Wolfspeed Inc (WOLF) 2006 Q2 法說會逐字稿

Good afternoon.

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

At this time I would like to welcome everyone to the Cree, Inc. second 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, January 19th, 2006.

Thank you.

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

Mr. Garrabrant, you may begin your conference, sir.

Thank you, Alicia, and good afternoon.

Welcome to Cree's second 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 pleased to assist you.

Today Chuck Swoboda, our Chairman and CEO, in Cyndi Merrell, our CFO, will report on our results for the second 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, expects, 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'd like to note that as a result of SEC rules we will be limiting our comments regarding Cree's second quarter of fiscal year 2006 to a discussion of the information included in our earnings release and 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 the call are copyrighted property of the Company, and no other recording or reproduction is permitted, unless authorized the Company in writing.

Consistent with our previous conference calls, we're 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 Web-casting our conference call to allow more flexibility for our conference call attendees.

A replay of the Web-cast will be available on our website through February second, 2006.

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

Starting this quarter we will report financial results from our primary business in Durham as continuing operations, and our silicon microwave business as discontinued operations.

For comparative purposes to our previous guidance, which did not reflect discontinued operations accounting, second quarter total revenue was at the high end of our target range at $108.9 million.

For continuing operations, we reported record revenue of $105.6 million with net income of $20.1 million or $0.26 per share.

Revenue from continuing operations increased 3% sequentially, from 102.9 million to 105.6 million.

This growth was driven primarily by increased LED sales due to strong demand for our XLamp products and incremental growth in silicon carbide material sales.

The initial success we're having in our XLamp business is very encouraging and provides an exciting foundation from which to grow our business over the next year.

Gross margin from continuing operations was 49%, which is in line with our target range.

Q2 R&D expenses increased to $14.8 million or 14% of sales as we continue to invest in the development of higher-brightness LED chips and high-power LED components.

As we start the third quarter we're focused on a number of challenges.

The first calendar quarter of the year, our fiscal Q3, is typically a slower quarter for mobile phone component sales, due to normal seasonality.

We're working with our customers to increase our market share in white LEDs for display backlights as well as other non-mobile phone applications to help offset this seasonality.

We need to increase our chip brightness and expand our applications expertise for packaging white LEDs to help our customers convert a higher percentage of our chips' blue output into white, and therefore better compete for the high-end white business.

With the growing sales momentum for XLamp, we could be capacity-limited for these products in Q3.

Therefore, we need to increase our internal XLamp production and qualify additional capacity at a manufacturing partner to support this growing business.

We plan to continue to extend the capability of our XLamp products to expand Cree's leadership position in the LED lighting market and support our longer-term growth strategy.

We are also increasing our sales and marketing investment, to expand our communications activities, to promote Cree's product leadership and further developed our brand for the emerging global lighting market.

Our ability to meet these objectives, as well as the normal operating challenges, will be important factors in how well we're able to take advantage of tremendous emerging market opportunities and continue to build on our financial success.

For the third quarter, we're targeting revenue from continuing operations to increase to a range of 105 to $110 million.

These targets are based on our plan to offset seasonally lower demand for LED chips in mobile phones with additional LED chips sales for non-bubble applications like gaming, increased XLamp shipments and higher silicon carbide Schottky sales.

We currently have almost 80% of our target revenue booked or under contract for Q3.

We target Q3 LED unit sales growth in will be somewhat offset by LED price declines in a range of 3 to 5%, which is similar to Q2.

Based on our current forecast, product mix, pricing trends and target cost reductions, overall Company gross margins is targeted in a similar range as Q2, at 49%, plus or minus a point or two.

Q3 operating expenses are targeted at approximately 25% of revenue as we continue to invest in R&D to support LED development projects and SG&A increases to support our expanded marketing activities.

Based on these assumptions, we're targeting Q3 earnings of $0.25 to $0.27 per share from continuing operations.

At this time, we do not target any significant further financial impact from the discontinued silicon microwave operation.

At our annual shareholders meeting in early November, I discussed the importance of LED lighting applications to drive the next stage of our company's growth, and I outlined several high-level goals for calendar year 2006.

Two key goals were to grow XLamp products sales to at least 10% of overall LED sales by the end of the calendar year and to have at least one TV or monitor commercially released using Cree's new innovative Colorwave backlight technology.

As I mentioned earlier, we're seeing good growth in XLamp sales, and we are currently on-track to achieve the two key objectives for the year.

We also had targeted to announce an automotive head lamp design win with one of our LED chip customers.

At this time, it appears that these programs may go into production in the 2008 car model year.

LED unit sales increased 8% sequentially in Q2, while ASPs declined 5%, which was within our target range for the quarter.

The ASP decline was offset by lower costs, which also declined by 5% sequentially.

Approximately 80% of our LED chips were produced on 3-inch wafers in the quarter, which was a significant increase from Q1 and contributed to lower costs.

This represents a little less than 60% of total LED wafers, which means that there is still significant potential cost reduction benefits from further conversion to 3-inch.

Mid-brightness LED revenue increased as a percentage of our overall LED sales, as we had a strong quarter for mobile phone keypad applications.

This is similar trend to what we saw in the December quarter year ago.

The increase in 3-inch production helped reduce costs, which supported our strategy of the aggressive pricing on the mid-bright products while still delivering good margins.

Although high-brightness sales declined slightly from Q1 to Q2, the 6-month trend is still strong.

Within the high-brightness category, XLamp products sales grew the fastest.

On the high-brightness chip side, some customers reduced their requirements in the latter part of our second quarter, as some projects did not ramp as fast as expected, and they managed their purchases in preparation for the seasonally-slow March quarter in the mobile phone business.

Mobile products, which include more than just cellphones, continue to be the largest application for our LEDs, at approximately 50% of total LED sales.

Our customers are optimistic about the progress they are making to increase market share for white LEDs and currently are targeting additional gains in the first half of calendar 2006.

Overall, the LED chip market continues to be very competitive.

There is increasing optimism among our customers regarding new applications for lighting and large-format LCD backlighting, as well as continued growth in white LEDs for consumer mobile applications.

End customer demand in Japan is running about 10% lower than our original $200 million plan with Sumitomo for the fiscal year.

However, it is generally being offset by increased demand in Korea and sustained success in Taiwan and the rest of Southeast Asia.

In R&D, we are working to finish qualification of our first eV chip products, and we continue to sample customers to allow them to start their own qualification.

The eV chip is an important new product, as it provides X-class brightness in a platform that should be easier for many of our customers to use with standard production equipment and package design.

We continue to extend the performance of our X product family, and have recently started sampling our 30mW class XR chips to several customers.

Our challenge over the next quarter will be to successfully complete these new product qualifications and get them into production.

The high-power packaged LED market is becoming increasingly competitive as Cree and several other companies have started to have success in a market that was previously only served by one company.

With the addition of new products and performance levels from Cree and others, there are new applications emerging in LED lighting on a regular basis.

Based on our success over the last two quarters, it is becoming clear that our XLamp products are winning and starting to provide measurable growth for our LED business.

As we announced last week, we are starting to build some strong customer relationships and winning some exciting new projects for our products.

We have opened our first European sales office in Vienna, Austria, and are building a team to help us win in the important European market for LED lighting.

Our Colorwave development team is making tremendous progress.

It is clear that producing a commercially-viable, cost-effective LED backlight for large-scale LCDs requires not only great LED chip technology, but also the systems technology around the LED backlight.

As a result, we are making a significant investment to develop the systems technology to complement our LED development.

As was recently demonstrate at the CES show in Las Vegas, LED backlights for large-format LCD screens are generating significant excitement within the industry.

Since our current development programs are under nondisclosure agreements, I can't give you more details at this time.

However, we're clearly headed in the right direction and are on track to get the first product released this calendar year.

In the high-power product area, we saw increased interest for our silicon carbide Schottky diode products in Q2 with incremental sales gains.

We have been successful in expanding our design wins in the power supply segment, and we are finding new opportunities to displace traditional silicon power devices in certain applications.

One of the longer-term applications for our power devices is motor control, which includes hybrid electric vehicle applications.

For hybrid vehicles, we believe that our silicon carbide technology should provide an increase in efficiency and reduction in vehicle complexity and weight, which could result in increased miles-per-gallon.

Our applications team is working to quantify these benefits.

Our silicon carbide microwave foundry business is solid, and we are starting to see increased demand for gallium nitride microwave foundry services as well.

From a discrete RF product standpoint, we are focusing our commercial product development on a new line of gallium nitride device products, targeted at communications applications, such as WiMax.

Your search for a new CFO continues to be one of our highest priorities.

We are talking with a number of strong candidates, but we are not ready to make a decision at this time.

We are pleased that Cyndi Merrell has agreed to extend her contract, to stay on as CFO through the end of our reporting requirements for fiscal Q3.

I'm hoping to have a new CFO in place by then, but we are not going to shortchange the process.

I'm committed to taking whatever time is necessary to find the right candidate for Cree and find someone who has the skill to help us grow the Company to the billion dollar sales level and greater.

In the second quarter we delivered record revenue from continuing operations of $105.6 million with net income of $20.1 million or $0.26 per share.

The growth was driven primarily by increased XLamp product sales, with some incremental contribution from silicon carbide material products.

We are building on our momentum XLamp and target additional growth for these products in Q3 as we work to manage the market challenges, technology hurdles and execution risks facing our business.

In the second quarter, our balance sheet that even stronger as we generated $37 million in free cash, which drove our cash investments to $338 million.

We continue to target CapEx for fiscal 2006 in a range of 90 to $110 million, which includes the investment we are making in our new RTP fab, to start the transfer of our advance device products in the fourth quarter.

We are currently evaluating some smaller scale strategic financial investments related to the lighting business and other core technology areas.

Given the strength of our current business model, financial resources and market opportunity, we're in a great position to win as a company.

If we are able to continue to meet the many challenges facing our business, we should be positioned to take advantage of the tremendous emerging opportunities in LED lighting and increase shareholder value over the next few years.

We are targeting a good third quarter, which sets us apart from a lot of companies with significant mobile phone-related business, as we target revenue in a range of 105 to $110 million and earnings of $0.25 to $0.27 per share.

I will now turn the call over to Cyndi.

Our financial statements for the second quarter of fiscal 2006 include a change in how we report Cree Microwave, Sunnyvale results.

Because we were successful in winding down Cree Microwave operations, by the end of the third -- of the quarter, we have ceased using the Sunnyvale facility.

We are now required to report Cree Microwave, Sunnyvale as a discontinued operation.

Therefore, Cree Microwave's financial results for the second quarter appear separately at the bottom of our statement of income.

As a result, our second quarter revenue is reported at a record at $105,640,000.

Taken together with second quarter revenue earned from Cree Microwave, Sunnyvale operations of $3,312,000, which is now reflected net of expenses and loss from discontinued operations net of related tax benefits on our statement of income, our second quarter revenue would have increased 5% sequentially to $108,952,000. this amount would be at the top end of the revenue range targeted on the last conference call, which did not distinguish between revenue from continuing operations and discontinued operations.

In addition to the revenue generated at Cree Microwave, Sunnyvale for last time buys during the second quarter, revenue from continuing operations increased by $2,738,000 sequentially, due to higher revenue from XLamp products and silicon carbide materials.

For the second quarter of fiscal 2006 net income from continuing operations was $20,058,000 or $0.26 per share.

Overall, net income was $17,709,000 or $0.23 per share, which included several charges related to the closure of Cree Microwave's Sunnyvale facility.

These charges included a $3,075,000 accrual that we previously targeted to occur in the third quarter for our remaining lease obligations relating to the Sunnyvale, California facility, a $468,000 write-down for inventory that was not used in production, a $93,000 fixed asset impairment and $232,000 in severance costs for Cree Microwave employees.

Together, these items resulted in an after-tax charge of approximately $2.6 million or $0.03 per share for the December quarter.

At this time we believe that all significant write-downs related to the closure of the Sunnyvale facility are now completed.

However, there could be some future adjustments related to our estimates for the wind down of the lease that would be reflected as discontinued operations if they occur.

During the second quarter of fiscal 2006 net income also included approximately $3.5 million in pretax, non-cash stock compensation expense as we adopted a new accounting standard requiring us to expense stock options at the beginning of our fiscal year.

During the December quarter, LED sales made up 82% of our revenue and grew 2% sequentially to $86,516,000.

This increase in revenue was a result of higher sales of our XLamp products.

Unit shipments increased 8% over the September quarter, while our blended average sales price for LED declined 5% sequentially.

From time-to-time we review how we characterize our LED products in order to provide the most meaningful classification to our shareholders.

As the overall brightness of LED products continues to increase, we're adjusting the high-brightness category to include products typically greater than 20mW of brightness and primarily used as backlights for LCDs, outdoor displays and for general lighting purposes.

As a part of this change, our MegaBright products have been moved from the high-brightness category to the mid-brightness category.

During the second quarter, we also have combined our standard brightness category with our mid brightness devices, as we believe a separate classification is no longer helpful.

We have updated our conference call metrics included on our website for the past three quarters with this new classifications.

During the December period sales of our high-brightness devices made up 38% of LED revenue, while our mid-brightness devices were 62% of LED revenue.

Our high-brightness revenue was lower by 5 points sequentially after nearly doubling in the first quarter, due to our seasonal mix of business.

As a part of our quarterly review process, we determined in the December period that we have experienced a lower trend of customer returns over the past few quarters.

Therefore, in accordance with our revenue recognition policy, we reduced our allowance for sales returns, which increased LED revenue by $1.3 million and resulted in an increase to net income of approximately $758,000.

Material sales, which includes wafers and gemstone materials, were 8% of revenue for the second quarter, increasing 9% sequentially to $9,079,000.

Wafer revenue grew 6% to $5,431,000, due to greater demand for our bare silicon carbide wafers, while gemstone materials increased 14% sequentially to $3,648,000 due to increased demand from Charles & Covard.

Sales of our high-power products, which include Schottky diode and Wide bandgap microwave sales, were $3,044,000 and made up 3% of our overall revenue for the December period.

For the second quarter of fiscal 2006 contract revenue made up 7% of revenue, increased by $341,000 sequentially to $6,939,000, due to the timing of work performed on certain contracts.

For the three months ended December 26, 2005 gross margin was within our guidance on the last conference call at 49% of revenue.

Gross profit was improved by $1.1 million due to the reduction of our sales return reserve during the second quarter.

However, much of this benefit was offset by a $655,000 sequential increase in stock option expense being recorded to cost of sales.

During the first quarter of fiscal 2006 only $567,000 of stock option expense was included in cost of sales, as the remaining stock option expense was allocated to inventory in accordance with the Securities and Exchange Commission Staff Accounting Bulletin No. 107.

For the next few quarters, we target that stock option expense recorded to cost of sales will approximate $1.2 million per quarter.

During the second quarter LED profitability wasn't changed as both our blended average sales price and our average LED cost decreased 5% sequentially.

Our average sales price decline was primarily due to normal price reductions and our product mix shift toward our lower-priced, mid-brightness products.

Our average costs were lower in the December quarter, due to a combination of a higher percentage of our products being made from 3-inch wafers and the mix shift toward mid-brightness products.

Contract margins declined sequentially from 33% to 28% of revenue, due to the mix of contracts under which work was performed.

At this time, we target contract margins in the upper 20s as a percentage of contract revenue for our third quarter.

Research and development expenses were 14% of revenue for the three months ended December 25th, 2005, and increased $2 million or 16% sequentially to $14.8 million as we continue to increase our spending for high-power and brighter LEDs to drive product revenue over the next several quarters.

SG&A expenses were 10% of revenue and remained fairly even with September quarter results at $10.8 million.

Net interest income increased from 2.3 million to $3 million sequentially, due to our greater cash balance and higher interest rates received on our investments.

During the second quarter of fiscal 2006 our income tax expense included a $132,000 benefit relating to our investment in Color Kinetics.

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

Our actual tax provision for fiscal year 2006 is estimated at 32%.

For the second quarter of fiscal 2006 we recorded Cree Microwave's Sunnyvale results as a discontinued operation, as we completed our last-time buy orders for silicon-based products, terminated the employment of our remaining employees and either moved equipment to North Carolina or held it for sale.

We expect to close the facility during the next several weeks.

As a result of the discontinued operations treatment, we recorded a $2,349,000 loss from discontinued operations that is reported net of taxes on our statement of income.

This amount represents $3.2 million of revenue from the sale of silicon-based products, less expenses incurred by that business, including write-downs for fixed asset and inventory impairment, severance expense and a $3.1 million charge relating to our lease obligation for the facility.

The $3.1 million charge was recorded as an estimate based on the present value of the remaining lease rentals reduced by an estimate of sublease rental income that may be obtained for the property.

Cree is obligated under this operating lease until November 2011.

Without these charges, Cree Microwave, Sunnyvale operations ran slightly profitable for the second quarter.

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 the December 2005 quarter we did not repurchase any shares authorized under this program.

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

At the end of our second quarter our balance sheet continues to improve, as cash and short-term and long-term investments grew from $296 million to $338 million sequentially.

Our cash flows from operations increased from $31 million in the September quarter to $56.7 million for the three months ended December 25th, 2005.

Our second quarter cash flow was primarily generated by higher profit and a benefit from a decrease in accounts receivable, inventory and other current assets.

Our accounts receivable declined $3.9 million sequentially from continuing operations, which results in our days-sales-outstanding, which is based on our trailing monthly revenue profile to decrease from 39 days to 37 days sequentially.

Our inventory also declined $900,000 from continuing operations during the second quarter, due to inventory efficiencies.

Therefore, our days-on-hand, which has been a focus of our operations team, decreased from 50 to 46 days on a continuing operations basis during the second quarter.

Other current assets declined by more than $9 million sequentially due to the receipt of a tax refund during the quarter.

Capital expenditures and free cash flow were $19.3 million and $37.5 million, respectively, for the second quarter of fiscal 2006.

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

As we begin the third quarter fiscal 2006 we target revenue to increase to a range a 105 to $110 million, due to the growth in sales of our XLamp and Schottky diode products.

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

Research and development expenses are targeted in a range of 14 to 15% of revenue as we continue to focus on developing our high-power LEDs and higher brightness LED chips, and SG&A expenses are targeted to be approximately 10 to 11% of revenue, as we anticipate higher sales and marketing expenses for our lighting and power business unit.

In fiscal 2006 we began to expenses stock options for the first-time under SFAS No. 123R.

And as a result, our overall pretax expenses increased by approximately $3.5 million, which reduced our earnings per share by approximately $0.03 during the second quarter.

Based on an estimated 78 million shares outstanding, earnings per share is targeted in a range of $0.25 to $0.27 for the third quarter of fiscal 2006.

In the December quarter we were very pleased to deliver total revenue and earnings in the upper range of our guidance as our XLamp products led the way to our overall revenue growth.

Overall, our guidance combined revenue from continuing operations and discontinued operations.

We were also successful in manufacturing more of our LEDs from a 3-inch platform, which lowered our costs and enable us to maintain our gross margins.

As we enter the third quarter of fiscal 2006, we see additional opportunities to grow overall revenue in what is traditionally a seasonally slower period for our LED chips, from higher sales of our XLamp and Schottky diode products.

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

We will now take analysts' questions.

(OPERATOR INSTRUCTIONS).

Matthew Smith of CIBC.

I was wondering if you could give us a little bit more granularity about the revenue mix in the December quarter.

You mentioned a few times that XLamp contributed there.

I wondered how much came from that.

And when you look into the March quarter, directionally, if you can qualify it, if possible, how much of the revenue -- targeted revenue -- is going to come from XLamp?

And how do you see things building up there?

And I've got some follow-up questions.

XLamp obviously, as I said earlier, was one of the growth drivers in the quarter.

And so I think, as we look into the March quarter, we continue to see XLamp really kind of driving the LED overall revenue.

And that's real important, given the fact that our Q3 or the March quarter is generally seasonally down for overall mobile phone demand.

So what we're looking to do is use the non-mobile applications like gaming, additional marketshare to kind of try to offset the downside of the normal chip business and then use XLamp to grow in that quarter.

So we are pretty optimistic about that as we head into March.

When you look at December, did the concept cellphone businesses see any growth in LED revenues at all?

You know, overall, the hand -- if you look over the last six months you can see that, if you look at the data, the high-brightness has, on a 6-month basis, had made a pretty good move for us, which has really been handset-driven.

So I think, on a 6-month trend, we've seen a pretty good overall growth in that area.

At the same time, in December specifically, as I mentioned a little bit earlier, our customers basically got a little bit ahead of themselves.

So, net-net, it was pretty even quarter-to-quarter.

Can you describe how the pipeline of XLamp work has sort of built up since the last quarter?

Last quarter you announced the first multi-million dollar contract.

You subsequently announced another $5 million deal with Cannon.

Can you talk about what is the magnitude of work that you see out there, how much are you bidding on, how has it built up over the last three or four months?

And your visibility and level of confidence sounds good with respect to the end of year, but can you talk a bit about how you're going to get there and so on?

I think from where we are at today on XLamp -- we clearly have a sales funnel that's probably 2X what it was at this point a quarter ago.

So I think we see a lot of design activity from a number of customers.

I really don't think it's going to be major sales contract-driven, but actually a combination of a lot of different customers working on a lot of different designs.

So at this point, as we head into Q3, obviously, we have made it pretty clear we think XLamp is one of the growth drivers, and our confidence is pretty high.

Obviously, there's some execution risks associated with that, as we could be capacity constrained.

But we're doing things that we think we will be able to manage that this quarter and keep the business growing at a nice pace and set ourselves up, hopefully, for continued success as we get into Q4.

You mention execution risk, and you obviously put in a lot of cost in -- or some cost in -- with respect to developing the XLamp product.

How comfortable are you with the gross margin outlook for the balance of the calendar year?

Are you going to be able to maintain this 45, 49% sort of range, given that there's probably going to be some startup costs and so on associated with XLamp as momentum builds there?

So, obviously, we only have -- as you know, we only have targets for the March quarter, which is 49% plus or minus a couple of points, again.

As we go further out, we don't have a firm estimate for you.

You obviously understand the challenge for us, though, which is any new startup business for Cree generally is going to start out with significantly lower gross margins until you get through that investment stage.

And so it's really just going to depend on how the blend of the mix is.

How much growth do we get in chips, and how fast does XLamp grow in that balance?

I think over a longer period of time we feel pretty good that XLamp will be in the more normal range for our gross margin.

But over the next couple of quarters we are just going to have to kind of play it by ear.

One of the things you should realize is that in this quarter's numbers we saw some of those startup costs affect the gross margin from XLamp.

So they are already part of -- as you measure us from here going forward, we are already dealing with some of that as it starts to ramp up, even in or Q2 numbers.

Harsh Kumar of Morgan Keegan.

I want to ask the question that was asked earlier.

Maybe you can give us a percentage of XLamp business, if possible?

Unfortunately, we can't break that out for you at this time; it's not part of the numbers we put out there.

This is kind of a dumb question on my part, but what is the biggest obligation for XLamp?

Is it backlighting for handsets or something else?

No, no, no.

XLamp is very much a lighting-related project.

The customer that we announced last week, which is Space Cannon -- they are using it for a combination of things, things like outdoor lighting and buildings, bridgelighting.

They even have some applications they are working on for the upcoming Olympics.

So it's very much what I would call lighting or illumination-related applications on one side.

And then the other category we would generally say is specialty lighting, which includes everything from colored lights for pools and spas.

And then the third category is really kind of the colored architectural category, which is where CK would fill.

So I kind of put it into three categories -- general illumination/lighting kind of an outdoor market.

There's a specialty lighting market, which is everything from pools and spas to torch lights.

And then there is the third piece, which is what Color Kinetics does, which is really kind of a colored architectural market.

You had the first decrease in cost for LED in, I think, three quarters.

Is that primarily being driven by your 2 to 3-inch conversion reaching a certain critical level?

Can you just give us some clarity on that, what's driving that?

Definitely, obviously, as 3-inch continues to come online that helps us.

I also think you have to keep in mind that that's also a function of product mix.

So when our product mix is moving up the high-brightness change, the ASP's a little bit deceiving, because obviously you are adding in higher-value products to that average.

So you've got to be a little careful there, but definitely 3-inch was a benefit this quarter.

Now, guidance is basically going to 105 -- sorry, 107 kind of a range.

Should we be assuming that most of that -- hello?

Yes, it's on.

Should we be assuming that, for most of that increase from 105 and change is being driven by, basically, LEDs?

Or are you expecting increase in some of your other non-core businesses as well?

Our target is based on trying to drive growth in LEDs primarily from XLamp and as well as some incremental gains in our high-power products business.

Can you give us some kind of estimate or guesstimate on how much revenues you are getting from handsets, A, and then how much of it is coming from backlighting versus keypads at this point in time?

I think mobile phone products in general is about 50% of overall LED sales, which is about the same as it was the prior quarter.

In terms of keypad versus backlight, I don't have those exact numbers in front of me.

But they are approximately -- they are a similar size market for us, with backlight maybe being a little bit bigger at this point.

So backlight is greater than 50% of your 50% for mobile, at this point?

I think (Multiple Speakers)

In terms of revenues.

Yes, in revenues.

Okay, perfect, thank you.

Pierre Maccagno of Needham.

I want to ask about the XLamp.

Is that a part of your packaging now or you're outsourcing?

What are the plans for that?

The XLamp today we are producing here in our Durham factory and we're continuing to ramp that up this quarter.

And we are also in the process of qualifying a subcontractor to make some percentage of our production for us.

So it's a combination.

Right now, it's all Cree production, but by the end of this quarter it should be some contribution from our subcontractor as well.

So right now most of the packaging is done by you?

Yes.

And then could you talk a little bit about the LCD market, give us an idea of how large that could be for the TVs.

What is the content that you expect to have?

And how do you see that growing?

So, the LCD market -- there's obviously three of them, right?

There's the one we participate in today, which is the small LCDs for mobile products.

Then you have kind of got -- there is a middle market, which is kind of like mid-sized LCDs for things like notebook computers.

And then there's what we call the large LCD market, which is where we've got our Colorwave technology focused.

I think you're talking about the large LCDs; is that correct?

Correct, yes.

So that's basically for TVs or large monitors.

And if you look at the amount of lumens required to backlight monitors and look at some conversion ratio, you'll see why people get so excited about it.

It's potentially tremendous volumes.

You're talking about a market that could be -- on a unit basis it could be bigger than the entire LED market today, if there was ever full conversion.

And that's going to depend on a lot of factors including technology development and cost reductions.

But I think it's probably -- of the markets we're looking at, one of the single largest opportunities between that and then also -- a little bit longer term is, general lighting.

Those two things are probably the two biggest really large markets long-term.

But don't I want to mislead you, also.

We continue to see opportunity to grow market share in the small LCDs -- white LEDs with our chip customers.

And although our high-brightness didn't go up last quarter, our customers are actually, at their level, continuing to win new business.

So we remain optimistic there as well.

So tell me; this XLamp is right now used in handsets for the backlighting of the display?

No.

An XLamp is a very high-power LED.

So we basically, when we talk LCD backlight for handsets, that's a chip sale.

That's where we sell our X products and things like that.

The XLamp is used primarily for lighting-related applications, specialty lighting, outdoor types of illumination, signage, stuff that Color Kinetics does.

It could be used also for the flash in cameras -- in handsets, correct?

Generally, most people are not using those very high-end LEDs for flash; they are actually using a combination of smaller LEDs.

So we primarily address that market today through our chip business.

(OPERATOR INSTRUCTIONS).

Jed Dorsheimer of Canaccord Adams.

Looking at the current quarter, when you say gaming, I assume you mean Pachinko.

And I'm curious if you could talk a little bit about the demand that you're seeing in the particular quarter and next quarter.

And the reason for my asking is just because the Sumitomo business, you had mentioned, was down 10%.

So, could you give any more color or granularity there?

Let me give you kind of the Pachinko update, and then I'll address Sumitomo, because they are somewhat related and somewhat not.

Obviously, gaming, which is primarily driven by the Pachinko business, is generally stronger in our March quarter.

And so we are expecting that we'll have an additional -- we'll have a good quarter this year as well.

It's a large to forecast, Jed, primarily because it's pretty much a spot-type business; there's not a lot of long leadtime forecasting that they do in that marketplace.

But generally speaking, we are expecting it to have a good Q3.

And it's, frankly, too early to predict what it may or may not do in Q4.

As far as Sumitomo goes, if I look at kind of where we started a year ago and where we are at today, the business is still growing.

And I think, primarily, their challenge is the same as everyone else's, which is, a year ago, I think we all -- everyone predicted the LED market to grow a lot faster.

And, while it's been and okay year, it hasn't grown at the same rate.

And I think that's just represented in Sumitomo's numbers.

Looking at the OSRAM, could you talk about the impact?

Or let me ask it -- are you seeing any impact from the ThinGaN going into the Golden Dragon now over at OSRAM, where I think you previously supplied the power chip in there?

I think that we continue to sell OSRAM chips across our full range, everything from our small chips for mobile applications all the way up through our high-power products.

I know, they also have some products based on their ThinGaN.

But at this point we haven't seen a significant impact on our business from that.

And just maybe, lastly, turning to the displays in a little bit more color there, no pun intended.

If we look at the large backlighting market, I'm just curious.

When you talk about getting into production, the analysis that I've done is that when comparing an LED solution to a CCFL with inverter, it looks as if we are still about 2.3 times the cost.

And the OEMs seem to say that in the display market consumers will not pay a premium.

So I'm just curious; should we assume that we'll see price reduction of the LEDs between now and the end of the year in order to get those products into market?

Obviously, we are not in the business yet.

So, I can't -- unfortunately I don't have the cost factor in front of me;

I know it's more expensive today.

I'm not sure that's the same ratio we're working with at this point.

And we're going into this business knowing that you've got to get within striking distance.

At the same time, the people that we are talking to are looking at coming out with products that, frankly, are based on performance advantages over what is out there today.

And so I'm sure there will be a price -- I'm sure they will be priced higher than the standard product.

But we think we're within the range, and the impression they are giving us is they believe they are within the range to come on out with commercially-viable products -- again, really at the high-end, though.

I don't think we're looking at the 80% adoption rate;

I think we're looking at the 10% high-end type applications that will be looking at this first.

And then, what that does is, obviously, as we get his applications, that can drive volume, and volume drives cost.

And I think, over time, the two come together.

Does that make sense?

Thank you.

As far as the design, are you populating directly behind the display with a red, green and blue?

And are you using a Lambertian emitter on that?

Our Colorwave technology is -- we don't get into too many details.

What I can tell you is it is a DirectView-type backlight system.

The transition to 3-inch seems to be going a little bit better-than-expected for you.

Should we look at the slight hit in gross margins as just the XLamp introduction?

Or did utilization rates fall during the past quarter?

I would say that our margins are pretty much in line with where we thought they would be.

So I'm not sure what you mean by taking a little bit of a hit on margins.

But I think, in general, the 3-inch progress we have made is in line with where we thought it would be, so we continue to make steady progress.

And the good news is that while we have about 80% of the chips coming from 3-inch, a little bit -- around 60% of our wafers are3-inch.

So we still have some more benefits to come from 3-inch, and we're going to continue to execute on that conversion.

So I think it'll continue to help us.

But, to your point, XLamp, as we have said earlier, has slightly lower margins than our chip business.

So, as that ramps up, it could give us a little bit of a drag.

But for the Q3 time-frame we have given guidance that we would be around 49% again.

So hopefully that will be your best indicator of where we think we're going.

Michael Burton of ThinkEquity Partners.

I might have missed this, but I think you mentioned that there may be a lease obligation write-down in Q3?

No; we took it in Q2, already.

Okay, so there's nothing left there.

Alright, great.

Secondly, do you guys have a targeted rate that you are looking at for R&D and SG&A as a percentage of sales going forward?

Yes.

We have talked about how we are targeting about 25% in the Q3 number.

And as we go forward the thing to keep in mind is that he we're generally in investment mode with two business right now -- between XLamp, we're investing in our Colorwave technology, which is a little bit longer term.

And we also have our power switching business.

So, at this point, we're going to make those investments, and that percentage is going to be a little bit of a function of how well we're able to grow revenue.

But we're going to make the dollar investments, in either case, in the near-term.

And I think, as we get a little further into the year, as we start to get some additional revenue momentum on XLamp and our power business, then you'll start to see those numbers move back the other way a little bit.

Does that make sense?

Hans Mosesmann of Moors & Cabot.

Can you give us an update on the laser development and how that's coming along as it relates to potential Blu-Ray opportunities down the road?

Yes.

Obviously, the CES show generated a lot of excitement again for that, especially with announcements like Toshiba out there getting pretty aggressive.

From our standpoint, the market -- although there's definitely more excitement and I think we're starting to see some momentum from the people building the systems and getting stuff out there, it's still in it's early-stage.

And from our standpoint, we still haven't finished the development activities to get us to the lifetimes that we need.

So the good news is there still an opportunity ahead of us, and we're moving toward that.

At the same time, we've got to get the R&D finished.

And I think we made technical progress last quarter, but we are not there yet.

And until we do, we can get can't get into that game.

So at this point it's keep our head down and keep working on the R&D, and hopefully we will get that done here over the next few quarters and be able to get into the game.

And then a couple of follow-ups.

Going back to the XLamp, which is the meat of this conference call, it seems -- XLamp, as you set up distributors and relationships globally, when you ship product to these distributors, is it a sell-in or sell-through type of arrangement and how is that going to be done going forward?

Actually, in our XLamp business, some of it goes through distribution.

But a lot of it is, we're actually developing a lot of direct customer relationships at this point.

What we're finding is that, obviously, in certain countries we have distributors.

But there is -- I would say right now it's much more similar to what you're familiar with, which is the old just engineering design-in type sales.

So, these tend to be -- even if there's a distributor involved, these tend to be -- the demand is driven by specific projects that we win and then drives the demand from there.

So it is not really traditional distribution at this point.

Does that make sense?

Yes, it does.

The Sumitomo -- did you say that Sumitomo was down 10% in the quarter?

Or somebody may have said that;

I just want to get clarification.

No, no.

I said at this point Sumitomo is running at about 10% below the $200 million target contract rate that we started with about a year ago.

So we gave you kind of a rate that they are running at for the year.

I didn't catch the -- there was reduced allowances for returns?

Is that correct?

Yes.

What was the amount and the impact?

Yes, we reduced our sales allowance reserve by $1.3 million on the revenue line.

There's also an increase to cost of sales of about $200,000.

So the net impact of that adjustment is about $1.1 million benefit to the gross profit line.

Jed Dorsheimer of Canaccord Adams.

On the Space Cannon contract, is that in addition to the multi-million dollar contract you had last quarter?

Or was that actually the multi-million dollar contract?

Space Cannon is the specific contract we were referring to last quarter.

It looks like taxes, I think, were 36% this quarter.

How should we look at tax expense on a go-forward basis?

No; taxes were 32%, and I gave that remark in my script, that I expect that for this fiscal year.

Pierre Maccagno of Needham.

Regarding the possible capacity constraint, is that coming from the packaging part or the chip manufacturing part?

The capacity constraint is related to our XLamp packaging area.

So we actually believe we have the capacity in place or what -- we had the things in control of what we are trying to do here.

But at the same time the business is growing at a pretty rapid rate, so we really want to get the subcontractor online this quarter as well.

Long-term, you plan to have it all in-house, correct?

No, I think long-term, actually, we're going to have a split strategy.

I think you'll see us have some of our internal manufacturing capability.

I think there's a tremendous benefit to that.

At the same time, we have some subcontract partners we think we can leverage to be able to utilize them as well to be able to respond to increasing demand.

In terms of the chip manufacturing, how is the capacity utilization there?

Yes, the utilization there -- we don't break out specifically, but it's fair to say that we have some amount of burst capacity available.

One of the things to keep in mind, as we have converted to 3-inch, that that provides additional capacity in the same factory as we do that.

And so, while we are definitely getting some benefit as we convert, the full benefit you don't get until you actually get the factories fully loaded, which is not at this point.

There are no further questions at this time, sir.

Are there any closing remarks?

Thank you, Alicia.

We appreciate your interest and support and look forward to reporting our third quarter of fiscal year 2006 results on April 20th, 2006.

Thank you.

Thank you.

Thank you.

This concludes today's teleconference.

You may now disconnect.