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Edited Transcript of CREE earnings conference call or presentation 25-Apr-17 9:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 Cree Inc Earnings Call

Durham Apr 29, 2017 (Thomson StreetEvents) -- Edited Transcript of Cree Inc earnings conference call or presentation Tuesday, April 25, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charles M. Swoboda

Cree, Inc. - Chairman, CEO and President

* Daniel Castillo

Cree, Inc. - President of Lighting

* Michael E. McDevitt

Cree, Inc. - CFO and EVP

* Raiford Garrabrant

Cree, Inc. - Director of IR

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Conference Call Participants

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* Brian Lee

Goldman Sachs Group Inc., Research Division - VP and Senior Clean Energy Analyst

* Colin William Rusch

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Cynthia Michelle Motz

The Williams Capital Group, L.P., Research Division - Analyst

* Daniel Baksht

Pacific Crest Securities, Inc., Research Division - Associate

* Jeffrey David Osborne

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Paul Coster

JP Morgan Chase & Co, Research Division - Senior Analyst, Alternative Energy, and Applied and Emerging Technologies

* Richard Thomas Sewell

Stephens Inc., Research Division - Research Associate

* Sreekrishnan Sankar

BofA Merrill Lynch, Research Division - Director

* Stephen Chin

UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst

* Thomas Andrew Sepenzis

Northland Capital Markets, Research Division - MD and Senior Research Analyst

* Vishal B. Shah

Deutsche Bank AG, Research Division - MD and Senior Analyst

* Yeuk-Fai Mok

Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Cree Third Quarter Fiscal Year 2017 Earnings Call and Webcast. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn today's conference over to Raiford Garrabrant, Director, Investor Relations. Please go ahead.

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Raiford Garrabrant, Cree, Inc. - Director of IR [2]

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Thank you, Abigail, and good afternoon. Welcome to Cree's third quarter fiscal 2017 conference call. Today, Chuck Swoboda, our Chairman and CEO; Mike McDevitt, our CFO; and Danny Castillo, EVP and Head of our lighting business, will report on our results for the third quarter of fiscal year 2017.

Please note that we will be presenting non-GAAP financial results during today's call, and a reconciliation to the corresponding GAAP measures is in our press release and posted in the Investor Relations section of our website. Today's presentations include forward-looking statements about our business outlook, and we may make other forward-looking statements during the call. 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 third quarter of fiscal year 2017 to a discussion of the information included in our press 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. Consistent with our previous conference calls, we are 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 1 hour, we ask that analysts limit themselves to 1 question and 1 follow-up. If you have additional questions, please contact us after the call.

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

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [3]

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Thank you, Raiford. Fiscal Q3 revenue was $342 million, with non-GAAP EPS of $0.01 per share. These results include $0.10 per share of depreciation expenses related to the termination of the Wolfspeed transaction that was not in our targets for the quarter. If you exclude the restart and catch-up depreciation expenses related to the termination of the Wolfspeed transaction, our non-GAAP EPS results would have been $0.11 per share, which is on the lower end of our target range for the quarter. Wolfspeed LEDs were at/or above their target range for the quarter, while lighting revenue was about 12% lower than targeted.

As we announced in February, we have shifted our focus back to growing the Wolfspeed business as part of Cree. The business has performed well this fiscal year as our customers have further realized the value of our unique technology. Our Wolfspeed business enters fiscal Q4 with a very strong backlog and is targeted to be an important growth business for Cree.

LED demand was better than forecast in Q3 and although margins were slightly lower than forecast, overall profits were within the target range. We also made progress ramping up our new Dmax LED chip in the quarter. LED backlog for Q4 is currently ahead of this point last quarter.

We announced earlier today an agreement to form a joint venture for high-performance, mid-power packaged LEDs with San'an Optoelectronics. This JV combines Cree's technology leadership, sales channel and IP with San'an's tremendous manufacturing scale to provide our customers with mid-power LEDs to complement our high-power LED product offering. Cree will own 51% of the JV and the products will be sold to the Cree LED sales channel. We believe this JV provides a new growth opportunity for our LED business and target initial product sales from the JV in the first half of fiscal 2018 after the JV is fully established and the first products are qualified by the customers.

Lighting sales were lower-than-expected in Q3 driven by 2 primary factors. First, the U.S. commercial lighting market was seasonally slower than forecast as has been reported by several other manufacturers. Second, our win rate was lower on quoted projects due primarily to delays related to lingering effects of a third-party supplier driver issue that impacted product quality in our fiscal Q2. We're targeting some growth in fiscal Q4, and Danny Castillo, Executive Vice President and Head of our lighting business, will provide some additional commentary later on this call.

The company is building a solid foundation for growth in all 3 businesses for fiscal 2018. The Wolfspeed business is doing well and is in a uniquely position to benefit from the market shift to silicon carbide power devices and gallium nitride RF devices as both a substrate and a device supplier. The LED business is making progress with new high-power LED technology and is now positioned to grow revenue by leveraging the new JV to also serve our customers' mid-power product needs. Our lighting team is strengthening the fundamentals and laying the groundwork to grow revenue and profits in this business, and I'm confident they will deliver.

I'll now turn the call over to Mike McDevitt to review our third quarter financial results in more detail as well as our targets for the fourth quarter of fiscal 2017.

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Michael E. McDevitt, Cree, Inc. - CFO and EVP [4]

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Thank you, Chuck. I will be providing commentary on our financial statements on a 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 the non-GAAP information to the corresponding GAAP measures for all periods mentioned on this call is posted on our website or provided in our press release, along with a historical summary of other key metrics.

As a reminder, our fiscal Q3 targets provided in January were based on the closing the Wolfspeed transaction in the quarter, which we believe was likely at the time. As a result of the termination of the transaction, there are 3 significant items that were not in those targets. The items are: Wolfspeed depreciation and amortization expense resumption and catch-up due to the operating segment no longer being held for sale. This resulted in our Q3 GAAP net loss being increased by $24 million or $0.24 per share and our non-GAAP net income being reduced by $10 million or $0.10 per share.

The primary difference between the GAAP and non-GAAP impact is the effective tax rate for each. An $86 million increase in our GAAP net loss or $0.88 per share for a tax valuation allowance on our U.S. deferred tax assets and other deferred charges that were recorded in the quarter. We determine these charges were required due to our 3-year cumulative U.S. pretax loss position combined with the transaction termination, which we had anticipated would generate sizable U.S. taxable income to utilize the deferred tax assets and other deferred charges. This charge was excluded from our non-GAAP results. These 2 items were partially offset by the termination fee received from Infineon net of additional transaction costs resulting from the deal being terminated.

This fee and these costs were excluded from our non-GAAP results but reduced our GAAP net loss by $11 million or $0.11 per share. Combining these items increased our GAAP net loss by $99 million or $1.01 per share and decreased our non-GAAP net income by $10 million or $0.10 per share, excluding these items our Q3 GAAP and non-GAAP results were at the low end of our targeted ranges for earnings and earnings per share.

For the third quarter of fiscal 2017, consolidated company revenue was $342 million and non-GAAP earnings were $1 million or $0.01 per share. Excluding the Wolfspeed depreciation and amortization restart and catch-up I had just described, non-GAAP earnings were $11 million or $0.11 per share.

Our non-GAAP earnings exclude noncash stock-based compensation, acquired intangibles amortization, the Wolfspeed transaction termination fee, transaction costs related to the terminate of Wolfspeed sale and other items. For consolidated operations, the excluded amount is $100 million net of tax or $1.03 per share, which was $86 million net of tax higher than targeted primarily due to the significant items related to the Wolfspeed transaction termination I mentioned earlier.

Fiscal 2017 third quarter revenue and non-GAAP gross profit for our reportable segments were as follows: Lighting Products revenue decreased to $154 million, which was 12% lower than targeted. Gross profit was $35 million for a 23% gross margin. The lower commercial revenue also resulted in underutilization of our factory, which along with a higher warranty reserves caused a decrease in gross profit and margin.

LED Products revenue was $132 million and gross profit was $32 million for a 24.7% gross margin. Revenue was above our target range due to better-than-expected demand while also reducing distributor inventories. Gross profit was within the target range as higher revenue helped to offset lower gross margins, which were primarily the result of mix and costs associated with the new LED chip ramp.

Wolfspeed revenue was $56 million and gross profit was $26 million for a 47% gross margin. Revenue, gross profit and margin all exceeded our targets. The Wolfspeed segment had strong demand at both the substrate and device level. Gross margins were better than target due primarily to improved factory productivity. The gross profit and gross margins included approximately $5 million of normal quarterly depreciation, which were not in our Q2 results or our Q3 targets while the business was being held for sale.

Non-allocated costs totaled $5 million for the third quarter of fiscal 2017 and are included to reconcile to our $88 million non-GAAP gross profit for 26% gross margin.

Non-GAAP operating expenses for Q3 were $94 million and were $2 million below our target for the quarter, due primarily to lower variable sales expenses associated with the lower commercial lighting sales. Our non-GAAP operating loss was $5 million. Excluding the $15 million pretax Wolfspeed depreciation restart and catch-up impact, non-GAAP operating income was $10 million.

We ended the quarter with $439 million in cash and investments net of line of credit borrowings, an $18 million increase from Q2. At the end of the quarter, we had $153 million outstanding on our line of credit. For the quarter, we generated $44 million of cash from operations and spent $25 million for capital expenditures, which yielded free cash flow of $19 million. During Q3, we spent $6 million to repurchase 200,000 Cree shares. Fiscal 2017 year-to-date, we have repurchased 4.4 million Cree shares for $104 million. With the termination of the Wolfspeed transaction, we have limited our stock buyback activity while we update our longer-term capital needs to support the targeted growth in Wolfspeed.

For fiscal 2017, we target $95 million plus or minus of capital spending, which is primarily related to infrastructure projects to support our longer-term growth and strategic priorities. Overall, we target fiscal 2017 free cash flow of $120 million plus or minus. While we are still developing our capital investment and free cash flow targets for our fiscal 2018, we currently estimate the company will be free cash flow positive again in fiscal 2018. This is inclusive of the capital required to expand capacity for our Wolfspeed business, which is currently capacity constrained but excludes capital required to support potential lighting-related M&A. We will provide fiscal 2018 capital targets during our Q4 earnings call in August.

Day sales outstanding increased 5 days from December to 39 days at the end of March. Inventory days on hand decreased a day from December to 103 days at the end of March. The inventory decrease primarily relates to our targeted reductions in lighting finished goods. This was partially offset by an increase in LED work in process to support the LED new product ramp and the capitalization of the restart at Wolfspeed manufacturing depreciation. Our midterm inventory target is 90 to 100 days.

Q4 total company backlog is tracking ahead of this point last quarter. We target Q4 company revenue in the range of $340 million to $360 million. We target lighting revenue to grow 2%, plus or minus sequentially, as growth in commercial is partially offset by seasonally slower consumer sales.

We target revenue from our LED business to be 4% higher, plus or minus sequentially, and our Wolfspeed business to be flat to slightly higher than Q3. Our Wolfspeed business is currently limited by factory capacity, which we've already started to address.

Given the current state of our lighting business, we have reevaluated the business to identify spending that is not aligned with our current growth strategy for this business. During Q4, we are taking action to remove certain costs that are targeted to yield an $8 million annual benefit. The financial benefit of this rightsizing initiative will not be fully realized until the first quarter of fiscal 2018.

We target Q4 non-GAAP gross margins increasing to 29%, plus or minus. This increase will be driven primarily by lighting with incremental improvement in LED and Wolfspeed margins. Lighting margins are targeted to improve due primarily to a higher mix of commercial sales and a higher reseen factory utilization.

During Q4, the new Dmax LED chip platform will begin ramping into higher volume production, which we target to provide some margin improvement in our core high-power LED business in the first half of fiscal 2018. We are targeting Q4 operating expenses to be $97 million, plus or minus, which is $3 million higher than Q3, primarily due to costs associated with rightsizing our lighting business and the joint venture start-up cost. We will be consolidating the joint venture's operations into our results in reporting the JV's revenue and gross profit as part of our LED segment.

Additionally, Cree will receive a royalty for the Cree IP license to the JV, commissions for our LED sales force selling the JV's products and reimbursement for administrative services performed on the JV's behalf.

We target Q4 non-GAAP operating income to be between $2 million to $8 million. We target a 17% Q4 non-GAAP effective tax rate and we target Q4 non-GAAP net income to be between $2 million to $7 million or $0.02 to $0.07 per diluted share. Our non-GAAP EPS target excludes acquired intangible amortization, noncash stock-based compensation and other items. Our Q4 targets are based on a number of factors that could vary, including overall demand, product mix, factory execution and the competitive environment.

I will now turn the discussion back to Chuck.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [5]

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Thanks, Mike. We're uniquely positioned as a market-leading innovator in all 3 businesses and target growth in each of these segments over the next several years. These businesses are in different phases of their growth and generally operate on different market cycles. This should provide more business diversity and less cyclical results over time.

We are focused on the following priorities to support our strategy to deliver higher revenue and profit. We're investing in the Wolfspeed business to increase capacity and further develop the technology to support longer-term growth opportunities in silicon carbide materials, silicon carbide power devices and modules, and gallium nitride RF devices. We've invested in these technologies since the company was founded almost 30 years ago, and we're now starting to see more significant growth as a result of this investment. Our silicon carbide materials and power device technology is being designed into the latest generation of electric vehicles, enabling more efficient electric drives and charging systems. We currently have considerable demand with orders in the fiscal 2018 from the first applications, which has stressed our silicon carbide materials capacity. We're negotiating some longer-term supply contracts with our customers and we've begun investing in additional capacity to support the projected demand ramp for these products in the coming years.

In addition to the Power side of the business, we're also working with several large RF device companies to supply gallium nitride dye to enable their next-generation products needed for the rollout of 5G wireless networks.

We plan to grow the LED Products business by expanding our product offering with new high-power and mid-power products that leverage our market leadership to increase our share at existing LED customers while also opening new applications for our technology. In the high-power segment, we continue to innovate. We recently announced our next-generation NX high-power LED platform that will power the next generation of Cree's lighting class LEDs. The new platform combines our new Dmax LED chip with innovative light conversion and packaging technology, enabling our new Extreme Density, or XD, LED components. Even though we've just introduced the first XD components, we've already started ramping up the Dmax LED chips, which are being used in certain existing components to provide a performance improvement and to reduce costs over the next year. These innovations continue to position Cree to lead in the high-power LED segment.

To better leverage the Cree brand, channel and IP, we're also expanding our product offering with high-performance mid-power LED components from our recently announced joint venture with San'an. This partnership is designed to give our LED business yet another growth path with a high-performance mid-power product line to complement our market-leading high-power LEDs and serve our customers' mid-power LED requirements. We target growing Lighting Products revenue and increasing margins by investing in our channel relationships, improving execution and continuing to deliver innovative lighting solutions.

I'm going to turn the call over to Danny Castillo to provide some additional insight on our lighting business.

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Daniel Castillo, Cree, Inc. - President of Lighting [6]

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Thanks, Chuck. It has been an exciting transition to Cree over the last 5 months. I have spent the last 25 years in electrical and lighting businesses, and despite the short-term revenue challenges we faced in Q3, I'm convinced that Cree is uniquely positioned to win in the North American lighting business. The recent revenue trend is due to a combination of our low win rate on quoted projects due to issues like the supplier quality on product components we had in our fiscal Q2, and an overall slower market for lighting in the quarter as reported by several other lighting companies.

The lighting and electrical business is fundamentally about building and strengthening channel-partner relationships that benefit both parties over time. We have a great reputation as the LED lighting market innovator, but after spending most of my time with our agents and distributors over the last several months, I believe that we've under-invested in the customer service and the channel relationship side of the business. This is something I've experienced in prior roles and have started to taking steps to address these gaps. The internal fundamentals have been improving for more than a quarter but it takes time to regain trust and translate these improvements to more share and a higher win rate with our partners.

We have talented and committed people at Cree, but I'm also adding some new talent who have strong industry relationships and experience to help accelerate the learning curve both internally and externally. As Mike mentioned earlier, we're adjusting our lighting operating expenses to remove costs that aren't aligned with our growth strategy while still investing in key areas to drive longer-term growth such as with smart lighting, which we will be showcasing at LIGHTFAIR in May.

We target some incremental improvement in Q4, but I believe it will take several quarters to rebuild significant momentum in this business. I'm confident that the combination of improved service, innovative products like SmartCast and solid execution can drive strong revenue growth and deliver improved profits over time.

I will now turn the call back to Chuck.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [7]

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Thanks, Danny. As part of our focus on improving in lighting, we're continuing to invest in developing smart building solutions. We recently announced our SmartCast Intelligence Platform, which we believe is the first intuitive lighting system to leverage the Internet of Things by combining Cree's industry-leading SmartCast Power over Ethernet LED lighting network with the company's innovative analytic software to transform lighting and sensor data into actionable insights. I believe this is just the beginning of transforming lighting into a much larger market opportunity over time.

We are entering a new and exciting phase in Cree's development as a company. The strength of our balance sheet gives us the ability to invest in Wolfspeed, while continuing to pursue our LED and lighting growth plans. These businesses are unified by our ability to innovate and change industries with disruptive technologies, creating superior-performing products that allow our customers to deliver more value while consuming less energy.

While we have work to do to realize the full potential of each business, our success over the last 30 years has been based on our ability to adapt, innovate and help our customers succeed. We're making investments to support the growth, adding talent to bring in new expertise and adjusting our strategy to respond to changing market dynamics. As we've finish fiscal Q4 and start to look ahead, I believe all 3 businesses are poised for growth in fiscal 2018.

We will now take analyst questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Paul Coster with JPMorgan.

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Paul Coster, JP Morgan Chase & Co, Research Division - Senior Analyst, Alternative Energy, and Applied and Emerging Technologies [2]

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I got a quick follow-up, so this is for Chuck. However, can you just compare and contrast the San'an JV with the Lextar investment that you've made previously? How is this different? And why is this one going to work?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [3]

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Yes, Paul, Lextar was a minority investment and that was really designed to around getting access to sapphire chip supply. And I would tell you that we continue to use Lextar, and they've done a great job being one of our major sapphire chip suppliers. The San'an JV is quite different. This is a JV that actually make mid-power packaged LED components. So as you know, Cree's been primary focused on the high-power segment for the last several years. This JV will now give us access to high-performance packaged, high-power product line and allow our sales channel the ability to serve customers not only what they're buying in high power, but now actually be able to also work on the mid-power applications as well as get into some new customers. So I think it's a -- for us, it's an opportunity to expand the LED portfolio that our components team is selling and expanding the number of customers we can sell to.

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Paul Coster, JP Morgan Chase & Co, Research Division - Senior Analyst, Alternative Energy, and Applied and Emerging Technologies [4]

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Just a quick question on the guidance. So the revenue outlook is sort of captures what you've just printed really. It's going to be flat throughout the year yet the EPS number is down. Can you just talk us through what the delta there is? Why is it that EPS isn't a bit higher on a -- higher revenue run rate in the next sequential quarter?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [5]

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Yes. So Paul, if you look at the revenue, we are targeting actually a little -- in the middle point of that range is a little bit of revenue growth. People are looking at about 2% for lighting, that's commercial being up, offset by a consumer being seasonally down. We got LED's up about 4% and Wolfspeed in a similar range and that's really capacity constraint. So there's a little bit of revenue growth in there. On the earnings side, the thing you're probably missing is there's about $3 million of additional OpEx is one of them, and that's really related to some of the expense reductions we're going to be making in the lighting business as well as the JV start-up costs. So we are targeting gross margin that go up, but have some additional OpEx in this quarter that shouldn't repeat again as we get into the next fiscal quarter. Mike, did you want to add anything to that?

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Michael E. McDevitt, Cree, Inc. - CFO and EVP [6]

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Yes, just to clarify that. At the midpoint, we'll be up a little bit on pretax profit versus the normalized Q3, but we'll also have a 17% GAAP -- non-GAAP tax rate versus we had a lower tax rate in Q3 to catch up year-to-date.

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Operator [7]

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Our next question comes from Craig Irwin with Roth Capital. Our next question comes from Brian Lee with Goldman Sachs.

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Brian Lee, Goldman Sachs Group Inc., Research Division - VP and Senior Clean Energy Analyst [8]

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I had a couple actually, and maybe to start off on the San'an JV. Chuck, if you could just clarify a little bit, is there any incremental CapEx that's going to be involved with this JV? And then, I know you're talking about having the 51% stake. Is there any kind of take-or-pay agreement or sort of supplier arrangement embedded in this? And then I have a couple of follow-ups.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [9]

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Sure. So there is no incremental CapEx to Cree's business. So Cree is bringing the -- we're obviously both making a small capital investment and to get the JV started, Cree's brings the brand, the channel, the IP. San'an really brings the manufacturing side of it. So the JV itself will have very -- have essentially no significant CapEx. And then from a 51-49, it's a straight up 51-49. There's no embedded other kinds of relationships between the 2 behind the scenes there.

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Brian Lee, Goldman Sachs Group Inc., Research Division - VP and Senior Clean Energy Analyst [10]

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Okay. That's great, that's helpful. Are they, I guess, as a follow-up, is there -- there's not a take or pay, but is there any sort of allocated capacity specific to Cree as part of this JV? I know you guys are saying that's a strategic motivation for entering the JV and then there some exclusivity and some of the [ geos ] that you outlined in the press release. So that would be kind of -- the second follow-up I had and then just if I could quickly squeeze one in. What is this strategy to do the JV with San'an? What implications does it have for the front-end epi capacity you have in North Carolina? And then I thought you also had a decent amount of capacity downstream in China to do some of the packaging as well? So would be interested to hear anything on that front.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [11]

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Yes, so, Brian, I think the first to think about is from a sales standpoint, Cree will actually -- Cree's sales force will be exclusively selling JV products everywhere, but in China and a couple of other Asian countries. So generally speaking, these products will be sold by the Cree sales force. Keep in mind, this is not a chip joint venture, this is a package component. So today, Cree is primarily a high-power components supplier. This JV now gives us a product line to give us access to that. You should also keep in mind that San'an is primarily a chip supplier. So between the 2 companies, San'an is getting the ability to actually participate at the package components level as a mid-power company and Cree is able to participate there. So it's really for both of us, it's an expansion of the access to the markets for both of our business. Today, in terms of capacity, I think Cree's capacity is pretty much fully dedicated to our high-power business. And so this is really, I would say, it doesn't really conflict with that, it really is incremental on top of it for both companies.

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Operator [12]

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Our next question comes from Harsh Kumar with Stephens.

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Richard Thomas Sewell, Stephens Inc., Research Division - Research Associate [13]

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This is Richard in for Harsh. Wanted to talk about the overall lighting market. I know that you guys are expecting to see some rebound in the commercial side, what gives you the confidence there? And then secondly, what are the inventory levels in the lighting side?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [14]

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Yes. So from a lighting market standpoint, obviously, as we reported in pretty much every other lighting company, Q1 was soft. As we look out for the year, if I look at a couple more of the market indicators, whether I think -- take the ABI or Dodge, both of them suggest that even if Q1 calendar was soft, for the year, they're suggesting that nonresi construction will be up. So from a Cree standpoint, we think the market will -- is still based on those factors targeted to grow for the year. Second, from a Cree standpoint, we're not just looking to grow with the market, but we're looking to expand with new products getting us into new applications. So that's the other really growth driver for our business as we look forward. In terms of inventory, we do not see a significant change in inventory, in the channel from a Cree standpoint in the quarter. So for us, there was no significant change one way or another. Internally, we actually reduced our internal inventories in the quarter.

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Richard Thomas Sewell, Stephens Inc., Research Division - Research Associate [15]

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Got you. That's extremely helpful. And then the driver issue that you had this quarter, is that completely behind you? And how should we think about that going forward? Is there going to be any kind of lingering effect from that?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [16]

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Yes. So the issue actually occurred in Q2 where we had to, basically, replace some of our then -- our third-party suppliers with new suppliers. So during that process, we've put products on hold. The lingering effect actually happened in this quarter. So our win rate on quoted projects actually went down. And so when those products went on hold, some of that business got pushed to other suppliers because of the challenges we had just delivering during Q2. I feel like the quality issues are behind us, actually, effective exit in Q2, it's more of when does the win rate recover. Right now, we're targeting to see some incremental growth in lighting this quarter. So we would expect to see -- start to see some improvement in our fiscal fourth quarter. And at least as we get started here, that's what the early indicators in the quarter would suggest is we're on track for that.

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Operator [17]

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Our next question comes from Vishal Shah with Deutsche Bank.

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Vishal B. Shah, Deutsche Bank AG, Research Division - MD and Senior Analyst [18]

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Chuck, I'm just trying to reconcile a few comments that your competitors have made on the lighting space around the broader market and your guidance. How much of your quarterly guidance is a function of the supplier issues being fixed versus the broader market recovering because it sounds like from some of your peers, it sounds like the market, the lighting market is expected to remain soft for the next couple of quarters until maybe late Q2, Q4 as when they expect a recovery. So I'm just wondering what kind of visibility do you have around that? And then secondly, do you see any Asian players entering the space, and increased competition under the core lighting market?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [19]

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Yes, no problem, Vishal. The first one -- all right, I'm glad you asked so I can clarify. So if I think about our Q3 numbers, I'd say that the broader market was probably about half of the decline and half was the stuff related to our driver, roughly. So obviously, as our driver, she's improved, we believe we can recover some of that and that's somewhat independent of what the market recovers significant in the quarter. So that's driving our near-term guidance, and maybe why we're incrementally more optimistic in the short term. Regarding the Asian players, there clearly are a lot of products that are being brought into the country. I don't know that, that's a significant change in how the market's been done for a long time. If you think about Cree's strategy, there's kind of a spec market, I would say. That's not really a market where you see a lot of the imports. But in what we kind of call it, internally, the stock-and-flow business, they're kind of the middle to lower end of the market that typically flows through distribution. There are definitely a lot of products that come from a variety of suppliers. In fact, the Cree's strategy is -- the Cree brand is focused on the spec side, but we're actually putting some things in place to actually be able to service that part of the stock and flow with some other brands that we should be having out here over the next couple of months.

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Vishal B. Shah, Deutsche Bank AG, Research Division - MD and Senior Analyst [20]

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That's helpful. And just one follow-up on the automotive segment, I know you guys in the past talked about working with some auto suppliers. Can you maybe just update us on the progress you've made on that front? And when we should expect some announcements on that front?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [21]

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Yes. So the goal was to get our first automotive LED component qualified by the end of this fiscal year. I think we're on track to getting through that qual. We can't really say anything until that officially happens and then we'll be able maybe talk about when we can start seeing some incremental business. I think there's a long-term investment. It's something that I would expect we'll get some incremental benefit in fiscal '18, but this is a multiyear process to get design across a variety of platforms. But it starts with getting those first product qualified. And as of right now, we're still on track to get that done this quarter but there's still got a little work left to do to make that happen.

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Operator [22]

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Our next question comes from Tom Sepenzis with Northland.

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Thomas Andrew Sepenzis, Northland Capital Markets, Research Division - MD and Senior Research Analyst [23]

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Just curious if you could go in a little bit in terms of the CapEx you're expecting for Wolfspeed, when it will it take -- start to take effect and when we could see an expansion of the capacity there since you're assumedly at full capacity right now.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [24]

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Yes. So we've already started making investments to address the silicon carbide wafer side of it. And so I would estimate that we'll start to get some improvement maybe late fiscal Q1, early fiscal Q2 of next year. So it will be tight this quarter and, hopefully, we'll start to see some improvement as we get into the early part of fiscal '18. We've also already started making investments on the device side of the business. And I'd say, those will be in a similar time when we should start to see those improvements. So we already had some in process, some of this is a timing issue of how fast the new product -- the new equipment gets installed and gets qualified. But they're both underway. And I would expect as we get quarter 2 down the road, we should start to see some opportunity to take advantage of more of the demand on the Wolfspeed side of the business.

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Thomas Andrew Sepenzis, Northland Capital Markets, Research Division - MD and Senior Research Analyst [25]

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Great. And then just (inaudible) it seems to be kind of in the mid- to high-40s now. Is that a sustainable rate? Or would that be something that you're going to target to try to get to the low-50s? And if so, how would you do that?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [26]

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Yes. So I think right now we're -- last quarter and, Mike, correct me, I think we're around 47% for the business.

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Michael E. McDevitt, Cree, Inc. - CFO and EVP [27]

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Yes, that's correct.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [28]

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If you look at it, I think that's a reasonable level. Obviously, there's a lot of moving pieces that's a function of mix between power RF and materials. And so as long as we're in that range kind of the high 40s, near 50, I think we're doing the right thing, and our focus is more at that point, it's about how do we take advantage of the growth opportunity? So we're clearly doing things to improve yields and drive cost down. But we're early stages of that market and at the same time, we want to keep doing things to get design into those next applications. So I think where we're at today, plus or minus, is a pretty good range for at least the foreseeable future.

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Operator [29]

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Our next question comes from Colin Rusch with Oppenheimer.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [30]

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You guys mentioned that you are trending the product portfolio a little bit on the lighting side. Can you just give us a bit more color on where those targeted products are? And are you subtracting from a portfolio or retiring any products here in the near term?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [31]

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Yes. Mostly what we're doing on the lighting side is we're looking to expand. So we have some products that will open some additional applications. For everything from the SmartCast, the new product we talked there, is really software that we get to add to our SmartCast system. So that's an opportunity to sell not only hardware, but actually start to look at some different revenue models on the smart side of the business. So that's a pretty exciting piece of it. There's new products coming in the outdoor side of our business as well as we have some indoor products. A lot of those -- I don't want to take the thunder away from the fact that we'll be announcing a few of those things between now and our LIGHTFAIR trade show. So there's a lot of stuff coming. And then we also have some new products targeted for some different channels. So what I would say is it's both different applications but also products targeted for certain channels. And over the next probably 2 to 3 weeks, you'll see a number of different announcements come out because, really, we use LIGHTFAIR as the big unveiling of a lot of that to get that out there.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [32]

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Okay, perfect. And then on Wolfspeed, there's an awful lot of development happening in the automotive space right now. Can you talk a little bit about the automotive exposure you have in terms of the development programs, the number of programs you're working on? And are there any vehicles that are in full production at this point in terms of the revenue base for Wolfspeed?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [33]

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Yes. So keep in mind, Wolfspeed, we participate 2 ways, right? We have both -- we are a substrate supplier to most of the other major device companies and we have our own device business. We have products that, devices that are being worked on for certain parts of some new vehicle programs that are coming. But we're also very focused on substrate supply to a number of other device companies. So it's a combination of both, none of which -- no specific programs that I'm allowed to disclose at this point. But I feel pretty comfortable that we have the ability to participate both as a device company, as well as a material supplier to the other major device companies.

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Operator [34]

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

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [35]

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First question is on margin. So on this current quarter, you talk about lighting mix will shift a little more back towards commercial, retail being a bit smaller, you talked about driver should be behind you. But your guidance kind of implied margins, not much change in margins. What can help you bring lighting margin back to the way it was before?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [36]

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Yes, well, so, Edwin, the way I think about margins is if you look at our margins, if you take out the catch-up depreciation in our third quarter, let's say, our margins would have been roughly around 27% and we're targeting 29%. So we're targeting a couple of hundred basis point improvement. Most of that is driven by the lighting. There's some incremental contribution that's in Wolfspeed. So I actually feel like we are targeting pretty good margin improvement from the company overall, driven by lighting in the quarter.

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Yeuk-Fai Mok, Needham & Company, LLC, Research Division - Senior Analyst of Semiconductor Capital Equipment [37]

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Okay. And then, I guess, the question around acquisition. Historically, you guys have talked about potentially looking for acquisition to augment your business. Now that Wolfspeed deal is not happening, does it change your appetite for a larger transaction, and maybe specifically light driver given the issue there, does it make sense to maybe bring that in-house or buy something or develop something around the drivers?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [38]

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Yes. So look, I think about it in a couple different ways. So as Mike mentioned earlier in his comments that he is -- we have -- we're still putting together a plan for next year. But from a preliminary view, we're pretty comfortable that we will generate enough cash flow that we can increase CapEx at Wolfspeed and still have capital available to pursue M&A if that's something we choose to do. With that being said, and I think Danny would probably agree, this next couple of quarters, it's about improving the execution, getting some of the things running better. But I think we still believe that M&A is an important part of the lighting strategy but it's probably more of a 12- to 18-month strategy than a 6-month strategy as we really focus more on the execution there. In terms of drivers, honestly, I think with that, it's really been a supply-chain exercise. I feel very good about our current suppliers that are helping us there. We've gone through a pretty extensive process over the last 6 months. And I actually think we'll be well served by the people we're working with now in the channel. I don't know, Danny, anything else you want to add to that?

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Daniel Castillo, Cree, Inc. - President of Lighting [39]

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I would say we're aligned with world class suppliers on the driver side of the business.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [40]

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Yes, and I think that actually going to give us opportunity to actually rebalance what we're focused on internally and actually put more of our R&D on driving some of the new product platforms.

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Operator [41]

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Our next question comes from Krish Sankar with Bank of America Merrill Lynch.

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Sreekrishnan Sankar, BofA Merrill Lynch, Research Division - Director [42]

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I had 2 of them. First one, Chuck, on the San'an deal and the one you guys talked with Lextar like 3 years ago. It looks like -- is it fair to assume that given that your capital capacities all high-power and deals with Lextar and San'an from mid-power, the longer-term your view is that maybe a medium product, they could probably grow higher or faster than high power and is it why you want to have a footprint? Or is there another way to look at it? And then I had a follow-up on Wolfspeed.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [43]

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Yes. The way I think about it is this, look, our high-power business has done real well over the last few years. But what's become clear, especially in a lot of lighting applications, some applications are high-power, works better in some, mid-power is the preferred choice. And so we have this investment and all of this IP and brand and channel and really it's a practical choice to be able to offer those customers that are buying our high-power LEDs the ability to also buy high-quality mid-power. And it's -- from one, it's a chance to really expand our business with existing customers as well as open up some applications where, frankly, high-power is just not the choice. So for Cree it's more of a -- we focused on high-power. I think it's done a good job of differentiating us and helping us continue to lead. But I think we recognize that in lighting and in some other applications, mid-power is a practical choice. So we want to have the products to be able to service that for those customers. So it's -- for us it's a chance to expand the serviceable market for our business.

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Sreekrishnan Sankar, BofA Merrill Lynch, Research Division - Director [44]

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Got you. That's really helpful. And then I'll follow up on Wolfspeed, actually a 2-part question on Wolfspeed. Number one, if there was a U.S.-based strategic that was interested in Wolfspeed, would you be willing to reconsider the asset sale? And number two is, I do understand and I believe in the long-term opportunity in both autos and 5G. For Wolfspeed, I'm just kind of wondering, in terms of 5G, when do you expect the real sales to happen. Is it going to be tied with the build-out in 2019, 2020? Do you think you're going to start seeing sales earlier for you guys?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [45]

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Yes. So look, we spent 2 years looking at a lot of options and talking to a lot of different companies on Wolfspeed. And what we proved is that, with the Infineon deal, we've proved it's a very valuable asset and if anything, it's become more valuable because that team has continued to execute really well. As I said when -- as we've put out when the deal was terminated, that we really think we have a great business there. And I -- we think the best way to extract value here at least for the foreseeable future is to invest and take advantage of growth in the various markets. So that's really what we're spending our time focused on. In terms of what markets are out there, clearly, power, auto is probably the growth driver that's changing power fast right now. And so I think that's probably the most exciting. 5G is a little hard to call. There's, I think, if you look at it from a pure technical standpoint, gallium nitride will be, by far, the best technical way to solve 5G. I think there are still some companies trying to push silicon a little harder to make it work. My sense is that will be the bigger growth driver, although, we have some GaN in some of the systems that are out there today. I think it's a little hard to call the exact timing of that. But we're starting from such a small base, any movement in that direction, I think, starts to drive that. So well, auto, EV is kind of in now, I think over the next year, we'll see some increased demand on the 5G side, maybe a little bit behind power. But I see that not too far behind.

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Operator [46]

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Our next question comes from Stephen Chin with UBS.

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Stephen Chin, UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst [47]

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First question on technology regarding the JV. Am I correct in assuming that the LED chip or the packaging will be silicon carbide substrate as opposed to sapphire?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [48]

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No, you shouldn't assume that. It's a silicon carbide-based chip. We're going to make mid-power LEDs that are competitive with the other mid-power LEDs that are out there in the marketplace. In fact, it's unlikely Cree will be making very many of those chips. Most of those chips will be coming from the market San'an or other people.

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Stephen Chin, UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst [49]

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All right. And one more question, could you maybe give a little more color on the monetization of Cree's IP and distribution channels in this field. I'm trying to get a sense of without really projecting a number, but the size of potential sales and earnings power?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [50]

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From the JV?

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Stephen Chin, UBS Investment Bank, Research Division - MD in the Technology Group and Research Analyst [51]

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Yes, correct.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [52]

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Yes. So if you think about it today, I think that if you look at high-power versus mid-power, mid-power is the larger market. It's probably roughly a $4 billion LED components business that we don't really service much today. So I think there's tremendous opportunity. It ranges everything from lighting, to backlighting and just about every application in between. So I think that probably from a margin standpoint, it's likely to be a slightly lower margin than what our typical LED business is. But we would expect that the JV, net-net, will be accretive and generate profits overall. So it may have a slightly dilutive effect on the gross margin percentage, but we think it will be accretive from profits overall. Anything you want to add to that, Mike?

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Michael E. McDevitt, Cree, Inc. - CFO and EVP [53]

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No, that covered it.

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Operator [54]

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Our next question comes from Jeff Osborne with Cowen.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [55]

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Just a follow-up question, so if I was a Cree salesperson, how would you incentivize me to sell either the JV product or the Cree product? You've been competing against mid-power for years. I guess, just how do you expect the sales people to react with that the 2 alternatives?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [56]

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I think the sales people will be pretty pleased. The fact is that most applications, high power wins because it's a better solution. And when mid-power wins, it's a better way to solve the lighting problem. Cree has -- our own lighting portfolio, we have mid-power LEDs in some applications and high power in other. The difference in the past was the Cree salesman only had a high power offering. Now it gives us the opportunity in that customer that whichever is the better solution, we're going to support it. And if Cree wasn't offering, it's someone else would anyway. So to us, it's really an opportunity to expand the market opportunity for our sales team and our company.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [57]

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Got it. Just 2 quick ones. Would this salesperson be only going after the mid-power section that's related to the lighting one, which I think is about 30% of the market? And then, Chuck, any comments you have on the pricing? I know it was topical 3 months ago when you had your last call, just that some folks are trying to raise pricing, just curious what you're seeing in the market?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [58]

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Yes. So look, I think, think of it -- think of the Cree salesman, if sells -- he's happy to service the customer what they need for their application. And if it's high power, it's high power, it's mid-power, it's mid-power. They'll be doing both and we think that's the best way to service most customers because most lighting companies especially are buying both and that would be the right way to handle that. In terms of pricing, I think there's a lot of discussion about chip pricing out there. I think what we see is at least buying chips in the marketplace because we've continued to do that. There's still is the ability to see some cost reductions from the merchant suppliers out there. But remember, we're buying high-performance, mid-power chips. So when we're buying those chips, we're not on the very low end, we're on the middle to higher end of the market. I think the discussion that -- a lot of the discussion around pricing stabilizing is really on the very low end of that segment of the marketplace, which is not the place we participate anyways. But that's speculation on my part because what we are seeing is continued opportunities to get some additional cost downs from the external chip suppliers.

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Operator [59]

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Our next question comes from Daniel Baksht with Pacific Crest.

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Daniel Baksht, Pacific Crest Securities, Inc., Research Division - Associate [60]

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Just back on the JV. Do you plan to use the new capacity generated from the new JV in your lighting business? And could that help your lighting margins?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [61]

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So, today, I think our lighting business already a value. It looks at mid-power LEDs. So I think, obviously, the lighting team will look at JV LEDs as one of the potential suppliers to it. So I think that's an option. But think of it, it's really meant to be bigger than that. It's really meant to open up the very large mid-power market that we're not serving today for our sales team and really leverage. The investment we've made building a brand in high power but providing customers with maybe of fuller suite of products.

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Daniel Baksht, Pacific Crest Securities, Inc., Research Division - Associate [62]

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Okay, great. Then maybe a question for either Danny or Chuck, can you go into some of the steps you're taking to regain some of the trust in the lighting market and the strength in your channel partners?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [63]

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Yes, I'll let Danny handle that one.

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Daniel Castillo, Cree, Inc. - President of Lighting [64]

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Daniel, I would say, over the last 5 months, I've spent a lot of time out in the field with agents and customers and they're coming back with 2 key things. And they're asking us to continue to innovate and that's going to be our differentiator as we go forward. And also to deliver best-in-class customer service. So I think if we're able to do those 2 things, we'll put the business back on a growth pattern and start delivering in Q4.

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Operator [65]

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(Operator Instructions) Our next question comes from Cindy Motz with Williams Capital.

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Cynthia Michelle Motz, The Williams Capital Group, L.P., Research Division - Analyst [66]

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I just -- I wanted to follow up on that, Danny. I guess, wouldn't it be fair to say just with lighting that maybe the margins were a little off? I understand the whole thing about the market and everything, but you are launching a lot of new products. You're making new hires, you said you're trying to get everything in shape. So that's part of the reason why, Chuck, you chimed in, too, but why the gross margins are expected to probably go up. And then just following that, so in terms of the agency channel, are you broadening that as well? Are you focused on that? And then my last one was on SmartCast. Just how are you going to -- how are you marketing that, like, is that going to -- are you working with partners there? Or are you talking to your distribution channels about that? How does that work as well?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [67]

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Well, Cindy, let me start with the margin piece and I'll let Danny come back and give you a commentary on the agents and the SmartCast. So I think what we're doing primarily on margins is, I mean, as we go forward, so as we put some additional volume in the factory, we should get a benefit there. We also have new products coming out and we believe the mix of new products will be overall accretive to margins. And then the third piece is that Danny and his team have a number of cost-reduction activities. And I would say as I look out not only in Q4 but in next year, those are the 3 levers that really drive lighting margins overall. As far as what we're doing with agents on our SmartCast, I'll let Danny talk to it.

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Daniel Castillo, Cree, Inc. - President of Lighting [68]

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Cindy, I would say on the agent side, obviously, I think we're seen as the LED lighting market innovator, and we have areas of strength in around our customer service and channel relationships. And then in those channel relationships is how we see aligning and strengthening our relationships with the agent base. With respect to SmartCast, I think, obviously, we're doing well in SmartCast. I think the biggest things I could point to is the McLaren hospital that we recently did, out in Michigan. And that's obviously an opportunity where we think we can drive new revenue streams around the hardware, the sensor data and the analytics, and even test new models around recurring revenue and trying to drive that as we go forward.

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Cynthia Michelle Motz, The Williams Capital Group, L.P., Research Division - Analyst [69]

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Wait, do you have some of your existing customers asking you now more about SmartCast as well, just in the whole IoT thing?

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Daniel Castillo, Cree, Inc. - President of Lighting [70]

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Absolutely.

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Cynthia Michelle Motz, The Williams Capital Group, L.P., Research Division - Analyst [71]

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All right. Okay. If I could do one more follow-up, just in terms of the supplier question that you had, just sort of, it sounded like in April, I know it's just a short time, like, I know it was an issue for second quarter. You said it was still lingering, Chuck. But it sounded like in April maybe, you're seeing some signs that people are feeling fine now. I mean, is that safe to assume or...

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [72]

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What I would say is that, we corrected the issue in Q2, but it's still affecting the win rate as we were in our Q3. So we converted less of the quoted business. I'd say as far as how people are feeling, Danny's been spending all the time in the channel, maybe he can give a little bit of color to how people are feeling right now.

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Daniel Castillo, Cree, Inc. - President of Lighting [73]

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I think we've been out with all of our key agents and distributor partners. We've explained what happened and I think they're supporting us as we get -- going here in the fourth quarter.

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Operator [74]

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Our next question comes from [ Jason Rosenthal ] with Canaccord Genuity.

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Unidentified Analyst, [75]

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Just one for me, hoping to get a bit more color on the broader lighting market weakness. So is that short cycle, small project like we're hearing from others? And I guess, what's your take on what's driving the weakness?

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [76]

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I would say, our estimate, we would say, it's similar to short cycle stuff, although I would say that's more of an estimate. I think it's a little hard to predict exactly what's coming. But the best estimate is it's more of the short cycle kind of turns business.

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Operator [77]

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That does conclude today's question-and-answer session. I'd like to turn the call back to Mike McDevitt for further remarks.

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Michael E. McDevitt, Cree, Inc. - CFO and EVP [78]

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Thank you for your time today. We appreciate your interest and support and look forward to reporting our fourth quarter results on August 22. Good night.

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Charles M. Swoboda, Cree, Inc. - Chairman, CEO and President [79]

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Thank you.

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Operator [80]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Have a great day.