WOLFSPEED, INC. - Quarter Report: 2006 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 24, 2006

or

For the transition period from              to             

Commission File Number: 0-21154

CREE, INC.

(Exact name of registrant as specified in its charter)

(919) 313-5300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

    Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

The number of shares outstanding of the registrant’s common stock, par value $0.00125 per share, as of January 5, 2007, was 76,602,056.

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CREE, INC.

FORM 10-Q

For the Three and Six Months Ended December 24, 2006

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

CREE, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

The accompanying notes are an integral part of the consolidated financial statements.

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CREE, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

(Unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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CREE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW

(In thousands)

(Unaudited)

The accompanying notes are an integral part of the consolidated financial statements.

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CREE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 24, 2006

(Unaudited)

1. Basis of Presentation

The consolidated balance sheet at December 24, 2006, the consolidated statements of income for the three and six months ended December 24, 2006 and December 25, 2005, and the consolidated statements of cash flow for the six months ended December 24, 2006 and December 25, 2005 have been prepared by Cree, Inc. (collectively with its subsidiaries, the “Company”) and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to present fairly the consolidated financial position, results of operations and cash flows at December 24, 2006, and for all periods presented, have been made. The consolidated balance sheet at June 25, 2006 has been derived from the audited financial statements as of that date.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s fiscal 2006 Annual Report on Form 10-K. The results of operations for the period ended December 24, 2006 are not necessarily indicative of the operating results that may be attained for the entire fiscal year.

2. Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.

Fiscal Year

The Company’s fiscal year is a 52- or 53-week period ending on the last Sunday in the month of June. The Company’s 2007 fiscal year extends from June 26, 2006 through June 24, 2007 and is a 52-week fiscal year. The Company’s 2006 fiscal year extended from June 27, 2005 through June 25, 2006 and was also a 52-week fiscal year.

Reclassifications

Certain fiscal 2006 amounts in the accompanying consolidated financial statements have been reclassified to conform to the fiscal 2007 presentation. These reclassifications had no effect on previously reported consolidated net income or shareholders’ equity.

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Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at December 24, 2006 and June 25, 2006, and the reported amounts of revenues and expenses during the three and six months ended December 24, 2006 and December 25, 2005. Actual amounts could differ from those estimates.

Revenue Recognition

The Company provides its customers with limited rights of return for non-conforming shipments. In addition, certain of the Company’s contractual sales arrangements provide for limited product exchanges and the potential for reimbursement of certain sales costs. As a result, the Company records an allowance, which is recorded as a reduction of product revenue in the consolidated statements of income and as a reduction to accounts receivable in the consolidated balance sheets.

The Company estimates its allowance in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”). Specifically, the Company reviews historical sales returns and other relevant data and matches returns or other credits to the quarter when the sales were originally recorded. Based on historical return percentages and other relevant factors, the Company estimates its potential future exposure on product sales that have been recorded. The allowance for sales returns at December 24, 2006 and June 25, 2006 was $5.7 million and $5.4 million, respectively.

In accordance with SFAS 48, the Company also records an estimate for the value of product returns that it believes will be returned to inventory in the future and resold. As of December 24, 2006 and June 25, 2006, the Company estimated the cost of future product returns at $1.1 million and $1.7 million, respectively, which is recorded in prepaid expenses and other current assets in the consolidated balance sheets.

3. Acquisition

Through a wholly owned subsidiary, the Company acquired all of the outstanding capital stock and options of INTRINSIC Semiconductor Corporation and its wholly owned subsidiary (“INTRINSIC”) on July 10, 2006. The acquisition has been accounted for under the purchase method of accounting as prescribed by SFAS No. 141, “Business Combinations.” All related goodwill and other intangible assets have been accounted for in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.”

The Company changed the name of INTRINSIC to Cree Dulles, Inc., effective July 10, 2006. All financial information of Cree Dulles, Inc., and its wholly owned subsidiary are included in the consolidated financial statements of the Company from the date of acquisition.

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The total purchase price is as follows (amounts in thousands):

The purchase price has been allocated based on estimated fair values of assets acquired and liabilities assumed. The Company’s purchase price allocation is as follows (amounts in thousands):

4. Discontinued Operations

During fiscal 2006, the Company discontinued the operations of its silicon-based radio frequency and microwave semiconductor business conducted by its Cree Microwave subsidiary (“CMI”). As of December 25, 2005, the Company completed production of all last time buy orders for CMI’s silicon products and terminated its remaining employees. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has reported the operating results of CMI for the three and six months ended December 24, 2006 and December 25, 2005, and the assets and liabilities of CMI on the balance sheet at December 24, 2006 and June 25, 2006, as a discontinued operation.

The Company believes the significant write-downs related to the closure of CMI’s business have been completed; however, there may be future adjustments to the estimated accrual of future lease obligations. During the second quarter of fiscal 2007, the Company entered into a sublease agreement for its Sunnyvale facility. As a result of entering into this agreement, the Company has adjusted its accrual for future lease obligations by $394,000 to reflect the actual payments agreed to under the terms of the sublease. The following table summarizes the changes

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attributable to costs incurred and charged to expense related to the exit activities for CMI, which are reflected in liabilities of discontinued operations in the consolidated balance sheets:

The following table summarizes the amounts of revenue and pre-tax income (losses) reported in discontinued operations for the respective income statement periods presented:

5. Inventories

Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out (“FIFO”) method for finished goods and work-in-process accounts. The Company uses the average cost method to value raw materials. The Company records a reserve against inventory once it has been determined that conditions exist which may not allow the Company to sell the inventory for its intended purpose, the inventory’s value is determined to be less than cost or it is determined to be obsolete. The charge for the inventory reserves is recorded in cost of revenue in the consolidated statements of income. Reserves are adjusted quarterly to reflect inventory values in excess of forecasted sales, as well as overall inventory risk assessed by management.

The following is a summary of the components of inventory:

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6. Investments

The Company currently holds 864,385 shares of Color Kinetics, Incorporated (“Color Kinetics”) common stock. During the second quarter of fiscal 2007, the Company sold 931,275 shares of Color Kinetics common stock for $16.7 million and recognized a $11.4 million gain. During the first quarter of fiscal 2006, the Company sold 63,782 shares of Color Kinetics common stock for $954,000 and recognized a $587,000 gain. As of December 24, 2006 and June 25, 2006, the Company had recorded cumulative unrealized holding gains on its investment in Color Kinetics of $13.1 million and $18.7 million, or $8.2 million and $11.8 million, net of tax, respectively. The calculation of the unrealized gains was based on the closing share price of Color Kinetics common stock as of December 22, 2006 and June 23, 2006 to determine the fair market value of the Company’s investment of $18.1 million and $29.1 million, respectively.

7. Intangible Assets

The following table reflects the components of intangible assets:

Customer relationships are amortized over ten years. Developed technology is amortized over seven years. Patent and license rights are amortized over twenty years.

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8. Earnings Per Share

The following computation reconciles the differences between the basic and diluted earnings per share presentations:

Potential common shares that would have the effect of increasing diluted earnings per share are considered to be antidilutive. In accordance with SFAS No. 128, “Earnings per Share,” these shares were not included in calculating diluted earnings per share. For the three and six months ended December 24, 2006, there were 8 million shares in both periods that were not included in calculating diluted earnings per share because their effect was antidilutive. For the three and six months ended December 25, 2005, there were 6.3 million and 5.4 million shares, respectively, not included in calculating diluted earnings per share because their effect was antidilutive.

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9. Shareholders’ Equity

The following presents a summary of activity in shareholders’ equity for the six months ended December 24, 2006 (dollars and shares in thousands):

10. Stock-Based Compensation

The Company currently has one equity-based compensation plan from which stock-based compensation awards can be granted to employees and directors. In addition, the Company has five plans that have been terminated as to future grants, but under which options are currently outstanding. The Company also has an Employee Stock Purchase Plan (“ESPP”) that provides employees with the opportunity to purchase common stock at 85% of the fair market value of the common stock at two designated times each year.

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The Company recorded stock-based compensation of $2.7 million and $6.4 million in the three and six months ended December 24, 2006, respectively. The Company recorded stock-based compensation of $3.5 million and $6.3 million in the three and six months ended December 25, 2005, respectively. Approximately $368,000 and $713,000 of stock-based compensation was allocated to inventory in the Company’s consolidated balance sheets as of December 24, 2006 and December 25, 2005, respectively.

The fair value of each award is estimated on the date of grant using the Black-Scholes-Merton option-pricing model using the following assumptions:

The following table summarizes option activity as of December 24, 2006, and changes during the six months then ended:

As of December 24, 2006, there was approximately $23.6 million of total unrecognized compensation costs related to stock-based compensation arrangements. The unrecognized compensation cost is expected to be recognized over a weighted-average period of two years. The weighted-average grant-date fair value of options granted during the six months ended December 24, 2006 was $18.94. The total intrinsic value of options exercised during the six months ended December 24, 2006 was $1.9 million.

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A summary of nonvested shares of restricted stock awards outstanding under the Company’s 2004 Long-Term Incentive Compensation Plan as of December 24, 2006, and changes during the six months then ended, follows:

As of December 24, 2006, there was approximately $4.1 million of total unrecognized compensation costs related to nonvested restricted stock share-based compensation arrangements. The unrecognized compensation cost is expected to be recognized over a weighted-average period of four years.

11. Income Taxes

For the three and six months ended December 24, 2006, the Company’s effective tax rate, including discrete items, was 12% and 24%, respectively. The variation between income tax expense and pretax accounting income is primarily due to the retroactive reenactment of the research and experimentation tax credit, the release of valuation allowances on deferred tax assets related to Federal capital loss carryforwards and state taxes.

For the three and six months ended December 25, 2005, the Company recorded reductions in income tax expense of $132,000 and $2.3 million, respectively, related to realized and unrealized capital gains on its investment in Color Kinetics. In fiscal 2002, the Company recorded a capital loss associated with certain other marketable securities that was carried forward for tax purposes. However, the Company fully reserved the tax benefits associated with the loss because it was more likely than not such benefits would expire unused by the Company. Based on SFAS No. 109, “Accounting for Income Taxes,” the valuation allowance should be adjusted for any new realizable federal capital gains or losses. The increase in the market value of the Company’s investment in Color Kinetics was an unrealized capital gain that the Company could offset against the fiscal 2002 loss carry forward. For this reason, a portion of the valuation allowance associated with the prior year capital loss was reversed initially and has been adjusted in each subsequent quarter as the market value of the Company’s investment in Color Kinetics changed.

In future periods, the Company will continue to adjust its deferred tax asset valuation allowance in connection with any increase or decrease in the value of its investment in Color Kinetics, which could increase or decrease the income tax expense for such period.

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12. Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”) to provide enhanced guidance when using fair value to measure assets and liabilities. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value and, while not requiring new fair value measurements, may change current practices. The Company is currently evaluating the impact SFAS 157 will have on its consolidated financial statements. The standard is effective for the Company beginning in fiscal 2009.

Also in September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires using both an income statement approach and a balance sheet approach in assessing materiality of misstatements and is effective for the Company in fiscal 2007. The adoption of SAB 108 is not expected to have a material impact on the Company’s financial position or results of operations.

The Company continues to assess the impact that FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), will have on its consolidated financial statements. Issued by the FASB in June 2006, FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal 2008.

13. Commitments and Contingencies

On September 11, 2006, the Company, together with the Trustees of Boston University as co-plaintiffs, filed a complaint against BridgeLux, Inc. (formerly eLite Optoelectronics) for infringement of two U.S. patents. The two patents are No. 6,657,236, entitled “Enhanced Light Extraction in LEDs through the Use of Internal and External Optical Elements,” which is owned by the Company, and No. 5,686,738, entitled “Highly Insulating Monocrystalline Gallium Nitride Thin Films,” which the Company has licensed from the University on an exclusive basis. The suit was filed in the U.S. District Court for the Middle District of North Carolina and seeks monetary damages and injunctive relief to prohibit BridgeLux from infringing these patents. BridgeLux has filed a motion to dismiss the complaint contending that it is not subject to personal jurisdiction of the court and that venue is improper.

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On October 17, 2006, BridgeLux filed a complaint against the Company in the U.S. District Court for the Eastern District of Texas alleging infringement of U.S. Patent No. 6,869,812, entitled “High Power AlInGaN Based Multi-Chip Light Emitting Diode,” and seeking unspecified monetary damages and injunctive relief. On December 11, 2006, the Company filed an answer to this complaint in which the Company denied any infringement. Together with Boston University, the Company also asserted counterclaims against BridgeLux for infringement of the ‘236 and ‘738 patents originally asserted in the North Carolina case. In addition, the Company counterclaimed against BridgeLux for infringement of U.S. Patent Nos. 6,614,056 and 6,885,036 both entitled “Scalable LED With Improved Current Spreading Structures.” The Company’s counterclaims seek monetary damages and injunctive relief to prohibit BridgeLux from infringing these four patents. The Company also requested declaratory judgments that BridgeLux’s ‘812 patent is not infringed, is invalid based in part on our earlier ‘056 and ‘036 patents, and is unenforceable due to fraud and/or inequitable conduct committed before the U.S. Patent Office. BridgeLux has moved to sever and either dismiss or stay the proceedings on the infringement counterclaims.

On October 17, 2006, BridgeLux filed a complaint against the Company and Boston University in the U.S. District Court for the Northern District of California. The complaint seeks a declaratory judgment of non-infringement and invalidity with respect to the ‘236 and ‘738 patents and of non infringement with respect to U.S. Patent No. 6,600,175, entitled “Solid State White Light Emitter and Display Using Same,” which the Company owns, and U.S. Patent No. 6,953,703, entitled “Method of Making a Semiconductor Device with Exposure of Sapphire Substrate to Activated Nitrogen,” which we license from the University on an exclusive basis. After the Company filed its counterclaims in the Texas actionasserting the ‘056 and ‘036 patents, BridgeLux amended its complaint in the California action to add a request for a declaratory judgment of non-infringement with respect to these. The Company has moved to dismiss BridgeLux’s declatory judgment claims regarding the ‘236, ‘738, ‘056 and ‘036 patents on its prior filings in North Carolina and Texas and to dismiss the claims regarding the ‘175 and ‘703 patents for lack of subject matter jurisdiction.

Please refer to Part I, Item 3 of the Annual Report on Form 10-K for the fiscal year ended June 25, 2006 for a description of other material legal proceedings.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Information set forth in this Quarterly Report on Form 10-Q contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All information contained in this report relative to future markets for our products and trends in and anticipated levels of revenue, gross margins and expenses, as well as other statements containing words such as “may,” “will,” “anticipate,” “target,” “plan,” “estimate,” “expect,” and “intend,” and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business, economic, and other risks and uncertainties, both known and unknown, and actual results may differ materially from those contained in the forward-looking statements. Any forward-looking statements we make are as of the date made and we do not intend to update them if our views later change. These forward- looking statements should not be relied upon as representing our views as of any date subsequent to the date of this quarterly report. To review risk factors that could cause actual results to differ, see “Risk Factors” in Part II, Item 1A, of this report and in Part I, Item 1A, of our Annual Report on Form 10-K for the fiscal year ended June 25, 2006.

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, our consolidated financial statements, including the notes thereto.

Overview

We develop and manufacture semiconductor materials and electronic devices made from silicon carbide, or SiC, gallium nitride, or GaN, and related compounds. The majority of our products are manufactured at our main production facilities in Durham and Research Triangle Park, North Carolina. We also use subcontractors in Asia to perform some of our manufacturing steps for certain LED and power products. We generate revenues from the following product lines:

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Industry Dynamics

Our business is primarily selling high-brightness LED products, which is affected by a number of industry factors, including design trends in mobile products, overall demand in products using high-brightness LEDs, an intense and constantly evolving competitive environment, and intellectual property issues. Currently, the most significant market for our LED chips is for illumination purposes in mobile products, including LCD backlighting, keypad illumination and flash units for camera phones. LED unit sales for mobile products are impacted by the number of LEDs used in a product, which varies depending on design trends and the brightness of the LEDs used in an application. Average LED sales prices generally decline each year as market players implement pricing strategies to gain or protect market share. To remain competitive, LED producers generally must increase product performance and reduce costs to support lower average sales prices. The mobile phone segment has become more competitive over the last several quarters which has caused companies to lower prices at a faster rate than was previously estimated. Finally, vigorous protection and pursuit of intellectual property rights characterize the semiconductor industry. Customers’ purchasing decisions can be influenced by whether a product may infringe valid intellectual property rights.

Highlights of the Second Quarter of Fiscal 2007

The following is a summary of our financial results in the three months ended December 24, 2006:

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Outlook for Fiscal 2007

We target that the LED chip market will continue to be challenged in the second half of fiscal 2007. We plan to continue to expand our global sales, marketing and distribution capabilities to support increased sales of our new LED components and high-power products.

For the remainder of fiscal 2007, we plan to work on increasing the brightness of our LED chips and packaged LED products. We plan to continue cost reduction initiatives for both our LED and SiC-based high-power products by converting to four-inch wafer production and transferring more of our production to our subcontractors in Asia. In addition, we target to invest $90 million to $100 million in capital expenditures, primarily at our North Carolina sites. This will support unit volume growth and is a critical part of our overall product cost reduction initiatives.

We plan to evaluate strategic investments to expand and strengthen our technology and product portfolio as well as to increase access to our targeted markets.

Critical Accounting Policies

The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. On a regular basis, management reviews our accounting policies, assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and we may be exposed to gains or losses that could be material.

Our significant accounting policies are discussed in Note 2, “Summary of Significant Accounting Policies and Other Matters,” of the Notes to Consolidated Financial Statements, included in Part 2, Item 8 of our Annual Report on Form 10-K for the fiscal year ended June 25, 2006. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating our reported financial results. These policies require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors.

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Results of Operations

The following table shows our consolidated statements of income expressed as a percentage of total revenue from continuing operations for the periods indicated:

Comparison of Three Months Ended December 24, 2006 and December 25, 2005

Revenue. Revenue from continuing operations decreased 16% to $88.8 million in the second quarter of fiscal 2007 from $105.6 million in the second quarter of fiscal 2006. Product revenue decreased 17% to $81.5 million from $98.8 million in the quarter-to-quarter comparison. The decrease in product revenue resulted from the decline in revenue of LED chip products partially offset by an increase in revenue from our high-brightness LED packaged products, materials and high-power products.

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LED revenue declined 24% to $65.5 million in the second quarter of fiscal 2007 from $86.5 million in the second quarter of fiscal 2006, making up 74% of our total revenue from continuing operations. While unit shipments of our LED products increased 5% over the second quarter of fiscal 2006 due to slightly higher customer demand for mid-brightness products, our blended average LED sales price decreased 28% due to increasing price competition and changes in product mix for both high-brightness and mid-brightness devices. Sales of our mid-brightness products decreased 37% in the second quarter of fiscal 2007 and represented 52% of LED revenue, down from 63% in the second quarter of fiscal 2006. Sales of our high-brightness products declined 3% and represented 48% of LED revenue, up from 37% in the second quarter of fiscal 2006. The decrease in sales of high-brightness chips was offset by an increase in sales of high-brightness LED packaged products.

Materials revenue increased 16% to $10.6 million in the second quarter of fiscal 2007 from $9.1 million in the second quarter of fiscal 2006, making up 12% of our revenue from continuing operations. The primary driver of the increase in material revenue was a 13% increase in the average sales price due to changes in product and customer mix in combination with a 3% increase in the number of units sold.

Revenue from our high-power devices increased 75% to $5.3 million in the second quarter of fiscal 2007 from $3.0 million in the second quarter of fiscal 2006. The increase in revenue was primarily the result of higher sales of our Schottky diode and SiC MESFET products. Revenue from high-power devices was 6% of revenue from continuing operations in the second quarter of fiscal 2007.

Contract revenue increased 6% to $7.3 million in the second quarter of fiscal 2007 from $6.7 million in the second quarter of fiscal 2006, making up 8% of total revenue from continuing operations. The increase in revenue is primarily due to the start of new contract awards and contracts acquired in connection with the acquisition of INTRINSIC Semiconductor Corporation, or INTRINSIC.

Gross Margin. Gross margin from continuing operations in the second quarter of fiscal 2007 declined 42% to $30.4 million from $52.2 million in the second quarter of fiscal 2006. Our gross margin percentage decreased from 49% to 34% of revenue from continuing operations in the quarter-to-quarter comparison. The decrease was caused primarily by lower gross margins on sales of LED chip products as average selling prices declined faster than cost reductions due to increased pricing pressure in the marketplace for our LED chip products, lower factory utilization and higher startup costs related to the new component product lines.

Contract gross margins decreased to 20% in the second quarter of fiscal 2007 from 27% in the second quarter of fiscal 2006 as our mix of contract work has shifted towards projects that have a higher cost share component.

Research and Development. Research and development expenses from continuing operations decreased 1% in the second quarter of fiscal 2007 to $14.6 million from $14.8 million in the second quarter of fiscal 2006. Research and development spending supported our continued development of higher brightness LED chips, high power packaged LEDs, larger wafer process development and ongoing development for high-power devices.

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Sales, General and Administrative. Sales, general and administrative (“SG&A”) expenses from continuing operations increased 16% in the second quarter of fiscal 2007 to $12.6 million compared to $10.8 million in the second quarter of fiscal 2006. During the second quarter of fiscal 2007, SG&A expenses reflected higher costs incurred in connection with the defense of our intellectual property, as well as continued spending on sales and marketing to support our incremental growth, the building of our global sales and marketing teams, and the continued development of the Cree brand.

Impairment or Loss on Disposal of Long-Lived Assets. Impairment or loss on the disposal of long-lived assets decreased to $85,000 in the second quarter of fiscal 2007 compared to $132,000 in the second quarter of fiscal 2006 as a result of the long-lived assets disposed of in each comparative quarter.

Gain on Investments in Securities, Net. During the second quarter of fiscal 2007, we sold 931,275 shares of Color Kinetics common stock for $16.7 million and recognized an $11.4 million gain.

Interest Income, Net. Net interest income increased 34% to $4.0 million in the second quarter of fiscal 2007 from $3.0 million in the second quarter of fiscal 2006 due to the higher interest rates received on our investments.

Income Tax Expense. Income tax expense from continuing operations for the second quarter of fiscal 2007 decreased 77% to $2.2 million from $9.4 million in the second quarter of fiscal 2006 primarily due to a decrease in taxable income. The decrease in income tax expense was also attributable to a decrease in our effective tax rate from 32% to 12%, which is primarily due to the retroactive reenactment of the research and experimentation tax credit of $1.0 million and a $2.0 million adjustment to the valuation allowance on deferred tax assets relating to federal capital loss carryovers. We currently target our effective tax rate for the remainder of fiscal 2007 to be approximately 31%, which does not reflect changes in the market price for shares of Color Kinetics common stock, which we treat as a discrete item each quarter.

Income (Loss) from Discontinued Operations, Net of Tax. In the second quarter of fiscal 2007, we entered into a sublease agreement for our Sunnyvale facility. As a result of entering into this agreement, we have adjusted our accrual for future lease obligations by $394,000 to reflect the actual payments to be received under the terms of the sublease agreement. This adjustment, offset by the continued expense arising from the Sunnyvale facility, resulted in our recording $245,000 of pre-tax net income, or $216,000 after-tax, for our discontinued Cree Microwave business in the second quarter of fiscal 2007. In the second quarter of fiscal 2006, we recorded a pre-tax operating loss of $3.5 million, or $2.3 million after-tax, as our Cree Microwave business generated revenue of $3.3 million from last time buy orders offset by heavy fixed costs incurred to operate the Sunnyvale facility. We also incurred additional charges related to the closure of this business in the second quarter of fiscal 2006 including $232,000 in severance expense, a $468,000 write-down of inventory that was scrapped, a $93,000 fixed asset impairment, and a $3.1 million charge for an accrual relating to the remaining lease contract obligation for the Sunnyvale facility.

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Comparison of Six Months Ended December 24, 2006 and December 25, 2005

Revenue. Revenue from continuing operations decreased 8% to $192.7 million in the first half of fiscal 2007 from $208.5 million in the first half of fiscal 2006. Product revenue decreased 8% to $178.9 million in the first half of fiscal 2007 from $195.1 million in the first half of fiscal 2006. The decrease in product revenue resulted from the decline in revenue of LED chip products partially offset by an increase in revenue from our high-brightness LED packaged products, materials and high-power products.

LED revenue declined 13% to $148.2 million in the first six months of fiscal 2007 from $171.1 million in same prior year period, making up 77% of our total revenue from continuing operations. While unit shipments of our LED products increased 18% over the first half of fiscal 2006 due to higher customer demand for LED chip products used in mobile phones and other products and high-brightness LED packaged products, our blended average LED sales price decreased 27% due to increasing price competition and changes in product mix for both high-brightness and mid-brightness devices. Sales of our mid-brightness products decreased 15% in the first six months of fiscal 2007 and represented 59% of LED revenue, down from 60% in the first six months of fiscal 2006. Sales of our high-brightness products declined 11% and represented 41% of LED revenue, up from 40% in the first half of fiscal 2006. The decrease in sales of high-brightness chips was offset by an increase in sales of high-brightness LED packaged products, which was driven by an increase in the number of units sold during the first six months of fiscal 2007.

Materials revenue increased 19% to $20.8 million in the first half of fiscal 2007 from $17.5 million in the first half of fiscal 2006, making up 11% of our revenue from continuing operations. The primary driver of the increase in wafer product revenue was a 39% increase in the average sales price due to changes in product and customer mix. The increase in sales price was somewhat offset by a 14% decline in the number of units sold.

Revenue from our high-power devices increased 56% to $9.9 million in the first six months of fiscal 2007 from $6.3 million in the first six months of fiscal 2006. The increase in revenue was primarily the result of higher sales of our Schottky diode and SiC MESFET products. Revenue from high-power devices was 5% of revenue from continuing operations in the first half of fiscal 2007.

Contract revenue increased 2% to $13.8 million in the first six months of fiscal 2007 from $13.5 million in the first six months of fiscal 2006, making up 7% of total revenue from continuing operations. The increase in revenue is primarily due to the start of new contract awards and contracts acquired in connection with the acquisition of INTRINSIC.

Gross Margin. Gross margin from continuing operations in the first six months of fiscal 2007 declined 30% to $73.3 million from $104.4 million in the first six months of fiscal 2006. Our gross margin percentage decreased from 50% to 38% of revenue from continuing operations in the same period comparison. The decrease was caused primarily by lower gross margins on sales of LED chip products as average selling prices declined faster than cost reductions due to increased pricing pressure in the marketplace for our LED chip products, lower factory utilization and higher startup costs related to the new component product lines.

Contract gross margins decreased to 21% in the first half of fiscal 2007 from 30% in the first half of fiscal 2006 as our mix of contract work has shifted towards projects that have a higher cost share component.

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