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 27, 1998
Commission file number: 0-21154
CREE RESEARCH, 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
$0.005 per share, as of January 19, 1999 was 13,004,469.
CREE RESEARCH, INC.
FORM 10-Q
For the Quarter Ended December 27, 1998
INDEX
Page No.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at December 27, 1998
(unaudited) and June 28, 1998 3
Consolidated Statements of Income for the three
and six months ended December 27, 1998 and
December 28, 1997 (unaudited) 4
Consolidated Statements of Cash Flow for the six
months ended December 27, 1998 and December 28, 1997
(unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk 21
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 6. Exhibits and Reports on Form 8-K 22
SIGNATURES 23
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PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements
CREE RESEARCH, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
December 27, June 28,
1998 1998
------------ --------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents $ 12,769 $ 17,680
Marketable securities 905 657
Accounts receivable, net 12,110 10,479
Inventories 3,402 2,543
Deferred income tax 264 1,952
Prepaid expenses and other current assets 691 1,347
------------ --------
Total current assets 30,141 34,658
Property and equipment, net 44,972 36,476
Patent and license rights, net 1,641 1,525
Other assets 1,349 65
------------ --------
Total assets $ 78,103 $ 72,724
============ ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable, trade $ 4,097 $ 5,595
Current maturities of long term debt 121 17
Accrued salaries and wages 550 391
Other accrued expenses 990 1,052
------------ --------
Total current liabilities 5,758 7,055
Long term liabilities:
Long term debt 9,879 8,650
Deferred income tax 2,477 2,154
------------ --------
Total long term liabilities 12,356 10,804
Shareholders' equity:
Preferred stock, par value $0.01; 3,000 shares -- --
authorized at December 27, 1998 and 2,750
shares authorized at June 28, 1998; none
issued and outstanding
Common stock, par value $0.005; 30,000 shares 65 65
authorized at December 27, 1998 and 14,500
shares authorized at June 28, 1998; shares
issued and outstanding 12,920 and 12,989 at
December 27, 1998 and June 28, 1998,
respectively
Additional paid-in-capital 49,583 49,676
Retained earnings 10,341 5,124
------------ --------
Total shareholders' equity 59,989 54,865
============ ========
Total liabilities and shareholders' equity $ 78,103 $ 72,724
============ ========
The accompanying notes are an integral part of the
consolidated financial statements.
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CREE RESEARCH, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)
Three Months Ended Six Months Ended
---------------------------- --------------------------
December 27, December 28, December 27, December 28,
1998 1997 1998 1997
------------ ------------ ------------ ------------
Revenue:
Product revenue, net $12,805 $ 8,164 $23,525 $16,369
Contract revenue, net 1,233 1,942 2,792 3,944
------------ ------------ ------------ ------------
Total revenue 14,038 10,106 26,317 20,313
Cost of revenue:
Product revenue 6,377 4,946 11,792 10,365
Contract revenue 1,045 1,600 2,252 3,252
------------ ------------ ------------ ------------
Total cost of revenue 7,422 6,546 14,044 13,617
------------ ------------ ------------ ------------
Gross profit 6,616 3,560 12,273 6,696
Operating expenses:
Research and development 1,121 527 1,927 920
Sales, general and 1,450 850 2,668 1,985
administrative
Other expense 298 390 567 390
------------ ------------ ------------ ------------
Income from operations 3,747 1,793 7,111 3,401
Interest income, net 20 169 135 332
------------ ------------ ------------ ------------
Income before income 3,767 1,962 7,246 3,733
taxes
Income tax expenses 916 490 2,029 1,093
------------ ------------ ------------ ------------
Net income $ 2,851 $ 1,472 $ 5,217 $ 2,640
============ ============ ============ ============
Earnings per share:
Basic $0.22 $0.12 $0.41 $0.21
============= ============= ============ ============
Diluted $0.21 $0.11 $0.39 $0.20
============= ============= ============ ============
The accompanying notes are an integral part of the
consolidated financial statements.
-4-
CREE RESEARCH, INC.
CONSOLIDATED STATEMENTS OF CASH FLOW
(In thousands)
Six Months Ended
-----------------------------
December 27, December 28,
1998 1997
------------ ------------
(Unaudited)
Operating activities:
Net income $5,217 $2,640
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 2,341 2,067
Loss on disposal of property, equipment and 951 320
patents
Amortization of patent rights 56 50
Amortization and write off of goodwill -- 86
Proceeds from sale of marketable trading 489 --
securities
Purchase of marketable trading securities (232) (1,500)
Gain on marketable trading securities (116) --
Changes in operating assets and liabilities:
Accounts receivable (1,964) (2,258)
Inventories (859) 1,161
Prepaid expenses and other assets 1,004 148
Accounts payable, trade (3,073) (783)
Accrued expenses 420 889
------------ ------------
Net cash provided by operating activities 4,234 2,820
------------ ------------
Investing activities:
Purchase of property and equipment (10,380) (5,704)
Proceeds from sale of property and equipment 189 340
Purchase of patent rights (194) (200)
------------ ------------
Net cash used in investing activities (10,385) (5,564)
------------ ------------
Financing activities:
Proceeds from issuance of long-term debt 1,333 3,259
Net proceeds from issuance of common stock 2,527 2,139
Receipt of Section 16(b) common stock profits 594 --
Repurchase of common stock (3,214) --
------------ ------------
Net cash provided by financing activities 1,240 5,398
------------ ------------
Net (decrease) increase in cash and cash (4,911) 2,654
equivalents
Cash and cash equivalents:
Beginning of period 17,680 10,448
============= ============
End of period $ 12,769 $ 13,102
============= ============
Supplemental disclosure of cash flow information:
Cash paid for interest, net amounts $ 275 $ --
capitalized
============= ============
Cash paid for income taxes $ 1,396 $ 219
============= ============
The accompanying notes are an integral part of the
consolidated financial statements.
-5-
CREE RESEARCH, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Basis of Presentation
The consolidated balance sheet as of December 27, 1998, the consolidated
statements of income for the three and six months ended December 27, 1998 and
December 28, 1997, and the consolidated statements of cash flow for the six
months ended December 27, 1998 and December 28, 1997 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 27, 1998, and all periods
presented, have been made. The balance sheet at June 28, 1998 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 1998 Form 10-K. The results of
operations for the period ended December 27, 1998 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 1999. In fiscal 1998, the Company changed its fiscal year from
the twelve months ending June 30, to the 52 week period ending on the last
Sunday in the month of June. The Company's current fiscal year will extend from
June 29, 1998 to June 27, 1999.
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.
-6-
(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.
(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 as a separate component of stockholders'
equity.
The Company's short-term investments are comprised of equity securities that are
classified as trading securities, which are carried at their fair value based
upon quoted market prices of those investments at December 27, 1998, with net
realized and unrealized gains and losses included in net earnings.
As of December 27, 1998, short-term investments consist of common stock holdings
in C3, Inc. ("C3"), the majority of which were purchased in November 1997 and
September 1998. The Company's CEO has, through a binding agreement, promised to
indemnify the Company for losses of up to $450,000 for the net difference
between the aggregate cash consideration paid by the Company for the shares of
C3 common stock and the cash proceeds received by the Company upon the sale of
C3 common stock. This indemnity covers losses that may result from the sale of
shares purchased in November 1997 and September 1998 below the purchase price
paid, offset by gains realized on shares acquired directly from C3 in January
1997 (see below). Payment of this obligation is due within ten days after
receipt by the CEO of the Company's written demand made pursuant to a vote of
the majority of the members of the Board of Directors other than the CEO.
Realized losses on shares of C3 stock sold by the Company were $254,000 and
$46,000, for fiscal 1998 and 1999, respectively. At December 27, 1998, a net
unrealized gain, including shares acquired directly from C3 (see below), of
$383,000 was recognized to bring the valuation of shares held to market.
Therefore, approximately $120,000 and $116,000 of other income was recorded for
the three and six months ended December 27, 1998, respectively. Approximately
$32,000 of net losses were recorded to other income (expense) in fiscal 1998.
Since the net unrealized gain on shares held exceeded realized losses on shares
sold, there was no receivable recorded from the CEO as of December 27, 1998.
In addition to the shares of C3 purchased in November 1997 and September 1998,
the Company acquired 24,601 shares of C3 common stock in January 1997. These
shares were issued pursuant to an option C3 granted to the Company in 1995. The
option gave the Company the right to acquire, for an aggregate consideration of
$500, one percent of the outstanding common stock of C3. C3 retained the right
to waive the consideration and issue the stock at any time, which it elected to
do in January 1997. The shares issued pursuant to the option are restricted
securities within the meaning of Rule 144 under the Securities Act of 1933,
which permits the sale of such securities without registration if certain
conditions are met. The shares first became eligible for sale under Rule 144 in
the third quarter of fiscal 1998.
-7-
Long Term Debt
The Company obtained a term loan from a commercial bank of up to $10,000,000 to
finance the purchase and upfit of a production facility and service and
warehouse buildings in November 1997. As of December 27, 1998 the entire
$10,000,000 loan was outstanding, including a current portion of $121,000 and a
long term amount of $9,879,000. The loan, which is collateralized by the
purchased property, accrues interest at a fixed rate of 8% and carries customary
covenants, including the maintenance of a minimum tangible net worth and other
requirements. Accrued interest is due monthly until May 1999, at which time the
outstanding principal balance will be amortized over twenty years until 2011,
when the loan balance becomes due.
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:
December 27, June 28,
1998 1998
------------ ------------
(In thousands)
Raw materials $ 1,338 $ 999
Work-in-progress 1,220 752
Finished goods 844 792
------------ ------------
Total Inventory $ 3,402 $ 2,543
============ ============
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 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 cost of
capital expenses. Cost-plus funding is determined based on actual costs plus a
set percentage margin. For 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 submission of a written
report to document the results of such research.
-8-
The revenue and expense classification for contract activity is determined 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 27, December 28, December 27, December 28,
1998 1997 1998 1997
------------ ------------ ------------ ------------
(In thousands)
Net R&D costs $ - $ 161 $ - $ 281
Government funding - 311 - 598
============ ============ ============ ============
Total direct costs $ - $ 472 $ - $ 879
incurred
============ ============ ============ ============
As of December 27, 1998, all funding under contracts where the Company
anticipates that direct costs will exceed amounts to be funded has been
exhausted. Therefore, the Company anticipates that all future funding under
existing contracts will be reflected as contract revenue while direct costs will
be reported as contract cost of revenue.
Significant Sales Contract
In September 1996, the Company entered into a Purchase Agreement with Siemens AG
("Siemens"), pursuant to which Siemens agreed to purchase LED chips made with
the Company's gallium nitride-on-silicon carbide technology. In April 1997 and
December 1997, contract amendments were executed that provided for enhanced
product specifications requested by Siemens and larger volume requirements,
respectively.
In September 1998, the Company and Siemens further amended the contract to
extend the Purchase Agreement with respect to shipments to be made on or after
June 29, 1998. The third amendment obligates the Company to ship, and Siemens to
purchase, stipulated quantities of both the conductive buffer and the new high
brightness LED chips and silicon carbide wafers through fiscal 1999. The
agreement also limits Siemens' right to defer shipments to 30% of scheduled
quantities for items to be shipped in more than 24 weeks after initial notice
and 10% of scheduled quantities for items to be shipped in more than 12 weeks
after initial notice. In both cases, Siemens would be required to accept all
product within 90 days of the original shipment date. Additionally, the
amendment provides for higher per unit prices early in the contract with
reductions in unit prices as the cumulative volume shipped increases.
In December 1998, the Company and Siemens further amended the contract to
include greater quantities of conductive buffer LED chips to be shipped during
fiscal 1999 and to extend the
-9-
contract for these shipments through September 1999. This amendment also
provides for higher per unit prices early in the contract with reductions in
unit prices as the cumulative volume shipped increases. As was the case with the
third amendment, these higher prices were negotiated by the Company to offset
higher per unit costs expected earlier in the contract.
Income Taxes
The Company has established an estimated tax provision based upon an effective
rate of 28%. The estimated tax rate was based on tax reduction strategies being
implemented by the Company. 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.
Deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to differences between financial statement carrying
amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which those temporary differences are expected to be
recovered or settled.
The actual income tax expense attributable to earnings for the six months ended
December 27, 1998 differed from the amounts computed by applying the U.S.
Federal tax rate of 35% to pretax earnings as a result of the following:
Amount Percent
-------------- --------------
(In thousands)
Federal income tax provision at statutory rate $ 2,536 35.0%
State tax provision 174 2.4
Decrease in income tax expense resulting from:
Foreign sales corporation (306) (4.2)
State tax incentives (167) (2.3)
Research and development credits (85) (1.2)
Change in valuation allowance (123) (1.7)
-------------- --------------
Income tax expense $ 2,029 28.0%
============== ==============
The following are the components of the provision for income taxes for the six
months ended December 27, 1998 (in thousands):
-10-
Current:
Federal $ 1,182
State 175
---------
Total Current Portion 1,357
Deferred:
Federal 782
State (110)
---------
Total Deferred Portion 672
Net Provision $ 2,029
=========
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities are as follows:
December 27, June 28,
1998 1998
------------- ------------
(In thousands)
Deferred tax assets:
Net operating loss carryforwards $ 948 $1,304
Research tax credits 92 169
Compensation accruals 70 62
Inventory capitalization 130 120
Bad debt allowance 64 56
Alternative minimum tax 158 261
Foreign tax credit 153 270
State incentive credits 165 --
------------- ------------
Total gross deferred tax assets 1,780 2,242
Less valuation allowance (167) (290)
------------- ------------
Net deferred tax asset 1,613 1,952
Deferred tax liabilities:
Property and equipment, due to 2,477 2,154
depreciation
------------- ------------
Gross deferred tax liabilities 2,477 2,154
------------- ------------
Net deferred tax asset (liability) $(864) $(202)
============= ============
The net change in the total valuation allowance for the six months ended
December 27, 1998 was $123,000. The primary reason for the reduction in the
valuation allowance for the six months ended December 27, 1998 was the
implementation of tax strategies to utilize these assets. Realization of
deferred tax assets associated with the NOL carryforwards is dependent upon the
Company generating sufficient taxable income prior to their expiration. Although
realization is not assured for the remaining deferred tax assets, management
believes it is more likely than not that they will be realized through future
taxable earnings. However, the net deferred tax assets could be reduced in the
future if management's estimates of taxable income during the carryforward
period are significantly reduced.
-11-
As of December 27, 1998, the Company has net operating loss carryforwards for
federal purposes of $3,493,000 and $2,346,000 for state purposes. The
carryforward expiration period is 2011 to 2013 for federal tax purposes and from
2000 to 2003 for state purposes. The Company anticipates that each of these
carryforwards will be utilized by the end of the current fiscal year.
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 27, December 28, December 27, December 28,
1998 1997 1998 1997
------------ ------------ ------------ ------------
(In thousands, except per share amounts)
Net income $ 2,851 $ 1,472 $ 5,217 $ 2,640
Weighted average common shares 12,832 12,789 12,876 12,699
------------ ------------ ------------ ------------
Basic earnings per common share $ 0.22 $ 0.12 $ 0.41 $ 0.21
============ ============ ============ ============
Net income $ 2,851 $ 1,472 $ 5,217 $ 2,640
Diluted weighted average common
shares:
Common shares outstanding 12,832 12,789 12,876 12,699
Dilutive effect of stock options 1,002 847 665 823
and warrants
------------ ------------ ------------ ------------
Total diluted weighted average 13,834 13,636 13,541 13,552
common shares
------------ ------------ ------------ ------------
Diluted earnings per common share $ 0.21 $ 0.11 $0.39 $ 0.20
============ ============ ============ ============
Potential common shares that would have the effect of increasing diluted income
per share are considered to be antidilutive. In accordance with SFAS 128, these
common shares were not included in calculating diluted income per share. As of
December 27, 1998, there were no potential shares considered to be antidilutive.
For the three and six months ended December 28, 1997, there were 300,000 shares
that were not included in calculating diluted income per share because their
effect was antidilutive.
-12-
New Accounting Pronouncements
In fiscal 1999, the Company adopted Statement of Financial Accounting Standards
No. 130, "Reporting Comprehensive Income" ("SFAS 130"), which establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS 130 only impacts
financial statement presentation as opposed to actual amounts recorded. Other
comprehensive income includes all nonowner changes in equity that are excluded
from net income. This Statement has no financial statement impact for an
enterprise that has no items of other comprehensive income in any period
presented. During the three and six months ended December 27, 1998 and December
28, 1997, the Company had no items of other comprehensive income.
In fiscal 1999, the Company adopted Statement of Financial Accounting Standards
No. 131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131"). SFAS 131 changes the way public companies report segment
information in annual financial statements and also requires those companies to
report selected segment information in interim financial statements to
shareholders. SFAS 131 also establishes standards for related disclosures about
products and services, geographic areas, and major customers. The application of
the new rules does not have a significant impact on the Company's financial
statements.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133,
"Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"),
which is required to be adopted in years beginning after June 15, 1999. Because
of the Company's minimal use of derivatives, management does not anticipate that
the adoption of the new Statement will have a significant effect on earnings or
the financial position of the Company.
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, which statements
represent the Company's judgment concerning the future and are subject to risks
and uncertainties that could cause the Company's actual operating results and
financial position to differ materially. Such forward-looking statements can be
identified by the use of forward-looking terminology such as "may," "will,"
"anticipate," "believe," "plan," "estimate," "expect," and "intend" or the
negative thereof or other variations thereof or comparable terminology. The
Company cautions that any such forward-looking statements are further qualified
by important factors that could cause the Company's actual operating results to
differ materially from those in the forward-looking statements, including, but
not limited to, fluctuations in our operating results, production yields in our
manufacturing processes, whether we can produce commercial quantities of high
brightness blue and green LEDs, our dependence on a few customers, whether we
can manage our growth effectively, assertion of intellectual property rights by
others, adverse economic conditions, and insufficient capital resources. See
Exhibit 99.1 for additional factors that could cause the Company's actual
results to differ.
-13-
Overview
Cree Research, 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 light emitting diode ("LED") products.
The Company offers LEDs at two brightness levels -- high brightness blue and
green products and standard blue products. The Company's LED devices are
utilized by end users for automotive backlighting, liquid crystal display
("LCD") backlighting (including use in wireless handsets), indicator lamps,
miniature white lights (such as replacements for miniature incandescent bulbs),
indoor sign and arena displays, outdoor full color stadium displays, traffic
signals and other lighting applications.
The high brightness products, which were introduced to the market in September
1998 in limited quantities, are currently being integrated into our
manufacturing facility for full production. During the first six months of
fiscal 1999, margins realized on the high brightness products were substantially
lower than those derived from our standard blue LED product, as the yield was
lower than the standard product. Historically, we have experienced low margins
with many new product introductions, and we are working to make improvements to
output and yield during the second half of fiscal 1999. We anticipate that the
high brightness products will contribute greater volumes as yield improvements
are obtained.
We believe that in order to increase market demand for all of our LED products,
we must continue to substantially lower average sales prices. Historically, we
have been successful in achieving lower costs for the standard blue product.
During the remainder of fiscal 1999, we plan to focus on reducing costs through
higher production yields and from higher volumes as fixed costs are spread over
a greater number of units.
We also derive revenue from the sale of advanced materials made from SiC that
are used primarily for research and development. We also sell SiC crystals to
C3, which incorporates them in gemstone applications. During late fiscal 1998
and the first six months of fiscal 1999, C3 purchased equipment from us, which
has more than doubled the capacity for the production of crystals for C3.
The balance of our revenue is derived from government contract funding. Under
various programs, U.S. Government entities further the development of our
technology by supplementing our research and development efforts. All resulting
technology obtained through these efforts remains our property after the
completion of the contract, 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 funding is expected to exceed
direct costs over the life of the contract. For contracts under which direct
costs are anticipated to exceed amounts to be funded over the life of the
contract (i.e., certain cost share arrangements), direct costs are reported as
research and development expenses with related reimbursements recorded as an
offset to those expenses.
-14-
On September 24, 1997, the Board of Directors changed the Company's fiscal year
from the twelve months ending June 30 to a 52 or 53 week year ending on the last
Sunday in the month of June. The Company's 1998 fiscal year extended from July
1, 1997 to June 28, 1998.
Results of Operations
Three Months Ended December 27, 1998 and December 28, 1997
Revenue. Revenue increased 39% from $10.1 million in the second quarter of
fiscal 1998 to $14.0 million in the second quarter of fiscal 1999. This increase
was attributable to an increase in product revenue of 57% from $8.2 million in
the second quarter of fiscal 1998 to $12.8 million in the second quarter of
fiscal 1999. This rise in product revenue was a result of the 128% increase in
sales of our LED products in the second quarter of fiscal 1999 compared to the
second quarter of fiscal 1998. Growth in LED volume was due in part to the
introduction of the new high brightness devices, but mostly was a result of
strong demand for the standard brightness product. This volume increase was
partly offset by a 35% decline in the average sales price of the standard blue
LED chip during this same period. We believe that in order to increase volume,
we must continue to lower average sales prices.
Revenue attributable to sales of SiC materials was 88% higher in the second
quarter of fiscal 1999 than in the same period of fiscal 1998 due to a
significant increase in sales to C3 for gemstone applications. During the second
quarter of fiscal 1998, C3 was in initial stages of operation; therefore, unit
sales were limited. Revenue from sales of SiC wafers increased 48% in the second
quarter of fiscal 1999 as compared to the second quarter of fiscal 1998, due to
quality improvements in wafers, along with the availability of the larger
two-inch wafer during fiscal 1999. During the second quarter of fiscal 1999,
sales from our displays business declined 95% over the prior year period as we
have chosen to de-emphasize this product line. Contract revenue received from
U.S. Government agencies declined 36% during the second quarter of fiscal 1999
compared to the second quarter of fiscal 1998, as a significant contract that
funded optoelectronic research was exhausted in early fiscal 1999.
Gross Profit. Gross margin climbed to 47% of revenue during the second quarter
of fiscal 1999 as compared to 35% during the second quarter of fiscal 1998. This
increase is predominantly attributable to design and manufacturing improvements
that occurred over the past year resulting in significant reductions in cost.
With the introduction of the new conductive buffer LED technology in the fourth
quarter of fiscal 1998, we were able to significantly lower costs of production
due to the fewer manufacturing steps required with the new chip structure and
improved yield. During the second quarter of fiscal 1998, we began to fabricate
devices on a larger two-inch wafer; however, we were still in the process of
establishing this new manufacturing design and had not achieved production
efficiency. In addition, the larger two inch wafer had not been in full
production for much of the period; therefore, average die yields during the
second quarter of fiscal 1998 were significantly lower. Wafer costs for SiC
material sales also declined 21% during the second quarter of fiscal 1999 over
the comparative period due to more efficient processes and improved yield.
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Research and Development. Research and development expenses increased 113% in
the second quarter of fiscal 1999 to $1.1 million from $0.5 million in the
second quarter of fiscal 1998. Much of this increase was caused by significantly
higher costs for the initial development of the new high brightness LED
products. 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 or
decrease.
Sales, General and Administrative. Sales, general and administrative expenses
increased 71% in the second quarter of fiscal 1999 to $1.5 million from $0.9
million in the second quarter of fiscal 1998 due primarily to two insurance
events that were recorded in the second quarter of fiscal 1998. As a result of
the dismissal of a securities class action lawsuit in November 1997, we were
reimbursed $0.2 million for costs incurred in connection with the lawsuit. Most
of these expenses were recorded in fiscal 1997. In addition, we received a $0.2
million reimbursement of medical expenses due to a negotiated cost cap in a
partially self-funded insured health plan. As a result of our increased
profitability during the second quarter of fiscal 1999 over the second quarter
of fiscal 1998, the profit sharing accrual (which is based on 5% of net income)
has also grown $0.1 million. 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 or possibly decline.
Other (Income) Expense. Other expenses have decreased 24% to $0.3 million during
the second quarter of fiscal 1999 from $0.4 million for the second quarter of
fiscal 1998. 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. In the second quarter of
fiscal 1998, we had written off certain fixed assets that were impaired in
value. These write-downs exceeded the fiscal 1999 leasehold write-downs offset
by the investment income.
Interest Income, Net. Interest income, net has decreased 88% to $0.02 million in
the second quarter of fiscal 1999 from $0.2 million in the second quarter of
fiscal 1998 due to interest expense incurred. In November 1997, we obtained a
term loan from NationsBank to fund the acquisition and construction of our new
manufacturing facility in Durham, North Carolina. The majority of the interest
incurred in the second quarter of fiscal 1999 has been expensed.
Income Tax Expense. Income tax expense for the second quarter of fiscal 1999 was
$0.9 million compared to $0.5 million in the second quarter of fiscal 1998. This
increase resulted from increased profitability during the second quarter of
fiscal 1999 over fiscal 1998.
Six Months Ended December 27, 1998 and December 28, 1997
Revenue. Revenue increased 30% from $20.3 million in the first six months of
fiscal 1998 to $26.3 million in the first six months of fiscal 1999. This
increase was attributable to an increase in product revenue of 44% from $16.4
million in the first six months of fiscal 1998 to $23.5 million in the first six
months of fiscal 1999. This rise in product revenue was a result of the 128%
increase in sales of our LED products in the first six months of fiscal 1999
compared to
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the first six months of fiscal 1998. Growth in LED volume was due in part to the
introduction of the new high brightness devices, but mostly was a result of
strong demand for the standard brightness product. This volume increase was
partly offset by a 40% decline in the average sales price of the standard blue
LED chip during this same period. We believe that in order to increase volume,
we must continue to lower average sales prices.
Revenue attributable to sales of SiC material was 84% higher in the first six
months of fiscal 1999 than in the same period of fiscal 1998 due to a
significant increase in sales to C3 for gemstone applications. During the first
six months of fiscal 1998, C3 was in initial stages of operation; therefore,
unit sales were limited. Revenue from sales of SiC wafers increased 43% in the
first six months of fiscal 1999 as compared to the first six months of fiscal
1998, due to quality improvements in wafers, along with the availability of the
larger two-inch wafer during fiscal 1999. During the first six months of fiscal
1999, sales from our displays business declined 96% over the prior year period
as we have chosen to de-emphasize this product line. Contract revenue received
from U.S. Government agencies declined 29% during the first six months of fiscal
1999 compared to the first six months of fiscal 1998, as a significant contract
that funded optoelectronic research was exhausted in early fiscal 1999.
Gross Profit. Gross margin climbed to 47% of revenue during the first six months
of fiscal 1999 as compared to 33% during the first six months of fiscal 1998.
This increase is predominantly attributable to design and manufacturing
improvements that occurred over the past year resulting in significant
reductions in cost. With the introduction of the new conductive buffer LED
technology in the fourth quarter of fiscal 1998, we were able to significantly
lower costs of production due to fewer manufacturing steps required with the new
chip structure and improved yield. During the first six months of fiscal 1998,
we introduced a smaller LED chip size and, in December 1997, we began to
fabricate devices on a larger two-inch wafer. As of December 1997, we were still
in the process of establishing these new manufacturing designs and had not
achieved production efficiency. In addition, the larger two inch wafer had not
been in full production for much of the period; therefore, average die yields
during the first six months of fiscal 1998 were significantly lower. Wafer costs
for SiC material sales also declined 47% during the first six months of fiscal
1999 over the comparative period due to more efficient processes and improved
yield.
Research and Development. Research and development expenses increased 109% in
the first six months of fiscal 1999 to $1.9 million from $0.9 million in the
first six months of fiscal 1998. Much of this increase was caused by
significantly higher costs for the initial development of the new high
brightness LED product. 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 or
decrease.
Sales, General and Administrative. Sales, general and administrative expenses
increased 34% in the first six months of fiscal 1999 to $2.7 million from $2.0
million in the first six months of fiscal 1998 due primarily to two insurance
events that were recorded in the second quarter of fiscal 1998. As a result of
the dismissal of a securities class action lawsuit in November 1997,
-17-
we were reimbursed $0.2 million for costs incurred in connection with the
lawsuit. Most of these expenses were recorded in fiscal 1997. In addition, we
received a $0.2 million reimbursement of medical expenses due to a negotiated
cost cap in a partially self-funded insured health plan. As a result of our
increased profitability during the first six months of fiscal 1999 over the
first six months of fiscal 1998, the profit sharing accrual (which is based on
5% of net income) has also grown $0.2 million. 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 or possibly decline.
Other (Income) Expense. Other expenses have increased 45% to $0.6 million during
the first six months of fiscal 1999 from $0.4 million for the first six months
of fiscal 1998. 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. This was offset somewhat by
income recognized under our equipment build-out agreement with C3. In 1998, we
sold to C3 equipment manufactured by us at cost plus a reasonable overhead
allocation. The overhead allocation was recorded as "Other income."
Interest Income, Net. Interest income, net has decreased 59% to $0.1 million in
the first six months of fiscal 1999 from $0.3 million in the first six months of
fiscal 1998 due to interest expense incurred. In November 1997, we obtained a
term loan from NationsBank to fund the acquisition and construction of our new
manufacturing facility in Durham, North Carolina. While much of the interest was
capitalized during the last half of fiscal 1998, the majority of the interest
incurred in the first six months of fiscal 1999 has been expensed.
Income Tax Expense. Income tax expense for the first six months of fiscal 1999
was $2.0 million compared to $1.1 million in the first six months of fiscal
1998. This increase resulted from increased profitability during the first six
months of fiscal 1999 over fiscal 1998. Our effective tax rate during the first
six months of fiscal 1999 was 28% compared to 29% in the first six months of
fiscal 1998.
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 27, 1998, we had
working capital of approximately $24.4 million, including $13.7 million in cash
and cash equivalents and marketable securities.
Operating activities generated $4.2 million in cash during the first six months
of fiscal 1999. This was attributable primarily to net income of $5.2 million
and other non-cash expenses of $3.3 million. These amounts were partly offset by
an increase of $2.0 million in accounts receivable, a $0.9 million rise in
inventory and a $3.1 million decrease in accounts payable.
Most of the $10.4 million of cash used by investing activities in the first six
months of fiscal 1999 was related to expenditures associated with the continued
construction of our new
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manufacturing facility in Durham, North Carolina. We also increased
manufacturing capacity by adding new equipment to support the epitaxial
deposition and clean room fabrication processes.
The $1.2 million of cash provided by financing activities in the first six
months of fiscal 1999 related primarily to the receipt of $1.8 million and $0.7
million in proceeds from the exercise of stock warrants and stock options from
the Company's employee stock option plan, respectively. In addition, $0.6
million was received from a Director as payment of profits from a short-swing
transaction in our securities and $1.3 million was funded as the final draw from
the long term debt arrangement with NationsBank. We currently have a $10.0
million loan outstanding from NationsBank. We expect to pay off this loan with
the proceeds from our secondary stock offering described in the registration
statement on Form S-3 filed by the Company with the Securities and Exchange
Commission on January 14, 1999. These cash proceeds were offset by a $3.2
million cash outlay for the repurchase of our common stock. This stock was
repurchased at an average price of $13.68. The stock warrants exercised were
distributed in connection with the Company's September 1995 private placement
and have an exercise price of $27.23. As of December 28, 1998, warrants remained
outstanding to purchase 234,575 shares; these warrants will expire in September
2000.
We are currently engaged in construction activities related to a new clean room
fabrication facility. We also intend to expand our facility for new crystal
growth and test and packaging areas in calendar 1999. These additions will allow
the Company to consolidate all LED and wafer manufacturing facilities to one
site with improved manufacturing capabilities. In addition, in order to keep
pace with anticipated growth in LED and wafer sales and provide expanded
facilities for our new microwave product line, the Company anticipates a second
phase of expansion to facilities and infrastructure to begin in early fiscal
2000. We anticipate total costs for these expenses to be between $15 and $18
million. Estimates for equipment costs related to this expansion total between
$15 and $17 million. We plan to fund these capital projects from the proceeds of
our secondary stock offering. In addition, we are in the process of purchasing a
79-acre site close to our present facility for $1.5 million. We anticipate that
internally generated cash plus the proceeds of the secondary stock offering will
be sufficient to fund our capital requirements for the next 12 months.
Impact of the Year 2000
State of Readiness
We have adopted a Year 2000 compliance plan and formed a team of information
technology professionals assigned the task of identifying and resolving any Year
2000 issues that may affect our business. Our compliance plan has four phases:
inventory, assessment, remediation and testing. We have completed an inventory
for all of our computer systems, computer related equipment and equipment with
embedded processors, as well as our products, and are in the process of
assessing those systems. We have completed this assessment with respect to
approximately 80% of our systems and expect to complete our assessment of the
remaining systems by February 1999. In addition, we have determined that our
products are of a nature that they are not subject to failure as a result of
Year 2000 issues. Although we cannot control
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whether and how third parties will address the Year 2000 issue, we also are in
the process of contacting critical vendors and suppliers to assess their ability
to ensure smooth delivery of products without disruptions caused by Year 2000
problems. In the course of our assessment, we have not yet identified any Year
2000 issues that would affect our ability to do business; however, our
assessment is not complete, and there can be no assurance that there are no Year
2000 issues that may affect us. Once we complete the assessment phase, we will
prioritize and implement necessary repairs or replacements to equipment and
software to achieve Year 2000 compliance. We expect to complete this phase by
March 1999. The final phase will consist of a testing program for all repairs.
We anticipate that all testing will be completed by April 1999.
Costs
We have not prepared estimates of costs to remediate Year 2000 problems;
however, based on currently available information, including the results of our
assessment to date and our replacement schedule for equipment, we do not believe
that the costs associated with Year 2000 compliance will have a material adverse
effect on our business, results of operations or financial condition.
Year 2000 Risks
Although we believe that our Year 2000 compliance plan is adequate to address
Year 2000 concerns, there can be no assurance that we will not experience
negative consequences as a result of undetected defects or the non-compliance of
third parties with whom we interact. Furthermore, there can be no assurance that
there will not be a delay in, or increased costs associated with, the
implementation of corrections as the Year 2000 compliance plan is performed,
such as unexpected costs of correcting equipment that has not yet been fully
evaluated. If realized, these risks could result in an adverse effect on our
business, results of operations and financial condition.
We believe that our greatest risk stems from the potential non-compliance of our
suppliers. We depend on a limited number of suppliers for certain raw materials,
components and equipment necessary for the manufacture of our products.
Accordingly, if those suppliers are unable to process or fill our orders or
otherwise interact with us because of Year 2000 problems, we could experience
material adverse effects to our business. We are in the process of assessing the
Year 2000 status of our suppliers and are investigating alternative sources of
supply. As a consequence of our dependence on limited sources of supply, we
generally maintain a significant inventory of certain critical materials and
require suppliers to keep certain amounts of inventory available for us;
however, there can be no assurance that we will have enough materials on hand to
continue production without interruption in the event one or more of our
suppliers experiences Year 2000 problems that affect its (their) ability to
supply us. Any supply chain disruptions would affect our ability to manufacture
our products which could result in material adverse consequences to our
business, results of operations and financial condition.
-20-
Contingencies
We have not yet developed a contingency plan to address what would happen in the
event we are unable to address the Year 2000 issue. The contingency plan is
expected to be completed after the inquiry of vendors and customers is
completed.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
No material changes in market risk have been identified during the most recent
quarter.
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
The Company's Annual Meeting of Shareholders convened on November 3, 1998. The
following proposals were introduced and voted upon:
PROPOSAL NO. 1 -- Election of Directors
Votes Votes
Name For Withheld
------------------- ----------- ------------
F. Neal Hunter 11,740,086 203,680
Calvin H. Carter, Jr. 11,870,286 73,480
John W. Palmour 11,869,286 74,480
Walter L. Robb 11,853,486 90,280
Michael W. Haley 11,738,686 205,080
Dolph W. von Arx 11,722,686 221,080
James E. Dykes 11,715,486 228,280
PROPOSAL NO.2 -- Amendment and Restatement of Articles of Incorporation
FOR 7,543,630
AGAINST 595,781
ABSTAINED 41,635
BROKER NON-VOTES 3,762,720
PROPOSAL NO.3 -- To ratify the selection of Ernst & Young LLP as auditors for
the fiscal year ending June 27, 1999
FOR 11,613,306
AGAINST 13,091
ABSTAINED 28,369
BROKER NON-VOTES 289,000
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The matters listed above are described in detail in the Company's definitive
proxy statement dated October 1, 1998, for the Annual Meeting of Shareholders
held on November 3, 1998.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit Description
------- -----------------------------------------------------------------
10.1 Amended and Restated Equity Compensation Plan effective
December 7, 1998
10.16 Fourth Amendment to Purchase Agreement between the Company and
Siemens AG dated December 16, 1998 (1)
10.17 Second Amended and Restated Indemnity Agreement between the
Company and F. Neal Hunter dated September 25, 1998
27 Financial Data Schedule
99.1 Risk Factors
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the
quarter ended December 27, 1998.
- ----------------------
(1)Confidential treatment of portions of this document is being requested
pursuant to Rule 24b-2 of the Securities and Exchange Commission.
-22-
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 RESEARCH, INC.
Date: January 28, 1999 /s/ Cynthia B. Merrell
----------------------------------------
Cynthia B. Merrell
Chief Financial Officer and Treasurer
(Authorized Officer and Chief Financial
and Accounting Officer)
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