-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PDYinUtD/y2Gd/LY5ngwqt8KidJTdQ1bF2N41huOd9eRuILqq/NTeP2gNGxAn9qd 2M2Qw8BJknzBDtPzQOujlQ== 0000895419-00-000004.txt : 20000203 0000895419-00-000004.hdr.sgml : 20000203 ACCESSION NUMBER: 0000895419-00-000004 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19991226 FILED AS OF DATE: 20000131 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CREE INC CENTRAL INDEX KEY: 0000895419 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 561572719 STATE OF INCORPORATION: NC FISCAL YEAR END: 0627 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-21154 FILM NUMBER: 518403 BUSINESS ADDRESS: STREET 1: 4600 SILICON DR CITY: DURHAM STATE: NC ZIP: 27703 BUSINESS PHONE: 9193615709 MAIL ADDRESS: STREET 1: 4600 SILICON DR STREET 2: STE 176 CITY: DURHAM STATE: NC ZIP: 27703 FORMER COMPANY: FORMER CONFORMED NAME: CREE RESEARCH INC /NC/ DATE OF NAME CHANGE: 19940224 10-Q 1 QUARTERLY REPORT ON FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 26, 1999 Commission file number: 0-21154 CREE, INC. (Exact name of registrant as specified in its charter) North Carolina 56-1572719 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 4600 Silicon Drive Durham, North Carolina 27703 (Address of principal executive offices) (Zip Code) (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 The number of shares outstanding of the registrant's common stock, par value $0.0025 per share, as of January 20, 2000 was 32,989,048. CREE, INC. FORM 10-Q For the Quarter Ended December 26, 1999 INDEX Page No. PART I. FINANCIAL INFORMATION -------- Item 1. Financial Statements Consolidated Balance Sheets at December 26, 1999 (unaudited) and June 27, 1999 3 Consolidated Statements of Income for the three and six months ended December 26, 1999 and December 27, 1998 (unaudited) 4 Consolidated Statements of Cash Flow for the six months ended December 26, 1999 and December 27, 1998 (unaudited) 5 Notes to Consolidated Financial Statements (unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 PART II. OTHER INFORMATION Item 1. Legal Proceedings 18 Item 4. Submission of Matters to a Vote of Security Holders 18 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 -2- PART I. FINANCIAL INFORMATION Item 1. Financial Statements CREE, INC. CONSOLIDATED BALANCE SHEETS (In thousands) December 26, June 27, 1999 1999 ------------ ---------- ASSETS (Unaudited) Current assets: Cash and cash equivalents $ 38,164 $ 42,506 Marketable securities 5,708 6,145 Accounts receivable, net 18,478 16,285 Inventories 4,609 3,977 Deferred income tax 296 296 Prepaid expenses and other current assets 455 558 ------------ ---------- Total current assets 67,710 69,767 Property and equipment, net 88,291 69,884 Patent and license rights, net 1,937 1,731 Deferred income taxes 2,827 2,827 Other assets 147 8 ------------ ---------- Total assets $ 160,912 $ 144,217 ============ ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable, trade $ 6,128 $ 7,487 Accrued salaries and wages 1,512 819 Other accrued expenses 6,410 1,239 ------------ ---------- Total current liabilities 14,050 9,545 Long term liabilities: Long term liability 30 -- Deferred income tax 4,650 4,650 ------------ ---------- Total long term liabilities 4,680 4,650 Shareholders' equity: Preferred stock, par value $0.01; 3,000 shares -- -- authorized at December 26, 1999 and June 27, 1999; none issued and outstanding Common stock, par value $0.0025; 60,000 shares 74 73 authorized; shares issued and outstanding 29,700 and 29,258 at December 26, 1999 and June 27, 1999, respectively Additional paid-in-capital 113,311 111,136 Retained earnings 28,797 18,813 ------------ ---------- Total shareholders' equity 142,182 130,022 ------------ ---------- Total liabilities and shareholders' equity $ 160,912 $ 144,217 ============ ========== The accompanying notes are an integral part of the consolidated financial statements. -3- CREE, INC. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) (Unaudited)
Three Months Ended Six Months Ended --------------------------- --------------------------- December 26, December 27, December 26, December 27, 1999 1998 1999 1998 ------------- ------------ ------------ ------------ Revenue: Product revenue, net $ 22,136 $ 12,805 $ 40,392 $ 23,525 Contract revenue, net 1,794 1,233 3,585 2,792 ------------- ------------ ------------ ------------ Total revenue 23,930 14,038 43,977 26,317 Cost of revenue: Product revenue 10,075 6,377 19,572 11,792 Contract revenue 1,122 1,045 2,258 2,252 ------------- ------------ ------------ ------------ Total cost of revenue 11,197 7,422 21,830 14,044 ------------- ------------ ------------ ------------ Gross profit 12,733 6,616 22,147 12,273 Operating expenses: Research and development 1,911 1,121 2,843 1,927 Sales, general and 2,639 1,450 4,565 2,668 administrative Other (income) expense (8) 298 92 567 ------------- ------------ ------------ ------------ Income from operations 8,191 3,747 14,647 7,111 Interest income, net 573 20 1,142 135 ------------- ------------ ------------ ------------ Income before income taxes 8,764 3,767 15,789 7,246 Income tax expense 2,980 916 5,368 2,029 ------------- ------------ ------------ ------------ Net income $5,784 $ 2,851 $ 10,421 $ 5,217 ============= ============ ============ ============ Other comprehensive income, net of tax: Unrealized holding gain 1,981 -- (437) -- (loss) ------------- ------------ ------------ ------------ Comprehensive income $7,765 $ 2,851 $ 9,984 $ 5,217 ============= ============ ============ ============ Earnings per share: Basic $0.20 $0.11 $0.35 $0.20 ============= ============ ============ ============ Diluted $0.18 $0.10 $0.33 $0.19 ============= ============ ============ ============ Shares used in per share calculation: Basic 29,587 25,664 29,462 25,752 ============= ============ ============ ============ Diluted 31,594 27,668 31,404 27,082 ============= ============ ============ ============
The accompanying notes are an integral part of the consolidated financial statements. -4- CREE, INC. CONSOLIDATED STATEMENTS OF CASH FLOW (In thousands) Six Months Ended ----------------------------- December 26, December 27, 1999 1998 ------------ ------------ Operating activities: (Unaudited) Net income $ 10,421 $ 5,217 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,447 2,341 Loss on disposal of property, equipment and 44 951 patents Amortization of patent rights 67 56 Proceeds from sale of marketable trading -- 489 securities Purchase of marketable trading securities -- (232) Loss (gain) on marketable trading securities -- (116) Changes in operating assets and liabilities: Accounts receivable (2,193) (1,964) Inventories (632) (859) Prepaid expenses and other assets (35) 1,004 Accounts payable , trade (1,360) (3,073) Accrued expenses 5,894 420 ------------ ------------ Net cash provided by operating activities 16,653 4,234 ------------ ------------ Investing activities: Purchase of property and equipment (22,898) (10,380) Proceeds from sale of property and equipment -- 189 Purchase of patent rights (274) (194) ------------ ------------ Net cash used in investing activities (23,172) (10,385) ------------ ------------ Financing activities: Proceeds from issuance of long-term debt -- 1,333 Net proceeds from issuance of common stock 2,177 2,527 Receipt of Section 16(b) common stock -- 594 profits Repurchase of common stock -- (3,214) ------------ ------------ Net cash provided by financing activities 2,177 1,240 ------------ ------------ Net decrease in cash and cash equivalents (4,342) (4,911) Cash and cash equivalents: Beginning of period 42,506 17,680 ============ ============ End of period $ 38,164 $ 12,769 ============ ============ Supplemental disclosure of cash flow information: Cash paid for interest, net amounts $ -- $ 275 capitalized ============ ============ Cash paid for income taxes $ 268 $ 1,396 ============ ============ The accompanying notes are an integral part of the consolidated financial statements. -5- CREE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) BASIS OF PRESENTATION The consolidated balance sheet as of December 26, 1999, the consolidated statements of income for the three and six months ended December 26, 1999 and December 27, 1998, and the consolidated statements of cash flow for the six months ended December 26, 1999 and December 27, 1998 have been prepared by the Company and have not been audited. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial position, results of operations and cash flow at December 26, 1999, and all periods presented, have been made. The balance sheet at June 27, 1999 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 generally accepted accounting principles have been condensed or omitted. It is suggested that these condensed financial statements be read in conjunction with the financial statements and notes thereto included in the Company's fiscal 1999 Form 10-K. The results of operations for the period ended December 26, 1999 are not necessarily indicative of the operating results that may be attained for the entire fiscal year. ACCOUNTING POLICIES Fiscal Year The Company's fiscal year is a 52 or 53 week period ending on the last Sunday in the month of June. Accordingly, all quarterly reporting reflects a 13 week period in fiscal 2000 and fiscal 1999. The Company's current fiscal year extends from June 28, 1999 through June 25, 2000. Investments Investments are accounted for in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). This statement requires certain securities to be classified into three categories: (a) Securities Held-to-Maturity -- Debt securities that the entity has the positive intent and ability to hold to maturity are reported at amortized cost. (b) Trading Securities -- Debt and equity securities that are bought and held principally for the purpose of selling in the near term are reported at fair value, with unrealized gains and losses included in earnings. -6- (c) Securities Available-for-Sale -- Debt and equity securities not classified as either securities held-to-maturity or trading securities are reported at fair value with unrealized gains and losses excluded from earnings and reported in retained earnings. As of December 26, 1999, the Company's short-term investments consisted of common stock holdings of Microvision, Inc. ("MVIS"). The Company purchased 268,600 common shares in a private equity transaction in May 1999 at a price of $16.75 per share. In August 1999, MVIS filed a registration statement for the Company's sale of these shares; however, Cree agreed not to sell the shares until at least January 6, 2000. As of December 26, 1999, the Company was restricted from trading these shares and since management views this transaction as an investment, the shares are accounted for as "available for sale" securities under SFAS 115. Therefore unrealized gains or losses are excluded from earnings and are recorded directly in retained earnings. As of December 27, 1998, the Company's short-term investments consisted of common stock holdings in C3, Inc ("C3"), the majority of which were bought in November 1997. The Company also acquired additional shares of C3 in September 1998 and acquired 24,601 shares directly from C3 pursuant to the exercise of an option in January 1997. This investment was treated for accounting purposes as a trading security, with net realized and unrealized gains and losses included in net earnings. All common shares of C3 held by Cree were subsequently sold during fiscal 1999. Recognized gains on shares of C3 stock recorded to the statement of income during fiscal 1999 by the Company were $140,000. This amount was recorded as other income. Long Term Debt In November 1997, the Company entered into a term loan with a commercial bank for up to $10.0 million to finance the purchase and upfit of the new main facility in Durham, North Carolina. Approximately $3.0 million was disbursed under the loan to finance the initial purchase of the facility with the remaining proceeds disbursed on a monthly basis based on actual expenditures incurred. The loan, which was collateralized by the purchased property and subsequent upfits, accrued interest at a fixed rate of 8% and carried customary covenants, including the maintenance of a minimum tangible net worth and other requirements. As of December 27, 1998 the entire $10.0 million loan was outstanding, including a current portion of $121,000 and a long term amount of $9.9 million. On February 17, 1999, the entire $10.0 million indebtedness was repaid with proceeds received from a public stock offering. During the three and six months ended December 27, 1998, the Company capitalized interest on funds used to construct property, plant and equipment in connection with the facility. Interest capitalized for the three and six months ended December 27, 1998 was $34,000 and $118,000, respectively. Inventories Inventories are stated at the lower of cost or market, with cost determined under the first-in, first-out (FIFO) method. Inventories consist of the following: -7- December 26, June 27, 1999 1999 ------------ ------------ (In thousands) Raw materials $ 1,729 $ 1,290 Work-in-progress 1,579 1,675 Finished goods 1,301 1,012 ------------ ------------ Total Inventory $ 4,609 $ 3,977 ============ ============ Research and Development Accounting Policy The U.S. Government provides funding for several of the Company's current research and development efforts. The contract funding may be based on either a cost-plus or a cost-share arrangement. The amount of funding under each contract is determined based on cost estimates that include direct costs, plus an allocation for research and development, general and administrative and the cost of capital expenses. Cost-plus funding is determined based on actual costs plus a set percentage margin. For the cost-share contracts, the actual costs are divided between the U.S. government and the Company based on the terms of the contract. The government's cost share is then paid to the Company. Activities performed under these arrangements include research regarding silicon carbide and gallium nitride materials. The contracts typically require the submission of a written report that documents the results of such research. The revenue and expense classification for contract activities is based on the nature of the contract. For contracts where the Company anticipates that funding will exceed direct costs over the life of the contract, funding is reported as contract revenue and all direct costs are reported as costs of contract revenue. For contracts under which the Company anticipates that direct costs will exceed amounts to be funded over the life of the contract, costs are reported as research and development expenses and related funding as an offset of those expenses. The following table details information about contracts for which direct expenses exceed funding by period as included in research and development expenses: Three Months Ended Six Months Ended December 26, December 27, December 26, December 27, 1999 1998 1999 1998 ------------ ------------ ------------ ------------ (In thousands) Net R&D costs $ 134 $ - $ 174 $ - Government funding 331 - 398 - ------------ ------------ ------------ ------------ Total direct costs $ 465 $ - $ 572 $ - incurred ============ ============ ============ ============ -8- Significant Sales Contract In September 1996, the Company entered into a Purchase Agreement with Siemens AG ("Siemens"), pursuant to which Siemens agreed to purchase light emitting diode ("LED") chips made with the Company's gallium nitride-on-silicon carbide technology. In April 1997, December 1997 and September 1998, contract amendments were executed that provided for enhanced product specifications requested by Siemens and larger volume requirements, respectively. In December 1998, the Purchase Agreement was amended to provide for additional shipments of LED products through September 1999. The Purchase Agreement was subsequently assigned to an indirect subsidiary of Siemens, OSRAM Opto Semiconductors GMBH & Co. OHG ("Osram"), effective as of January 1, 1999. In August 1999, the Company entered into a new Purchase Agreement with Osram, pursuant to which Osram agreed to purchase and the Company is obligated to ship stipulated quantities of both the standard brightness and the high brightness LED chips and silicon carbide wafers through September 2000. The agreement calls for certain quantities of standard brightness and high brightness LED chips to be delivered by month. In the event the Company materially defaults in delivering shipments, Osram may recover liquidated damages of one percent per week of the purchase price of the delayed product, subject to a maximum of ten percent of the purchase price. If product shipments are delayed six weeks or more due to circumstances within the Company's control, then in lieu of liquidated damages, Osram may claim damages actually resulting from the delay up to 40% of the purchase price of delayed products. The contract also gives Osram limited rights to defer shipments. For products to be shipped in more than 24 weeks after initial notice, Osram can defer 30% and 20% of standard brightness and high brightness LEDs, respectively. For products to be shipped in more than 12 weeks, but less than 24 weeks, Osram may defer 10% of scheduled quantities for both standard brightness and high brightness LEDs. Also, additional quantities of high brightness LEDs stipulated in the contract may be deferred to the next quarter with 60 days notice at the election of Osram. In all cases, Osram would be required to accept all products within 90 days of the original shipment date. Additionally, the Purchase Agreement provides for higher per unit prices early in the contract with reductions in unit prices being available as the cumulative volume shipped increases. The higher prices were negotiated by the Company to offset higher per unit costs expected earlier in the contract. Depreciation The Company has adopted lower useful lives on new manufacturing equipment. The useful life for all manufacturing equipment purchased since the beginning of fiscal year 2000 is estimated to be 5 years. No changes have been made to the estimated useful life of 9 years for manufacturing equipment placed in service prior to fiscal 2000. In management's estimate, this policy change was necessary due to technology changes anticipated with the future development of larger diameter wafers. Based on information available at this time, management estimates that the change in policy may reduce the Company's fiscal 2000 net income by $660,000 or $0.02 per share, but actual results may vary. -9- Income Taxes The Company has established an estimated tax provision based upon an effective rate of 34%. The estimated effective rate was based upon projections of income for the fiscal year and the Company's ability to utilize remaining net operating loss carryforwards and other tax credits. However, the actual effective rate may vary depending upon actual pre-tax book income for the year or other factors. EARNINGS PER SHARE The Company presents earnings per share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128 required the Company to change its method of computing, presenting and disclosing earnings per share information. All prior period data presented has been restated to conform to the provisions of SFAS 128. The following computation reconciles the differences between the basic and diluted presentations: Three Months Ended Six Months Ended December December December December 26, 27, 26, 27, 1999 1998* 1999 1998* -------- -------- -------- -------- (In thousands, except per share amounts) Net income $ 5,784 $ 2,851 $10,421 $ 5,217 Weighted average common shares 29,587 25,664 29,462 25,752 -------- -------- -------- -------- Basic earnings per common share $ 0.20 $ 0.11 $ 0.35 $ 0.20 ======== ======== ======== ======== Net income $ 5,784 $ 2,851 $10,421 $ 5,217 Diluted weighted average common shares: Common shares outstanding 29,587 25,664 29,462 25,752 Dilutive effect of stock options 2,007 2,004 1,942 1,330 and warrants -------- -------- -------- -------- Total diluted weighted average 31,594 27,668 31,404 27,082 common shares -------- -------- -------- -------- Diluted earnings per common share $ 0.18 $ 0.10 $ 0.33 $ 0.19 ======== ======== ======== ======== * Weighted average shares and per share amounts have been adjusted for the two for one stock split effective July 26, 1999. Potential common shares that would have the effect of increasing diluted income per share are considered to be antidilutive. In accordance with SFAS No. 128, these shares were not included in calculating diluted income per share. As of December 26, 1999 and December 27, 1998, there were no potential shares considered to be antidilutive. -10- On July 13, 1999 the Company filed a Form 8-K announcing a two-for-one split of its common stock. The stock split was effected by an amendment to the Company's Articles of Incorporation that became effective at the close of business on July 26, 1999. With the effectiveness of the amendment, each issued and unissued authorized share of common stock, $0.005 par value per share, was automatically split into two whole shares of common stock, $0.0025 par value per share. On July 30, 1999, the Company issued to each holder of record of common stock a certificate evidencing the additional shares of common stock resulting from the stock split. All references in this document to common stock and per common share data have been adjusted to reflect the common stock split. SUBSEQUENT EVENT On January 20, 2000, the Company completed a public offering of 3,289,000 shares of its common stock at a price to the public of $85.125 per share. The Company received net aggregate proceeds of approximately $266.1 million after deducting underwriting discounts and commissions and estimated offering costs. The net proceeds will be used primarily for manufacturing facility expansion and purchase of additional equipment, the acquisition of an additional facility, research and development, and general corporate purposes. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Information set forth in this Form 10-Q, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Act of 1934. These statements represent our judgment concerning the future and are subject to risks and uncertainties that could cause our actual operating results and financial position to differ materially. Forward looking statements are typically identified by the use of such terms as "may," "will," "anticipate," "believe," "plan," "estimate," "expect," and "intend" and similar words, although some forward looking statements are expressed differently. Our actual operating results could differ materially from those contained in the forward looking statements due to a number of factors, including fluctuations in our operating results, production yields in our manufacturing processes, whether we can produce sufficient quantities of high brightness blue and green LEDs to meet demand, our dependence on a few customers, whether new customers will emerge, whether we can develop, introduce and create market demand for new products, whether we can manage our growth effectively, assertion of intellectual property rights by others and adverse economic conditions. See Exhibit 99.1 for additional factors that could cause our actual results to differ. -11- OVERVIEW Cree, Inc. is the world leader in developing and manufacturing semiconductor materials and electronic devices made from silicon carbide ("SiC"). We recognize product revenue at the time of shipment or in accordance with the terms of the relevant contract. We derive the largest portion of our revenue from the sale of blue and green LED products. We offer LEDs at two brightness levels: high brightness blue and green products and standard brightness blue products. Our LED devices are utilized by end users for automotive dashboard backlighting, liquid crystal display ("LCD") backlighting, including wireless handsets and other consumer products, indicator lamps, miniature white lights, indoor sign and arena displays, outdoor full color stadium displays, traffic signals and other lighting applications. LED products represented 57% of our revenue for the first six months of fiscal 2000 and represented 48% of our revenue in the first six months of fiscal 1999. During the first six months of fiscal 2000, revenues derived from sales of high brightness LEDs were greater than 60% of the total LED sales mix. Historically, we have experienced low margins with many new product introductions, including the high brightness products. We have continued to make improvements to output and yield since the high brightness products were introduced in fiscal 1999. During the first six months of fiscal 2000, we made progress towards our fiscal 2000 goal of a 50% cost reduction for high brightness LED products through a 36% reduction in unit costs from the fourth quarter of fiscal 1999. During the remainder of fiscal 2000, we plan to focus on reducing unit costs through higher production yields and increased volume. We derive revenue from the sale of SiC wafers that are used for device production and research and development. In addition, we sell SiC crystals to C3, which uses them in gemstone applications. Sales of advanced materials made from SiC represented approximately 35% of our revenue for the first six months of fiscal 2000 and approximately 41% during the first six months of fiscal 1999. During late fiscal 1998, fiscal 1999 and early fiscal 2000, C3 purchased crystal growth equipment we constructed but retain to use in manufacturing material for C3; this equipment has more than doubled our capacity allocated to the production of crystals for C3. In the fall of 1999, C3 announced lower sales and higher inventory levels than anticipated. C3 also launched a new marketing campaign for its gemstone products. Recently, we agreed that C3 could reschedule approximately one-half of its purchase commitments from the first half of calendar 2000 to the second half of the year. We anticipate that overall sales to C3 will decrease in calendar 2000 and we may use manufacturing capacity that becomes available due to a reduction in sales to C3 for our other product applications. We anticipate that product revenue from C3 will decrease to less than 10% of our revenue for the fourth quarter of fiscal 2000 and will continue to decline as a percentage of revenue through the first half of fiscal 2001. The balance of our revenue, 8% for the first six months of fiscal 2000 and 11% for fiscal 1999, is derived from government contract funding. Under various programs, U.S. Government entities support the development of our technology by supplementing our research and development funding. We retain ownership of patent rights on technology developed under such contracts, subject to certain license rights retained by the government. Contract revenue includes funding of direct research and development costs and a portion of our general and administrative expenses and other operating expenses for contracts under which we expect funding to exceed direct costs over the life of the contract. For contracts under which we anticipate that direct costs will exceed amounts to be funded over the life of the contract (i.e., certain cost-share arrangements), we report direct costs as research and development expenses with related reimbursements recorded as an offset to those expenses. -12- In June 1999, we announced the introduction of the first of a family of RF and microwave transistor products made from SiC. These products are designed for use in a variety of power amplification applications. A second phase of transistor products is expected to be available in fiscal 2000. We expect that these products will be marketed to a variety of amplifier producers for a number of uses, including wireless base station and digital broadcast applications. While distribution of these products on a sample basis commenced in early fiscal 2000, we believe that these products will be sold in limited quantities as evaluation kits during fiscal 2000 since design cycles for the target applications generally exceed six months. There can be no assurance that customers will develop applications requiring commercially significant volumes of our RF products or that such products will be successful in the market. In September 1996, we entered into an agreement with Siemens under which Siemens agreed to purchase a fixed quantity of our blue LED chips. In December 1998, this agreement was amended to provide for additional shipments of LED products through September 1999. This contract was assigned to Osram, an indirect subsidiary of Siemens, effective January 1, 1999. Siemens (including its Osram subsidiary) accounted for 40% of our revenue for fiscal 1998 and 37% of our revenue in fiscal 1999. In August 1999, we entered into a new purchase agreement with Osram pursuant to which Osram agreed to purchase, and we are obligated to ship, stipulated quantities of both standard brightness and high brightness LED chips, as well as SiC wafers, through September 2000. This contract gives Osram limited rights to defer shipments. It also provides for recovery of liquidated damages, and actual damages in some instances, if we materially default in meeting shipment schedules. The contract provides for higher unit prices early in the contract term, with unit price reductions becoming available as the cumulative volume of products shipped increases. RESULTS OF OPERATIONS Three Months Ended December 26, 1999 and December 27, 1998 Revenue. Revenue increased 71% from $14.0 million in the second quarter of fiscal 1999 to $23.9 million in the second quarter of fiscal 2000. This increase was attributable to an increase in product revenue of 73% from $12.8 million in the second quarter of fiscal 1999 to $22.1 million in the second quarter of fiscal 2000. This rise in product revenue was a result of the 105% increase in sales of our LED products in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. Growth in LED volume was due to a significant increase in demand for high brightness blue and green LED products which represented over 50% of total LED shipments for the second quarter of fiscal 2000. As a result of the increasing mix of high brightness products, average LED sales prices have increased 25% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. Revenue attributable to sales of SiC materials was 37% higher in the second quarter of fiscal 2000 than in the same period of fiscal 1999 due to a significant increase in sales to C3 for gemstone applications. During the fourth quarter of fiscal 1999 and the first quarter of fiscal 2000, C3 purchased additional equipment from us to increase our capacity to manufacture gemstone products for them by more than 50%. Recently, we agreed to spread shipments of gemstone products for the remainder of fiscal 2000 over the next twelve months. We believe that these reduced orders for the second half of fiscal 2000 can be offset with additional LED revenue. Contract revenue received from U.S. Government agencies increased 45% during the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999 due to additional awards received in late fiscal 1999 and in the first quarter of fiscal 2000. -13- Gross Profit. Gross margin was 53% of revenue during the second quarter of fiscal 2000 as compared to 47% during the second quarter of fiscal 1999. This increase is due primarily to the increases in LED sales volumes and average sales price per chip for LEDs discussed above. In addition, higher throughput and manufacturing yield on high brightness LEDs and materials products have resulted in lower unit costs. Wafer costs for SiC material sales also declined 44% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. Research and Development. Research and development expenses increased 71% in the second quarter of fiscal 2000 to $1.9 million from $1.1 million in the second quarter of fiscal 1999. Much of this increase was caused by greater investments for research in the RF and microwave and optoelectronics programs. In addition, spending under the MVIS contract was higher than funding received. We anticipate that internal funding for the development of new products will continue to grow in future periods, while we believe that government funding for our development projects will remain constant. Sales, General and Administrative. Sales, general and administrative expenses increased 82% in the second quarter of fiscal 2000 to $2.6 million from $1.5 million in the second quarter of fiscal 1999, due to greater spending to support the overall growth of the business. We anticipate that total sales, general and administrative costs will increase in connection with the growth of our business; however, we believe that as a percentage of revenue they will remain constant. Other (Income) Expense. Other (income) expense has decreased 103% to ($8,000) during the second quarter of fiscal 2000 from $298,000 for the second quarter of fiscal 1999. In the second quarter of fiscal 1999, we realized impairments to leasehold costs as a result of management's decision to move equipment from our leased facility to our new manufacturing site. This was offset somewhat by investment income recognized on stock held in C3. Interest Income, Net. Interest income, net has increased to $570,000 in the second quarter of fiscal 2000 from $20,000 in the second quarter of fiscal 1999 due to a higher available cash balance as a result of the public stock offering in February 1999. Interest rates were also higher in fiscal 2000. A portion of the proceeds from the public stock offering was used to repay the $10.0 million term loan from NationsBank in the third quarter of fiscal 1999; therefore, no interest expense was incurred in the second quarter of fiscal 2000. Interest expense incurred with the term loan was capitalized as a part of the construction improvements made to the facility in fiscal 1999. However, the majority of the interest incurred in the second quarter of fiscal 1999 was expensed. Income Tax Expense. Income tax expense for the second quarter of fiscal 2000 was $3.0 million compared to $900,000 in the second quarter of fiscal 1999. This increase resulted from higher profitability during the second quarter of fiscal 2000 over the same period in fiscal 1999 and a higher effective tax rate. Our tax rate during the second quarter of fiscal 2000 was 34% compared to 24% in the second quarter of fiscal 1999 due to a reduction in the reserve for deferred tax assets. -14- Six Months Ended December 26, 1999 and December 27, 1998 Revenue. Revenue increased 67% from $26.3 million in the first six months of fiscal 1999 to $44.0 million in the first six months of fiscal 2000. This increase resulted from an increase in product revenue of 72% from $23.5 million in the first six months of fiscal 1999 to $40.4 million in the first six months of fiscal 2000. This rise in product revenue was largely a result of the 99% increase in sales of our LED products in the first six months of fiscal 2000 compared to the first six months of fiscal 1999. Our high brightness LED products experienced the heaviest demand. While our LED chip volume has grown 88% in the first six months of fiscal 2000 over units shipped in the first six months of fiscal 1999, our average sales prices for LEDs have also increased 6% in the first six months of fiscal 2000 over the same period in the prior year. The greater average sales price reflects a significant shift in mix to the higher priced high brightness LED products. For the first six months of fiscal 2000, more than 60% of LED sales were attributable to high brightness products. For the first six months of fiscal 1999, less than 15% of LED sales were from high brightness products. Revenue attributable to sales of SiC material was 41% higher in the first six months of fiscal 2000 than in the same period of fiscal 1999 due to a significant increase in sales to C3 for gemstone applications. During the fourth quarter of fiscal 1999 and the first quarter of fiscal 2000, C3 purchased additional equipment from us to increase our capacity to manufacture gemstone products for them by more than 50%. Recently, we agreed to spread shipments of gemstone products for the remainder of fiscal 2000 over the next twelve months. We believe that these reduced orders for the second half of fiscal 2000 can be offset with additional LED revenue. Contract revenue received from U.S. Government agencies increased 28% during the first six months of fiscal 2000 compared to the first six months of fiscal 1999 due to new contracts that have been awarded to us during fiscal 2000. Gross Profit. Gross profit increased 80% from $12.3 million in the first six months of fiscal 1999 to $22.1 million in the first six months of fiscal 2000. This increase is due primarily to the increases in LED sales volumes and average sales price per chip for LEDs discussed above. During the first six months of fiscal 2000, the average cost of high brightness LEDs has been reduced 36%. Margins on wafer and gemstone products have also improved during the first six months of fiscal 2000 as higher quality materials are being produced with greater yields. Research and Development. Research and development expenses increased 48% in the first six months of fiscal 2000 to $2.8 million from $1.9 million in the first six months of fiscal 1999. Much of this increase was caused by a greater investment made for research in the RF and microwave and optoelectronics programs. We anticipate that internal funding for development of new products will continue to grow in future periods, while we believe that government funding for our development activities will remain constant. -15- Sales, General and Administrative. Sales, general and administrative expenses increased 71% in the first six months of fiscal 2000 to $4.6 million from $2.7 million in the first six months of fiscal 1999, due to greater spending to support the overall growth of the business. We anticipate that total sales, general and administrative costs will continue to increase in connection with the growth of the business; however, we believe that as a percentage of revenue they will remain constant. Other Expense. Other expense decreased 84% to $92,000 during the first six months of fiscal 2000 from $567,000 for the first six months of fiscal 1999. In the first six months of fiscal 1999, we realized impairments to leasehold costs as a result of management's decision to move equipment from our leased facility to our new manufacturing site. Interest Income, Net. Interest income, net increased 746% to $1.1 million in the first six months of fiscal 2000 from $135,000 in the first six months of fiscal 1999 due to a higher available cash balance as a result of the public stock offering in February 1999. Interest rates were also higher in fiscal 2000. In addition, in November 1997, we obtained a $10.0 million term loan from NationsBank to fund the acquisition and construction of our manufacturing facility in Durham, North Carolina. The majority of the interest incurred in the first six months of fiscal 1999 was expensed. Income Tax Expense. Income tax expense for the first six months of fiscal 2000 was $5.4 million compared to $2.0 million in the first six months of fiscal 1999. This increase resulted from higher profitability during the first six months of fiscal 2000 over the first six months of fiscal 1999 and a higher effective tax rate. Our tax rate during the first six months of fiscal 2000 was 34% compared to 28% in the first six months of fiscal 1999 due to a reduction in the reserve for deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES We have funded our operations to date through sales of equity, bank borrowings and revenue from product and contract sales. As of December 26, 1999, we had working capital of $53.7 million, including $38.2 million in cash and cash equivalents. Operating activities generated $16.7 million for the first six months of fiscal 2000 compared with $4.2 million generated during the comparative period in fiscal 1999. This increase was primarily attributable to higher profitability and was supplemented by timing differences and the net increase in accrued expenses due mostly to a higher income tax provision. We invested $22.9 million in capital expenditures during the first six months of fiscal 2000 compared to $10.4 million during the same period in the prior fiscal year. The majority of the increase in spending was due to new equipment additions to increase manufacturing capacity in our crystal growth and epitaxy areas. Also, we recently completed a 42,000 square foot facility expansion at our production site near Research Triangle Park, North Carolina. -16- We are currently engaged in construction activities relating to a 125,000 square foot expansion of our epitaxial and clean room fabrication facilities. We also intend to expand our facility for RF and microwave test and packaging areas in calendar 2000. We believe these additions will allow us to dramatically increase capacity at our facility for LED, RF and microwave and power products. We anticipate total costs for these facilities to be between $25.0 million and $30.0 million. Estimates for equipment costs relating to this expansion total between $25.0 million and $30.0 million. We also recently committed to purchase a 120,000 square foot facility under construction on 17.5 acres of land near our present facility. We plan to use this facility for sales, general and administrative and research and development personnel, as well as for general employee services functions. The cost to acquire this facility (not including the upfit costs for completing the shell building) is $8.1 million. We plan to fund all of these expansion activities with the net proceeds of the January 2000 stock offering. Although from time to time we evaluate potential acquisitions of and investments in complementary businesses and anticipate continuing to make such evaluations, we have no present commitments or agreements with respect to the potential acquisition of or investment in another business. Cash provided by financing activities during the first six months of fiscal 2000 reflected the receipt of $2.2 million in proceeds from the exercise of stock options from our employee stock option plan. At September 27, 1998, we had a loan outstanding for $10.0 million from a commercial bank to finance portions of the upfit of the production facility. The final draw to this loan was made during the first quarter of fiscal 1999 for $1.3 million. The loan was subsequently paid off in the third quarter of fiscal 1999. We also committed $3.2 million during the first quarter of fiscal 1999 to repurchase common stock. We anticipate that internally generated cash plus the proceeds of the January 2000 stock offering will be sufficient to fund our capital requirements for the next 12 months. IMPACT OF THE YEAR 2000 Even though the date is now past January 1, 2000 and we have not experienced any immediate adverse impact from the transition to the Year 2000, we cannot provide assurance that our suppliers and customers have not been affected in a manner that is not yet apparent. In addition, certain computer programs which were date sensitive to the Year 2000 may not process the Year 2000 as a leap year, and any negative consequential effects remain unknown. As a result, we will continue to monitor our Year 2000 compliance and the Year 2000 compliance of our suppliers and customers. Item 3. Quantitative and Qualitative Disclosures About Market Risk No material changes in market risk have been identified during the most recent quarter. -17- PART II - OTHER INFORMATION Item 1. Legal Proceedings In December 1999 the Company intervened as a party to a lawsuit pending in Tokyo District Court brought by Nichia Corporation against Sumitomo Corporation, one of the Company's distributors in Japan. Nichia's complaint against Sumitomo, filed December 1, 1999, alleged that certain blue LEDs sold by Sumitomo infringe a Japanese patent owned by Nichia. The allegation pertained to the Company's standard brightness LED products purchased by Sumitomo. The complaint principally sought provisional relief in the nature of a preliminary injunction prohibiting Sumitomo from making further sales of the product in Japan. The Company, as an intervenor, filed a response that denied any infringement with respect to its products. Nichia thereafter voluntarily dismissed the first complaint but commenced a second action against Sumitomo in Tokyo District Court seeking a permanent injunction based on the same patent. The complaint in the second suit was filed December 24, 1999. The Company has intervened in the second suit and filed a response denying any infringement. No monetary damages for infringement have been sought in either action. The Company believes the infringement claim is without merit and intends to vigorously defend its products against the claim. Item 4. Submission of Matters to a Vote of Security Holders The Company's Annual Meeting of Shareholders was held on November 2, 1999. The following proposals were introduced and voted upon: PROPOSAL NO. 1 -- Election of Directors Votes Votes Name For Withheld ------------------------ ----------------- --------------- F. Neal Hunter 26,381,618 281,803 Calvin H. Carter, Jr. 26,381,694 281,727 John W. Palmour 26,381,674 281,747 Walter L. Robb 26,375,554 287,867 Michael W. Haley 26,380,804 282,617 Dolph W. von Arx 26,084,724 578,697 James E. Dykes 26,381,054 282,367 PROPOSAL NO. 2 - Approval of amendment to Articles of Incorporation to change name to Cree, Inc. FOR 26,571,069 AGAINST 74,077 ABSTAINED 18,275 BROKER NON-VOTES 0 PROPOSAL NO. 3 - Approve amendments to the Equity Compensation Plan FOR 16,319,065 AGAINST 1,497,423 ABSTAINED 83,599 BROKER NON-VOTES 8,763,334 -18- PROPOSAL NO. 4 - Approval of adoption of 1999 Employee Stock Purchase Plan FOR 17,153,415 AGAINST 504,881 ABSTAINED 59,635 BROKER NON-VOTES 8,945,490 PROPOSAL NO. 5 - Ratification of the selection of Ernst & Young LLP as auditors for the fiscal year ending June 25, 2000 FOR 26,628,967 AGAINST 14,476 ABSTAINED 19,978 BROKER NON-VOTES 0 The matters listed above are described in detail in the Company's definitive proxy statement dated September 30, 1999, for the Annual Meeting of Shareholders held on November 2, 1999. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: 99.1 Certain Business Risks and Uncertainties (b) Reports on Form 8-K: No reports on Form 8-K were filed by the Company during the quarter ended December 26, 1999. -19- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CREE, INC. Date: January 31, 2000 /s/ Cynthia B. Merrell --------------------------------------------- Cynthia B. Merrell Chief Financial Officer and Treasurer (Authorized Officer and Chief Financial and Accounting Officer) -20- EXHIBIT INDEX Exhibit No. Description - ----------- ---------------------------------------- 99.1 Certain Business Risks and Uncertainties -21- EX-99.1 2 CERTAIN BUSINESS RISKS AND UNCERTAINTIES EXHIBIT 99.1 Certain Business Risks and Uncertainties Described below are various risks and uncertainties that may affect our business. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us, that we currently deem immaterial or that are similar to those faced by other companies in our industry or business in general may also impair our business operations. If any of the following risks actually occurs, our business, financial condition or results of future operations could be materially and adversely affected. Our operating results may fluctuate significantly and we may not be able to maintain our existing growth rate. Although we have had significant revenue and earnings growth in recent quarters, we may not be able to sustain these growth rates and we may experience significant fluctuations in our revenue and earnings in the future. Our operating results will depend on many factors, including the following: o our ability to develop, manufacture and deliver products in a timely and cost-effective manner; o our ability to produce enough usable product during each manufacturing step (our "yield"); o our ability to expand our production of silicon carbide, or SiC, wafers and devices; o demand for our products; o demand for our customers' products; o competition; and o general industry and global economic conditions. Our future operating results could be adversely affected by these or other factors. Additionally, if our future operating results are below the expectations of equity analysts or our investors, our stock price may decline. If we experience poor production yields, our operating results may suffer. Our SiC products are manufactured using technologies that are highly complex. Our customers incorporate our products into high volume applications such as automotive dashboards, wireless handsets and other consumer products, and they insist that our products meet exact specifications for quality, performance and reliability. The number of usable crystals, wafers and devices that result from our production processes can fluctuate as a result of many factors, including the following: o impurities in the materials used; o contamination of the manufacturing environment; o equipment failure, power outages or variations in the manufacturing process; and o losses from human error. Because many of our manufacturing costs are fixed, if our yields decrease our operating results would be adversely affected. In the past, we have experienced difficulties in achieving acceptable yields on both new and older products, and poor yields have adversely affected our operating results. We may experience similar problems in the future and we cannot predict when they may occur or their severity. Such problems could significantly affect our future operating results. If we are unable to produce adequate quantities of our high brightness leds, our operating results may suffer. We have made and continue to make substantial investments in equipment and facilities to manufacture high brightness blue and green light emitting diodes, or LEDs. We have accepted orders for these products in quantities that have sold out our existing and planned increases in production capacity for the next few quarters. These significant volumes also require improved production yields for the products to meet customer demand. Successful production of these products is subject to a number of risks, including the following: o our ability to consistently manufacture the products in volumes large enough to cover our fixed costs and satisfy our customers' requirements; and o our ability to improve our yields and reduce the costs associated with the manufacture of the products. Our inability to produce adequate quantities of our high brightness blue and green LEDs would have a material adverse effect on our business, results of operations and financial condition. For example, our current contract with our largest LED customer provides that the customer may recover liquidated damages, or in some cases actual damages, if we materially default in meeting delivery commitments. The markets in which we operate are highly competitive. The markets for our products are highly competitive. Our competitors offer blue and green LEDs made from sapphire wafers that are brighter than the high brightness LEDs we currently produce. In addition, some of our customers could compete with us. For example, Osram Opto Semiconductors GMBH and Co. OHG, or Osram, an indirect subsidiary of Siemens AG, and Shin-Etsu Handotai Co. Ltd., or Shin-Etsu, license some of our LED technology. Osram currently purchases large volumes of our standard brightness blue LEDs but also manufactures some of its volume requirements for these LEDs. Shin-Etsu may also seek to enter our LED markets. The market for SiC wafers is likewise becoming competitive as other firms have in recent years begun offering SiC wafer products or announced plans to do so. Also, other firms may develop new or enhanced products that are more effective than any that we have developed or may develop. These firms may develop technologies that enable the production of commercial products with characteristics similar to SiC-based products but at a lower cost. Many existing and potential competitors have far greater financial, marketing and other resources than we do. We believe that present and future competitors will aggressively pursue the development and sale of competing products. We also expect significant competition for products we are currently developing, such as those for use in microwave communications. We expect competition to increase. This could mean lower prices or reduced demand for our products and a corresponding reduction in our ability to recover development, engineering and manufacturing costs. Any of these developments could have an adverse effect on our business, results of operations and financial condition. Our operating results are substantially dependent on the development of new products based on our core SiC technology. Our future success depends on our ability to develop new SiC solutions for existing and new markets. We must introduce new products in a timely and cost-effective manner and secure production orders from our customers. The development of new SiC products is a highly complex process, and we have historically experienced delays in completing the development and introduction of new products. Products currently under development include high power radio frequency, or RF, and microwave devices, power devices, blue laser diodes and high temperature devices. The successful development and introduction of these products depends on a number of factors, including the following: o achievement of technology breakthroughs required to make commercially viable devices; o the accuracy of our predictions of market requirements and evolving standards; o acceptance of our new product designs; o our ability to recruit qualified development personnel; o our timely completion of product designs and development; o our ability to develop repeatable processes to manufacture new products in sufficient quantities for commercial sales; and o acceptance of our customers' products by the market. If any of these or other factors become problematic, we may not be able to develop and introduce these new products in a timely or cost-effective manner. We depend on a few large customers. Historically, a substantial portion of our revenue has come from large purchases by a small number of customers. We expect this trend to continue. For example, for fiscal 1999 our top five customers accounted for 81% of our total revenue. (These percentages consider sales to a distributor as sales to one customer). Sales to Osram accounted for 37% of our total revenue in fiscal 1999. In addition, sales to C3, Inc., or C3, accounted for 19% of our total revenue in fiscal 1999. Accordingly, our future operating results depend on the success of our largest customers and on our success in selling large quantities of our products to them. The concentration of our revenues with a few large customers makes us particularly dependent on factors affecting those customers. For example, if demand for their products decreases, they may stop purchasing our products and our operating results will suffer. Our customers use our products as components in their products. If other aspects of our customers' products infringe a third party's intellectual property rights, and our customers are then prohibited from selling their products, our business could be adversely affected. If we lose a large customer and fail to add new customers to replace lost revenue, our operating results may not recover. Under an exclusive supply agreement with an initial term extending to 2005, C3 must purchase from us each calendar quarter at least 50% (by dollar volume) of its requirements for SiC materials for use in production of gemstones during the quarter. In the fall of 1999, C3 announced lower sales and higher inventory levels than anticipated, as well as the launch of a new marketing campaign. Recently, we agreed that C3 could reschedule approximately one-half of its purchase commitments from the first half of calendar 2000 to the second half of the year. We anticipate that sales to C3 will decrease in calendar 2000. We may use excess capacity from C3-dedicated equipment for other applications, but if we are not able to replace these revenues with sales from other areas of our business, our financial results may be materially adversely affected. Our operations could infringe upon the intellectual property rights of others. Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. We cannot assure you that third parties will not attempt to assert infringement claims against us with respect to our current or future products, including our core products. We cannot predict the extent to which such assertions may require us to seek licenses or, if required, whether such licenses will be offered or offered on acceptable terms or that disputes can be resolved without litigation. One of our distributors in Japan was named in a lawsuit, filed in Japan in December 2000, alleging infringement of a Japanese patent and seeking an injunction that, if granted, would preclude the distributor from selling our standard brightness blue LED product in Japan. We have intervened in the action to participate in the defense against the claim of infringement. A result adverse to the distributor would impair our ability to sell this product in Japan. Subject to contractual limitations, we have an obligation to indemnify our distributor for certain patent infringement claims. Litigation to determine the validity of infringement claims alleged by third parties could result in significant expense to us and divert the efforts of our technical and management personnel, whether or not the litigation is ultimately determined in our favor. We cannot predict the occurrence of future intellectual property claims that may prevent us from selling products, result in litigation or give rise to indemnification obligations or damage claims. We face challenges relating to expansion of our production and manufacturing capacity. In order to increase production, we must expand our existing facilities or acquire new facilities, as well as purchase new manufacturing equipment. We are beginning to construct 125,000 square feet of additional space at our manufacturing facility and are in the process of purchasing another 120,000 square foot facility under construction on a 17.5-acre site near our existing facility. Expansion activities such as these are subject to a number of risks, including the following: o unforeseen environmental or engineering problems relating to existing or new facilities; o unavailability or late delivery of the advanced, and often customized, equipment used in the production of our products; o work stoppages and delays; and o delays in bringing production equipment on-line. These and other risks may affect the ultimate cost and timing of our current construction, as well as the acquisition of new facilities, which could adversely affect our business, results of operations and financial condition. For example, if we are not successful in meeting milestones associated with this expansion, we could have difficulty making shipments of previously ordered products; consequently, we could be in default under contracts with our customers and/or subject to penalties. We face significant challenges managing our growth. We have experienced a period of significant growth that has strained our management and other resources. We have grown from 188 employees on December 31, 1996 to 478 employees on December 26, 1999 and from revenues of $29.0 million for the fiscal year ended June 30, 1997 to $60.1 million for the fiscal year ended June 27, 1999. To manage our growth effectively, we must continue to: o implement and improve operational systems; o maintain adequate manufacturing facilities and equipment to meet customer demand; o add experienced senior level managers; and o attract and retain qualified people with experience in engineering, design, technical marketing and support. We will spend substantial amounts of money in supporting our growth and may have additional unexpected costs. Our systems, procedures or controls may not be adequate to support our operations, and we may not be able to expand quickly enough to exploit potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development, and administrative support. If we cannot attract qualified people or manage growth effectively, our business, operating results and financial condition could be adversely affected. Our operating results could be adversely affected if we encounter problems transitioning led production to a larger wafer size. Beginning in the second half of calendar 2000, we plan to begin shifting LED production from two-inch wafers to three-inch wafers. We must first qualify our production processes on systems designed to accommodate the larger wafer size, and some of our existing production equipment must be refitted for the larger wafer size. Delays in this process could have an adverse effect on our business. In addition, in the past we have experienced lower yields for a period of time following a transition to a larger wafer size until use of the larger wafer is fully integrated in production and we begin to achieve production efficiency. We anticipate that we will experience similar temporary yield reductions during the transition to the use of three-inch wafers, and we have factored this into our plan for production capacity. If this transition phase takes longer than we expect or if we are unable to attain expected yield improvements, our operating results may be adversely affected. The ongoing operation of our manufacturing facility is critical to our business. Our principal manufacturing facility in Durham, North Carolina currently includes a total of 214,000 square feet. The ongoing operation of this facility is crucial to our strategy of expanding manufacturing capacity to meet demand for our SiC products now and in the future. We began commercial production of products from our present facility in August 1998. We expect that production from this facility will increase throughout the remainder of fiscal 2000 and into fiscal 2001. Our inability to use all or a significant portion of our facilities for prolonged periods of time for any reason could have an adverse impact on our business. For example, a fire or explosion caused by our use of combustible chemicals and high temperatures during certain of our manufacturing processes would render some or all of our facility inoperable for an indefinite period of time. Our manufacturing process requires highly specialized customized equipment that is not easily replaced. Consequently, damage to or destruction of any or all of our facility could impair our ability to manufacture products for our customers. We rely on a few key suppliers. We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our SiC products, including key materials, components and equipment used in critical stages of our manufacturing processes. We generally purchase these limited source items with purchase orders, and we have no guaranteed supply arrangements with our suppliers. If we were to lose such key suppliers, our manufacturing efforts could be hampered significantly. Although we believe our relationship with our suppliers is good, we cannot assure you that we will continue to maintain good relationships with such suppliers or that such suppliers will continue to exist. Our business may suffer if government agencies or other customers discontinue their funding for our research and development. In the past, government agencies and other customers have funded a significant portion of our research and development activities. If this support is discontinued or reduced, our ability to develop or enhance products could be limited and our business, results of operations and financial condition could be adversely affected. We depend heavily on key personnel. Our success depends in part on keeping key technical and management personnel. For example, some of the equipment used in the production of our products must be modified before it is put to use and only a limited number of employees possess the expertise needed to perform these modifications. Furthermore, the number of individuals with experience in the production of SiC and related products is limited, and our future success depends in part on retaining those individuals who are already employees. We must also continue to attract qualified personnel. The competition for qualified personnel is intense, and the number of people with the experience that we need is limited. We cannot be sure that we will be able to continue to attract and retain other skilled personnel in the future. There are limitations on the protection of our intellectual property. Our proprietary technology is critical to our business, and our business could suffer if we are unable to sufficiently protect our intellectual property rights. Our intellectual property position is based in part on patents owned by us and on patents exclusively licensed to us by North Carolina State University, also known as N.C. State. We intend to continue to file patent applications in the future, where appropriate, and to pursue such applications with U.S. and foreign patent authorities, but we cannot be sure that any other patents will be issued on such applications or that our patents will not be contested. In the past, one of the important patents we license from N.C. State relating to SiC crystal growth was subject to a reissue proceeding in the U.S.; however, the patent was successfully reissued. Currently, a corresponding European patent is being challenged, which means that we could lose patent protection in Europe for this particular method. There is no assurance that other of our patents will not be contested. Also, because issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, we cannot be sure that any of our patents (or patents issued to N.C. State or other parties and licensed to us) will provide significant commercial protection. In addition to patent protection, we also rely on trade secrets, technical know-how and other unpatented proprietary information relating to our product development and manufacturing activities. We try to protect this information through the use of confidentiality agreements with our employees and other parties. We cannot be sure that these agreements will not be breached, that we would have adequate remedies for any breach or that our trade secrets and proprietary know-how will not otherwise become known or independently discovered by others. We may initiate litigation in the future to enforce our intellectual property rights. Litigation can be protracted, costly and distracting to key personnel. We cannot assure you that we will prevail in any litigation we initiate and, if we are not successful, the scope of our rights to important intellectual property could be diminished or eliminated. We are subject to risks associated with international sales. Sales to customers located outside the U.S. accounted for about 79% of our revenue in fiscal 1997, about 74% of our revenue in fiscal 1998 and about 62% of our revenue in fiscal 1999. We expect that revenue from international sales will continue to be a significant part of our total revenue. International sales are subject to a variety of risks, including risks arising from currency fluctuations, trends in use of the Euro, trading restrictions, tariffs, trade barriers and taxes. Also, export laws restrict sales of some of our products to customers in certain countries because of national security or other concerns. Because all of our foreign sales are denominated in U.S. dollars, our products become less price competitive in countries with currencies that are low or are declining in value against the U.S. dollar. Also, we cannot be sure that our international customers will continue to place orders denominated in U.S. dollars. If they do not, our reported revenue and earnings will be subject to foreign exchange fluctuations. We are subject to stringent environmental regulation. We are subject to a variety of government regulations pertaining to chemical and waste discharges and other aspects of our manufacturing process. For example, we are responsible for the management of the hazardous materials we use and disposal of hazardous waste resulting from our manufacturing process. The proper handling and disposal of such hazardous material and waste requires us to comply with certain government regulations. We believe we are in full compliance with such regulations as of the date of this report, but any failure, whether intentional or inadvertent, to comply with such regulations could have an adverse effect on our business. In addition, these regulations may affect our ability to expand or change our manufacturing facility. We face risks concerning year 2000 issues. Even though the date is now past January 1, 2000, and we have not experienced any immediate adverse impact from the transition to the Year 2000, we cannot provide assurance that our suppliers and customers have not been affected in a manner that is not yet apparent. In addition, certain computer programs which were date sensitive to the Year 2000 may not have been programmed to process the Year 2000 as a leap year, and any negative consequential effects remain unknown. As a result, we will continue to monitor our Year 2000 compliance and the Year 2000 compliance of our suppliers and customers. -----END PRIVACY-ENHANCED MESSAGE-----