Wolfspeed Inc (WOLF) 2007 Q2 法說會逐字稿

At this time, I would like to welcome everyone to the Cree Inc. second quarter 2007 fiscal year financial results conference call. [OPERATOR INSTRUCTIONS] As a reminder, ladies and gentlemen, this conference is being recorded today, January 18, 2007.

Thank you.

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

Mr. Garrabrant, you may begin your conference.

Thank you, and good afternoon.

Welcome to Cree's second quarter fiscal 2007 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'll be pleased to assist you.

Today Chuck Swoboda our Chairman and CEO; and John Kurtzweil, Cree's CFO will report on our results for the second quarter of fiscal year 2007.

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 the SEC filings noted in the release, mention important factors that could cause actual results to differ materially.

Also, we would like to note that as a result of SEC rules we will be limiting our comments regarding Cree's second quarter of fiscal year 2007 to a discussion of the information included in our earnings release and the materials posted on our website which you can find at www.cree.com by clicking on investor information and then click on financial metrics.

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

This call is being recorded on behalf of the Company.

The presentations and the recording of this call are copywrited property of the Company and no other recording is permitted unless authorized by 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're also webcasting our conference call to allow more flexibility for our conference call attendees.

A replay of the webcast will be available on our website through February 1, 2007.

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

Thank you, Raiford.

As we announced in early December, the second quarter was more challenging than we had originally targeted.

As revenues declined $89 million due to lower LED chip sales.

The LED slowdown was primarily due to lower sales of our mid brightness chip products for mobile phones and other applications.

Despite the challenges in the LED chip market we continue to make progress on our strategy to expand our business by leveraging our strengths in LED chip and silicon carbide materials technology to broaden our product line with higher value, component level products for they emerging markets in LED lighting and power.

During the quarter we successfully launched our new XRE series of XLamp LEDs and secured the first customer design wins for these products in high performance flashlight applications.

We expanded our product offering for silicon carbide power devices and we continued to build our sales and distribution capabilities with the hiring of Bob Pollock our new VP of Sales and the signing of our global distribution agreement with Arrow Electronics.

Our new LED lighting and high power product lines delivered double-digit growth in Q2 with LED component sales increasing to more than 10% of total LED revenue for the first time.

The growth in these new product lines is an important leading indicator of how we plan to grow the Company over the next several years.

I will now turn the call over to our CFO, John Kurtzweil to review our second quarter financial results and targets for Q3.

Thank you, Chuck.

For the second quarter of fiscal 2007 we reported revenue of 88.8 million with net income of 16.5 million or $0.21 per diluted share.

Earnings included a gain from the sale of marketable securities of $0.15 per diluted share related to the sale of a portion of an investment.

Revenue decreased 16% year-over-year and 15% from Q1 and was slightly below the revised targets provided in our press release dated December 7, 2006, as we increased our sales reserves to reflect the slowdown in our chip business.

These results included stock compensation expense of 2 million net of tax or $0.03 per share.

Please see the metrics page on our investor relations website for more details.

Q2 LED revenue of 65.5 million or 74% of sales declined 21% over Q1 and 24% from last year.

LED unit shipments decreased 15% from Q1 primarily due to lower sales of our mid brightness chip products for mobile phones and other applications.

LED units shipments increased 5% from last year.

Our blended average sales price for LED declined 7% from Q1 and 28% from last year.

The decline in average selling price was slightly less than the 11% in Q1 as a more favorable mix of higher price, high brightness chips partially offset the pricing pressure we experienced.

LED blended unit costs rose 10% from Q1 and 3% year-over-year as we built a higher percentage of high brightness products and had lower factory utilization in an effort to minimize the inventory build.

Our mix of mid brightness devices decreased to 52% of LED revenue from 64% in Q1 and 63% last year and was driven by lower orders of mid brightness chips for mobile phones and other applications.

High brightness product revenue increased to 48% of LED revenue from 36% in Q1 and 37% last year.

Q2 materials revenue which includes wafers and gemstone products was 10.6 million or 12% of sales and increased 4% sequentially and 16% over last year.

High-powered products revenue which includes Schottky diode and wideband gap microwave sales was 5.3 million or 6% of Q2 sales and increased 18% from Q1 and 75% over last year.

Contract revenue was 7.3 million or 8% of revenue for Q2 and increased 12% from Q1 and 6% over last year.

Q1 gross margin declined to 34% of revenue from 41% in Q1 and 49% last year.

The decline in gross margin is primarily attributable to lower factory utilization, continued pricing pressure for LED chips and higher start-up costs related to new product lines.

Contract gross margins decreased to 20% of revenue compared to 21% in Q1 and 27% last year as our mix of contract work has shifted toward projects that have a higher cost sharing component.

Q2 operating expenses of 27.3 million were generally in line with previously targeted levels and represented 31% of total revenue compared to 25% in Q1 and 24% last year.

Research and development expenses of 14.6 million or 16% of revenue were in line with Q1 and Q2 of last year.

Our research and development spending has continued to be primarily focused on EasyBright, XLamp, Colorwave, high power devices, and larger wafer development.

SG&A expenses increased by 0.6 million from Q1 and 1.8 million from last year to 12.6 million or 14% of revenue.

These expenses reflect planned spending to build our sales team and launch new marketing programs focused on developing the Cree brand plus increased legal expenses.

Net interest income of 4 million increased 0.1 million from Q1 primarily due to slightly higher interest rates.

Our effective tax rate for Q2 was 12% as we realized the gain on sale of investments of 11.4 million which was offset by preexisting loss carry forwards.

Specifically, we sold 931,275 shares of Color Kinetics in connection with their recent common stock offering generating net proceeds of approximately $17 million.

We are estimating the effective tax rate to be 31% which is better than we discussed last quarter and now reflects the reinstatement of the R&D tax credit going forward.

In June, 2006 our Board of Directors approved an extension of our stock repurchase program through June 2007.

During Q2 we repurchased 767,082 common shares for 13.3 million or $17.30 per share.

Year-to-date we have repurchased 1,067,082 common shares for 18.7 million or $17.54 per share. 4.4 million shares remained authorized for repurchase as of December 24, 2006.

Our balance sheet has remained solid.

Our cash, short-term, and long-term investments stand at 331 million, a decrease of 3 million from Q1 and 7 million from last year.

Cash flow from operations was 18.4 million for Q2 and capital expenditures were 26.8 million.

We targeted our capital expenditures to be in the range of 90 million to 100 million during this fiscal year.

This is 10 to 15 million lower than we were targeting last quarter as we have adjusted our capital spending through our revised revenue forecast.

Accounts receivable were 64.5 million at quarter's end, a decrease of 7.8 million from Q1 and an increase of 17.4 million over last year.

Our day sales outstanding increased to 65 from 63 in Q1 and 40 last year.

Inventory was 48.7 million at quarter end, an increase of 8.5 million from Q1 of which raw and whip accounted for 6 million of the increase.

Our days of inventory increased to 75 from 59 in Q1 and 46 during the same quarter one year ago.

The increase in inventory is primarily attributable to the lower than targeted revenue as a production plan was based on expectations for our higher targeted level of shipments.

Looking forward, we have slowed the factory to align production more closely with our estimates for end market demand.

We target inventory to decrease slightly in Q3 and further reduce inventory to more appropriate levels in the subsequent quarters.

Now I will give you an update regarding our outlook for the third fiscal quarter.

We are targeting revenue to be in a similar range as the 89 million reported in Q2.

We target incremental growth in LED components and EZchip products to help offset the normal seasonal slowness for LED chips in the mobile segment.

We targeted gross margins to be plus or minus 34% of revenue as the near term market conditions for our LED chip products continues to be challenging and the new products are currently contributing margins below the Corporate average.

Operating expenses are targeted to be approximately 31 to 32% of revenue.

Research and development expenses are expected to be similar to Q2 and continue to be focused on EZBright, XLamp, Colorwave, high power products, and larger wafer developments.

SG&A expenses are expected to increase as we expand our investment to build a global component salesforce and add resources to support our new distributors to drive growth for our lighting and power products plus increased legal expenses associated with protecting Cree's intellectual property.

Based on an estimated 77.5 million diluted shares outstanding, we target earnings per diluted share in a range of $0.04 to $0.05 for the third quarter of fiscal 2007.

Thank you.

I will now turn the discussion back to Chuck.

Thanks, John.

While the slowdown in our LED chip business has created challenges in the near term our overall strategy has not changed.

We're taking steps to manage near term fixed and variable expenses but we must continue to invest in LEDs and materials technology to provide higher performance capabilities for both our core businesses and to enable our new component products in lighting and power to drive the overall growth of the Company.

As we have outlined over the last few quarters, we're focused on five key areas to drive our strategy.

Our first priority is to ramp up EZBright LED chip production and expand the product family.

EZBright shipments continued to increase in Q2 as we started to win some business in gaming and signage applications with our EZ 290 chips and in camera flash and lighting applications with our high power EZchips.

We continue to work with our customer to qualify our EZ products for mobile white back-lighting applications and we currently target the first design wins to go into production in our fiscal Q4.

We're working on additional EZ products planned for release over the next two quarters to support both our LED chip customers as well as our internal LED component product lines.

Our second priority is to expand our component level product sales.

Component product revenue increased in Q2 for both LEDs and high-power products.

We've gotten great customer feedback on our new XRE series XLamp LEDs which are the first lighting class power LEDs in the market.

These products have raised the bar on power LED brightness and efficiency and are enabling some customers to consider using LEDs for applications that they previously viewed as several years off.

We have already secured customer design wins for this new product with several of the leading high performance flashlight manufacturers.

Based on these customers' comments it seems clear that improved brightness and efficiency can drive new design wins.

We target further success over the next several quarters and we continue to work on new designs some of which may take six to twelve months before they go into volume production.

We continue to develop LED products for both wide color gamut LCD back lighting and edge lit LCD back lighting.

We're working on component level products and systems technology to help enable these applications.

We currently have customer projects on both types of back lighting, and we remain on track to release our first products within the next six months.

High power product sales increased in the second quarter for both our silicon carbide Schottky power switching devices and our silicon carbide MESFET RF devices.

We target some incremental growth for these products over the next several quarters as we further expand our product offering to address additional slots in the current application such as server power supplies.

We're also working on mid-term projects to enable new customer products that can deliver higher levels of efficiency and more fully leverage the capabilities and value-added benefits of our silicon carbide and gallium nitride device technology.

Our third priority is to accelerate our cost reduction efforts.

We have qualified our first LED chip products on 4" and we plan to start running a small percentage of LED production on 4" wafers in the third quarter.

With the recent slowdown in the LED chip product line, we're not fully utilizing the factory which reduces some of the near term benefit of converting to larger wafers.

We will continue to qualify additional products on 4" over the next two quarters and convert products as appropriate to balance factory utilization and costs.

We increased our LED chip production in Asia over the last quarter and we continue to evaluate opportunities to further leverage lower cost capacity.

The Schottky diode product line is in the process of finishing their 4" qualification, and we should be converting fab starts over to 4" by the end of our fiscal Q3.

Our fourth priority is to expand our sales, marketing, and channel capabilities.

In the third quarter we hired a new Senior Vice President of Sales, Bob Pollock who brings almost 30 years of component level sales and sales management experience to Cree.

We signed a global distribution agreement with Arrow Electronics for our XLamp LEDs that should significantly expand our sales activity while leveraging their portfolio of complementary products and services.

We've expanded our sales team with new sales people in the U.S., Europe, and Asia.

Our marketing activities are helping to drive awareness of both our products and our brand as a premier high performance components company.

Overall we made tremendous progress building our sales, marketing, and distribution capabilities over the last quarter.

With our investments in this area, we should now have the core resources in place to start to drive additional sales momentum over the next year.

Our fifth priority is to identify and develop strategic opportunities to expand our product portfolio.

We continue to look for ways to leverage our strengths in technology and IP with our growing investment in component sales, marketing, and distribution to expand our product offering in lighting and power to build additional scale.

Our goal is to bring some of these opportunities to closure over the next twelve months.

Despite the near term challenges in our LED chip business, this is an exciting time at Cree.

Our continued investment in new technology like our EZBright chip platform and new lighting class XLamp LEDs has Cree better positioned today than ever before to deliver enabling component level products that can win in lighting and power.

We are starting to have some success in these new markets and our sales, marketing, and distribution capability has made great strides in the last six months and should provide us with new access to customers and applications that we simply could not reach or support in the past.

We need to manage the challenges in our LED chip product line and we're working on projects to improve our competitive position with further improvements of our EZBright product family and the qualification of 4" production capability.

We continue to have a very strong balance sheet that puts us in the enviable position to be able to continue to invest in the critical technology, products, and infrastructure to enable our future growth.

As we look ahead to our fiscal Q3, we target incremental growth in LED components and EZchip products to offset the normal seasonal lowness for LED chips in the mobile segment.

As a result, we're targeting overall revenue for the third quarter in a similar range as our Q2 results.

In summary, we are focused on the key points of our strategy and although we still have a lot of work to do, you can see from our results in Q2 that we are making good progress, and the early indicators are encouraging for growing revenue with our new component product line.

We will now take analyst questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Amit Kapur with Piper Jaffray.

Just have a couple of questions first maybe related to some of the mobile phone weakness you talked about.

Were you seeing weakness in overall units or was it just the continued mix shift towards some of the low end phones that maybe reduced some demand for LEDs, maybe if you can give a little bit more color on that?

Yes.

Basically what we saw last quarter was I think there was an overall slowdown in demand from an LED standpoint.

I think that's pretty similar to what we saw and many of the other people in the LED sector saw related to that.

As far as total mobile units, really what we're tracking is the LED usage side of it, so I really can't comment on total mobile phone production because there may be an increase on the low end that's offsetting it from a total unit percentage, but in terms of total LED consumption, what we saw was that it was down last quarter.

Okay.

Just to clarify it was probably more a unit issue rather than the pricing environment being significantly worse than you thought it would be?

I think what happens is that as the units come down the pricing environment gets worse as well.

I think it is fair to say it was a highly competitive quarter because once the unit slows I think it only increases the competitive dynamics.

Maybe that would segues into my next question in terms of just the overall competitive environment you're seeing.

In the past you've talked about [Nachia] being very price aggressive in the market and also facing some competition out of Taiwan, maybe you could update in terms of the overall environment you're seeing.

It probably hasn't changed a lot recently.

I think on the high-end it is still obviously Nachia owns the most share and they're defending their market pretty aggressively.

And obviously it's Cree and TG trying to win that share.

I think we've seen some data recently that came out of Japan where Nachia has commented that their margins have taken a pretty big hit over the last year, so I think they're seeing a similar phenomenon.

That would be the high-end.

On the low end continues to be primarily competing with the various suppliers generally out of Taiwan, and again there are people that are trying to keep their fabs filled, so I think that's driving the pricing dynamics overall.

Great.

Maybe one more question before I turn it over.

You talked a little about your own CapEx plans.

As you look across the industry, do you see more industry capacity being added in 2007 than we saw added in 2006 or what are some of your competitors doing in terms of some capacity add-on?

Generally speaking, I don't see capacity addition as a big driver of any of our competitors right now.

Obviously I think there is people that are making investments, but it is more technology driven than capacity driven.

In fact, one of the things we're seeing in Asia is that with the consolidation, for example at Epistar, the comments I have heard is they have got plenty of capacity.

They're mostly trying to figure out how to manage that consolidation and utilize it, so I don't see a big year -- at least at this stage for capital investments in terms of capacity driven.

Great.

Thanks a lot, guys.

Sure.

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

A couple of questions for you, Chuck.

First of all, how should we look at the -- how should we look at your LED business going forward?

I was a little confused with your commentary.

You expect the lighting business to be a growth business in the March quarter or the entire LED segment for your company to be a growth business in the March quarter?

Let me see is it I can clarify.

So, Harsh, what we're basically looking at is that we're seeing two areas of growth which is the EZBright chip product family and so that's a combination of applications.

It is things I mentioned earlier, things like everything from gaming to camera flash to some lighting applications, but that's really at the chip level, and then we also see continued growth in the LED component side of our business which is obviously focused on the wide array of lighting applications, everything from personal lighting to vehicle lighting and those types of things.

I think it is a combination of the LED component sector which includes lighting as well as some of the new EZBright chips for a variety of applications, and what that's doing, that's really offsetting the seasonal slowness in the overall chip business, so it is kind of a net wash.

Slowdown in chips, for the seasonality being offset by some incremental growth in EZBright as well as LED components and kind of gets us back to an even number.

So let me see if I understand this correctly.

Sorry I am still struggling with that.

Your mid brightness business, pretty fair to say will be down then while the high brightness business might be up.

Would that be a good way to think about it?

Yes, obviously, -- yes, with those friends trends out there, clearly the -- both the EZBright and the components tend to fall in the high brightness category.

That's a fair statement.

Chuck, how about going forward and beyond that, I know that you had a goal of about 60 to 70% growth over the next three years or so.

Is that still a pretty valid number?

Is that -- LED is something that we can look for growth beyond the March quarter, possibly out?

Yes.

As you know, Harsh, that's a three-year objective, and I actually don't see any reason that that's still not what we're going to be shooting for.

I think that as we continue to develop these products and get the sales channels in place, we really think there is tremendous market opportunities both in the LED side of the business and also in some of the new high power areas where that would be power and over time even RF.

We can drive the growth.

And so we still remain pretty focused on achieving that objective.

Great.

And then on the gross margin side, obviously you might be at a trough or might be a challenging times right now, but how should we think about your gross margins as we look out, let's say just beyond the March quarter, maybe a year out or so on and so forth?

I think that if I look out a year from now, obviously as we get some scale and some utilization back in the factory that's going to help us on the one side.

We've obviously got some pretty good cost reduction levers, but it takes volume to help utilize those on the chip side.

Then, what's on the other side of it, the new products, a year from now if we continue to build scale, obviously critical to drive the volumes up and build those businesses, and I don't see why we can't get it up closer to the 40% range.

Obviously our target is to try to get it back there.

I can't tell you if that will happen in three quarters or six.

But that's where we think we're headed back towards, and obviously we got some work to do to go make that happen.

Obviously as the component businesses grow, remember, Harsh, one of the things we can do is we have some ability to drive our own utilization since our internal product lines can drive the utilization on the chip side, so the goal is if we get the products out there and get the sales team to win those new designs, I think we can drive that.

Got it.

That's actually very helpful.

Last question and I will turn it over after this.

Tax rate should we be assuming 31, 32% for quarters beyond March?

Yes.

This is John.

That's the rate we're planning on all the way through next year as well.

Got it.

Thank you, guys.

Sure.

Your next question comes from the line of Pierre Maccagno with Needham & Company.

Hey, Chuck.

Hi, Pierre.

If you can give an overview of, at this point in the industry, what are the issues or opportunities regarding the LCD back lighting and the Edge back lighting and how close are we for this market to really take off because I think that's what's really going to drive the growth at Cree?

Well, based on -- you have the wide color gamut which is really the RGB large scale back lighting for things like TV's and maybe even some high end monitors, that segment, in that market we continue to see people in a lot of design activity.

There has been some people talking about some models that might be coming out although no one is really on the market selling them yet, we continue to move down that road.

We think there is definitely an opportunity for higher color fidelity products to -- for certain applications, but it is going to be focused on the high-end.

I think in the next twelve months obviously our goal is to get a product out in the market within the next six but sometime over the next twelve months I think we are going to see some products hit the market and test that, and I think -- so we'll be able to validate what is the value proposition our consumers is willing to pay for it.

Something to keep in mind is there is going to be a price premium associated with that technology.

Now, the other side of the market is the Edge-lit.

That's really where most people are talking about using Edge-lit.

This is a white LED approach primarily focused on the notebook segment right now.

There is a number of companies talking about projects that they have going on to try to get something released here sometime over the next -- most discussions talk about some models hitting in the summer.

Again, there has really only been a couple models that have tested this in the past, and the big guys haven't really gotten in the business yet, and I think that's what people are speculating is going to happen.

We've got some projects we're working on in that area, and we hope to be a part of those things, but that's a little bit different.

There is a much smaller price premium to enable that.

It is much more about adopting really LED technology in place of the CCFL that is in there today and really trying to drive a combination of design, form factor benefits, as well as some battery savings, and so I think you will see a lot more discussion about that, but I think we'll probably still sometime over the next six months I think we'll see the official announcement of the first products out there and we're competing with other people to try to win that business.

The issue there has been heating problems, correct?

Two different issues.

In the Edge-lit it is really not about heat.

Most of the issues in the Edge-lit business which is white LEDs have been either about cost or really one of the bigger issues recently has been the white LEDs necessary for a notebook backlight have to be much higher reliability than the LEDs that are good enough for your mobile phone.

There has been a lot of work on LED reliability, lifetimes that frankly exceed what's been available in the market in the past, and then also there is a big concern here really about -- the big OEMs like to really understand things like IP and supply chain things and so I think there is work on that side.

On the RGB side of it, that's much more about power consumption, heat, and things like that.

We believe that our Colorwave system solves the technical issues and it's really coming down now much more to are they willing to pay the premium for that solution?

Two different issues driving those two different markets right now.

And the Edge-lit, will you sell the package to chip or the package lamp or you would sell the chips for that product?

Really we're approaching it both ways.

Obviously we continue to sell our chip products for that marketplace, but we also have some programs where we're working with some companies like as we announced previously with LightOn where it is really we're doing more than just the chip, we're cooperating with them from a packaging standpoint and getting a little bit more involved in the final design of the product.

Okay.

Finally, your utilization what was it this quarter?

We don't give out a specific number, but I can tell you, Pierre, that it ended down pretty significantly.

Obviously we slowed the factory down a lot once we saw that the revenue wasn't coming in, so it is fair to say we got some excess -- we have some available capacity to support our future growth at this point.

Okay.

Just one last one.

If I hear your LED unit went up 10%, so what really went up was the power lamp, is that what drove it?

I don't think the units were up 10%.

Let me just check that.

Actually I think that from a unit standpoint they were actually down 15% sequentially, Pierre.

I think you're talking about maybe the costs were up quarter-over-quarter, and that's just a mix shift.

There is more high brightness and more costs associated with that as well as under utilization of the factories driving that as well.

Okay.

Thanks.

Sure.

[OPERATOR INSTRUCTIONS] The next question is from the line of Jiwon Lee with Sidoti and Company.

Hi, Chuck, just a quick question.

In terms of your internal production process to go after this high brightness component, did I hear you correctly, I think that you said to get that margin up to 40% level you feel that volume is more significant than whatever else is on the production side that you're doing?

In other words, how farther do you feel that you are along in terms of getting the full yield from these processes on the component side?

Yes.

Let me clarify what I was saying.

I clearly think that volume and scale are going to drive down the costs.

These are still -- we're still -- have a relatively small, although we finally are at the 10% of LEDs, it is still a relatively small scale business for us.

I think there is tremendous opportunity from driving scale over time to reduce the costs, but you're also correct.

Especially with the newer products that we're just launching and ramping up, we're still doing things like improving yield, refining processes, things like that.

So the traditional things that you would expect, yield improvements, learning curve improvements, process improvements.

Those are also going to be a factor.

But at the end of the day, from a component standpoint, we still don't have the scale yet to really drive some of the costs as well.

It is a combination of both.

My message really is until we have the scale, I don't think we're going to have the volumes to drive the cycles of learning to get the yields to where we want to do.

They kind of go hand-in-hand.

Fair enough.

And could you guide me a little bit on your sales trend in Japan through the quarter?

Yes.

I would tell you that Japan is pretty representative of the rest of our business.

We've been talking -- we know that the competition there increased, and we've kind of been talking about that for the last couple quarters, and the Japan business is really not any different than the rest of our business.

It has obviously slowed down from where it was a year ago, and we're working through those challenges and trying to work with our customer to win new design wins.

It is pretty -- I would say it is not -- I don't think it was significantly slower than the rest of our business last quarter.

I think it is pretty in line with the market.

Great.

Thank you.

Sure.

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

Hi, Chuck.

Thanks for taking my question.

No problem.

Just two actually, pretty straight forward here, but as a follow-up to the last question, could you comment on business in Korea and what you're seeing from a term perspective there, particularly in -- if you could segment out both on the handset side and then also on the -- your power chip, your power dye that you're selling into that market, too?

I would say that -- we don't break it out by market, but in reality I think, Jed, you could pretty -- our trends are pretty similar independent of the region that we're selling in right now.

I would say that we are -- continue to have some success in the -- really more in the handset I would say, our success is really more driven probably today by the display than the keypad.

If you look at last quarter with the mid brightness decline, it is pretty clear that our keypad business suffered more than our display business.

In fact, the high bright segment did pretty well quarter to quarter.

That's hanging in there obviously better than the mid brightness keypad side, but we're definitely having some success on the high-power LEDs.

Overall, the two combined are really what's driving that segment, and clearly the EZBright, it gives us and our customers a pretty big performance advantage.

It has really been a bright spot for helping drive some of these new applications, and they're not just lighting.

They kind of range from lighting, but they also get into things like camera flash.

Got you.

Just as maybe a follow-up to a point you brought up, the -- as you're focusing more on the display market, it looks as if that total available market is shrinking quite fast as you see Motorola with the Motophone that's gone on the E-ink solution, and you have got Samsung SDI that's been recently pretty aggressive in the market with their successful O-LED 2.2" display.

What are your thoughts on some of these alternative technologies, and as you move from the keypad to the display market, what's the risk that you're sort of moving into a market that won't be able to grow for you?

Given the fact that on a relative basis we still have pretty small share in the display piece of it, so absolutely.

I think, though, that those other technologies are less of a factor on the market than the competitive situation is today.

There is still tremendous volumes being consumed to back light small LCDs, and so I still think there is an opportunity for us, but it is an incremental opportunity, and -- but all things considered given that we have a relatively small market position it is still a nice opportunity for us to continue to pursue, and we're doing that in addition to everything else.

I think that it is really -- our strategy is -- that is one of the white applications that we want to win in, and we think it still provides for Cree a pretty good opportunity.

Got you.

Can you make any comments?

I think if we go back, I don't know, eight conference calls or seven conference calls there, I think once you did make a comment regarding sort of the breakout from a business perspective with sort of 50% and then it was -- I think there was a general comment that it was -- could view it as 75/25 between Keypad and between display, can you give any sort of update as far as what the display and what the keypad may represent out of that total handset proportion?

What I can tell you is that Keypad now represents less than half of our mobile business.

All right.

That's helpful.

Thank you.

Sure.

And one last question, maybe better for John, just looking at the inventories, inventories jumped up again, but at the same time gross margins look like they've also ticked down, so I am wondering if you could -- I got on the call late -- maybe give some color on inventories there and looking forward at margins, if you could give some additional color on what's causing the bottom to drop out in these margins?

In terms of the -- let me get the inventory question first.

In terms of the inventory, the inventory grew about 8.9 million last quarter, and of that about a little bit over 6 million of that was in whip and raw.

All of that is going to be good inventory.

It is just a matter of slowing down the factories and consuming that.

That's what we're going to be doing over this quarter.

We continue to the review the inventories going forward making sure that we've got good inventory in there, so that's really not an issue.

The inventory growth was based on slowing the production plants, which, as Chuck said earlier, and like you got on the call late, but we had lower utilization in the factory, and that you spread your fixed costs over a smaller base as well.

And, Jed, that's part of where then you get into your gross margin question because what we've got is that the gross margins, although we did build inventory we didn't build as much as we would have if we would have stayed on plan, and so clearly we had some effect on gross margin from an under utilization standpoint.

I think the other thing to keep in mind is that the -- if you look at the mix shift in what's going on in our business, the fact is that although the mid brightness shrunk they were still under a lot of pressure last quarter.

That also had an effect on that in terms of driving the mix down, and also we have a higher percentage of some of the newer products which are still below the Company average, so they're still blending that down as well.

Got you, maybe one last question.

Sorry.

I know I said that before, but--.

That's fine.

As far as the gross margins go, could you -- I know you've got a couple things going on where you have got low factory utilization that's hitting your margins.

I would have thought that the 8.9 million would have actually helped out margins and you wouldn't see the fall off that we saw.

Could you maybe give some additional color on what, from a margin perspective when you look at the two movements that you've done, one is moving production to the 3" from a cost perspective, and then, two, moving to the packaged for the power products, can you maybe talk about what the contribution between those two movements is causing from a margin perspective and I am just trying to -- and what I'm trying to get at is we look at your business, there has been a shift.

Other than just the utilization, so are we until you're able to get to some level is this business sort of a 35% type margin business in the next year, for example?

Yes.

I don't know.

I think the timing of that is really going to depend on how fast we get the new businesses ramped up, get the benefits from the scale, so I think that we're expecting incremental progress each of the next four quarters as those new businesses ramp up, and that should help from that standpoint.

But the reality is they are below the average right now.

So they are bringing that down, and I think that's fundamentally a matter of it's new products, relatively low scale, and still some immature yields that we're working through.

I think we're fighting all the traditional things you would think about on that side of the business, and that's probably -- I don't have it broken out this way, Jed, and John can comment if he wants, but I would say that's probably the drop.

Rough numbers I would say it is probably around half of the drop, and then the other part is simply that the inventory helped us, but the reality is that we still didn't build a lot of what we would have otherwise for our original plan, and so while some of it is in inventory, some of it truly went into some utilization, and then also remember that pricing was pushing pretty hard on the low end of the market.

So I think it is a combination of factors.

I think that obviously our targets for this upcoming quarter are pretty much in the same range, and it is really going to be the growth of the business that's going to give us that leverage going forward.

The other thing to keep in mind is that 4" will help us, but 4" is going to help us more once we get the volume moving, because obviously bigger wafers without the utilization, you only get a partial benefit.

Does that answer your question?

Yes, it does, but the last part just moving to the 4", isn't that going to only reduce your utilization more because you're going to be able to -- I mean I know yields will fall down, but are yields going to take a fall such that you're seeing basically a flat move from 3" to 4" as you go up from a chip perspective?

Or I would think as you're doubling your output as you make that move or more than doubling it, how can you manage utilization rates because as you move to that 4" because you're increasing your capacity at a significant pace on that move?

Yes.

So -- and you don't have the benefit of my earlier comments, so one of the things is while we have qualified it we're only converting a small percentage of our production to 4" in the short-term.

The comment earlier was we are trying to balance costs and utilization.

One of the things to keep in mind is that you do get some incremental benefits by going to 4" even if the utilization declines.

There is still -- there are still improvements you get, for example, large die yield better on a large wafer than they do on a small wafer as an example because you have less EdgeX losses.

There are some incremental benefits.

There is lower handling.

We do really get some variable benefits and some yield benefits depending on the products.

We're going to be pretty selective in the next couple of quarters and then obviously as the business ramps over time the idea is to have those products qualified and we'll launch those as they make sense, but if you're -- I think your question is are you going to get a lot of benefit in the short term, no, and our targets kind of reflect that.

We think that those benefits come a little bit further out as we get the volume to help drive it.

Thanks.

One final to move as you've done a good job adding some new distributors for some of these power products, what are the costs associated with adding those new distributors?

Are you paying them in stock or are there going to be -- how is that going to flow through operating costs or how will those costs -- or is that going to flow through operating costs or how will those costs -- or is that going to actually come in from a margin perspective?

It will actually be reflected in the margin is how that comes in.

All right.

Thank you.

Thanks for answering all of my questions.

Hey, no problem, Jed.

Your next question comes from the line of [Biden Naughtman] of Davenport & Co.

Hi.

A couple of quick questions.

First, can you just talk a little bit further about the increased selling effort that you're doing and maybe sort of how much infrastructure is in place, where you need to add infrastructure, and how we'll see that reflected on the income statement over the next few quarters, or how much growth we should look for in that line?

And then secondly, you talked about further building out the component product line, if you could talk a little bit about how complete you think that is and then what areas you need to do some work there?

From the sales side first and then I will come back to the component side of it, from a sales standpoint we've made a lot of additions here over the last few months, some even over the last few weeks, and it really comes in two flavors both there's Cree heads that we're adding, obviously new head of sales, we've obviously added regional managers in the U.S., Europe, and in Asia.

There is going to be some real dollars there.

Those are pretty much part of our targets for this quarter, and you will expect -- you should expect to see some incremental growth in Q4 and beyond, but I don't think it is going to come in big chunks after this quarter only because it should be fairly incremental.

Obviously we'll add additional inside sales and support to support the distributor.

The other thing we're really getting though, is in addition to the head count we're bringing on is really be getting the leverage out of the Arrow relationship.

So that's -- you'll see that, but it won't be on the sales line, right.

That will come in -- we'll have to pay for that in the margin side of the business, but -- so we think we're going to get a lot of leverage there some of which is baked into the targets we've given you for this quarter and some will come later but it will really be a variable cost associated with that business.

That's kind of where we're at.

But I think we've made in terms of what we wanted to accomplish this year, we've got a large chunk of those investments have been made.

Realize they've just come onboard and it is going to take a couple quarters to get some momentum there, to help them really start driving the design activity.

But we're in obviously a much stronger position now than we were six months ago or even three months ago.

To answer your question then on the component side, you're going to have to refresh me.

Exactly what did you want me to answer on that?

Yes, I was just -- you referenced sort of meeting the buildout, the product family on the components side, and I wanted to sort of hear a little bit about where you think you might need to add and what maybe specific markets you're targeting or form factors or where the R&D effort is focused there?

Yes.

So we have an XLamp family of products and we have the RGB family, we have a white family and actually our white comes in several flavors now.

What we're finding is that the white LED that you sell for a flashlight application isn't necessarily the same white LED you might sell for an indoor fixture, and that's maybe not the same white LED you might need for an outdoor municipal lighting fixture.

So the XLamp family itself is expanding in terms of generally in terms of colors, performance level and in some cases even sizes and shapes that are really designed for specific applications all within the general bucket of lighting.

I think what happens, then, is though that's really just at the kind of the watt power level up to maybe 3 watts.

Then there is also work we're doing on we have a 0.5 watt product thatwe're promoting that we've had released for a little while here, we're also looking at extensions to where is there a specific market segment that might need a slightly different version of that and there's lots of different applications.

I don't want to preannounce our product line that's coming, but you can be sure that we're looking at lots of places where we think high performance -- generally white oriented applications we can lever that, get some leverage on that market and you'll see us more announcements coming.

One of the examples is obviously we're working on things for Edge-lit LCD displays.

That's an example of one of the markets and we have other things we're working on and stay tuned for more to come there.

Thank you.

Sure.

Your next question is from the line of Hans Mosesmann with Nollenberger Capital.

A couple of questions, Chuck.

Most of my questions have been answered.

In South Korea there was news, I guess in late December that one of the courts there had invalidated several or all of Nachia's patents as it relates to wireless back lighting as I understand it.

Can you elaborate on what the -- if this is true by the way and can you elaborate what implications if any that Cree will have in terms of doing business in Asia with a lot of the capacity that's out there and IP questionable if you will?

Sure.

Based on the research that our team's done on what exactly was at stake and what was ruled, it is my understanding that these were some design patents.

These are not normal patents that you sue people on.

These are kind of like what is the specific, exact design look.

This is a kind of architectural type thing that you normally see or done in more products where people are worried about what's the shape of your wall outlet, kind of a decorative kind of thing.

So it was a pretty unusual lawsuit to start with, and it is my understanding that that was the patent that was invalidated.

It really has very little effect on Nachia's overall portfolio in Korea or anywhere else, and so I think that while it was obviously -- it's good for the guy who doesn't have to worry about that design patent, I think it has a very small effect on the reality -- on really what Nachia's portfolio and what the issues are that someone might have with that.

From our standpoint, I think that there has really not been a significant implication in the market.

I think there continues to be enough activity not just from Cree but from the other players out there that I think it still remains an issue.

Obviously people would -- there are some people, specifically those without a lot of IP that wish it would go away, but I think it was more of a one-off thing, and I don't think it really affects their overall portfolio very much, and again that's based on our analysis.

We weren't involved in that case, so I can only take the analysis we've done based on what was filed on it.

Okay.

That's helpful, and if you can comment on the seasonality or at least over the past two, maybe three years there has been some level of strength in Japan from Pachinko gaining -- what happened with that?

Is it still there or is it not or there's more competition if you can comment?

Pachinko is still an opportunity for us and it's still something that we've had success and we continue to have success in.

I think that what's happening, at least what we're seeing in Pachinko, and you're right, Hans, I think it was a couple years ago especially, we had a great kind of a March spike in the Pachinko business.

What we're seeing now is that the Pachinko cycles tend to be less specific, definitely this is viewed as the stronger Pachinko cycle, but there is a lot more packagers now driving that business, and the supply chains have changed to where we're getting Pachinko business.

I think last quarter we had a pretty good chunk of business that would have been in that segment, I don't have the specifics, and we kind of see it more all year-round.

Obviously we're looking to try to continue to win that.

I think that there are definitely people competing for it, but I look for it to continue to be a pretty strong piece for us.

I think it is just less dominated by seasonality and I think it is partially just due to supply chain issues.

Okay.

Then one quick one.

I didn't catch the depreciation number.

It might be in your metrics information, but if you can give that to me, that would be great, and that's it.

Hans, I don't have it but I will see if John does.

Yes, the depreciation expense is about 19, 20 million.

19, 20, great.

Thank you very much.

Sure.

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

Chuck, a question for you real quick.

I think right around the time when you guys had preannounced, I think you had mentioned that you had to walk away from a lot of the business because the conditions or the ASP's maybe that you were getting were unfavorable to where you wanted to be relative to your business.

Are you seeing any shift in that environment or is it still the same thing?

Well, I think there was a part of our business that -- obviously the market slowed, and I think the question you had asked me at one point, Harsh, I think it was, it seems like yours slowed a little faster than the market trends that you were watching.

I think part of that was that as it slowed we were basically bidding on business that it moved faster than we were bidding on it in some cases.

It was effectively -- we were just not servicing some of those chunks.

I think now as we go forward we're really managing the business to a different level if you look at what we're trying to do.

I think there is still spot businesses still important to our strategy, but we're a little less reliant on it than we were going into last quarter.

It doesn't mean it is still not challenging out there, but I think our business mix is a little different which takes a little bit of the pressure off that the stuff we're going after now is business we want to win.

That doesn't mean we won't still be opportunistic and go after some new opportunities when we can, but I think the mix is just a little less dependent on that this quarter than it would have been going into last quarter.

Got it.

Thank you.

Sure.

Your next question is from the line of Pierre Maccagno, with Needham & Company.

Chuck, yes, if you could qualify if there is a slower demand from handsets, is that because the number of LEDs per handset is decreasing and if that's the case, is that a trend if you could explain a little bit more on that.

Yes, Pierre, what we've seen in the past is generally March is the weakest quarter for purchases of LEDs for the mobile phone segment, and this has been going on probably for three, four, five years.

Generally in the past, Cree's had enough other business the cycles kind of work themselves out.

But I don't think the trend that we're seeing or even what we've seen some other companies talk about in our sector is really significantly different than the past.

I don't think it is a handset change.

I think it is kind of how that supply chain works, and then keep in mind that that supply chain has -- almost always has a slowdown in the March quarter.

I mean in Chinese new year, they generally consume less LEDs for that application this quarter.

I don't know that we're seeing anything significantly different than what we've seen in the past several years at this point.

But the units and handsets remains stable then going forward as the brightness of LEDs increase, isn't the units per handset decreasing?

Well, what's interesting is you also have features, functionality, you have bigger screens doing more things, trying to add more value, so we really -- there is definitely a segment of handsets that doesn't use a lot of LEDs, the very low cost segment, but in terms of the major segment that we've been servicing, we haven't seen a significant trend towards a big reduction in the number of LEDs.

Obviously, we'll see more in the year ahead, but that hasn't been what we've seen driving the trends.

Going forward, that could be an issue, correct?

I think it is always an issue.

You could also probably argue, Pierre, that if they keep making fancy screens and doing more with the mobile phones, adding camera features where they want to have better quality, you could also potentially see a need for more of the higher quality LEDs.

I think it is to be determined at this point.

Okay.

At this time, there are no further questions.

Speakers, are there any closing remarks?

Yes.

Thank you.

We appreciated your interest and support, and look forward to reporting our third quarter of fiscal year 2000 results on April 19, 2007.

Thank you.

Thank you.

This concludes today's conference call.

You may now disconnect.