Wolfspeed, Inc. (WOLF) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Welcome to Cree’s Second Quarter Fiscal Year 2017 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference call over to Raiford Garrabrant, Director of Investor Relations. Please go ahead.

Thank you, Abigail, and good afternoon. Welcome to Cree’s second quarter fiscal 2017 conference call. Today, A - Chuck Swoboda, our Chairman and CEO; and Mike McDevitt, our CFO, will report on our results for the second quarter of fiscal year 2017. Please note that we’ll be presenting non-GAAP financial results during today’s call, and a reconciliation to the corresponding GAAP measures is in our press release, and posted in the Investor Relations section of our website. Today’s presentations include forward-looking statements about our business outlook, and we may make other forward-looking statements during the call. Such forward-looking statements are subject to numerous risks and uncertainties. Our press release today and the SEC filings noted in the release, mention important factors that could cause actual results to differ materially. Also, we’d like to note that we’ll be limiting our comments regarding Cree’s second quarter of fiscal year 2017 to a discussion of the information included in our press release. We will not be able to answer any questions that would involve providing additional financial information about the quarter beyond the comments made in the prepared remarks. Consistent with our previous conference calls, we’re requesting that only sell-side analysts ask questions during the Q&A session. Also, since we plan to complete the call in the allotted time of one hour, we ask that analysts limit themselves to one question and one follow-up. If you have additional questions, please contact us after the call. Now, I’d like to turn the call over to Chuck.

Thank you, Raiford. We delivered very good results in fiscal Q2, with total combined company revenue of $401 million and non-GAAP earnings of $0.30 per share. These results are significantly above our targeted range due to the settlement of our patent infringement and false advertising lawsuit with Feit Electric, which was partially offset by an increase in our lighting reserves, which Mike will explain further in his remarks. If you exclude the effect of these two items, our second-quarter results would have been in the middle of our targeted range for both revenue and earnings. Regarding the Feit settlement, Cree has invested over $1.2 billion in R&D over the past 10 years to create fundamental technology that has enabled the LED lightning revolution, and it is our obligation to protect our intellectual property. This settlement and license agreement recognizes the value of our pioneering technology and ensures we are properly compensated while protecting consumers and Cree shareholders. Our licensing program now includes over 20 licensing partners. For continuing operations, the LED business delivered solid revenue and margins that were in line with our targets for the quarter. Core lighting revenue and margins were also in line with our targets as commercial lighting revenue growth offset lower consumer revenue due to lower than expected seasonal retail sales growth. We made progress improving margins in both our commercial and consumer lighting product lines in the quarter. Customer service levels remain good and lighting project quoting activity continued to improve, which is why we are targeting better than seasonal performance in Q3. We continue to make progress with our transition to Cree 3.0 and a more focused LED lightning technology company by improving fundamentals in our commercial and consumer lighting businesses. This, combined with solid execution in our LED business, puts us in a good position to grow future revenue and profits. While fiscal Q3 is a seasonally slower quarter for LEDs and the outdoor lighting business, we believe we are on the right track in building a solid foundation to support a multiyear effort to build a larger and more valuable company. I'll now turn the call over to Mike McDevitt to review our second-quarter financial results in more detail as well as our targets for the third quarter of fiscal 2017.

Thank you Chuck. I will be providing commentary on our financial statements on a non-GAAP basis, which is consistent with how management measures Cree's results internally. However, non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies. Non-GAAP information should be considered a supplement to and not a substitute for financial statements prepared in accordance with GAAP. A reconciliation of non-GAAP information to the corresponding GAAP measures for all periods mentioned on this call is posted on our website or provided in our press release, along with a historical summary of other key metrics. As a reminder, we previously announced an agreement to sell our Wolfspeed business to Infineon. We are reporting Wolfspeed as discontinued operations in our financial statements. As a result, I will be providing commentary on our results for our overall combined business, our continuing operations, and our discontinued operations. For the second quarter of fiscal 2017, combined Company revenue was $401 million and non-GAAP earnings were $30 million, or $0.30 per share, which were significantly above our targeted ranges. For continuing operations, revenue was $347 million and non-GAAP earnings were $20 million, or $0.20 per share, which was also well above our targeted ranges. Our combined and continuing operation results included the benefit from the Feit legal settlement, which was partially offset by additional lightning reserves. The additional reserves related primarily to third-party supply drivers for commercial lighting products that were identified as defective within the quarter. Excluding the impact of the Feit settlement and the additional lightning reserves, our combined and continuing operations non-GAAP results would've been in the middle of our targeted ranges. For discontinued operations, revenue was $54 million and non-GAAP earnings were $10 million, or $0.10 per share, which were slightly above the upper end of our targeted ranges. Our combined and discontinued operations include a $0.04 non-GAAP EPS benefit due to suspending depreciation and amortization on all Wolfspeed long-lived assets as required under GAAP for assets being held for sale. This benefit was built into our targets for the quarter. The non-GAAP earnings above exclude non-cash stock-based compensation, acquired intangibles amortization, transaction costs related to the pending sale to Infineon, and other items. For combined operations, the excluded amount is $24 million net of tax, or $0.24 per share, which was $3 million net of tax higher than targeted due to the decline in the valuation of our Lextar investment in the quarter. Fiscal 2017 second-quarter continuing operations revenue and non-GAAP gross profit for our reportable segments were as follows. Lighting products revenue increased 14% sequentially to $209 million, which was significantly above our targeted range. Gross profit was also well above our targeted range at $75 million for a 35.8% gross margin, a 900 basis point sequential increase. These results include the benefit from our confidential litigation settlement partially offset by the additional lightning reserves. Core lighting revenue and gross margins were in line with our targets, and gross margin improved from Q1 for both commercial and consumer. LED products revenue was $138 million and gross profit was $40 million, or 29.2% for the quarter, all of which were in line with our targets for the quarter. Non-allocated costs totaled $2 million for the second quarter of fiscal 2017 and are included to reconcile to $113 million non-GAAP gross profit for a 32.7% gross margin. Continuing operations non-GAAP operating expenses for Q2 were $88 million and above our targets for the quarter, due primarily to contingent legal costs associated with the settlement of the Feit case. Excluding the contingent legal costs, operating expenses were in line with our targets. Our non-GAAP operating income was $25 million, which was significantly above our targeted range. We ended the quarter with $421 million in cash and investments net of line of credit borrowings, a $19 million increase from Q1. At the end of the quarter, we had $170 million outstanding on our line of credit. For the quarter, we generated $102 million of cash from combined operations and spent $20 million for combined capital expenditures, which yielded free cash flow of $82 million. The $20 million spent on combined capital expenditures includes $10 million spent for Wolfspeed. During Q2, we spent $63 million to repurchase 2.7 million Cree shares. Fiscal 2017 year-to-date, we have repurchased 4.2 million Cree shares for $98 million. For fiscal 2017, we continue to target lighting and LED capital spending of $55 million, plus or minus, to support our continuing operations. Until the sale of Wolfspeed is completed, we will continue to invest capital to support the Wolfspeed business. We target Wolfspeed capital spending to be $15 million, plus or minus for Q3, which is in line with our previous guidance. Overall, we now target fiscal 2017 free cash flow of $120 million, plus or minus, which may change depending on the timing of the Wolfspeed sale. For continued operations, day sales outstanding decreased nine days from September to 32 days at the end of December. Inventory days on hand decreased five days from September to 107 days at the end of December. The inventory decrease primarily relates to our targeted reductions in commercial lighting finished goods. We forecast being in line with our 90 days, plus or minus, inventory days target within the next several quarters. Q3 total Company backlog is tracking behind this point last quarter, but in line with typical seasonal trends. We target combined Q3 Company revenue, which includes both continuing and discontinued operations in the range of $340 million to $370 million. We target combined non-GAAP net income for Q3 in a range of $10 million to $18 million, or $0.10 to $0.18 per diluted share. For continuing operations, we target Q3 revenue in a range of $285 million to $315 million. We target core lighting to be down slightly sequentially as growth in new products partially offsets normal seasonality. We target our LED business to be 10% lower, plus or minus, sequentially, which is slightly more than the typical seasonal decline due to the holiday timing impact. We target incremental improvement in Q3 core gross margins from continuing operations driven by lighting, which we anticipate will be partially offset by lower LED margins related primarily to higher [costs] associated with new products being ramped up and lower volumes in the quarter. We are targeting Q3 operating expenses from continuing operations to be $7 million lower than Q2 due to lower IP litigation spending and reduced brand promotional spending, which are partially offset by higher R&D for new LED product development. As mentioned last quarter, our continuing operations operating expenses include approximately $1.5 million of shared service costs that also support the Wolfspeed operations. We will receive reimbursement for most of these costs for a period of time after closing under a transitional services agreement with Infineon. We target Q3 non-GAAP net income from continuing operations to be between $1 million to $9 million, or $0.01 to $0.09 per diluted share. Our non-GAAP EPS target excludes acquired intangibles amortization, non-cash stock-based compensation, and other items. For discontinued operations, we target Q3 revenue from Wolfspeed to be $55 million, plus or minus, which is similar to Q2. We target Wolfspeed Q3 non-GAAP net income to be $9 million, plus or minus. This non-GAAP net income target includes a $4 million net of tax, or $0.04, benefit from the full impact, not including any depreciation or amortization expense from long-lived assets. Our Wolfspeed non-GAAP net income targets exclude acquired intangibles amortization, non-cash stock-based compensation, and transaction costs related to the pending sale to Infineon. Our Q3 targets are based on a number of factors that could vary, including overall demand, product mix, factory execution, and a competitive environment. I will now turn the discussion back to Chuck.

Thanks Mike. We are focused on the following goals to continue to build a more valuable LED lighting technology company. First, we are working to gain the necessary government approvals to complete the sale of Wolfspeed to Infineon. The process is progressing, and we currently target closing in our fiscal Q3, although we recognize that the process can be unpredictable. Our second priority is driving topline growth for our LED lighting business. We made progress in fiscal Q2 as commercial lighting revenue increased several percent sequentially due to increased demand across several product categories, including increased demand for our SmartCast product line. Smart lighting is a small but growing part of our overall lighting sales, and an area that we target for growth over the next several years as we expand the breadth and capability of our product offering. Although consumer lighting revenue declined in Q2, margins improved as we met our overall lighting targets for the quarter. Consumer feedback on our new LED bulbs has been positive and our premium strategy has helped us improve profitability in this product line while delivering a better return on our customers' investment in better light. While our products are priced higher than the competition, they perform better and last more than twice as long, which is the point of switching to LED in the first place and drives our overall brand position. Overall, for fiscal Q3, we target growth in new commercial lighting products to partially offset seasonal slowness related to both weather and the holidays. This, combined with the consumer revenue in a similar range, results in overall core lighting revenue targeted to be down a few percent from Q2. We continue to evaluate lighting growth opportunities through potential M&A. We are early in the process and taking a very measured approach as we look for the right business to complement our current product portfolio and enhance our channel relationships. We have the balance sheet to act when the right opportunity is available and we have the flexibility to be patient. The LED business performed well in Q2 and is targeted to be seasonally lower in fiscal Q3 due to two major holidays in the quarter. The market remains very competitive and we continue to focus our technology on the applications where we can add the most value to the customer. We continue to work on some mid to longer-term programs that are targeted to expand the LED business in both existing and new applications. One of the new applications that we have been pursuing is automotive lighting, where we believe our high power LED technology can enable emerging exterior vehicle applications. We’ve been an LED chip supplier to automotive for two decades and target releasing our first new automotive qualified XLamp LED components by the end of fiscal 2017. Our third priority is to improve operating margins. We target increased lighting gross margins to be the primary driver to improve operating margins over time. We made progress again in Q2, and we target the combination of higher value new products and lower costs to drive improved core lighting gross margins in Q3. LED margins are targeted to be slightly lower due to seasonally lower volumes and higher costs associated with the ramp up of new products. We target Q3 operating expenses from continuing operations to decline due primarily to lower legal and brand marketing expenses. To enable our revenue and profit goals, we must continue to innovate in all business segments to differentiate our products in the market while also improving the customer experience and service levels across the company. We made progress in Q2 as we announced expanded lighting product offerings and improved performance in our LS surface ambient product family, our IG parking luminaires, and our Essentia by Cree family. In LEDs, we released the industry's most efficient horticulture LEDs and our new XHP 50.2 LED, which delivers the highest lumen density in its class. We remain focused on further improving our ability to deliver innovative products that exceed customer expectations in terms of performance, value and quality as we strive to set new standards for LED lighting. As we begin the new calendar year, we still have some work to do to complete the sale of our Wolfspeed business. We've made progress in lighting, and LEDs continues to execute well to our plan. Our balance sheet is in good position to support our targeted growth plans, and closing Wolfspeed will further strengthen our ability to fund share repurchases and pursue inorganic lighting growth in the medium to longer term. The fundamentals in our business have improved over the last several quarters, and we see emerging opportunities to grow our LED business in the mid- to longer-term by addressing new markets like automotive exterior lighting. We remain focused on building a larger and more valuable LED lighting technology company by bringing better light to our customers, light that works better and lasts longer, paying for itself every day, light that is smart enough to not only improve the lighting environment but becomes an integral part of enabling smart buildings, thereby expanding the market and channel opportunity for Cree. To put it simply, we are committed to providing our customers with the best light and the best value in LED lighting. We will now take analyst questions.

[Operator Instructions]. Our first question comes from John Quealy with Canaccord Genuity. Your line is open.

Good afternoon folks. First question, in terms - please clarify if I misheard, but in terms of lighting and market demand, can you characterize that again for us? Was it fine throughout the quarter? What are you seeing now? And then I have a quick follow-up. Thanks.

Yes. I would say that our lighting - I'm assuming you're talking about commercial lighting. So, commercial lighting …

That’s right.

Market demand was generally as expected in the quarter, kind of followed the normal trend. I think keep in mind our business is probably - we are, as we improve execution, we are probably seeing the benefit of some of the things we control internally, not necessarily just what's going on in the market. So, our business was kind of as expected, and then that offset, partially offset, what was going on in the consumer lighting business, which was a little lower, but net result the overall lighting numbers came in about as expected.

Okay. Thanks Chuck. And my follow-up actually leads into the op expenses. So Q3 lower by $7 million in SG&A and you talked about lower brand spending and obviously lower litigation costs. Can you talk about that lower brand spending? Is residential retail lighting hitting metrics that you want it to, and is that a run rate that we should think about for the rest of the year? Thanks guys.

Yes. So the way to think about brand spend, John, is that we have an investment cycle that's typically in the fall. So we launch new series of bulbs. We typically accompany that launch with an investment in brand spend to kind of get the new product out there and get awareness up. Once that awareness is up, then we can, generally are going to reduce here in this quarter and in the next and then depending on what the product cycle is, that brand spend typically comes back in the fall. And when it does, it is a function a bit of if we are launching new products or not. So what I would say is that lower level we see in Q3, I’d expect something similar in Q4 and then as we get into the new calendar year and the new lighting season, then there may be some adjustments upwards depending on what the exact product launches are for next year.

Our next question comes from Paul Coster with JPMorgan. Your line is open.

Thank you. Chuck, I know you've already given us a hint of some of the strategic moves you're making with this long-term view in mind, but I am just wondering if you could give us some sense of what your manufacturing strategy might be, particularly in the context of change of administration in Washington, DC.

Yes. Paul, what I would say is that we don't have any short-term plans to change what we're doing in LEDs. I think we are in an okay place there. I think when it comes to lighting, the primary manufacturing facility for Cree is in our Racine facility. We do use some sub coms. We have some in Mexico as well as we do bring in some product from China, but the majority is already made in the US. There's a lot of moving pieces with the administration. I think we are going to see how that settles out. We are going to operate business as usual right now, but I think our supply chain in the way we are set up, we have the flexibility to adjust on a relatively short-term basis if we need to. So I think we're going to wait and see, but obviously monitor things closely and if we need to, we will make adjustments, but right now, business as usual.

Just a quick follow-up. Obviously some success with pressing your patent claims through the ITC. Do you feel like there's more opportunity to do so, particularly with exports from elsewhere in the world?

You know, Paul, we have an ongoing licensing program. I think we have now over 20 licensing partners, so I think we’ll continue to pursue that. I think the settlement is obviously good because it validates the strength of some of those patents that were in suit. With that being said, our strong preference is to license and not have to litigate to get to these situations. So hopefully some of our success, and maybe after people have seen some of the claims that were validated in the suit, that will make it a little easier to do licensing instead of having to go through things like the ITC in the future. But we are going to continue to pursue licensing as part of the business. The big growth driver is still growing product sales and product profits, but it does add incrementally to the bottom line.

Our next question comes from Craig Irwin with ROTH Asset Management. Your line is open.

Good evening and thank you for taking my questions. The first thing I wanted to ask about is LED fixture price degradation. We are hearing quite broadly that this seems to be decelerating notably into 2017. Is this something that you are seeing? And maybe can you discuss how this impacts not just your lighting products business, but potentially your chips and components business over the course of the next couple of quarters?

Yes, Craig, what I would tell you is that, from a lighting fixture standpoint, we are seeing what I would consider to be somewhat normal pricing trends quarter to quarter. Obviously, there has been some deflation over the past few quarters. I don't see a significant trend one way or another. Typically, in our business, because we are launching a lot of new products, it tends to be product family changes more than price degradation within them. There obviously is some. So I don't know that I've seen a significant change, at least in our business at this point. In terms of LEDs, there's a lot of talk in the market about what's going on in LEDs. I think most of it is coming at the chip level. So I think what that means in terms of our segment of the market, which is the high-power LED segment, I think we are going to target more typical competitive trends right now. Obviously we'll monitor that, but I think it's a little early on the LED side to call it change in the trend yet. Obviously there's a lot of talk, but I usually like to give this a couple of quarters to see what the real trend turns out to be. So kind of business as usual on LEDs right now, and that means competitive.

Great. And then another market related question for you. Data out in the last couple of days from NEMA seems to point to an acceleration of the conversion of the HID market over to being more of an LED market. This seems to be an area I would call a particularly good match for Cree's traditional lighting portfolio, your high-power chips. Can you comment whether or not this is an area of focus for you as far as new product introductions, or new opportunities, over the course of the next year, and would you maybe comment that this is something you're seeing as well?

Craig, I think that it's pretty clear that LED has become the de facto standard in most segments, but outdoor for sure. And outdoor is where you see more HID. Obviously, there is some indoor use of HID in some of the high bay applications, but then there's a lot of outdoor. If you look at where a lot of our lighting portfolio is, it would be in applications that have historically had at least some part of the product in HID. So I think it's generally a good trend. I don't know that it changes the trajectory of the business because I think, I think we've probably been seeing a bigger conversion to HID over the last year or two that maybe was clear to others. I think that's what's driven a couple of those market segments. So I think it's a positive - it's a good trend. I don't know though that it changes the trajectory significantly at this point.

Our next question comes from Brian Lee with Goldman Sachs. Your line is open.

Hey guys. Thanks for taking the questions. Maybe first off, a little bit of color on the LED component segment if you could. Just the negative 10% sequential growth you're guiding to, it's the worst since 2011 based on the data we have in front of us. And then the high-level margin commentary also sounds like we are hitting another low in that segment. So, all of that seems a bit at odds with some of the commentary coming out of the LED supply chain over the past few months with utilization pricing maybe having firmed a bit. So I just wanted to try to reconcile a bit how much of this might be a bit more structural, increase specific versus it sounds like, Chuck, right now, you think it's more timing-driven.

Yes, a couple of things, Brian. First of all, there is a lot of noise in the supply chain, but I tend to not react too fast to that over the many years of listening to the noise. Let's give it a quarter or two and see what turns into real pricing in the marketplace. So I've heard the same things, but my sense is that a lot of that talk is speculating on the lower end of the market. As factories get full, they are getting rid of some of their worst business, which is really not a part of the market Cree is in. So, we're going to continue to target a more normal trend, at least from the supply chain right now, but obviously we’ll monitor that. In terms of the other - and I'm going to talk margin first. The other thing to keep in mind is that obviously when our factory is a little less loaded, we typically have a little lower margin. That's normal. The other thing is we’re doing, and I think Mike mentioned this in his comments earlier, is we have a short-term headwind on LEDs. We are ramping up a new LED chip product family that goes across a couple of our product lines. That will cost us a little bit in margin here this quarter and maybe a little bit in the next. I think as we get that fully ramped up, we actually expect that to be a benefit to us. But as we go through the initial ramp up, that costs us a little bit of money in the short-term, but definitely the thing we want to go do as it helps the business overall. As far as revenue goes, normally, I think we're probably in a 5%, 6% range is what you probably saw in the last couple of years. The difference is that the way our quarters fell, we have the [indiscernible] impact of the Christmas, New Year's holiday and then again the Chinese holiday. So when we look at the number of selling days, it tends to have a bigger impact on this quarter than in the past. So if we just look at it on a ratio of days that we will have actively selling in the market, the 10% is a lot closer to the 6% in the past than you might think. So we don't see a significant change there one way or another. And obviously, if the market does stabilize and pricing really does improve, I would expect we would get the same benefit, but right now, we are taking a little bit more cautious view on the market.

Okay, great. And just to follow-up, Chuck, at the annual shareholder meeting at the end of last year, you pointed to this as part of the strategy around LED components. You're sort of reaffirming this on the call today. But can you maybe define a little bit of the parameters as you think about the automotive effort, which you've highlighted a couple of times over the past few months, and then the new product strategy in LED components that you just talked about as well? Are there levels of growth? Is it a margin story? What sort of parameters are you thinking about in terms of getting a bit more on the recovery path in that segment where you justify, I guess, continuing the commitment to the LED segment, given the ongoing investment? Thanks.

So Brian, we talked about how - and you heard for the last couple of quarters, focus on applications where our high-power technology adds real value to the end customer applications. And we started talking about automotive more publicly only recently, but that's been something we've been working on for a couple of years, and it's a great application. When you look at automotive exterior lighting, our high-power technology plays real well there. So we think that's a place that can drive revenue and profits. It will take a little while, right? That's not an instant design-in application, but we think, in the mid- to longer-term, that's an opportunity to add some revenue and profit to the LED business. The other thing we are looking at is how to take our technology and apply it to some other applications. In some cases, that will be extending it within lighting. And in other cases, it will be can we look for complementary applications to use the technology. I think those are a little harder to give any specifics on. I think the real message though is we think what we're doing in LEDs can not only deliver the results you are seeing today, but we think there are opportunities to add, at least incrementally, to both the revenue and the profit line here in the mid to longer-term. So that's why we think it's a good return and obviously it does a great job of supporting our lighting strategy overall.

Our next question comes from Joe Osha with JMP Securities. Your line is open.

Hello there. Thank you. I wanted to ask about the lighting products business. Obviously, there have been some operational challenges. As we brought new management in there, I'm wondering what steps might have been taken to reverse those. And in particular, I'm curious as to whether we think it might be reasonable to think about that business getting back to the run rate that it was enjoying say late in 2015. Thank you.

Yes Joe. So, obviously, you know we made a change last summer by bringing David Elien into the role of running the day-to-day commercial lighting business. And then about 90 days ago, Danny Castillo joined the team with an overall lighting leadership role. And I think David has obviously had more time to make an impact, but you can see that over the last few quarters, the fundamentals have started to improve, and I think that I would expect Danny will add similarly to the business. It's 90 days in so I think it's a little early there, but I think we are on the right track. Do I think it can return to old levels? Our target is to grow that business not only to the old levels but actually to beyond that. So it's not going to happen in one quarter. We think you fix the fundamentals and you rebuild the customer momentum. And as I said earlier, we did see - last quarter, we once again saw higher quoting activity. So, to us that's a good indicator of future demand. So I think we are working on the right fundamentals. At the same time, it will be likely incremental quarter-by-quarter activity because it's a big business and there's lots of things we've got to make happen. But yes, I think the team we have in place is going to make progress, and I think we'll continue to invest in the business and in the people to make that happen.

Thank you. And one follow-up. If you had to, with the money that you are hopefully going to have here from Wolfspeed in a bit, think about just at a high level what type of product lineup you would like to add to your business, do you have any thoughts about what that might be? I'm talking about organic growth here.

Yes. So I think we are being pretty open-minded. I think there's likely to be probably the right word is a more tuck-in, so they are complementary pieces to our product portfolio. But we compete across a number of different market segments. So the idea would be is what - is there a set of products that complements something we are doing and complements the channels we are in today? But I don't want to give too much specificity because we are looking at a number of different ideas, and it's likely not one. It’s likely there's - you need to look at the timing and the opportunities that are available. And these pieces will likely come together over multi years. So we might do something in the next year and I would imagine we will continue to look for other pieces over the next several years.

Our next question comes from Tom Sepenzis with Northland. Your line is open.

Thank you for taking my questions. I'm just curious. You mentioned that the settlement or the litigation move helped gross margins in the second quarter. And I'm just curious what are you thinking in terms of gross margins on a blended basis for Q3?

We didn't break out specific targets, but I can give you some qualitatives. So, if you look at what we said about last quarter, that if you exclude the benefit from the license agreement and the increase in the warranty reserves, last quarter we would've been generally in the middle of our target range for both revenue and profits. And then what we are targeting this quarter is that from a continuing ops standpoint, that we would expect LEDs to likely be a little bit lower just if we're going to have seasonally lower volumes, and that the lighting business will make some incremental progress to mostly offset that. So no specifics there, but it should at least give you a trend to work from.

Great, thank you. And then just in terms of the magnitude of the upper revenue in the December quarter and then the kind of lighter March revenue, was there any pull-in quicker just because of the holidays that impacted the trend here between December and March, or are you just seeing weaker demand overall the LED?

No. Honestly, Tom, if you look at - Tom, if you look at the business in December, we basically, if you just look at the core part of the business, take out the items I mentioned a minute ago, we’re pretty much in the middle of our range, plus or minus. So it kind of went as expected both for LEDs and for lighting. And in the March quarter, if you look at that business, we are targeting that to be down roughly about seasonally, LEDs a little more, lighting a little less, but net-net, that's about what I would expect it to be. If our business in those two areas is down roughly 5% quarter to quarter, that's about what we would normally expect to see for those businesses on average seasonally. So I think we are seeing a relatively normal trend right now.

Our next question comes from Edwin Mok with Needham & Company. Your line is open.

Thanks for taking my question. Chuck, first question on the consumer or the retail lighting. It sounds like volume is really down here. I'm just curious how you think about that strategy. You guys talk about using that as kind of a marketing tool, right? Is that still the same thinking process? And are you still just sticking with just that basically one main partner, Home Depot, or any thought about expanding the channel?

Edwin, look, I still think the consumer bulb business has done a great job building our brand, but also it's a real business now. And so what we've been focusing on over the last year is shifting that to a more premium strategy. That's actually aligned with what we want to do anyways as a company. And as a result, that with that shift, we've actually been able to improve the profitability of that business. So I think we're going to continue forward with that. I think we're going to look at what channels make the most sense. We have been real pleased with our work with the Home Depot over the last several years. I think we're going to continue to want to work with them, but at the same time, you can buy our products on Amazon and some other places today. And we will look for channels that complement what we are doing, but our goal is not to find every channel to sell our products, but to find places where people are willing to work with us to really promote what matters in LED bulbs and these premium features, because I think what we want to avoid is this race to making all LEDs cheap and not lasting very long, which kind of defeats the whole purpose of why we invented it in the first place.

Great. That's actually helpful. And then I think, if I caught your commentary correctly, you said that your lighting product margin, on an apples-to-apples basis, you expect to actually improve a little bit in 3Q versus 2Q, even though you expect lower sales. I'm just curious. What is driving that improvement? Is it mix or price, or anything that you can help us with that?

So what we would expect is that we’ll actually see a little bit of growth in the commercial lighting business, and that will - and that, combined with improvement in margins, both in commercial and consumer, will help us gain a little bit quarter to quarter.

But I would also say on the core products, we expect to just make some incremental improvement as we are selling next-gen newer products.

So, obviously, as new product get sold, we get a mix benefit.

Our next question comes from Vishal Shah with Deutsche Bank. Your line is open.

Thanks for taking my question. Chuck, what percentage of your commercial lighting segment product would be SmartCast product line? And what kind of margin profile do you expect for some of your new products, especially in some of the smart lighting products?

Yes, so we don't break it out. I would tell you it grew last quarter, but it's still a small percentage, so it's not a big number, but it is accretive. So the smart products have a higher margin than our standard products do today. So, as that grows, that generally is a positive from a mix standpoint. But I would also tell you that some of our other new non-smart products are also margin accretive. So, I think that we get a benefit as the new products increase as a percentage of our business right now.

Okay, great. Thank you. And just one market question. One of your competitors mentioned some slowdown in activity because of election cycle. Have you seen anything at all in the market? And what is your general take on where we are in terms of adoption rate and acceleration of demand, both in the outdoor and indoor lighting segment?

You know, look, there is definitely variability from month to month, and there's a lot of different factors that are going on in the marketplace, and they affect our business. I think the thing to keep in mind with Cree though is, as we've been working to improve the fundamentals, some of what we're seeing is just the benefit of improving those fundamentals. So we absolutely are affected by the same market trends, but a little bit of this is getting back - moving back towards where we were from an execution standpoint. So I think what you are seeing in our results is a little bit of a combination of those two things. But there's definitely variability in demand, just like we would expect this quarter that generally speaking, the outdoor business slows down in the winter. There's not as much activity. So that's typically what we see and that's part of our targets that we've given you as well.

Our next question comes from Stephen Chin with UBS. Your line is open.

Thanks for taking my question. First, can you maybe elaborate on the third-party commercial product, the reserve for the defective product? Was this a one-time impact, and can you maybe give us a sense of the size?

Yes. So, I think what you will see is when the Q comes out, roughly about an $8 million increase in our warranty reserves, and it's related to a third-party driver that was used in a couple of our major product lines. So, we now have a new driver qualified and in production, and what that reserve is it really accounts for the impact of what we would expect to be a higher return rate on those products that had that particular driver over the next 10 years.

Okay, thank you. And just as sort of a follow-up to the previous question, is all of the cash that you're expecting to receive, all that $585 million net cash from the sale of Wolfspeed, is that all onshore?

Yes. It would all be onshore.

Okay. But outside of that, related to the new administration, do you think that you could potentially benefit from proposed changes to the tax code and potentially a lower rate on repatriation?

You know, look, there is definitely things that have been proposed that would benefit us, and there's also a lot of stuff about trade and importing that I think could add variability on the other side. At this point what I would say is a lot of moving pieces. We are not - I think it's just premature to make - speculate the net pros and cons. There's obviously some good stuff in there. There’s obviously some things that would force us to adjust. I think, net-net, we think we'll be fine as a result of all this, but we've actually got to see what turns into legislation and what gets actually implemented. So I think we're going to evaluate it and kind of run the business as normal until we see what actually gets implemented.

Our next question comes from Krish Sankar with Banc of America Merrill Lynch. Your line is open.

Thanks for taking my questions. Two of them. One is to an earlier question, when you get back to your lighting products run rate in 2015, let’s say you get to like over $250 million, what kind of a gross margin would that business be able to sustain? Can you get to over 30% on the lighting side? And then the second question is, given that you're coming off a seasonal bond, is it fair to assume both the LED and the lighting products should actually sequentially grow in the June quarter relative to March? Thank you.

Yes, so second question first, we would expect that LEDs will grow in the June quarter versus March. That's a typical normal seasonal trend. I don't have specific targets. It’s premature, but that would be the normal trend and that would be our expectation at this point. In terms of the lighting business, I would also expect that, given the increased quoting activity we saw over the last couple of quarters, that we would start to at least see some benefit from that in our fiscal Q4, the June quarter. So that would be I think the answer to both of those questions. The other question you asked was what would likely the margins be as we grow the lighting revenue. So, our target, and I've said this before in our annual shareholder meeting and other places, is we target over time, and this will take time, is to make incremental partners in gross margin over the next several years and target to getting that - those lighting margins back into the mid-30s would be at least our next milestone. So that's we are targeting and it will take some time and a lot of good execution and the benefit of new products, but that's what we are focused on.

Thanks guys.

Our next question comes from Daniel Baksht with Pacific Crest Securities. Your line is open.

Thanks very much. Kind of a follow-up to the last question, given the settlement with Feit, do you continue to expect a better second half versus first half for revenue?

Yes, you know, I would say on the core business, absolutely. I think a little bit is going to be what the target happens in Q4. So we don't have our Q4 targets yet. We would definitely - we are currently targeting both LED and lighting to grow, but since we don't have specific targets, I can't really give you that granularity of the numbers right now.

Okay, fair enough. And then the second question, does your discontinued guide reflect expectations for contribution for a full quarter?

Yes, it does.

Our next question comes from Colin Rusch with Oppenheimer. Your line is open.

Thanks for taking my question. This is Kristen on for Colin. I just want to talk a little bit about the quoting activity that you mentioned, and maybe if you could build on how much of that lighting business is stock and flow versus projects at this point.

The quoting activity is generally project quoting activity, so that's when we are measuring that. We are not really measuring - there really isn't - the way we build that metric it’s not based on stock inflow. It will be based on projects. So that's a metric. We do have stock inflow business, but that's not what we are measuring when I give you that benchmark.

Okay. Can you give a little color as to what you're seeing on the project side then?

Yes, so what we said is that the quoting activity, which is generally projects, it had increased in our fiscal Q1 and it increased again in our fiscal Q2. So that's as much color as we've given you so far on that. And then we would expect, just to put that in perspective, it's typically a nine to 12 month cycle to convert quoting activity into business.

Great. Thank you very much.

Our next question comes from Cindy Motz with Williams Capital. Your line is open.

Thanks for taking my question. I'm sorry if you already answered this. I dropped off at one point. I know you answered about lighting margins, where you see they're going. For LED margins, would you expect them - maybe I think you said third quarter a little bit seasonally down then, but going forward, you have a target for that. And then also just at the shareholder meeting back in October, you had talked a lot about maybe developing more the agency lines and channels and different things like that. So I was just looking for an update on how that was going. Thanks.

So let me take the question on LEDs first and then I'll come back to your question on lighting channels. So in LEDs, we are targeting Q3 to be seasonally down in margins a little bit, lower volumes typically to that. We also have some, in the short-term, some higher costs as we ramp up the new product, as I mentioned earlier. I think as that product ramp kind of comes through this quarter and into next, as it ramps up, that kind of headwind should go away. And that's really a function of what is the product mix, and what's the competitive environment, and how do some of these new activities open new applications? And look, it's just hard to predict. I think, in the near term, I would expect the business to be in a similar range, plus or minus. But going forward, those other dynamics, what the market is doing as well as which of our new products are ramping up at what speed, is going to add some variability to that. So it's hard to give you anything more than kind of the qualitative measures that are going to affect that. In terms of the shareholder commentary around channels, we are absolutely working to continue to strengthen our channel. What that really means is, in many cases, it's making investments to help our current agents and distribution partners be more successful selling our products. And in some cases, it's bringing on additional partners, but it's really a combination of those two things. There's no one item to report I would say that are we making - we are making incremental progress each quarter. But this is not a one or two quarter thing. This is something we’ll be working on for the next few years. And one of the reasons we want to add some incremental products in organically is that that typically improves our position in finding good channel partners.

Great. Thanks.

Our next question comes from Craig Irwin with ROTH Asset Management. Your line is open.

Thanks for taking the follow-up question. So Chuck, I wanted see if you could maybe give us a little bit more detail on the chip family that you're investing for right now. I know you guys don't put money into CapEx unless you feel it's a material benefit to the business. If you could frame out the scope of the investment and the timeline potentially, and what portion of your existing portfolio this chip family would be relevant for? Thank you.

Yes, Craig, this is not a significant capital investment. This is really an operating investment. So as we bring on a new technology, it's in several of our XLamp families. I don't have the specific breakout for you. But as we ramp that up, typically during a ramp up of a new product, we have - incur some higher costs. It's typically yields as you scale up the new product. So I would expect -and this is pretty typical for in the past when LEDs was the primary focus of the business. It's just we have a new product chip coming online. It actually gives us a performance benefit in the market and actually should give us a cost benefit in the mid to longer-term. But in the short-term, it costs a little money to do that. So that's what we are doing, and I think that it's going to lead to a better net position, but in the short-term, cost us a little more in yields.

And can you confirm if those are the 2500 lumen XHP chips that you've press released recently or if it's something else?

So that's a component. So these are actually the chips that go into a couple of different components. So we have chip product families that end up in various components. So the XHP has certain products in chip families. I'll be honest with you, Craig. I can't tell you exactly what's in that particular XHP chip, but what I would tell you is in several of our product lines, this new chip goes into, and that's driving some of the short-term costs.

Great. Thanks for the clarification.

[Operator Instructions]. Our next question comes from John Quealy with Canaccord Genuity. Your line is open.

Thanks again. In terms of potential deployment of the Wolfspeed cash, Chuck, can you talk about any processes you're doing on the M&A side? Is it likely to see a fairly quick transaction, or what's your thoughts, especially where multiples are and available properties are in the lighting group or LED group? Thanks.

John, so obviously, there's a lot of lighting companies in North America, and they are at various stages of their life cycle. So I think we are being pretty open-minded. We are talking to a number of different people, looking at a lot of different things that are out there. And it's really going to be a combination of fit and timing. From a Cree standpoint, the first focus is we want to get the Wolfspeed deal closed. That's what we need to get done first. And then it will be what opportunities are out there. It doesn't mean we are not evaluating them today. We are actively doing that. But if I had to guess, if things stay on the current course, we are likely to have some type of an M&A transaction in calendar 2017, but it's certainly not going to happen, at least at this point, before the Wolfspeed deal closes. And that exact timing, we are still in the evaluation stage on a number of different things. So I feel okay about the values out there. I would tell you that some people have a very high value on themselves and it doesn't mean those are the way we're going to start. So there's lots of different properties out there, and it's just really which one fits best with our portfolio and our needs in the next couple of years.

Thanks again.

Thank you. That concludes today's question-and-answer session. I'd like to turn the call back to Mike McDevitt for closing remarks.

Thank you for your time today. We appreciate your interest and support and look forward to reporting our third-quarter results on April 25. Good night.

Good night.

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