Cree, Inc.
Q2 2015 Earnings Call Transcript

Published: 21 Jan 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to Cree’s second quarter 2015 earnings conference call. [Operator instructions.] I would now like to hand the conference over to Mr. Raiford Garrabrant, director of investor relations. Sir, you may begin.

[Raiford Garrabrant:]

Thank you, operator, and good afternoon. Welcome to Cree's second quarter fiscal 2015 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 [phone], and we will be pleased to assist you. Today, Chuck Swoboda, our chairman and CEO, and Mike McDevitt, our CFO, will report on our results for the second quarter of fiscal year 2015. Please note that we will be presenting both GAAP and non-GAAP financial results in our remarks during today's call, which are reconciled in our press release and posted in the Investor Relations section of our website at www.cree.com, under quarter results on the financial information tab. 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 and revenue, gross margin and earnings, plans for new products, and other forward-looking statements indicated by words like anticipate, expect, target, and estimate. Such forward-looking statements are subject to numerous risks and uncertainties. Our press release today, and the SEC filings noted in the release, mention important factors that could cause actual results to differ materially. Also, we'd like to note that we will be limiting our comments regarding Cree's second quarter of fiscal year 2015 to a discussion of the information included in our earnings release. We will not be able to answer any questions that would involve providing additional financial information about the quarter beyond the comments made in the prepared remarks. This call is being recorded on behalf of the company. The presentations and the recording of this call are copyrighted property of the company, and no other recording, reproduction, or transcription 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. Also, since we plan to complete the call in the allotted time of one hour, we ask that analysts limit themselves to one question and one follow up. We recognize that other investors may have additional questions, and we welcome you to contact us after the call by email or phone. We're also webcasting our conference call, and a replay will be available on our website through February 3. Now, I would like to turn the call over to Chuck.

[Chuck Swoboda:]

Thank you, Raiford. Fiscal Q2 revenue was $413 million, which was on the upper end of our target range due to strong growth in LED lighting. Non-GAAP net income increased 28% sequentially to $38 million, or $0.33 per diluted share, due primarily to improved gross margins and an $0.08 per share tax benefit related to the retroactive reinstatement of the federal R&D tax credit. Excluding the catch-up tax benefit, non-GAAP earnings per share would have been $0.25, which was above our target for the quarter. The sales trends for Q2 were as follows. Lighting revenue increased 33% year over year and 3% sequentially to $230 million, driven by double-digit growth in LED fixtures, which more than offset the expected lower LED bulb sales. LED revenue decreased 29% year over year and 13% sequentially to $152 million, due to the lower LED demand primarily in China. Power and RF revenue increased 18% year over year and was similar to Q1 at $31 million. Q2 non-GAAP gross margin increased 150 basis points sequentially to 33.9%, due primarily to improved lighting margins, which more than offset the lower mix of LED sales. The gross margin trends were as follows. Lighting segment margins increased to 28.1%, driven by improved lighting execution and a more favorable mix. LED segment margins were similar at 39.1%, due to strong factory cost management, which offset significantly lower factory utilization. Power and RF segment margins were slightly lower, at 55.5%, primarily due to product mix. Q2 non-GAAP operating margin was the same as Q1 at 8.2%. This is better than targeted and reflects the improvement in our lighting business and ability to offset the slowdown in LEDs. Company backlog for Q3 is slightly behind this point last quarter. We target flat to higher lighting demand in the quarter to be offset by slightly lower LED demand due to normal seasonality and the Chinese New Year holiday. We are well-positioned to continue to win in LED lighting. Our product pipeline is strong. We’re building good sales momentum and our brand is growing in the market. While the LED competitive environment remains challenging, we believe that our high power LED technology positions Cree for long term success in high performance LED lighting applications. The power and RF product line also continues to deliver good revenue and profits. Based on our view that we’re well-positioned to continue to grow the company and increase profits over the next several years, we spent $266 million on share repurchases in the quarter. I will now turn the call over to Mike McDevitt to review our second quarter financial results in more detail as well as our targets for the third quarter of fiscal 2015.

[Mike McDevitt:]

Thank you, Chuck. I will be providing commentary on our financial statements on both a GAAP and non-GAAP basis, which is consistent with how management measures Cree’s results internally. However, non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies. Non-GAAP information should be considered as supplement to, and not a substitute for, financial statements prepared in accordance with GAAP. A reconciliation of non-GAAP information to the corresponding GAAP measures for all quarters mentioned on this call is posted on our website, along with a historical summary of other key metrics. For the second quarter of fiscal 2015, revenue was $413 million, which was on the upper end of our targeted range of $400 million to $420 million. GAAP earnings increased 9% sequentially to $12 million or $0.10 per diluted share for the second quarter of fiscal 2015, and non-GAAP earnings increased 28% sequentially to $38 million or $0.33 per diluted share. Non-GAAP earnings exclude $26 million of expense net of tax, or $0.23 per diluted share, from the amortization of acquired intangibles, asset retirement charges, fair value accounting on our Lextar investment, and stock based compensation. GAAP and non-GAAP earnings per share were higher than our targeted range, due primarily to improved gross margins and a one-time tax benefit related to the retroactive reinstatement and extension of the U.S. R&D tax credit. Excluding the impact of the R&D tax credit, our GAAP earnings would have been $9 million or $0.08 per diluted share, which was at the upper end of our targeted range for the quarter. Excluding the impact of the R&D tax credit, non-GAAP earnings would have been $29 million, or $0.25 per diluted share, which was above our target range for the quarter. Q2 GAAP gross margins were 33.1% and non-GAAP gross margins were 33.9%, which excludes $3.4 million of stock based compensation. This was at the upper end of our non-GAAP target of 33.5% plus or minus, and represents 150 basis points sequential increase due primarily to improved lighting margins. Fiscal 2015 second quarter revenue and gross profit for our reportable segments were as follows. Lighting products revenue grew 33% year over year and 3% sequentially to $230 million and gross profit grew 16% sequentially to $65 million, for a 28.1% gross margin, which is a 320 basis point increase sequentially. LED products revenue declined 29% year over year and 13% sequentially to $152 million and gross profit declined 12% sequentially to $59 million for a 39.1% gross margin, which was similar sequentially. Power and RF products revenue grew 18% year over year and was similar sequentially at $31 million. Gross profit declined 3% sequentially to $17 million for a 55.5% gross margin. In determining gross profit for our segments, we do not allocate certain employee benefit costs, stock based compensation, and acquisition related costs. These non-allocated costs totaled $4 million for the second quarter of fiscal 2015 and are included to reconcile to our $137 million GAAP gross profit. Operating expenses for Q2 were $127 million on a GAAP basis and $106 million on a non-GAAP basis, both of which were within our targeted range. Non-GAAP operating expenses exclude approximately $14 million of stock based compensation expense, $6 million of charges from amortization of acquired intangibles, and $1 million for asset retirement charges. Our non-GAAP operating income was $34 million or 8.2%, which was higher than targeted for the quarter. Our Q2 GAAP and non-GAAP tax rate was minus 2% for the quarter, which was less than our 22.5% target for Q2. The Q2 tax rate includes a one-time benefit related to the retroactive reinstatement and extension of the R&D tax credit. This includes the catch-up benefit for the first three calendar quarters of 2014 as well as the benefit for the December quarter, which we did not include in our targets because the reinstatement wasn’t approved until late December. We ended the quarter with $830 million in cash and investments, a $275 million decline sequentially. The sequential decrease was due primarily to spending $266 million to repurchase 8.1 million Cree shares, $80.5 million to purchase a 13% ownership in Lextar, and $55 million of capital expenditures, which were partially offset by $15 million of cash provided from operations and a net $105 million drawn on our line of credit within the quarter. Q2 free cash flow was negative $40 million due primarily to a $59 million working capital build. Our working capital build was due primarily to a $43 million sequential decrease in accounts payable related to higher purchases earlier in the quarter versus our September quarter and a $22 million increase in inventory as LED inventory reductions were offset by an increase in lighting inventory. The lighting inventory build was higher than we had forecast due to a combination of increased in-transit inventory to account for recent increases in shipping times from Asia and a short term increase as we qualify and ramp up two new subcontractors. If we exclude these two items, overall inventory was similar to Q1. For Q3, we target lower inventory levels as new subcontractors come online and further reduce capital spending, which should support positive free cash flow. Days sales outstanding were 48 days as compared to 50 days at the end of September and in line with our 50 day plus or minus target range. Inventory days on hand increased to 108 days as compared to 96 days at the end of September. As mentioned earlier, we target lower lighting inventory levels going forward as the new subcontractors come online, which should bring our days back down to our 90-day plus or minus targeted range over time. Property, plant, and equipment additions were $50 million and patent additions were $5 million in the second quarter. Capital spending in Q2 was lower than Q1 and in line with our lower spending planned for fiscal 2015. For the second half of fiscal 2015, we target property, plant, and equipment spending to be approximately $90 million, which is in line with our fiscal 2015 target of $200 million plus or minus. In January, the company closed on a $500 million working capital line of credit facility and repaid the original $150 million facility. The purpose of this facility is to provide the company short term flexibility to optimize returns on our cash and investment portfolio while funding share repurchases, capital expenditures, and other general business needs. In October, our board authorized an increase to the facility in conjunction with the authorization to increase the share repurchase program to $550 million for fiscal 2015. Fiscal year to date, we have spent $320 million to repurchase 9.3 million Cree shares, and the increased facility will help support additional repurchases while allowing us flexibility to maximize our cash investment returns. At this time, we target Q3 revenue to be in the range of $395 million to $415 million, which is comprised of lighting sales flat to slightly higher sequentially as higher indoor LED fixture sales offset seasonally lower outdoor sales, LED sales down single digits due to normal seasonality and the Chinese New Year holiday, and Power/RF sales similar to Q2. We target Q3 non-GAAP gross margins in a similar range to Q2 at 33.5%, plus or minus, and GAAP gross margins to be 32.6%, plus or minus. We target incremental lighting gross margin improvement in Q2 due to factory productivity improvements and cost reductions, while LED and power/RF segment margins are targeted to be slightly lower due to lower factory loading. This Q3 target is based on a number of factors that could vary, including overall demand, product mix, factory execution, and the competitive environment. Our GAAP gross margin targets include stock based compensation expense of approximately $3.4 million, while our non-GAAP targets do not. We are targeting Q3 operating expenses to be similar sequentially as increased spending to fund our IP enforcement strategy is offset by reductions in other areas. Our GAAP operating expense targets include $14 million of noncash stock based compensation expense, $1 million of asset retirement charges, and $6 million of charges for amortization of acquired intangibles. Loss and disposal of assets is targeted to be similar to Q2. We target our Q3 and Q4 tax rate to be 17%. Our tax rates will fluctuate based on our overall earnings, the tax jurisdictions in which our income is actually earned, and other tax benefits that may or may not become available to Cree in future periods. GAAP net income for Q3 is targeted to be between $3 million to $8 million. Based on an estimated 112.4 million days sales outstanding, our GAAP EPS target is between $0.03 to $0.07 per diluted share. Non-GAAP net income is targeted to be between $23 million to $28 million, or $0.21 to $0.25 per diluted share. Our non-GAAP EPS target excludes amortization of acquired intangibles, asset retirement charges, changes in the fair value of our Lextar investment, and noncash stock based compensation in the amount of $0.18 per share. Thank you, and I’ll now turn the discussion back to Chuck.

[Chuck Swoboda:]

Thanks, Mike. We’re focused on four priorities to drive our business in fiscal 2015. Our first priority is to leverage Cree technology to lower up front customer cost and further improve payback. As we have demonstrated many times in the past, innovation is the key to leading the market, creating value for our customers, and driving growth. In Q2, we did just that by redefining high power LEDs for lighting, with the announcement of our new SC5 technology platform, which doubles light output to enable radically lower system costs by up to 40% in the most lighting applications. The SC5 technology platform is built on Cree’s industry best silicon carbide technology and features significant advancements in epitaxial structure, chip architecture, and an advanced light conversion system optimized for best thermal and optical performance. We announced the commercial availability of XLamp extreme high power LEDs, which are the first LEDs powered by Cree’s revolutionary SC5 technology platform. The XLamp XHP50 and XHP70 LEDs provide twice the lumen output and improved reliability compared to previous LEDs of the same size. Based on initial customer feedback, we are confident that the groundbreaking technology of the new XHP LEDs offers significant system advantages to drive the next major innovations in high performance LED lighting system design. Our second priority is to continue to drive LED lighting growth and build the Cree brand in both the consumer and commercial markets. The LED lighting business grew 3% sequentially and 33% year over year in the second quarter, driven by double-digit growth in lighting fixtures. We’ve made tremendous progress growing both the volume and product breadth of our lighting business over the last several years, but I believe there is significant untapped potential in terms of both revenue and profitability. The growth has stretched the capabilities of our supply chain and factories, and it will take time to realize our full potential as we work through the expected challenges that come with a fast-growing technology business. In Q2, we introduced the third generation Cree LED bulb, which delivers superior light performance while looking even more like an incandescent light bulb through our innovative new 4Flow design. This new design provides the same cost savings and 25,000 hour lifetime that made the original Cree bulb America’s best-selling LED bulb. The bulb is now available at the Home Depot for $7.97, and it’s currently available for as low as $2.97 in certain markets with rebates. LED bulb shipments were lower, but in line with our targets for the second quarter as quarterly sell through increased during lighting season. Q2 sales were primarily driven by our GEN2 bulbs, and we should start to see the impact of the GEN3 bulb on our Q3 sales as it gains more shelf space and rebates become available in more markets. In addition, we recently announced the availability of the first in a family of Cree LED connected bulbs, combining the same Cree standard of superior light performance with new features for smart home environments. Our third priority is to expand our work with manufacturing partners to enable growth in LEDs and lighting and allow Cree’s factories to focus on the newest technologies that are not otherwise available in the market. While current LED volumes are lower than we had forecast during the summer, we continue to develop manufacturing partners to support our targeted, longer-term growth. We closed on our Lextar investment in Q2 and are working with them to supply LED chips as well as testing some initial lighting products. We plan to continue to leverage Asia-based partners, but we’re also working to expand our North American supply chain for certain volume lighting products. These new suppliers have similar cost structures when factoring in the higher shipping costs and logistics issues associated with bringing products to the U.S. from Asia and should enable us over time to reduce the ratio of finished goods inventory in transit. Our fourth priority is to generate incremental operating margin through revenue growth and incremental operating leverage across the business. We made solid progress in Q2 as operating margin was 50 basis points higher than targeted at 8.2%, due to the improvement in lighting gross margin. The growth in lighting and power and RF has been offset in the first half of fiscal 2015 by the decline in sales of LED products. We are optimistic about the long term growth prospects for LEDs based on initial customer feedback and our new SC5 based products and overall increased LED lighting adoption, but it will take time to work through the design cycles and current market conditions. Fiscal Q3 is a seasonally slower quarter for LEDs and lighting, but the LED business seems to have stabilized in the current revenue range, and we target overall company revenue growth in our fiscal Q4. We continue to pursue our strategy to reaffirm the value of our intellectual property in the market and in our financial results. We recent filed new patent lawsuits at the U.S. International Trade Commission as well as in the U.S. District Court in Wisconsin, related to LED bulbs that are being imported to the U.S. from Asia. The patents and suit cover both the LED technology and LED lighting system design. We have also filed a false advertising claim at the ITC related to misleading advertising claims that certain LED bulbs meet Energy Star standards, but in fact do not meet certain basic requirements. We have an obligation to our shareholders and our customers to protect our intellectual property rights. We believe this investment in legal costs is critical to drive our licensing program and ensure that consumers are getting the performance from LED lightbulbs that is being advertised and necessary to drive consumer adoption. As I mentioned earlier, Q3 total company backlog is slightly lower compared to this point last quarter, which is in line with the typical seasonal trend in our fiscal Q3. Our customers and distributors continue to operate on short lead times. LED factory utilization is targeted to remain at similar low level in Q3 while lighting factory utilization remains very high and execution continues to be a critical factor to meeting customer expectations and our financial targets. Based on our current backlog, forecasts, and trends in the business, we are targeting Q3 revenues slightly lower than Q2, in a range of $395 million to $415 million, which is comprised of lighting sales flat to slightly higher as higher indoor LED fixture sales offset seasonally lower outdoor sales, LED sales down single digits due to normal seasonality and the Chinese New Year holiday, and power and RF in a similar range as Q2. We target Q3 non-GAAP gross margins in a similar range as Q2 at 33.5% plus or minus. We target Q3 lighting segment gross margin to be incrementally higher than Q2 due to improved factory productivity and cost reductions, while LED and power and RF segment margins are targeted to be slightly lower due to factory loading. We target non-GAAP operating expenses in a similar range as Q2, as incremental spending to fund our IP strategy offsets savings in other areas. Our tax rate is projected at 17%, and as a result, we target non-GAAP earnings in a range of $0.21 to $0.25 per diluted share. Please note that our non-GAAP targets exclude amortization of acquired intangibles, stock based compensation expense, asset retirement charges, and the related tax effects. The market for LED lighting is still in the early stages and largely untapped in terms of installed lighting sockets. We continue to gain share in the commercial lighting market while the Cree LED bulb shapes the consumer lighting category and creates awareness for the Cree brand. Although the LED market remains challenging, our new SC5 based LED technology has once again redefined what is possible in system performance and cost to enable the next generation of lighting system designs. In the near term, we have adjusted our LED factory costs to operate more efficiently at current utilization levels, and we continue to make investments both at Cree and with our manufacturing partners to support the longer term growth in the business. We believe we’re on the right track as evidenced by our significant share repurchases in Q2, and we target additional repurchases in the second half of fiscal 2015. Our game-changing technologies, new product pipeline, and brand momentum give us great confidence in achieving our long term customer goal of 100% upgrade to LED lighting. We will now take analyst questions.

[Operator:]

[Operator instructions.] And our first question comes from Brian Lee with Goldman Sachs.

[Brian Lee:]

First, Chuck, on the factory cost improvements that you mentioned, that helped the LED products gross margin in the face of lower utilization, can you help us understand a little bit more what exactly is going on in terms of those factory cost improvements? And then is there any way you could quantify the gross margin impact? And then lastly, how sustainable are those initiatives if you do continue to see a relatively depressed utilization backdrop for the LED [unintelligible]?

[Chuck Swoboda:]

So, what I would tell you is that within LEDs, keep in mind that in our fiscal Q1, we had an inventory build, so we had some more significant inventory reserves, which essentially kind of put our Q1 results into a similar range that we were going to actually see in Q2 at the lower volumes. And so, what we really had to do is the cost improvements are really more about cost management. It’s about how do you take various costs out of the factory to run at the lower utilization levels, and that’s a variety of things. There’s no one big lever. What we’re targeting in our Q3 is -- the assumption is that even though LEDs will be down a little bit, gross margins will be similar to down slightly, and that’s just managing those costs again. And so, the assumption is that if we can get through Q3 and then see some seasonal rebound, we’ll start to get some utilization benefits, at least incremental ones, as we head into Q4, on the LED side.

[Brian Lee:]

And then my follow up was just again, on the LED product segment. I’m not sure if you would agree, but it does seem like there’s some structural headwinds emerging in that segment for you guys, not just cyclical. And yet gross margins have held up relatively well compared to prior troughs. But when I look at your R&D spending, it’s up over 150% over that time period, so wondering what triggers you might be looking for to rationalize costs there, and if you’re thinking it’s still a reconciled budget [ph] relative to the opportunity given the revenue declines you’ve seen.

[Chuck Swoboda:]

Well, keep in mind that the R&D spend that you’re looking at is the company R&D spend, so it encompasses what we’re doing not only in LEDs, but in our lighting business as well as in our power and RF business. So we’re looking at R&D on a holistic basis and look at various opportunities. With that being said, I think the other subtlety to this is while the LED revenue is down from where it was six months ago, keep in mind that we have a very large internal customer, and so that’s not being included in the revenue numbers. And we do want to make investments to support some of the enabling things we’re doing in that business longer term. So we’ll continue to look at R&D as a percentage of sales, but right now, we believe that those investments give us significant innovation advantage, which is how we drive, fundamentally, the growth of the business in the mid to longer term, and we think that makes sense.

[Operator:]

Our next question comes from Paul Coster of JPMorgan.

[Paul Coster:]

Just want to focus on the utilization a little bit more, if you don’t mind. It sounded like you have some kind of capacity constraint as it relates to fixtures. I don’t know what to make of bulbs and lamps. And then am I right in thinking here that you’re not making incremental investment in the LED capacity at this time and that you’re just waiting until current utilization starts to spike?

[Chuck Swoboda:]

Yeah, so let me take those backwards. LED capacity, no, we’re not making any new equipment investments on the LED capacity side. We’re really trying to balance the current utilization, which is lower, with the demand, and over time, as we would target growth to kind of ramp up our utilization as well as bringing on some of our manufacturing partners. Switching gears to lighting and fixtures, I would say that bulbs and lamps, we have capacity to support that business. On the fixture side, that’s actually where we’ve been running fully utilized, and that’s a combination of we are qualifying additional subcontractors to add some capacity there as well as doing things in our factory in Racine. But the growth in that business has been really strong, and we’ve been challenged here over the last quarter or two to really continue to scale up with that demand. I think we’re doing an okay job, but there’s more work ahead of us.

[Paul Coster:]

My follow up question relates to Lextar. So, we’re only a short time into this relationship. What is it that you are using them for? And I’m assuming it’s mid power. If it is mid power, is that also weighing on the use of your high power LEDs?

[Chuck Swoboda:]

So, the Lextar relationship has started out and is primarily focused in the near term on LED chips, which you would consider to be mid power chips. But that is really to service a set of customers that we weren’t really using our factory for that anyway. So I think it has not a significant effect on our factory utilization at this point. And we have actually done things over the last quarter to balance our assets versus what we use with our partners. So I think we’ve got that balanced out. Longer term, I think we look at Lextar as not only potentially a chip partner, but really across our supply chain, just like we’re looking at some other suppliers for various things, from LEDs all the way through the lighting systems business.

[Operator:]

Our next question comes from Vishal Shah with Deutsche Bank.

[Vishal Shah:]

Chuck, on the lighting business, I know you’ve seen some nice improvement in margins. How should we think about margins long term? Can you get back to the corporate average levels that you’ve talked about in the past in that business, especially considering the mix changes?

[Chuck Swoboda:]

Yeah, you know, I think that the goal is to make incremental improvements. So I don’t have a longer term target. A little bit of that’s a little difficult, because really, we have within lighting, you have our commercial lighting business, which we’re targeting to make incremental improvements again in our Q3 there. But at the same time, you’ve got a mix shift going on, so the consumer side is fundamentally a lower margin business for us. So that mix shift affects it, but if you just break that out, we’re targeting that we can make incremental improvement in the commercial side in this quarter, and I would think we can make, even going forward, beyond that. As far as does it get to the corporate average, I don’t have a longer term projection for you at this point, because as long as we make incremental improvement, we’ll get the leverage we’re looking for in the model in the near to mid term.

[Vishal Shah:]

And then just on the LED business, again, if you think about the pricing environment right now, how much more leverage do you have to maintain margins in that business, and where are you with the six inch transition?

[Chuck Swoboda:]

On six inch, I don’t have an exact number for you, but I think in the pricing environment, maybe what we’re missing is that it continues to be very competitive. But one of the things we did, which is different from most of the other LED companies, is our business is smaller than it was six months ago. So we’ve decided to focus on the applications where we think our technology adds the most value, which means we think we can get the best margins in that part of the business. And so we are pretty high power centric, focused in those areas, which I think gives us a slightly different model than what a lot of the other people are doing who are trying to fill their factories with some of the low and mid power end. So you know, it’s hard to tell you what the future holds in that pricing environment, but I think if we keep innovating and doing new things like our SC5 technology, which gives us double the lumens per package, I think we have a lot of other innovation that can continue to give us things that allow us to produce lumens at a lower cost per lumen, which then gives us the ability to continue to move with the market over time.

[Operator:]

Our next question comes from Jed Dorsheimer from Canaccord.

[Jed Dorsheimer:]

Chuck, maybe a little bit of a medium-term type question with respect to the LED components business. There’s been a clear shift from the high power to mid power, and the relative difference seems, if a high power chip or component costs $0.50, a mid power might cost about $0.15. So taking two mid powers, the relative difference might be somewhere between $0.30 and $0.50, but you need secondary optics in that mid power type solution, which has been more appealing to some of the consumer type bulb applications. So my question, with that said, is do you see a shift over the medium term where the high power products, that you’ll see that come back based on technology criteria? Or because of yields where they are, between mid and high, do you think that this is the new normal that we will be in, sort of in perpetuity?

[Chuck Swoboda:]

Yeah, so I think you’ve got to separate it a little bit by application. So if we were making linear light tubes, your analysis is obviously dead on, and even some of the more large, kind of non-focused lighting applications, where there’s no optics or anything else. What we’re actually seeing with our high power, and what we’re doing with the SC5 platform, is we’re actually looking at trying to fundamentally shift how the entire cost of the system comes together. And so if you look at the applications we’re targeting, it would be more expensive to build that application with mid power LEDs than with high power LEDs because of what you’re trying to do. Now, these tend to be higher performance, they tend to be more of the commercial, industrial side, and they tend to be higher lumen densities or total lumen output or how the device is being used. So I think what we really see today is you have high performance applications where high power is just a fundamentally better choice, and you have other applications where you can use either one. And if you can choose either one, then I think what you’re seeing is that the pricing environment in mid power has made that the more attractive option. What we’ve tried to do is focus our efforts on where we add value. Is there a new normal? I think that in the near to medium term, I think this is the market we’re going to have to work through. That’s why we’ve got to design products that make our customers’ products work better, and that’s how we can win. If I step back a little bit, if I look at our financial model and the competitors, many of whom are losing money, I think those markets rationalize. And so I think the reality is that your numbers you gave are differences in price, and I’m not sure what the comparison there is. The difference in cost and the difference in price are disconnected right now. And I think those markets eventually rationalize. But I don’t know the timeframe, so the way we’re planning the business is assuming that we just have to deal with the fact that people are going to give away mid powers for now and we’re going to focus on places we add more value than that.

[Jed Dorsheimer:]

And just as a follow up question, just housekeeping, on the $500 million line of credit, is that being used primarily for buyback purposes? Or are there other intentions for opening that line of credit?

[Chuck Swoboda:]

I’ll let Mike give you that answer. A-Mike McDevitt So Jed, in the near term, it’s basically to provide flexibility. So we are using some of it for the buyback, but it could fund some of the infrastructure capex, where we can maximize the return on the invested cash that we already have, and we don’t have to sell those investments.

[Chuck Swoboda:]

Think about it more as if we don’t have to sell our investments. We sell them on our schedule instead of the schedule of the needs of the business. We’re making a little bit of extra money using that line of capital in the short term.

[Operator:]

Our next question comes from Mike Ritzenthaler from Piper Jaffray.

[Mike Ritzenthaler:]

On pricing within lighting products, I was curious about whether it’s possible to bifurcate some of the margin lifts that we saw this quarter from less pricing pressure versus cost outs. It sounded like in your prepared remarks, you highlighted the cost outs in some of the raw material efficiencies. Just wondering if there’s less pricing pressure, or if we saw less pricing pressure in the fourth quarter within the lighting products.

[Chuck Swoboda:]

The lighting trend you saw, there wasn’t a significant shift in pricing dynamics, one way or another. The two things we saw that drove our lighting margins are first, we had a favorable mix shift, so more commercial, less consumer, on a percentage basis, is going to help our margins. Second, within the commercial segment, we did get benefits from the various productivity and cost outs. I don’t have the exact breakout for you, but roughly, those were the two big pieces that moved the number during the quarter.

[Mike Ritzenthaler:]

The lawsuit initiated this quarter comes after a period of relative peace in the industry, and I’d just be curious about your view. I guess, why now, and why this potential strategy may not beget a costly back and forth.

[Chuck Swoboda:]

Look, we’re always evaluating products that are coming into the market and looking at our options, and I think at this point, the timing’s a function of when certain products are in the market, and when our team determines that this is the best course of action. We’ve got a pretty simple strategy, right? We prefer people not to import infringing products, and we’d like to get paid for our IP. And so I think we’ll continue to evaluate what’s the most practical way to solve those problems, and we’ll see where it leads from here.

[Operator:]

The next question comes from Edwin Mok with Needham & Company.

[Edwin Mok:]

First one, just quickly on the LED component side. I think you talked about Q4 you expect business to recover. Is that seasonal? Is that [unintelligible] inventory right now? Is there any kind of [channel] [unintelligible] and you expect by that quarter? Any kind of color you can provide, either on channel or the demand?

[Chuck Swoboda:]

I mean, keep in mind, when we put that out there, we don’t have great visibility. So what we’re really looking at though, is that the business is shaping up like a normal year in LEDs, and so we would expect some seasonal increase as we get into our fiscal fourth quarter, just based on the fact that when you get through the March quarter, you get past Chinese New Year, there’s usually some incremental growth in the business. We obviously have lots of activity on new products and trying to drive new designs, but it’s a little too early to call on those. I think they give us more of a mid to longer term opportunity. But that’s how we get to that outlook.

[Edwin Mok:]

And then just quick question on capex. How much of your capex that you’re now spending kind of related to the lighting side, on fixtures and stuff that you mentioned? And I think you guys have ramped up capex over the last few quarters. Do you have any kind of access, LED and [MOCVD] equipment that you have not turned on, and therefore haven’t impacted your depreciation yet? Should we expect some of those coming later on?

[Chuck Swoboda:]

Let me give you kind of the higher level answer, and then I’ll let Mike answer your depreciation question. In terms of the capex we’re spending, really what we have going on right now is the majority of the investment is really for some infrastructure, buildings, to support longer term growth in the three year timeframe. So the majority is not equipment to build more product in any of our businesses. It’s really some infrastructure things that we think are prudent to do now as we plan for that next phase of growth. So this is not about adding incremental equipment, and really in any of our products. There are obviously some things we have to do in lighting right now, but those are relatively small dollars, some things in power and RF, and really no new equipment in the LED space, because we have available capacity. As far as depreciation or what it could be on the impact on the future, I’ll pass that to Mike.

[Mike McDevitt:]

So, in the short term, as Chuck mentioned, the capex is more longer term in nature. So there’s some of the capacity that’s for lighting and power/RF that would turn on in kind of the near term, but the infrastructure in that, that’s more like an FY16 type of event, when that would start to be placed in service.

[Operator:]

And our next question comes from Mark Heller from CLSA.

[Mark Heller:]

Chuck, I was wondering if you could talk about what you’re expecting mix will be maybe this quarter and over the next few quarters, for the SC5 platform.

[Chuck Swoboda:]

SC5 is going to be a very small percentage of the mix in LEDs this quarter. We got the technology platform launched, we did some early sampling. The XHP, the first two products, got released in December, so those are now in customers’ hands, and we’re doing actual design work with them on next generation. You know, nine months is typically when we get the first read on a new platform. We’ll obviously have some initial customers go early, but the majority of what we’re targeting in LEDs is our existing product line, and frankly, the new products we were releasing last summer. So there was a series of products, if you go back to the summertime, that we were announcing. Those are the ones that are more likely to turn into new design wins and ramp up here in the next couple of quarters.

[Mark Heller:]

And for a quick follow up, for the lighting business, for the March quarter, is mix still helping you, meaning the bulbs business would still be down sequentially, or flat? And any expectations for the June quarter for the bulb business?

[Chuck Swoboda:]

Yeah, I would say that in the March numbers, that while we’re targeting the overall to be flat to up a little bit, we would say that if it’s up, it’s probably some incremental growth, both on the consumer and the commercial side. There’s not a big mix shift into those numbers. The only mix shift will be actually within the commercial side, where we expect that the seasonal slowness in outdoor will be offset by the indoor. But between the two, kind of the consumer commercial piece, I wouldn’t expect significant percentage changes.

[Operator:]

Our next question comes from Harsh Kumar from Stephens.

[Harsh Kumar:]

Chuck, first question, I think at some point in time in your commentary, you made a statement that the LED business for Cree is stabilizing, your business is stabilizing at current levels of revenues. I’m curious about the color. Would you be able to give us some color around that statement and also maybe throw in some color on the markets themselves in the LED global markets?

[Chuck Swoboda:]

Not sure if maybe I didn’t make my comments clear earlier. I think what I’m trying to make sure people understand is that while our external business has declined, we have an internal growing lighting business. And so the LED business that we measure, which is what we report, is what we sell externally. The internal customer year over year, as you can see in the lighting numbers, has grown. And so there’s really a partial offset internal in our factory to what we have to supply to the internal customer, and that’s really what I was talking about earlier.

[Harsh Kumar:]

I got you. Thanks for the color. And then secondly, there’s been a dramatic shift in your buyback mentality. I’m curious why now, why here, and what are you seeing in your business? Of course, we’re not complaining, obviously, about this buyback, but what are you seeing that makes you so optimistic about a couple hundred million dollars a quarter in terms of buyback?

[Chuck Swoboda:]

Well, look, I think if you just look at the things we have going on, right? We have a healthy, growing lighting business that continues to have good success in the market. Our LED business appears to have stabilized at these kind of lower levels, so I think we’ve kind of adapted the business to this level. And we still have power and RF that has some interesting opportunities more in the mid term. And based on that assessment, we felt like a pretty significant buyback made a lot of sense given our outlook on the mid to longer term prospects for the company.

[Operator:]

Our next question comes from Jeff Osborne from Cowen & Company.

[Jeff Osborne:]

Just wondering, Chuck, if you can talk about the shift mix between indoor and outdoor as it relates to the second quarter that you just completed. You certainly highlighted the trends or expectations for the third quarter. That was question one. And question two is just how should we think about the impact to gross margins as the GEN3 bulb starts hitting the shelves in the second half of your fiscal year, relative to the impact or negative impact that the GEN2 bulb had? Should there be less of a negative drag there, or some more trends given the $2 lower price point?

[Chuck Swoboda:]

On the mix indoor versus outdoor, I don’t think there was a significant shift within the commercial segment last quarter. We saw growth in both sides of that, so I don’t have the exact numbers sitting in front of me, but you should assume it was relatively neutral within the commercial segment. Then if I look at GEN3, although the bulb is priced $2 lower, it is targeted to have a similar margin structure as the GEN2 bulb, so that shouldn’t change our consumer margins significantly one way or another.

[Jeff Osborne:]

And just a quick follow up. With the GEN3 bulb, use your own chips? Or would you be potentially qualifying third-party chips for that? I’m just trying to impact what the utilization impact would be on the semiconductor side.

[Chuck Swoboda:]

The GEN3 bulb can use either.

[Operator:]

[Operator instructions.] And our next question comes from Sven Eenmaa from Stifel.

[Sven Eenmaa:]

Wanted to ask about the Lextar and what are your plans of using Lextar chips in your lighting product portfolio.

[Chuck Swoboda:]

Lextar is one of several companies that we have qualified to provide chips, what we would typically refer to as mid power chips that get used in a variety of products, both Cree’s lighting products but as well as we use in some of our LED components. And so they’re going to typically end up in areas where honestly, they’re typically more distributed lighting applications. The majority of our products use our own chips today, but there are some examples where we would use a mid power, for example. And a light tube would be an example of where we would use that as well.

[Sven Eenmaa:]

And the second question I have is in regard to Home Depot. When are the pricing discussions occurring there, and how should we think about pricing adjustments with that customer?

[Chuck Swoboda:]

With the Home Depot, that is a never ending conversation. And it’s a function of things we’re doing working with them and things that are happening in the market. So there’s not any one milestone that you can measure. It’s an ongoing process.

[Operator:]

Our next question comes from Avinash Kant of D.A. Davidson and Company.

[Avinash Kant:]

If you look at the revenue that you have seen in the LED products business, they have declined significantly since the last year’s levels. Now, hypothetically, if revenues were to come back to the same level where they were more than a year ago, do you think you would be able to get to the same margins that you had at that time?

[Chuck Swoboda:]

Hypothetically, if we had the same level of revenue, if it’s for the products we’re targeting today, I think we would see a higher utilization and would drive higher margins. But we don’t have any targets one way or another at this point.

[Avinash Kant:]

So I’ll just follow up on the same line. The thing we’re trying to figure out is that the decline in margins, is that directly proportional to the volume decline that you have seen, or is there something else, clearly more pricing there?

[Chuck Swoboda:]

If you’re looking at it on a longer term basis, I’d say probably the biggest change in the LED business from last summer has been the volume decline. There is some impact, because it’s obviously a very tough pricing environment right now. Both are impacting, but I would say the bigger lever, at least in the last six months, has been the volumes in our factory. And that’s because we’re always doing things to reduce cost, and that idea is to try to keep up with the pricing environment, but when you also have the volume change at the same time, that’s what you’ve seen in the shift.

[Operator:]

Your next question comes from Krish Sankar of Bank of America.

[Krish Sankar:]

Chuck, is there a way you can quantify how much of your output from the LED products goes to the downstream lighting business?

[Chuck Swoboda:]

It’s a significant customer, but the majority is still external customer sales. I don’t have a specific breakout for you. So it’s primarily still an external sales business, but the internal customer is a significant piece of it.

[Krish Sankar:]

And then a follow up. More of a theoretical question. But I’m just wondering, if it ever comes to it, how easy is it to split the LED component business from the lighting products business, if you had to split it into two different companies?

[Chuck Swoboda:]

Today, while we get the benefit from being vertically integrated, we have a team that’s dedicated to selling LED components as a core part of our mission, and to sell those to a lot of other companies. So since we’re not working on that right now, I don’t know that I have all the specifics, but they’re semi-independent businesses. With that being said, there is an advantage of thinking about things vertically, and that you can move both sides of the variables. And I think that given the nature of where lighting is, and the amount of innovation still in front of us, I remain convinced that there is a benefit to having a vertically integrated relationship, at least for the foreseeable future.

[Operator:]

Thank you. I’m showing no further questions at this time. I would like to hand the conference back over to Mr. Mike McDevitt for closing remarks.

[Mike McDevitt:]

Thank you for your time today. We appreciate your interest and support, and look forward to reporting our third quarter results on April 21. Good night.

[Chuck Swoboda:]

Thank you.