks to be Asian die I should say.

I know you spoke about this agreement with Nachia licensing Optotech, as well as High Link and I was curious if looking forward how that will help Cree.

I know you talked about it I guess bolstering your IP position.

Could you give a little bit more clarity on that?

Well, 2 things, one is I think there's always been some percentage of phones, that's why we started our awareness campaign that we can find with other people's products and those are the examples that we use then to go out and, as I like to say, raise awareness with the customer.

So obviously I think that's going to be an ongoing process and we will continue to do that.

I think the key thing to look at is 2 things.

One is first of all from a keypad standpoint as an example we -- we look at our, with UT230 growing as fast as it is from a unit basis, it's clear we sold a lot more chips last quarter for that application than even the quarter before on a unit basis, even though it's a lower priced product.

So we know that from a unit standpoint we were ramping up pretty heavily through the quarter.

As far as IP goes, the perspective I would give you is that if you go back 9 to 12 months ago there was a feeling that, yeah, that Nachia's claiming they are going to get us, they are going to get us, maybe they won't, maybe Cree won't and there was almost a willingness to take a chance.

I think what we've seen now is that now that you have Nachia actually picking a partner, for example in Taiwan like they did with Optotech.

It actually -- in addition to Cree saying IP matters, you have other people saying IP matters in those markets and generally speaking it reinforces, for the customers that care about it, it reinforces the value of that.

That's why I say we believe it's helped us and that's really based on the perspective that our customers share with us.

All right.

Thank you.

I will pass it on.

Sure.

Thanks.

Your next question comes from the line of Jason Tsai with ThinkEquity Partners.

Just a couple of quick questions, I might of missed this.

But could you just go over what your utilization, capacity utilization was in the quarter?

And then the percent that's been converted to 3-inch thus far?

We said approximately 15 percent for the quarter was 3-inch.

So 15 percent of the wafers, of the LEDs wafers we made.

And from a utilization, I didn't break that out earlier.

What I can tell you is that as the quarter ended we were capacity constrained on X products and we had available capacity on some of our other older or mid-brightness products.

What's going to help alleviate the capacity constraint in the X class products going into the March quarter?

Is that going to be more 3-inch capacity or is that just going to be better yield on 3-inch?

Can you give us a little sense on that?

You probably should think about 3-inch and X class as 2 separate items.

So 3-inch is about just bringing different products, converting and moving each product line over.

On the X class, what we are doing there is that as you ramp up up that process it's a different chip design, so obviously we have to qualify additional tools and processes and we are in the middle of doing that.

So it's really more of about qualifying additional tool and machine capacity for those types of processes.

Okay.

All right.

Thanks a lot.

Sure.

Your next question comes from the line of Robert Lerner with Sidoti & Company.

Good evening.

Good evening.

I was wondering about the -- your penetration into the backlighting -- the LCD backlighting on the cell phones.

I think you said that the XT line you were able to get in on the keypads pretty well for the white LEDs, but not quite so well for the backlighting?

Yes.

So where we're coming from is a situation where most of our success has been in the keypad, and that we've been obviously driving our XT product line brighter and brighter trying to put our customers in a position to win there.

What I can tell you is that we've started to have some success and it's reflected in the increase in orders we had at the end of last quarter and then if I look at where we are positioned this quarter, that with our XT backlog going into Q3 we feel very good about additional success in the upcoming quarter for the backlighting application.

So this is mainly just a brightness issue or is there something else that's preventing you from getting in?

I think it's been a lot of factors over time, but clearly brightness helps our customers make brighter white LEDs to help them go out and compete pretty much head to head and usually with a Nachia for these slots. nd I think that as we've continued to come out with new XT products and brighter products that I think we put them in a better position and at the same time over the last year I think a lot of them have come down the learning curve on the white technology, which has probably helped in parallel I think has been a key piece of this as well.

Thank you.

Sure.

Your next question comes from the line of Chris Montano with Wells Fargo Securities.

Just a quick follow up.

Can you talk at all about the geographic demand that you experienced in 2Q and what it looks like going forward?

Yes, the way I describe it without getting into a lot of details, is I would say that in Q2 we saw more strength in Japan than in our other markets and for Q3 I would say that Japan continues to be stronger.

I would not classify that, although I guess I would be careful with reading into that.

I think what we have in Japan is some customers that are having success on the new designs with the high-end products, so I think it's less geographic demand than those customers having more success on the high-end white products in that area.

So I would say that we remain -- Japan looks pretty strong.

If there's some softness it's generally not in Japan right now.

Okay.

And one last follow up.

I think I missed this, but with respect to gross margins, you are saying that UT230 gross margin, even though the ASP is lower, the gross margin may not be lower than the corporate average.

What do you attribute the overall decline of the gross margin on a quarterly -- sequential quarter basis to?

So if I look at it, the UT230 is what I said earlier it's in the same range as our other LED products.

There's obviously a range of gross margin across there.

I would attribute it to a couple of things.

First of all we are trying to ramp up a product, the X class products, and as we did that we did not, we were not able to make as many of those as we wanted to, and as part of that going through that ramp up incurred additional costs associate with that, so we lost out 2 ways from a gross margin.

We missed out on LED revenue we otherwise could have had because we couldn't make the products and at the same time we had the additional costs from the -- from the issues of trying to ramp up the capacity and going through that learning curve.

In addition to that we had the 3-inch conversion which didn't go as fast and we had some learning curve issues there.

So if you add up those things together I think it -- if I look at it obviously ASPs came down a little faster than we projected, but as much as anything costs were higher than we expected.

To me it was more of a cost issue, although definitely ASPs didn't help, but if I was attributed the major driver is cost.

Thanks a lot, Chuck.

Sure.

Your next comes from the line of Matthew Smith with CIBC World Markets.

Yes, hi.

I was hoping I could draw some comments from you with respect to the LCD TV and monitor market opportunity there.

What sort of customers are you talking with and how advanced are you and when do you think we might see some wins there and some penetration?

Thanks.

Sure.

So obviously we are pretty excited about the potential in that marketplace and we are making a concerted effort to be successful there.

But we are also at a very early stage.

I think as you are well aware the only company with a commercially available product today is Sony and that uses the Lumuleds [ph] backlight system.

Where we are at is we are talking to several customers, although we are primarily focused in one place right now, we are actually at the stage of building demos for both TV and monitors.

So what we demonstrated at the CES Show Stoppers event is actually a 40-inch LCD TV where we have retro-fitted it to use our LED backlighting technology.

And so we are at the stage of building up prototypes and demos to show to major manufacturers to try to basically win those slots.

Those slots though, really aren't going to be decided probably for the next 6 months.

They really ramp up for next fall, and when I say ramp up you will see the first couple of models at this point.

So we are in a critical time.

The next 6 months are really going to shape who is going to be in a strong position there.

The other thing to keep in mind is that that market has a secondary benefit for us, which is there are other packagers trying to win in that market so we also see that that market were drive shift demand as well.

So our chip investment we are making is -- can benefit us for the LCD backlighting in terms of what we are doing within the Cree lighting group, but also what we are trying to do in terms of develop brighter chips and increase our sales there through our packaging customers.

A follow up if I may.

What sort of size products do you think you will see initial success with?

Are we talking about the 37 to 42-inch sizes or is it more mainstream than that do you think?

No, I think the initial product, because at this point in time it looks like the initial LED design while having better color gamets and other nice features will be more expensive, so I believe the thinking right now that we are hearing is that it will be focused on the 40-inch and larger TV market and if they are in monitors only on a very high-end ones of those as well to get started.

But that's pretty typical for any new technology introduction.

Thanks very much.

Sure.

At this time there are no further questions.

Ms. Merrell are there any closing remarks?

Yes.

We appreciate your interest and support and look forward to reporting our third quarter fiscal-year 2005 results in mid-April.

Thank you.

Thank you for participating in today's conference call.

You may now disconnect.