Wolfspeed Inc (WOLF) 2006 Q1 法說會逐字稿

Good afternoon.

My name is [Nikki], and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cree Incorporated first quarter 2006 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, October 20, 2005.

Thank you.

I would now like to introduce Raiford Garrabrant, Director of Investor Relations of Cree Incorporated.

Mr. Garrabrant, you may begin your conference.

Thank you, Nikki, and good afternoon.

Welcome to Cree's first quarter fiscal 2006 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 happy to assist you.

Today, Chuck Swoboda, our Chairman and CEO, and Cindy Merrell our CFO, will report on results for the first quarter of fiscal year 2006.

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

These may include comments concerning trends in 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 SEC filings noted in the release mention important factors that could cause actual results to differ materially.

Also, we'd like to note that as a result of SEC rulings, we will be limiting our comments regarding the first quarter of fiscal year 2006, 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 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 certified 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 flexible for our conference call attendees.

A replay of the webcast will be available on our website through November 3, 2005.

Now I'd like to turn the call over to Chuck.

Thank you, Raiford.

In the first quarter of fiscal 2006, we recorded record revenue of $103.9 million with earnings of $21.7 million or $0.28 per share.

The earnings included a $0.03 per share benefit related to our investment in Color Kinetics that was not included in our original targets for the quarter.

If you exclude this benefit, earnings were $0.01 higher than our target range of $0.22 to $0.24 per share.

Revenue increased 5% sequentially and was driven by incremental growth in LED's, high-power products, and government contracts.

Gross margin was in line with our targets at 49% and includes some portion of our overall stock option-related expenses.

Greater than 60% of LED chips were produced on 3 inch wafers in the quarter, which was a nice increase from Q4.

Based on our current forecast, we target the 3-inch percentage to increase again in Q2.

As we targeted, Q2 R&D expenses increased $3 million from the prior quarter as we shifted resources back to the product development area to focus on several new LED chip projects, as well as higher power LED components and larger wafers.

As we head into the second quarter of fiscal 2006, we are focused on a number of challenges.

We need to accelerate our research and development efforts to deliver higher performance products to enable our customers to win in both the existing applications like mobile phone back lights and camera flash, as well as the emerging applications in lighting.

We operate in several highly competitive markets, and we need to continue to drive down costs through yield and process improvements, productivity gains as well as the continued conversion to 3 inch wafers.

We plan to continue to invest in sales and marketing to drive the new business areas.

The LED market is not growing as fast as was previously projected, and we need to stay focused on our challenges so we're well positioned to take advantage of the new applications as they start to emerge over the coming quarters.

In Q2, we are targeting company revenue to increase to a range of 106 to $109 million, based on incremental growth from LED's and high-power products.

One of the key factors to meeting our targets will be our ability to increase LED brightness to enable our customers to gain market share in white application, and provide a competitive advantage for our X-line of products.

We currently have approximately 80% of our target revenue booked or under contract for Q2.

We target Q2 LED unit sales growth across our product families, which will be somewhat offset by LED price declines in the range of 3 to 5%.

As we continue to execute our strategy to increase our market share for white application.

Based on our current product -- forecast product mix, pricing trends, and target cost reductions, overall company gross margin is targeted in the same range as Q1 at 49%, plus or minus a point or two.

Q2 operating expenses are targeted at approximately 24% of revenue as we increased R&D spending to drive new product development and SG&A to support the growth of our sales infrastructure.

Based on these assumptions, we are targeting Q2 earnings of $0.24 to $0.27 per share.

We remain optimistic about the tremendous growth opportunities for our products in lighting, power, and communications, and continue to invest in technology and infrastructure to position our company for success as new applications in these areas start to emerge.

As a result, we continue to target capital spending for the year in a range of 90 to $110 million.

Although this may be revised higher over the next few months based on some new products currently in development and other evaluation at our customers.

LED unit sales increased 10% sequentially in Q1 and were mostly offset by an 8% decline in ASP's for the quarter, which is slightly more than our target range.

The ASP change was driven by higher sales at low cost UT230 chip, and our aggressive high brightness sales strategy to enable our customers to win new business and grow our market share.

Unit sales increased across our product families, led by a strong increase in XT chip sales for white application.

Mobile phone applications increased to more than 50% of our overall LED sales and was driven by a strong growth in LCD backlighting.

This demonstrates that our strategy to increase market share for white LED's is working as we have gotten traction with multiple design win.

Looking at the overall LED market, there continues to be some amount of unit growth, but we see an imbalance of capacity and demand in the mid to low performance end of the market.

This has resulted in increased ASP pressure in this segment of the market, which has led to some consolidation in Taiwan.

We anticipate that there will be additional consolidation over the next several quarters, which is healthy for our industry and should result in an improved overall market environment over the next year.

In spite of these challenges, our business in the mid to low end of the market is done well, and we still see a premium based on IP and overall quality and performance.

In the higher-end markets, demand seems to be increasing for the high performance products where our customers primarily compete with Nokia, although we have heard new brightness claims for Toyota GoSi.

We continue to push our performance and IP strength to increase our market share.

While we work with our customers on designs for the emerging applications that we believe will be key to fuel the next wave of growth for our industry.

Our LED chip R&D teams continue to push the envelope on performance, and we recently starting sampling our new easy bright chip technology.

This platform has been under development for the last two years and is an important milestone some our development road map.

This technology has several major benefits.

It is designed to provide X class chip performance that is compatible with our customer's existing manufacturing process, it enables higher optical output in certain package designs, and it should allow us to scale our chip performance to larger chip sizes and increase the brightness of our power chip products.

We have converted more of our high brightness products to 3-inch wafers, and this project remains a high priority for our team, especially as we get ready to launch the new easy-bright product family.

In the near term, we are striving to develop a 30 milliwatt class chip, which our customers have indicated is needed for the next application of high performance white LED application.

This is a challenging goal and timeline, but we need to keep raising the bar on performance to maintain our leadership position in the market.

Our investment in sales and marketing for the XLamp business is starting to yield positive results.

Although sales growth in Q1 was modest, we are building momentum for the second half of fiscal 2006.

We are developing customer relationships to drive our growth, and their feedback in our product performance gives us confidence that the business can and should emerge over the course of this year.

I believe we are turning the corner from a start-up product line to one that can drive overall revenue growth for Cree.

We are working on designs for applications ranging from flashlights to spotlights, from exit signs to emergency signals, and from architectural signage to garage lighting.

We are building our distribution channels to increase our overall sales reach, and our direct sales team is winning new business.

We recently booked a multimillion dollar order for XLamp products that extends over the next year to support exciting end-applications that include lighting at the Olympic games, bridges, and a variety of commercial buildings.

We believe this is only the beginning of what we are targeting to be a solid period of sustained growth for our products in solid state lighting.

The recent opening of our new Cree Asia-Pacific office in Hong Kong should provide a strong operating base to support our Asian customers with local technical expertise, application support, and sales assistance for this fast emerging market.

We continue to make progress developing our lighting component platform for LCD TV and monitor applications.

This platform, which we have branded Color Wave, has captured the interest of several OEM's, and we are currently working on prototype developments with these companies.

The projects are in the early phases of development and we are confident that some of these projects should lead to commercial product launches over the next year.

We need to keep in mind that this is a tremendous technology shift for this industry.

So we are going to have to be patient in working with the early adopters to prove that LED back lights are viable for high-volume applications before the overall market can start to consider a large scale shift.

From a product portfolio perspective, we target that the Color Wave products could start to contribute to our overall revenue growth in the second half of calendar 2006.

In our high-power products business, we have seen a nice rebound in demand for our core silicon carbide shock E products in power supply applications.

The shift is being driven by two factors -- we are starting to overcome customer concerns about silicon carbide technology in general, and we have a better sense for the value proposition to compete with existing silicon technology.

Sales of our wide bandgap silicon carbide and gallium nitride RF products have continued to go well for both our discreet products and mimic foundry service.

Both the power and RF product lines are in the early stage as we continue to develop our understanding of the customers and market opportunities, build our sales team, and continue to develop the products.

This business will likely take longer to gain momentum than the lighting business, based where we are today and the longer design cycles for these applications.

We are making progress and on the right track to make high power products an important contributor to our mid to longer term growth.

As we previously announced, we're in the process of exiting the silicon RF business and closing our Sunnyvale operations.

The project is on schedule, and we should complete last-time product shipments in the December quarter.

We are reducing operating costs as part of the shut down, but the major operating benefits will occur starting in our fiscal Q3, after the factory has been closed.

The laser team is making progress on new device designs using our propriety gallium nitride substrate technology.

We are also increasing our cooperation with our partner in Japan, to accelerate our development efforts and increase our exposure to the end applications.

We don't have commercial level results at this point, but with the combined efforts of the two teams, I am optimistic that we are on the right track.

In the first quarter, we delivered record revenue of $103.9 million and earnings of $21.7 million or $0.28 per share.

We were able to drive overall revenue growth and maintain healthy profits in our LED business despite a tough competitive environment.

We continue to manage the challenges in terms of technology development, cost reductions, and building our sales infrastructure, and we remain optimistic about the opportunities in the year ahead.

We are starting to gain momentum in the lighting business, which should put us in a much better position to grow our revenue, even if if the overall LED market does not grow as fast as in previous years.

Our balance sheet continues to get stronger as cash and investments grew to $296 million.

This puts us in a great position to continue to invest in our core technology and infrastructure, while giving us the flexibility to use some of these funds more strategically.

We are targeting a good second quarter with revenue increasing to 106 to $109 million and earnings of $0.24 to $0.27 per share.

I will now turn the call over to Cindy.

Thank you, Chuck.

We begin our new fiscal year with strong results as our revenue passed the 100 million per quarter milestone for the first time in our history and earnings per share exceeded our guidance given in the last conference call.

For the first quarter, sales increased 5% sequentially to $103,856,000 due to the growth in LED's, high-power products, and contract revenues.

Our LED revenue grew $1 million over the June quarter, while our high-power products and contract revenues increased by $1.2 million and $2.1 million respectively.

Net income was $21,720,000, which was a 3% increase sequentially and included approximately $2.9 million in pretax, noncash stock compensation expense as we adopted a new accounting standard requiring us to expense stock options for the first time.

During the first quarter, we also incurred $787,000 in pretax charges for winding down Cree Microwave California facility.

Together, these items resulted in an after-tax charge of approximately $2.5 million or $0.03 per share.

These items were offset by a $587,000 pretax, or $399,000 after-tax gain, recorded on the sale of a small portion of our Color Kinetics investment and a $2.2 million tax benefit that resulted primarily from the change in market value of our investment in Color Kinetics.

Together, these items increased earnings per share by approximately $0.03.

Overall, earnings per share was $0.28 for the first quarter of fiscal 2006.

LED revenue grew 1% sequentially to $84,621,000, and made up 82% of our overall sales in the September quarter.

Our unit shipments increased 10% in the June quarter, while our blended average sales price per LED declined 8% sequentially.

During the September period, our high brightness devices grew from 65% to 68% of LED revenue, while our mid-brightness devices declined sequentially to 28 % from 32% of LED sales.

Our standard brightness chips increased from 3% to 4% of LED revenue during the first quarter.

Material sales, which include wafers and gemstone materials, were 8% of revenue for the first quarter, increasing 5% sequentially to $8,326,000.

Wafer volume decreased 3%, while our average sales price for wafers declined 1% compared to the fourth quarter due to changes in our product mix.

Gemstone materials revenue increased 25% sequentially to $3,199,000, due to the increased demand from Charles and Covard.

During the September quarter, revenue of Cree Microwave Sunnyvale increased 36% sequentially to $954,000, or 1% of revenue, as we began our -- to ship our last-time buy orders to customers.

We expect to finish last-time buy orders in December 2005, and as a result, revenues for Cree Microwave Sunnyvale is targeted at approximately $2.8 million for our second quarter.

Revenue from our high-power products business, which includes silicon carbide epitaxy diode and microwave sales increased to $3,296,000 and made up 3% of our overall revenue for the September quarter.

Contract revenue increased by $2.1 million sequentially to $6,598,000, due to new contract awards such as our previously announced program with Darpa.

Contract revenue made up 6% of overall revenues for the three months ended September 25, 2005.

Gross margin was within our guidance on the last conference call at 49% of revenues for the three months ended September 25, 2005.

Gross margin was reduced by approximately one percentage point, or $828,000, due to a $200,000 reserve for inventory related to the Cree Microwave Sunnyvale business and a $628,000 charge resulting from stock option expense that was recorded for the first time due to a change in accounting rules.

During the first quarter, LED profitability declined as our blended average sales price increased 8% sequentially, while average costs were unchanged compared to the June quarter.

Our average sales price declined in part because of a strong product mix shift to UT230 chips to support keypad application ramp-up for mobile products.

We also lowered our sales price on some of our high-brightness products and increased our performance specifications as part of our strategy to increase market share in white LED's used for mobile products.

The higher brightness specifications required us to support the new design wins resulted in lower yields for certain products.

Therefore, the average cost of our LED products remained unchanged for the June quarter as the benefit from increased 3-inch production was offset by lower yields.

Contract margins remained at 33% of revenue in the first quarter, due to our current mix of contracts.

For the three months ended September 25, 2005, Cree Microwave lost $2.2 million pretax, including $787,000 of charges for the planned closure of the Sunnyvale facility.

These charges included a $200,000 reserve for inventory, a $196,000 impairment of patents, and a $391,000 severance expense incurred in the first quarter of fiscal 2006.

At this time, we expect to finish the production of our last-time buy orders and complete most of our employee layoffs by December, 2005.

Research and development expenses were 12% of revenue for the three months ended September 25, 2005, and increased 33% sequentially to $12.8 million.

These results included $1.1 million of stock option expense as we adopted a new accounting policy in the September quarter.

We also increased our overall spending for larger wafers and brighter LED's.

SG&A expenses were 11% of revenue and increased 13% from the June quarter to $11.1 million.

These results included $1.2 million of stock option expense in the September quarter due to the new accounting pronouncement.

Besides the impairment charge for the writedown of patents and severance expenses for our Sunnyvale facility, operating expenses also included a $581,000 impairment for building improvements and other asset disposals of the Durham facility during the first quarter of fiscal 2006.

During the September quarter, we sold 63,782 shares of our investment in Color Kinetics, which generated $587,000 gain that is included in nonoperating income.

As of September 25, 2005, we held 1,795,660 shares of Color Kinetics common stock as a marketable security.

Net interest income increased from $1.7 million to $2.3 million sequentially due to our greater cash balance and higher interest rates received in our investments.

During the first quarter of fiscal 2006, our income tax expense included a $2.2 million benefit relating to our investment in Color Kinetics.

Because Cree had a lifetime capital offset that was reserved for in its entirety in a prior year, under generally accepted accounting principles, we were required to reverse a portion of the tax reserves associated with a prior year capital loss whenever there's an increase in the market in our investment in Color Kinetics.

This adjustment reduces our tax expense.

In addition, as the market value of our investment in Color Kinetics decreases, we have to increase our tax reserve for the capital all carry forward, which increases our overall tax expense.

As of September 25, 2005, the price of Color Kinetics stock increased in value compared to the price of June 25, 2005, and as a result, Cree reduced its income tax expense by $2 million in the first quarter of fiscal 2006.

Cree was also able to realize a $200,000 tax benefit associated with a sale of 53,782 shares of Color Kinetic stock in the first quarter of fiscal 2006.

Going forward, we will be required to continue to record the tax effect of any increase or decrease in the value of our investment in Color Kinetics as a reduction or increase in our tax expense each quarter.

Our actual tax provision for the first quarter of fiscal 2006 was 32% rather than 33% that was previously estimated.

In May 2004, our Board of Directors authorized an additional 5.1 million shares to be repurchased under a stock repurchase program, which was extended through June, 2006.

During September, 2005, quarter, we did not repurchase any shares authorized under this program.

Therefore, as of September 25, 2005, we have 5.5 million shares remaining under the program that have been authorized for repurchase.

At the end of our first quarter, our balance sheet remains strong as our cash and short-term and long-term investments grew from $277 million to $296 million sequentially.

Our cash flow from operations remains strong at $31 million.

Our first quarter cash flow was primarily generated by higher profits and have benefited from a decrease in inventory and an increase in accrued expenses.

Cash flow from operations was somewhat offset by a $16.8 million increase in our accounts receivable balance in the September quarter, which was the result -- which -- the result of the increase of our accounts received balance, our day sales outstanding, which is based on a trailing revenue profile, increased from 32 days to 39 days sequentially and is more in line with our target range of 45 to 60 days.

Our inventory days on hand, which has been a focus of our operations team, decreased from 59 to 50 days during the first quarter.

Capital expenditures and free cash flow were $12.5 million and $18.5 million respectively for the first quarter of fiscal 2006.

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

As we begin the second quarter fiscal 2006, we target revenue to increase to a range of 106 to $109 million.

We target gross margin in the similar range as our first quarter, or approximately 49% of revenue, plus or minus a point or two.

Research and development expenses are targeted in a range of 12 to 13% of revenue as we focus on developing our next generation of LED chips, and SG&A expenses are targeted to be 10 to 11% of revenue as we anticipate higher sales and marketing expenses for our newer business units.

During the first quarter of fiscal 2006, we began to expense stock options for the first time under SFAS No. 123R.

As a result of -- our overall pretax expenses increased by approximately $2.9 million and reduced our earnings per share by approximately $0.03 per share during the first quarter.

During the second quarter of fiscal 2006, we target stock option expense to increase that approximately $3.5 million or $0.03 per share as $725,000 of stock option expense was allocated to inventory in our first quarter in accordance with the Securities and Exchange Commission Staff Accounting Bulletin number 107.

In addition, we target that we will incur approximately $500,000 for a combination of severance expense and the cost to move some production equipment associated with the wind down of Cree Microwave California's facility that we estimate will reduce earnings per share by nearly one-half of $0.01.

While we expect to complete wind down of the Sunnyvale operations by December, 2005, we will not be able to fully vacate the facility until the March quarter.

Therefore, we target a writedown of approximately 5 to $6 million associated with the remaining lease obligation to occur in the third quarter.

Based on an estimated 78 million shares outstanding, earnings per share is targeted in a range of $0.24 to $0.27 per share for the second quarter of fiscal 2006.

In the September quarter, we were very pleased to report our first period with revenue in excess of $100 million, which has been a long standing milestone for us.

We also made progress in our goals to win market share in the white cell phone backlight market, and succeeded in manufacturing more LED's from the 3-inch platform.

As we enter the second quarter of fiscal 2006, we see additional opportunities to increase sales from our solid state lighting business and grow overall revenues to new record levels.

Thank you, and I would like to now turn the discussion back to Chuck.

Thank you, Cindy.

We will now take analyst's questions.

[ OPERATOR INSTRUCTIONS]

Your first question comes from Matthew Smith.

Hi, Cindy.

Hi, Chuck.

How are you?

Fine, how are you?

Nice quarter.

I was hoping -- you said in your prepared remarks that roughly 50% of revenues came from the handset market, which I think is a shift up sequentially, and partly on seasonality.

I wondered if you could help us understand how the split is changing between the keypad and the backlighting within the handset -- for the LCD -- and how is that impacting your -- how did that impact revenues during the quarter?

I guess I'm interested to know what sort of -- are you seeing a growing level of confidence among your customer base with respect to your -- with respect to your products for the handset LCD market, and what sort of visibility and comfort levels do you have for consistent growth or continued growth through the latter part of FY06?

Thanks.

Let's see if I get that.

If I missed part of it, you can jump back in here.

So, if you look at mobile phones grew to a little more than 50% for the quarter, and it was definitely the biggest growth driver.

I'm sure part of that is the seasonality that comes with this quarter, and I would say that that's probably what affects things like our keypad business and the UT230.

I think on the other side, we're that -- really, we're seeing more growth though in what I would call the white LED, especially the LCD backlighting segment.

That was actually -- grew faster than even the keypad segment.

I would say both things are happening.

We got a benefit from the seasonality, at the same time, I think our white strategy to grow market share for the LCD backlight definitely also started to get momentum.

I think our outlook going forward is that we're fairly optimistic that that momentum can if we keep driving up the performance and winning new design slots.

Does that answer your question?

Yes, it does.

I guess what I'm trying to get at is -- how much visibility is your customer base giving you?

I mean -- for instance, what I'm trying on get a feel for is how much of the market have you got out, do you think, relative to each year in LCD's, and where do you think you can go here?

Can you go to 15%, 20%, 30%, and over what sort of timeframe?

I mean I know I'm trying to push you on something here, but can you give us any feel at all about your ambitions for this particularly market, I guess?

Our ambition has always been to go out and take some amount of significant share.

Obviously, over the last several quarters, this has been a project we've continued to work on.

Where we're at today is -- I would tell you we're probably still a relatively small share in the marketplace.

You know, for us, this isn't something that we're starting to get some traction and starting to win some designs, but I think there's significant growth opportunity available, but I would also tell you that the key is really -- it's not visibility in new designs, it's keeping the momentum.

And so, I think that we've had success over the last couple of quarters.

You can see it in our results this quarter, but we have to keep doing that, which means that we've got to keep going out and fighting for new designs and doing things from a performance and price standpoint that allow our customers to win.

So, it's an ongoing thing.

We're confident that we -- we think we can keep it going.

It's an ongoing process.

Okay.

Thanks a lot, Chuck.

Sure.

Your next question comes from Harsh Kumar of Morgan Keegan.

Hi, guys.

Hey, Chuck.

Hey, Cindy.

A couple of questions -- first of all -- tax rate.

You talked a little bit about that, and I think it was from Color Kinetics.

Can you give me the number again -- the benefit -- was it around around $2 million?

The total benefit in our tax line for Color Kinetic stock includes two pieces -- it includes every time the stock price goes up, we reverse some of the previous capital losses that we took on capital loss carry-forwards that we did not take. we fully reserved for.

So, there's $2 million give-back associated with that, and then we had a $200,000 realized gain because we sold some shares.

So, in the numbers, $2.2 million of benefit in our tax line.

Got it.

Okay.

And I guess if we were to try to normalize numbers, should we be assuming $0.32 going forward because we can't speculate on Color Kinetics stock price, I guess?

Right.

I don't forecast what's going to happen with Color Kinetics stock price, but if you look at our tax provision for the year, excluding that, it's estimated at 32%.

Got it.

Chuck, question for you.

Can you give us some semblance of your success in backlight designs for handsets, maybe some revenue run rate or design momentums, something we can tangibly look at?

Harsh, I'm not going to be able to break out the numbers further than what I talked about.

It was mobile phones is -- grew the fastest, it's more than 50% and the single biggest driver to that was the LCD backlight application, but all of that being said, we still have a relatively small share of that market, so we additional growth opportunity.

As far as design wins, numbers, parts of revenue, we don't break that out.

Okay.

Also, can I get your assumptions for unit growth, if possible, for December quarter -- LED's.

We don't break those out, either.

I can tell you that we're obviously targeting the growth to come from a combination of LED's and from our high-powered products business, and so some portion of that is in the LED segment, but we don't break out the unit growth.

Fair enough.

In looking at your cause for LED's for the last two quarters, they've been basically flattish.

Can you try to tie for us where your 3-inch conversion process, if that's a big driver?

And what are you doing to basically bring the costs down on a per-unit basis for LED's?

Yes, what you've seen over the last couple quarters is we are making progress on 3-inch, in fact.

We saw a nice increase over the last quarter.

What's happening, though, is with the high brightness segment, as we go out and get aggressive from pricing, we're also doing things from a specifications standpoint to push the limits to help our customers win those designs, which puts pressure on our yields.

So, really what we're seeing is that the benefits we're getting from 3-inch are being offset by some of the things we're doing in our market share strategy.

I think over time, once we get up the learning curve on some of those things -- obviously, there's lots of things we can do from a cost production stand-point.

It's a combination of yields, scaling up some of the new products, and as well as continuing to drive down the 3-inch.

So, we think there is cost reduction opportunities going forward, but just, during the period right now, as we're pushing for market share, it's kind of off -- with the benefit of 3-inches getting offset by the new product and the higher brightness area.

Hey, Chuck, I was hoping you would give us the number for 3-inch conversion, if at all?

I think I said it earlier, Harsh.

I think I said that we were a little bit -- we were more than 60% of the chips in the quarter were on 3-inch.

Okay.

Got it.

Thank you very much.

Appreciate it.

[ OPERATOR INSTRUCTIONS ]

Your next question comes from Jon Dorsheimer of Adams, Harkness and Hill.

Hi, thank you.

A couple of questions.

Chuck, utilization rates during the quarter, can you just give us an idea of -- of where those were?

You mean in terms of like capacity utilization?

Yes.

Well, you know, I don't have an exact figure for you.

I would tell you that we have some available capacity, but I don't even have a good benchmark number to give you, Jed, I'd just be guessing, but we're not running full capacity right now.

All right.

And looking at the CapEx a little bit closer, which you've obviously seems like you're building -- building out a little capacity, the -- could you give us a flavor on -- thus far what you've spent?

Or has that mostly been for equipment, has that been for property, any sort of flavor on that, or additional color?

Yes.

So, I think for this year so far you can kind of see when you're looking at the balance sheet and stuff that we're -- you know, the -- if you look at the cash flow, you can see that they've actually slowed down a little bit in terms of stuff coming online.

I think what you will see is you will see the CapEx first of all be a little bit more loaded to the second half of our fiscal year.

So, that's one factor to keep in mind.

The other thing I would tell you, though, is most of what we're spending it on is for new equipment, and it's a combination of capacity and new process technology.

As we push into the new product areas, we are investing in process equipment that allows us to build products to do things different.

So, as we do -- for example, as with go to brighter LED's, there is new process technology involved in that, and the easy bright product is going to require additional investment, and frankly, we're doing some things to get our new fab ready so that at some point, we will be able to turn that on this fiscal year, and that's really planning for the future a little bit.

Great.

Then this easy bright chip technology that you were talking about --

Yes.

Curious when you mentioned the ability to scale the performance -- are you using a thin silicon carbide substrate?

And, is there any photon loss -- as you expand the chip from '01, is the chip a -- like a 200-micron squared or is it more of a 1 millimeter type squared technology?

What I'm basically describing is that generally our -- our standard chips are effectively about -- I don't know, 260, 290-microns, somewhere in there on a square.

That's a normal size chip we would sell.

As we go larger than that, for example like our XB900 power chip, when you take that technology and you scale it up, you don't get a one-for-one increase in brightness.

In other words, the area goes up more than the brightness does.

What the new technology does is it really creates an emitter that emits light so that as we scale it up, we're more efficient at extracting light in the larger chip sizes.

That's what we're talking about.

So the idea is that we can take some of the really good performance results that we've demonstrated on the small chips, and we're hoping to translate that into the power chip business.

I think, as you know, the power chip generally has been less efficient from everybody out there over the last several years, even though we can do pretty amazing things, it's still not at level of the best small chips.

What we're trying to do is scale up that light extraction to the larger chips.

Does that kind of explain what we're talking about?

Yes, I figured that -- I just -- maybe what I'm trying to get at is -- I'm curious as to what technology you're using to get it closer to parody too, and perhaps maybe you can give us an idea of where you're at as far as this scalability?

I've heard that some of the technology has the opportunity to actually scale quite nicely because you don't have the -- as much edge loss.

I'm wondering, one, if you're thinning the silicon carbide, and two, what you're seeing from losing photons around the edges.

The way to think about it is -- definitely -- as the technology approaches the problem one way, this is a -- the idea is to create more of a surface emitter than an edge emitter.

Instead of using shaped outside edges, we're trying to pull the light out of the surfaces of the chip.

So, it would be more analogous to the same concept of what they're trying to do in thin GaN, which is create a surface emitter versus an edge emitter.

It would be the same idea.

As far as -- and I'd be happy offline to walk you through it as we get -- put more information out, kind of how it works, but it's a similar concept to say if you want to scale a larger area, and you're just using the edges, that's a disadvantage.

We tried to make more of a surface emitter.

Does that -- so, I -- if that -- that would be analogous, I think to your thin GaN discussion.

Great.

That's actually quite helpful.

And then, two more questions, and I will pass it on.

The multi-million dollar order that you were talking about, I think in part of the XLamp discussion --

Yes.

Where -- you had mentioned a couple of different applications.

Is that specifically for more of the lighting-type applications?

Yes.

The order we talked about is a customer that's in the -- it's a lighting-type company, and so there are various things.

Some of the applications we talked about -- everything from bridges to buildings to some lighting at the Olympic games.

So, yes, I would put it into more of the lighting/illumination category of outdoor lighting.

Great.

Do you own shares in that customer?

No.

All right.

Thank you.

I will pass it on.

Sure.

Your next question comes from Hans Mosesmann of Moors & Cabot.

Thank you.

I've got a few questions, guys.

Number one, did LED inventories increase in the quarter, or did they go down consistent with the overall inventory?

You know, Hans, I don't have that broken out, but I would assume they went down with it -- actually, Cindy is shaking her head.

Yes, they did.

So they scaled down with the overall inventory.

Okay.

Can you -- can you indicate how big [inaudible - speaker muffled] is these days as a percentage of overall sales?

We don't break it out on a quarterly basis, Hans.

Obviously, they're still our largest -- by far our largest customer, but we don't break it out on a quarterly basis.

Okay.

Can you remind me what they were for last fiscal year?

Yes, for the year that just ended -- Cindy, do you have that handy?

Yes, 42% I think -- 41%, 42%.

Okay.

That's helpful.

Thanks.

And then a couple of others -- R&D in Q1 was down about a million dollars less than expected.

In terms of -- for modeling purposes, can we expect that kind of volatility in Q2 or in following quarters?

No, Hans.

I think what you see is if you go back to Q4, you will notice it was actually abnormally low in Q4, and so we're in the process of trying to ramp that up, and our goal is to really get it back to historical levels.

And obviously, when you're trying to make a change, you will obviously see more variability than when it's more steady stay.

I think the targets that Cindy had put out for the upcoming quarter, I think, are 12 to 13% is the R&D range.

So I think it should be a little bit more predictable this quarter since we're not trying to change it as significantly.

Okay, thanks.

And then two others -- had been up 25% the last couple of quarters.

In terms of modeling, should we assume it to be at current levels, or is there any more growth from this particular customer?

You know what?

I would tell you, at this time, it's something we update you on each quarter.

We generally try not to put any forecasting there since they kind of give their own guidance.

So we're going to probably track whatever it is their demand is at this point.

Obviously, while it was a nice little increase, it's still a relatively small part of our business, but we don't tend to give out forecasts for that going forward.

Okay.

Last question.

In terms of your business with the Department of Defense, your -- the locations where you do the R&D and the development for that particular customer -- are those secure areas?

And the reason I'm asking you is because of the INS situation that we heard of -- about yesterday or the day before.

So, I'm curious -- I just want to know if there's a potential where the government contracts could be questionable, or your opportunity to give government contracts in the future could be impacted by that situation?

Hans, we don't worry about that at all.

I would tell you that obviously, it was an unfortunate situation that affected a small number of Cree employees and then some of our contract employees, but I would tell you that -- I think it was even in the quote that was issued.

I know that the Department of Immigration put out their quote where the agents said that Cree -- Cree's standards exceed the requirements of the government contract -- of a government contractor.

So I think that says -- that pretty much says it all, where they think we stand.

This is one of the things we have to deal with today.

But I feel -- we don't have -- I don't believe will have any impact on our business, and I'm very confident in that.

But are these secure areas where you're doing this particular work for the Department of Defense?

We do department -- work for the Department of Defense in secured areas.

Yes, that is where we do the work for them.

Okay.

And these guys -- just to be precise -- these guys were not in the areas?

I can tell you the Department of Defense isn't worried about it.

I cannot give you the insight you're looking for.

That is not public information.

Okay, fair enough.

Thanks a lot.

Yes.

[OPERATOR INSTRUCTIONS]

We do have one follow-up question from Jonathan Dorsheimer of Adams, Harkness & Hill.

Hi, thank you.

The gemstone materials seems like it saw a good increase.

I'm curious -- what are the requirements to build out capacity for our -- for the furnaces there?

Are you able to use your -- to switch over your LED furnaces to 8-6 furnaces, or is that not possible?

Is it really sort of a forklift or a brand-new build-out?

Thanks.

Yes, you know, over the years we've basically developed a methodology, which gives us some flexibility.

There is generally, between product tines, there is a little bit of changeover, but generally speaking our capacity is pretty flexible, and we direct it as to where the demand is.

Whether it's 2-inch or 3-inch or the gemstones materials versus other things, we have flexibility to be ave able to move it around with a little bit of change over time.

And when I say 'move around,' it's really 'convert it.'

We don't move any equipment.

Great, thank you.

Sure.

At this time, there are no further questions.

Mr. Raiford Garrabrant, are there any closing remarks?

Yes.

We appreciate your interest and support, and look forward to reporting our second quarter of fiscal year 2006 results on January 19, 2006.

Thank you.

Thank you.

Thanks.

This concludes today's Cree Incorporated first quarter 2006 fiscal year financial results conference call.