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CREE INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Information set forth in this Quarterly Report on Form 10-Q contains various "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). All information contained in this report relative to future markets for our products and trends in and anticipated levels of revenue, gross margins and expenses, as well as other statements containing words such as "believe," "project," "may," "will," "anticipate," "target," "plan," "estimate," "expect" and "intend" and other similar expressions constitute forward-looking statements. These forward-looking statements are subject to business, economic and other risks and uncertainties, both known and unknown, and actual results may differ materially from those contained in the forward-looking statements. Any forward-looking statements we make are as of the date made, and except as required under the U.S. federal securities laws and the rules and regulations of the Securities and Exchange Commission (the SEC), we have no duty to update them if our views later change. These forward-looking statements should not be relied upon as representing our views as of any date subsequent to the date of this Quarterly Report. Examples of risks and uncertainties that could cause actual results to differ materially from historical performance and any forward-looking statements include, but are not limited to, those described in "Risk Factors" in Part II, Item 1A of this Quarterly Report. The following discussion is designed to provide a better understanding of our unaudited consolidated financial statements, including a brief discussion of our business and products, key factors that impacted our performance and a summary of our operating results. The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, and the consolidated financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended June 30, 2013. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods. Overview Cree, Inc. (Cree, we, our, or us) is a leading innovator of lighting-class light emitting diode (LED) products, lighting products and semiconductor products for power and radio-frequency (RF) applications. Our products are targeted for applications such as indoor and outdoor lighting, video displays, transportation, electronic signs and signals, power supplies, inverters and wireless systems. We develop and manufacture semiconductor materials and devices primarily based on silicon carbide (SiC), gallium nitride (GaN) and related compounds. In many cases, the properties of SiC and GaN offer technical advantages over traditional silicon, gallium arsenide (GaAs) and other materials used for electronic applications. Our LED products consist of LED components, LED chips and SiC materials. Our success in selling LED products depends upon our ability to offer innovative products and to enable our customers to develop and market LED-based products that successfully compete against other LED-based products and drive LED adoption against traditional lighting products. Our lighting products primarily consist of LED lighting systems. We design, manufacture and sell lighting fixtures and lamps for the commercial, industrial and consumer markets. In addition, we develop, manufacture and sell power and RF devices. Our power products are made from SiC and provide increased efficiency, faster switching speeds and reduced system size and weight over comparable silicon-based power devices. Our RF devices are made from GaN and provide improved efficiency, bandwidth and frequency of operation as compared to silicon or GaAs. The majority of our products are manufactured at our production facilities located in North Carolina, Wisconsin and China. We also use contract manufacturers for certain aspects of product fabrication, assembly and packaging. We operate research and development facilities in North Carolina, California, Wisconsin, India and China (including Hong Kong). Cree, Inc. is a North Carolina corporation established in 1987, and our headquarters are in Durham, North Carolina. Reportable Segments As of March 30, 2014, we have three reportable segments: • LED Products • Lighting Products • Power and RF Products For further information about our reportable segments, please refer to Note 12 "Reportable Segments" in our consolidated financial statements included in Item 1 of this Quarterly Report. 21-------------------------------------------------------------------------------- Table of Contents Industry Dynamics and Trends There are a number of industry factors that affect our business which include, among others: • Overall Demand for Products and Applications using LEDs. Our potential for growth depends significantly on the adoption of LEDs within the general lighting market and our ability to affect this rate of adoption. Although the market for LED lighting has grown in recent years, adoption of LEDs for general lighting is relatively low and faces significant challenges before widespread adoption. Demand also fluctuates based on various market cycles, a continuously evolving LED industry supply chain, and demand dynamics in the market. These uncertainties make demand difficult to forecast for us and our customers. • Intense and Constantly Evolving Competitive Environment. Competition in the LED and lighting industry is intense. Many companies have made significant investments in LED development and production equipment. Traditional lighting companies and new entrants are investing in LED-based lighting products as LED adoption has gained momentum. Traditional lighting companies have taken steps to try and limit access to their sales channels, including lighting agents and distributors. Product pricing pressures exist as market participants often undertake pricing strategies to gain or protect market share, increase the utilization of their production capacity and open new applications to LED-based solutions. To remain competitive, market participants must continuously increase product performance and reduce costs. To address these competitive pressures, we have invested in R&D activities to support new product development to deliver higher levels of performance and lower costs to differentiate our products in the market.• Technological Innovation and Advancement. Innovations and advancements in LED, power and RF technologies continue to expand the potential commercial application for our products, particularly in the general illumination, power electronics and wireless markets. However, new technologies or standards could emerge, or improvements could be made in existing technologies, that could reduce or limit the demand for our products in certain markets. • Regulatory Actions Concerning Energy Efficiency. Many countries have already instituted or have announced plans to institute government regulations and programs designed to encourage or mandate increased energy efficiency, even in some cases banning forms of incandescent lighting, which are advancing the adoption of more energy efficient lighting solutions such as LEDs. Government agencies are also involved in setting standards for LED lighting, which can affect market acceptance and the availability of rebates from government agencies or third parties such as utilities. While this trend is generally positive, these regulations are affected by changing political priorities and evolving technical standards which can modify or limit the effectiveness of these new regulations. • Intellectual Property Issues. Market participants rely on patented and non-patented proprietary information relating to product development, manufacturing capabilities and other core competencies of their business. Protection of intellectual property is critical. Therefore, steps such as additional patent applications, confidentiality and non-disclosure agreements, as well as other security measures are generally taken. To enforce or protect intellectual property rights, litigation or threatened litigation commonly occurs. Financial Results The following is a summary of our financial results for the nine months ended March 30, 2014: • Revenues increased to $1.2 billion for the nine months ended March 30, 2014 from $1.0 billion for the nine months ended March 31, 2013. • For the nine months ended March 30, 2014, gross margins remained consistent at 37.7% compared to 37.8% for the nine months ended March 31, 2013. For the nine months ended March 30, 2014, gross profit increased to $456.5 million from $382.5 million for the nine months ended March 31, 2013. • Operating income increased to $102.6 million for the nine months ended March 30, 2014 from $65.6 million for the nine months ended March 31, 2013. Net income per diluted share increased to $0.77 for the nine months ended March 30, 2014 from $0.50 for the nine months ended March 31, 2013. 22-------------------------------------------------------------------------------- Table of Contents • Combined cash, cash equivalents and short-term investments increased to $1.2 billion at March 30, 2014 compared to $1.0 billion at June 30, 2013. Cash provided by operating activities was $228.2 million for the nine months ended March 30, 2014, compared to $224.1 million for the nine months ended March 31, 2013. • Inventories increased to $251.2 million at March 30, 2014 compared to $197.0 million at June 30, 2013. Business Outlook We project that the markets for our products will remain highly competitive during fiscal 2014. We anticipate focusing on the following key areas, among others, in response to this competitive environment: • Lead with innovation and drive to cost parity. We continue to work on developing new LEDs, LED lighting systems, and Power and RF devices to deliver improved value that approaches cost parity with existing technology and solutions. We believe that as our technology approaches cost parity, the market for these products will expand significantly. • Build the Cree brand. We are working to build the Cree brand in both the commercial and consumer lighting segments by expanding our product offerings and continuing to invest in marketing the value of the Cree LED bulb and LED lighting directly to the end user. The level of investment will vary from quarter to quarter to optimize new product introductions, utility rebates, channel opportunities and seasonal trends. • Focus on select market segments to drive LED adoption. In addition to our broad sales strategies, we are focused on a number of market segments where we can upgrade existing lighting and drive LED adoption with a combination of new product offerings, short payback, expanded services and innovative channel approaches. • Translate product innovation into revenue and profit growth. We target revenue growth from new products and increased LED adoption and profit growth from the combination of higher sales, lower cost products and operating expense leverage. 23-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth certain consolidated statement of income data for the periods indicated (in thousands, except per share amounts and percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 2014 2013 Dollars % of Revenue Dollars % of Revenue Dollars % of Revenue Dollars % of Revenue Revenue, net $405,259 100 % $348,934 100 % $1,211,351 100 % $1,010,973 100 % Cost of revenue, net 255,265 63 % 215,924 62 % 754,822 62 % 628,438 62 % Gross profit 149,994 37 % 133,010 38 % 456,529 38 % 382,535 38 % Research and development 46,626 12 % 39,036 11 % 132,805 11 % 116,524 12 % Sales, general and administrative 65,368 16 % 62,140 18 % 197,589 16 % 174,885 17 % Amortization of acquisition-related intangibles 7,257 2 % 7,719 2 % 21,800 2 % 23,108 2 % Loss on disposal or impairment of long-lived assets 364 - % 863 - % 1,781 - % 2,385 - % Operating income 30,379 7 % 23,252 7 % 102,554 8 % 65,633 6 % Non-operating income, net 3,152 1 % 2,512 1 % 9,373 1 % 8,378 1 % Income before income taxes 33,531 8 % 25,764 7 % 111,927 9 % 74,011 7 % Income tax expense 5,367 1 % 3,607 1 % 17,585 1 % 15,328 2 % Net income $28,164 7 % $22,157 6 % $94,342 8 % $58,683 6 % Basic earnings per share $0.23 $0.19 $0.78 $0.51 Diluted earnings per share $0.23 $0.19 $0.77 $0.50 Revenues Revenues for the three and nine months ended March 30, 2014 and March 31, 2013 were comprised of the following (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change LED Products $201,119 $195,561 $5,558 3 % $634,164 $584,070 $50,094 9 % Percent of revenue 49 % 56 % 52 % 58 % Lighting Products 176,691 130,659 46,032 35 % 498,265 361,446 136,819 38 % Percent of revenue 44 % 37 % 41 % 36 % Power and RF Products 27,449 22,714 4,735 21 % 78,922 65,457 13,465 21 % Percent of revenue 7 % 7 % 7 % 6 % Total revenue $405,259 $348,934 $56,325 16 % $1,211,351 $1,010,973 $200,378 20 % Our consolidated revenue increased 16% to $405.3 million for the three months ended March 30, 2014 from $348.9 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, our consolidated revenue increased 20% to $1.2 billion from $1.0 billion for the nine months ended March 31, 2013. The year-over-year increase was due to higher sales across all three of our business segments, but driven primarily by strong sales in the Lighting Products segment. 24-------------------------------------------------------------------------------- Table of Contents LED Products Segment Revenue LED Products revenue represents the largest portion of our revenue with 49% and 56% of our total revenues for the three months ended March 30, 2014 and March 31, 2013, respectively. LED Products revenue increased 3% to $201.1 million for the three months ended March 30, 2014 from $195.6 million for the three months ended March 31, 2013, and 9% to $634.2 million for the nine months ended March 30, 2014 from $584.1 million for the nine months ended March 31, 2013. The increase in revenue was the result of an overall increase in the number of units sold, primarily from our newer products, partially offset by a decline in selling prices. The average selling prices for our LED products decreased for the three and nine months ended March 30, 2014 as compared to the three and nine months ended March 31, 2013 due primarily to market downward pricing pressure and sales of new lower cost products. Lighting Products Segment Revenue Lighting Products revenue represents 44% and 37% of our total revenues for the three months ended March 30, 2014 and March 31, 2013, respectively. Lighting Products revenue increased 35% to $176.7 million for the three months ended March 30, 2014 from $130.7 million for the three months ended March 31, 2013, and 38% to $498.3 million for the nine months ended March 30, 2014 from $361.4 million for the nine months ended March 31, 2013. The increase in revenue was the result of an overall increase in the number of units sold. The increased volume was partially offset by a reduction in selling prices primarily due to sales of new lower cost products. Power and RF Products Segment Revenue Power and RF Products revenue represents 7% of our total revenues for both the three months ended March 30, 2014 and March 31, 2013. Power and RF Products revenue increased 21% to $27.4 million for the three months ended March 30, 2014 from $22.7 million for the three months ended March 31, 2013, and 21% to $78.9 million for the nine months ended March 30, 2014 from $65.5 million for the nine months ended March 31, 2013. The increase in revenue was primarily the result of higher sales of RF products. The increased volume was partially offset by a reduction in selling prices primarily due to sales of new lower cost products. Gross Profit and Gross Margin Gross profit and gross margin for the three and nine months ended March 30, 2014 and March 31, 2013 were comprised of the following (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change LED Products gross profit $91,634 $85,728 $5,906 7 % $290,931 $245,381 $45,550 19 % LED Products gross margin 45.6 % 43.8 % 45.9 % 42.0 % Lighting Products gross profit 48,487 39,966 8,521 21 % 136,731 115,449 21,282 18 % Lighting Products gross margin 27.4 % 30.6 % 27.4 % 31.9 % Power and RF Products gross profit 15,675 12,033 3,642 30 % 44,452 35,253 9,199 26 % Power and RF Products gross margin 57.1 % 53.0 % 56.3 % 53.9 % Unallocated costs (5,802 ) (4,717 ) (1,085 ) 23 % (15,585 ) (13,548 ) (2,037 ) 15 % Consolidated gross profit $149,994 $133,010 $16,984 13 % $456,529 $382,535 $73,994 19 % Consolidated gross margin 37.0 % 38.1 % 37.7 % 37.8 % Our consolidated gross profit increased 13% to $150.0 million for the three months ended March 30, 2014 from $133.0 million for the three months ended March 31, 2013. Our consolidated gross margin decreased to 37.0% for the three months ended March 30, 2014 from 38.1% for the three months ended March 31, 2013. For the nine months ended March 30, 2014, our consolidated gross profit increased 19% to $456.5 million from $382.5 million for the nine months ended March 31, 2013. For the nine months ended March 30, 2014, our consolidated gross margin decreased to 37.7% from 37.8% for the nine months ended March 31, 2013. 25-------------------------------------------------------------------------------- Table of Contents LED Products Segment Gross Profit and Gross Margin LED Products gross profit increased 7% to $91.6 million for the three months ended March 30, 2014 from $85.7 million for the three months ended March 31, 2013, and increased 19% to $290.9 million for the nine months ended March 30, 2014 from $245.4 million for the nine months ended March 31, 2013. LED Products gross margin increased to 45.6% for the three months ended March 30, 2014 from 43.8% for the three months ended March 31, 2013, and increased to 45.9% for the nine months ended March 30, 2014 from 42.0% for the nine months ended March 31, 2013. LED Products gross profit and gross margin increased due to higher revenue, factory cost reductions, the introduction of new lower cost products and higher factory utilization. These benefits more than offset the decline in the average selling prices for the three and nine months ended March 30, 2014 as compared to the three and nine months ended March 31, 2013. Lighting Products Segment Gross Profit and Gross Margin Lighting Products gross profit increased 21% to $48.5 million for the three months ended March 30, 2014 from $40.0 million for the three months ended March 31, 2013, and increased 18% to $136.7 million for the nine months ended March 30, 2014 from $115.4 million for the nine months ended March 31, 2013. Lighting Products gross margin decreased to 27.4% for the three months ended March 30, 2014 from 30.6% for the three months ended March 31, 2013, and decreased to 27.4% for the nine months ended March 30, 2014 from 31.9% for the nine months ended March 31, 2013. Lighting Products gross profit increased for both the three and nine months ended March 30, 2014 as compared to the three and nine months ended March 31, 2013 due to growth in LED lighting products sales. Lighting Products gross margin decreased for both the three and nine months ended March 30, 2014 as compared to the three and nine months ended March 31, 2013 due to changes in product mix driven primarily by higher sales of consumer lighting products, which have lower gross margins. Power and RF Products Segment Gross Profit and Gross Margin Power and RF Products gross profit increased 30% to $15.7 million for the three months ended March 30, 2014 from $12.0 million for the three months ended March 31, 2013, and increased 26% to $44.5 million for the nine months ended March 30, 2014 from $35.3 million for the nine months ended March 31, 2013. Power and RF Products gross margin increased to 57.1% for the three months ended March 30, 2014 from 53.0% for the three months ended March 31, 2013, and increased to 56.3% for the nine months ended March 30, 2014 from 53.9% for the nine months ended March 31, 2013. Power and RF Products gross profit and gross margin increased due primarily to higher revenue, factory cost reductions, increased factory utilization and introduction of new lower cost products. These benefits more than offset the decline in the average selling prices for the three and nine months ended March 30, 2014 as compared to the three and nine months ended March 31, 2013. Unallocated Costs Unallocated costs were $5.8 million and $4.7 million for the three months ended March 30, 2014 and March 31, 2013, respectively. For the nine months ended March 30, 2014 and March 31, 2013, unallocated costs were $15.6 million and $13.5 million, respectively. These costs consist primarily of manufacturing employees' stock-based compensation, expenses for profit sharing and quarterly or annual incentive plans and matching contributions under our 401(k) plan. These costs are not allocated to the reportable segments' gross profit because our CODM does not review them regularly when evaluating segment performance and allocating resources. The increase of $1.1 million for the three months ended March 30, 2014 and $2.0 million for the nine months ended March 30, 2014 is primarily attributable to higher incentive and stock-based compensation incurred as a result of improved business performance in fiscal 2014 as compared to fiscal 2013. Research and Development Research and development expenses include costs associated with the development of new products, enhancements of existing products and general technology research. These costs consist primarily of employee salaries and related compensation costs, occupancy costs, consulting costs and the cost of development equipment and supplies. The following sets forth our research and development expenses in dollars and as a percentage of revenues (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change Research and development $46,626 $39,036 $7,590 19 % $132,805 $116,524 $16,281 14 % Percent of revenues 12 % 11 % 11 % 12 % 26-------------------------------------------------------------------------------- Table of Contents Research and development expenses for the three months ended March 30, 2014 increased 19% to $46.6 million from $39.0 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, research and development expenses increased 14% to $132.8 million from $116.5 million for the nine months ended March 31, 2013. These increases were primarily due to increased spending on research and development activities focused on new LED lighting products. Our research and development expenses vary significantly from quarter to quarter based on a number of factors, including the timing of new product introductions and the number and nature of our ongoing research and development activities. We anticipate that in general our research and development expenses will continue to increase over time to support future growth. Sales, General and Administrative Sales, general and administrative expenses were comprised primarily of costs associated with our sales and marketing personnel and our executive and administrative personnel (for example, finance, human resources, information technology and legal) and consist of 1) salaries and related compensation costs, 2) consulting and other professional services (such as litigation and other outside legal counsel fees, audit and other compliance costs), 3) marketing and advertising expenses, 4) facilities and insurance costs and 5) travel and other costs. The following table sets forth our sales, general and administrative expenses in dollars and as a percentage of revenues (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change Sales, general and administrative $65,368 $62,140 $3,228 5 % $197,589 $174,885 $22,704 13 % Percent of revenues 16 % 18 % 16 % 17 % Sales, general and administrative expenses for the three months ended March 30, 2014 increased 5% to $65.4 million from $62.1 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, sales, general and administrative expenses increased 13% to $197.6 million from $174.9 million for the nine months ended March 31, 2013. These increases were primarily due to an increase in spending on sales and marketing for lighting products, including commissions, trade shows and advertising, as we continue to expand our direct sales resources and channels and invest in building and promoting the Cree brand. Amortization of Acquisition-Related Intangibles As a result of our acquisitions, we have recognized various intangible assets, including customer relationships and developed technologies. During fiscal 2012, we acquired Ruud Lighting, resulting in $206.0 million of amortizable intangible assets, principally composed of developed technology, customer relationships and trade names. In fiscal 2008, we acquired LED Lighting Fixtures, Inc. (LLF), resulting in $41.2 million of amortizable intangible assets. These intangible assets are principally composed of developed technologies that specifically relate to technologies underlying the development of LED lighting products for the general illumination market. During fiscal 2007, we acquired INTRINSIC Semiconductor Corporation and COTCO Luminant Device Limited (now Cree Hong Kong Limited) (COTCO), resulting in $63.7 million of amortizable intangible assets principally composed of customer relationships and developed technology. 27-------------------------------------------------------------------------------- Table of Contents Amortization of intangible assets related to our acquisitions is as follows (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change Ruud Lighting $5,746 $5,743 $3 - % $17,238 $17,180 $58 - % COTCO 753 1,040 (287 ) (28 )% 2,259 3,121 (862 ) (28 )% LLF 750 750 - - % 2,249 2,249 - - % INTRINSIC 8 186 (178 ) (96 )% 54 558 (504 ) (90 )% Total $7,257 $7,719 ($462 ) (6 )% $21,800 $23,108 ($1,308 ) (6 )% Loss on Disposal or Impairment of Long-Lived Assets The following table sets forth our loss on disposal or impairment of long-lived assets (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, March 31, March 30, March 31, 2014 2013 Change 2014 2013 Change Loss on disposal or impairment of long-lived assets $364 $863 ($499 ) (58 )% $1,781 $2,385 ($604 ) (25 )% We operate a capital intensive business. As such, we dispose of a certain level of our equipment in the normal course of business as our production process changes due to production improvement initiatives or product mix changes. Due to the risk of technological obsolescence or changes in our production process, we regularly review our equipment and capitalized patent costs for possible impairment. We recognized a net loss of $0.4 million on the disposal of long-lived assets for the three months ended March 30, 2014 compared to a net loss of $0.9 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, we recognized a net loss of $1.8 million compared to $2.4 million for the nine months ended March 31, 2013. Non-Operating Income, Net The following table sets forth our non-operating income, net (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, 2014 March 31, 2013 Change March 30, 2014 March 31, 2013 Change Foreign currency (loss) gain, net ($368 ) $296 ($664 ) (224 )% $109 $424 ($315 ) (74 )% Gain on sale of investments, net 15 48 (33 ) (69 )% 25 84 (59 ) (70 )% Interest income, net 3,415 2,018 1,397 69 % 8,562 5,756 2,806 49 % Other, net 90 150 (60 ) (40 )% 677 2,114 (1,437 ) (68 )% Total non-operating income, net $3,152 $2,512 $640 25 % $9,373 $8,378 $995 12 % We have no debt or active lines of credit and therefore we are in a net interest income position. Our investments consist of municipal bonds, corporate bonds, U.S. agency securities, non-U.S. certificates of deposit and non-U.S. government securities. The primary objective of our investment policy is preservation of principal. Foreign currency (loss) gain, net. Foreign currency (loss) gain, net consists primarily of remeasurement adjustments resulting from consolidating our international subsidiaries. The changes in foreign currency (loss) gain, net are primarily due to fluctuations in the exchange rate between the Chinese Yuan and the United States Dollar. Gain on sale of investments, net. Gain on sale of investments, net was $15 thousand for the three months ended March 30, 2014 compared to $48 thousand for the three months ended March 31, 2013. For the nine months ended March 30, 2014, gain on sale of investments, net was $25 thousand compared to $84 thousand for the nine months ended March 31, 2013. Interest income, net. Interest income, net was $3.4 million for the three months ended March 30, 2014 compared to $2.0 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, interest income, net was $8.6 million compared to $5.8 million for the nine months ended March 31, 2013. The increase in interest income for the three and nine months ended March 30, 2014 was primarily due to earning higher investment yields and higher invested balances as compared to the three and nine months ended March 31, 2013. 28-------------------------------------------------------------------------------- Table of Contents Other, net. Other, net was $0.1 million for the three months ended March 30, 2014 compared to $0.2 million for the three months ended March 31, 2013. For the nine months ended March 30, 2014, other, net was $0.7 million compared to $2.1 million for the nine months ended March 31, 2013. The decrease for the nine months ended March 30, 2014 is due primarily to a one-time payment received in connection with the SemiLEDs patent litigation settlement which occurred in the first quarter of fiscal 2013. Income Tax Expense The following table sets forth our income tax expense in dollars and our effective tax rate (in thousands, except percentages): Three Months Ended Nine Months Ended March 30, 2014 March 31, 2013 Change March 30, 2014 March 31, 2013 Change Income tax expense $5,367 $3,607 $1,760 49 % $17,585 $15,328 $2,257 15 % Effective tax rate 16.0 % 14.0 % 15.7 % 20.7 % The variation between our effective income tax rate and the U.S. statutory rate of 35 percent is due to a percentage of our projected income for the full year being derived from international locations with lower tax rates than the U.S. and the impact of tax credits available in the current year. A change in the mix of pretax income of our various tax jurisdictions can have a material impact on our periodic effective tax rate. We recognized income tax expense of $5.4 million for an effective tax rate of 16.0% for the three months ended March 30, 2014 as compared to income tax expense of $3.6 million for an effective tax rate of 14.0% for the three months ended March 31, 2013. This increase in our effective tax rate was primarily due to the third quarter of fiscal 2013 tax benefit from the retroactive reinstatement and extension of the research and development credit being larger than the third quarter of fiscal 2014 tax benefits related to a statute expiration. The retroactive reinstatement and extension of the research and development credit provided a catch-up tax benefit for six quarters (fiscal 2012 and the first half of fiscal 2013) during the third quarter of fiscal 2013. The research and development credit expired in December 2013. For the nine months ended March 30, 2014, we recognized income tax expense of $17.6 million for an effective tax rate of 15.7% compared to $15.3 million for an effective tax rate of 20.7% for the nine months ended March 31, 2013. This decrease in our effective tax rate was primarily due to an increased percentage of our income being earned in lower tax jurisdictions and the tax benefit related to the receipt of U.S. federal tax credits awarded on November 15, 2013 as part of Phase II of the American Recovery and Reinvestment Act of 2009 (Internal Revenue Code Section 48C). Liquidity and Capital Resources Overview We require cash to fund our operating expenses and working capital requirements, including outlays for research and development, capital expenditures, strategic acquisitions and investments. Our principal sources of liquidity are cash and cash equivalents, marketable investments and cash generated from operations. Our ability to generate cash from operations has been one of our fundamental strengths and has provided us with substantial flexibility in meeting our operating, financing and investing needs. We have no debt or active lines of credit and have minimal lease commitments. Based on past performance and current expectations, we believe our cash and cash equivalents, investments, cash generated from operations and our ability to access capital markets will satisfy our working capital needs, capital expenditures, investment requirements, stock repurchases, contractual obligations, commitments and other liquidity requirements associated with our operations through at least the next 12 months. From time to time, we evaluate strategic opportunities, including potential acquisitions, divestitures or investments in complementary businesses and we anticipate continuing to make such evaluations. We may also access capital markets through the issuance of debt or additional shares of common stock in connection with the acquisition of complementary businesses or other significant assets or for other strategic opportunities. We may use a portion of our available cash and cash equivalents, or funds underlying our marketable securities, to repurchase shares of our common stock pursuant to repurchase programs authorized by our Board of Directors. With our strong working capital position, we believe that we have the ability to continue to invest in further development of our products and, when necessary 29-------------------------------------------------------------------------------- Table of Contents or appropriate, make selective acquisitions or other strategic investments to strengthen our product portfolio, secure key intellectual properties or expand our production capacity. Liquidity Our liquidity and capital resources depend on our cash flows from operations and our working capital. The significant components of our working capital are liquid assets such as cash and cash equivalents, short-term investments, accounts receivable and inventories, reduced by trade accounts payable, accrued salaries and wages, and other accrued expenses. Our working capital increased to $1.5 billion as of March 30, 2014 from $1.3 billion as of June 30, 2013, primarily due to $228.2 million cash provided by operating activities and $89.5 million cash provided by the net issuances of common stock from employee option exercises. These cash inflows were partially offset by payments for patent and licensing rights and purchases of property and equipment of $134.4 million. The following table presents the components of our cash conversion cycle for the three months ended March 30, 2014 and June 30, 2013: March 30, June 30, 2014 2013 Change Days of sales outstanding(a) 49 46 3 7 % Days of supply in inventory(b) 89 76 13 17 % Days in accounts payable(c) (56) (47) (9 ) 19 % Cash conversion cycle 82 75 7 9 % a) Days of sales outstanding (DSO) measures the average collection period of our receivables. DSO is based on the ending net trade receivables and the revenue for the quarter then ended. DSO is calculated by dividing ending accounts receivable, net of applicable allowances and reserves, by the average net revenue per day for the respective 90 day period. b) Days of supply in inventory (DSI) measures the average number of days from procurement to sale of our product. DSI is based on ending inventory and cost of revenue, net sold for the quarter then ended. DSI is calculated by dividing ending inventory by average cost of revenue, net per day for the respective 90 day period. c) Days in accounts payable (DPO) measures the average number of days our payables remain outstanding before payment. DPO is based on ending accounts payable and cost of revenue, net for the quarter then ended. DPO is calculated by dividing ending accounts payable by the average cost of revenue, net per day for the respective 90 day period. The increase in the cash conversion cycle was primarily driven by an increase in days of inventory partially offset by an increase in days in accounts payable. As of March 30, 2014, we had unrealized losses on our investments of $0.9 million. All of our investments had investment grade ratings, and any such investments that were in an unrealized loss position at March 30, 2014 were in such position due to interest rate changes, sector credit rating changes or company-specific rating changes. As we intend and believe that we have the ability to hold such investments for a period of time that will be sufficient for anticipated recovery in market value, we currently expect to receive the full principal or recover our cost basis in these securities. The declines in value of the securities in our portfolio are considered to be temporary in nature and, accordingly, we do not believe these securities are impaired as of March 30, 2014. 30-------------------------------------------------------------------------------- Table of Contents Cash Flows In summary, our cash flows were as follows (in thousands, except percentages): Nine Months Ended March 30, 2014 March 31, 2013 Change Net cash provided by operating activities $228,170 $224,070 $4,100 2 % Net cash used in investing activities (257,261 ) (270,954 ) 13,693 (5 )% Net cash provided by financing activities 107,765 46,350 61,415 133 % Effects of foreign exchange changes on cash and cash equivalents 95 87 8 9 % Net increase (decrease) in cash and cash equivalents $78,769 ($447 ) $79,216 The following is a discussion of our primary sources and uses of cash in our operating, investing and financing activities. Cash Flows from Operating Activities Net cash provided by operating activities was $228.2 million for the nine months ended March 30, 2014 compared to $224.1 million for the nine months ended March 31, 2013. This increase was primarily due to an increase in net income partially offset by changes in our working capital. Cash Flows from Investing Activities Our investing activities primarily relate to transactions within our investments, purchases of property and equipment and payments for patent and licensing rights. Net cash used in investing activities was $257.3 million for the nine months ended March 30, 2014 compared to $271.0 million for the nine months ended March 31, 2013. For the nine months ended March 30, 2014, our purchases of property and equipment were $119.6 million as compared to $55.4 million for the nine months ended March 31, 2013. Our capital spending increased as we continued to make investments in capacity to support our future growth. This increase was more than offset by lower net purchases of investments for the nine months ended March 30, 2014 compared to the nine months ended March 31, 2013. We continue to actively manage our capital spending. For fiscal 2014, we now target approximately $175.0 million of capital investment to support our strategic priorities. Cash Flows from Financing Activities Net cash provided by financing activities was $107.8 million for the nine months ended March 30, 2014 and $46.4 million for the nine months ended March 31, 2013. For the nine months ended March 30, 2014 and March 31, 2013, our financing activities primarily consisted of proceeds of $107.9 million and $47.0 million, respectively, from net issuances of common stock pursuant to the exercise of employee stock options, including the excess tax benefit on those exercises. Off-Balance Sheet Arrangements We do not use off-balance sheet arrangements with unconsolidated entities or related parties, nor do we use any other forms of off-balance sheet arrangements. Accordingly, our liquidity and capital resources are not subject to off-balance sheet risks from unconsolidated entities. As of March 30, 2014, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. We have entered into operating leases primarily for certain of our U.S. and international facilities in the normal course of business. Please refer to Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended June 30, 2013, in the section entitled "Contractual Obligations" for the future minimum lease payments due under our operating leases as of June 30, 2013. There have been no significant changes to the contractual obligations discussed therein. Critical Accounting Policies and Estimates For information about our critical accounting policies and estimates, see the "Critical Accounting Policies and Estimates" section of "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year ended June 30, 2013. 31-------------------------------------------------------------------------------- Table of Contents New Accounting Standards See Note 1, "Basis of Presentation and Changes in Significant Accounting Policies," to our unaudited consolidated financial statements in Part I, Item 1 of this Quarterly Report for a description of new accounting standards, including the effects, if any, on our consolidated financial statements. Item 3. Quantitative and Qualitative Disclosures About Market Risk For quantitative and qualitative disclosures about our market risks, see "Part II. Item 7A. Quantitative and Qualitative Disclosures About Market Risk" of our Annual Report on Form 10-K for the fiscal year ended June 30, 2013. There have been no material changes to the amounts presented therein. Item 4. Controls and Procedures Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Form 10-Q, our disclosure controls and procedures are effective in that they provide reasonable assurances that the information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the SEC's rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate. There have been no changes to our internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the third quarter of fiscal 2014 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 32-------------------------------------------------------------------------------- Table of Contents |