UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC. 20549

 


 

FORM 10-Q

 

(Mark One)

 

ý

 

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the quarterly period ended June 30, 2004

 

or

 

o

 

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the transition period from                 to                 

 

Commission File Number 000-24085

 


 

AXT, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE

 

94-3031310

(State or other jurisdiction of
Incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

4281 Technology Drive, Fremont, California 94538

(Address of principal executive offices) (Zip code)

 

(510) 683-5900

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ý NO o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at July 23, 2004

Common Stock, $.001 par value

 

23,046,320

 

 



 

AXT, INC.

FORM 10-Q

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements (unaudited)

 

Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003

 

Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2004 and 2003

 

Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2004 and 2003

 

Notes To Condensed Consolidated Financial Statements

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Item 4. Controls and Procedures

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Item 2. Changes in Securities and Use of Proceeds

 

Item 3. Defaults upon Senior Securities

 

Item 4. Submission of Matters to a Vote of Security Holders

 

Item 5. Other Information

 

Item 6. Exhibits and Reports on Form 8-K

 

Signatures

 

 

2



 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per share data)

 

 

 

June 30,
2004

 

December 31,
2003

 

Assets:

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

14,783

 

$

24,339

 

Short-term investments

 

19,858

 

14,669

 

Accounts receivable, net of allowance of $4,946 and $4,304 as of June 30, 2004 and December 31, 2003, respectively

 

4,390

 

6,297

 

Inventories

 

21,822

 

24,083

 

Prepaid expenses and other current assets

 

2,572

 

1,301

 

Assets held for sale

 

1,000

 

1,000

 

Total current assets

 

64,425

 

71,689

 

Property, plant and equipment

 

20,968

 

21,795

 

Other assets

 

3,290

 

4,237

 

Restricted deposits

 

8,615

 

9,302

 

Total Assets

 

$

97,298

 

$

107,023

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Current liabilities

 

 

 

 

 

Current portion of long-term debt

 

$

1,923

 

$

3,694

 

Accounts payable

 

2,791

 

2,638

 

Accrued liabilities

 

7,802

 

8,296

 

Accrued restructuring

 

1,040

 

 

Total current liabilities

 

13,556

 

14,628

 

Long-term debt, net of current portion

 

7,885

 

8,842

 

Other long-term liabilities

 

1,282

 

1,255

 

Total liabilities

 

22,723

 

24,725

 

Stockholders’ Equity:

 

 

 

 

 

Preferred stock, $ 0.001 par value per share; 2,000 shares authorized; 833 shares issued and outstanding

 

3,532

 

3,532

 

Common stock, $ 0.001 par value per share; 70,000 shares authorized; 23,047 and 22,957 shares issued and outstanding, respectively

 

155,371

 

155,178

 

Accumulated deficit

 

(85,335

)

(78,928

)

Accumulated other comprehensive income

 

1,007

 

2,516

 

Total stockholders’ equity

 

74,575

 

82,298

 

Total Liabilities and Stockholders’ Equity

 

$

97,298

 

$

107,023

 

 

See accompanying notes to condensed consolidated financial statements.

 

3



 

AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share data)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,524

 

$

8,519

 

$

19,300

 

$

17,054

 

Cost of revenue

 

8,695

 

7,844

 

17,938

 

16,106

 

Gross profit

 

829

 

675

 

1,362

 

948

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

3,203

 

2,819

 

5,973

 

5,319

 

Research and development

 

350

 

368

 

691

 

747

 

Restructuring charge

 

1,077

 

 

1,077

 

 

Total operating expenses

 

4,630

 

3,187

 

7,741

 

6,066

 

Loss from operations

 

(3,801

)

(2,512

)

(6,379

)

(5,118

)

Interest expense

 

58

 

108

 

167

 

223

 

Other expense (income), net

 

113

 

1,269

 

(54

)

1,038

 

Loss before provision for income taxes

 

(3,972

)

(3,889

)

(6,492

)

(6,379

)

Provision for incomes taxes

 

97

 

 

137

 

 

Loss from continuing operations

 

(4,069

)

(3,889

)

(6,629

)

(6,379

)

Discontinued operations:

 

 

 

 

 

 

 

 

 

Gain (loss) from discontinued operations

 

222

 

(2,747

)

222

 

(4,574

)

Loss from disposal

 

 

(11,100

)

 

(11,100

)

Net loss

 

$

(3,847

)

$

(17,736

)

$

(6,407

)

$

(22,053

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted loss per share:

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.18

)

$

(0.17

)

$

(0.29

)

$

(0.28

)

Gain (loss) from discontinued operations

 

0.01

 

(0.61

)

0.01

 

(0.69

)

Net loss

 

$

(0.17

)

$

(0.78

)

$

(0.28

)

$

(0.97

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted shares used in per share calculations

 

23,045

 

22,702

 

23,020

 

22,665

 

 

See accompanying notes to condensed consolidated financial statements.

 

4



 

AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

 

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

 

 

 

 

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net loss

 

$

(6,407

)

$

(22,053

)

Adjustments to reconcile net loss to net cash used in operations:

 

 

 

 

 

Depreciation

 

2,437

 

3,456

 

Amortization of marketable securities premium/discount

 

123

 

225

 

Non-cash restructuring charge

 

1,077

 

 

Loss on disposal

 

 

11,100

 

Impairment write-down on investments

 

 

1,257

 

Gain on disposal of property, plant and equipment

 

 

(11

)

Stock based compensation

 

 

28

 

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

1,907

 

11

 

Inventories

 

2,261

 

5,755

 

Prepaid expenses

 

(1,271

)

1,487

 

Other assets

 

3 9

 

(70

)

Accounts payable

 

153

 

(830

)

Accrued liabilities

 

(531

)

(1272

)

Income taxes

 

 

636

 

Other long-term liabilities

 

27

 

(107

)

Net cash used in operating activities

 

(185

)

(388

)

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Purchases of property, plant and equipment

 

(702

)

(1,704

)

Proceeds from sale of property, plant and equipment

 

 

5,172

 

Purchases of marketable securities

 

(20,650

)

(1,808

)

Proceeds from sale of marketable securities

 

10,422

 

4,700

 

Decrease (i ncrease ) in restricted cash

 

4,151

 

(3,623

)

Net cash (used in) provided by investing activities

 

(6,779

)

2,737

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from (payments of):

 

 

 

 

 

Issuance of common stock

 

193

 

185

 

Capital leases payments

 

 

(2,204

)

Long-term debt payments

 

(2,728

)

(485

)

Net cash used in financing activities

 

(2,535

)

(2,504

)

Effect of exchange rate changes

 

(57

)

(45

)

Net decrease in cash and cash equivalents

 

(9,556

)

(200

)

Cash and cash equivalents at the beginning of the period

 

24,339

 

13,797

 

Cash and cash equivalents at the end of the period

 

$

14,783

 

$

13,597

 

 

See accompanying notes to condensed consolidated financial statements.

 

5



 

AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1. Basis of Presentation

 

The accompanying interim condensed consolidated financial statements of AXT, Inc. (“AXT” or the “Company”) are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.

 

Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ materially from those estimates.

 

The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2003 Annual Report on Form 10-K and its Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on March 29, 2004 and May 24, 2004, respectively.

 

Revenues from continuing operations increased in fiscal 2003 compared to fiscal 2002. In response to continued net losses, the Company has taken measures including the continued shifting of production to China to reduce costs and increase cash flows. As of June 30, 2004, the Company had available cash, cash equivalents and liquid short-term investments of $34.6 million, excluding restricted deposits. The Company believes that its existing cash and liquid investments, cash generated from operations, coupled with additional efforts to reduce expenditures in support of the continuing substrate business will be sufficient to meet working capital expenditure requirements for the next 12 months. However, existing cash and liquid investments could decline during the remainder of 2004 due to a weakening of the economy, a loss in revenue, or changes in our planned cash outlay.

 

If the Company’s sales decrease, the ability to generate cash from operations will be adversely affected which could adversely affect its future liquidity, requiring it to use cash at a more rapid rate than expected and to seek additional capital. There can be no assurance that such additional capital will be available or, if available , that it will be at terms acceptable to the Company.

 

Certain reclassifications have been made to the prior years consolidated financial statements to conform to current period presentation.

 

Note 2 . Discontinued Operations

 

On June 24, 2003, the Company announced the discontinuation of its opto-electronics division, which was established as part of the acquisition of Lyte Optronics, Inc. in May 1999. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in the consolidated statements of operations. The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks.

 

On September 27, 2003 the Company completed a sale of substantially all of the assets of its opto-electronics business to Lumei Optoelectronics, Corp. and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi equivalent of $9.6 million. Proceeds of $1.0 million will be held in escrow for up to one year and will not be recorded until all claims, if any, are settled. We expect this escrow to be released, if no claims are made against it, on or about September 28, 2004. Of this $1.0 million escrow, up to $250,000 will be held in escrow for a second year and will not be recorded until all claims, if any, are settled. The Company retains a building located in Monterey Park, CA, that it intends to sell in 2004. This asset has been classified as held for sale on the condensed consolidated balance sheets as of June 30, 2004 and December 31, 2003.

 

6



 

The Company recorded a loss on disposal of $9.5 million during the nine months ended September 30, 2003.  The Company recorded a gain on discontinued operations of $0.2 million during the three and six month periods ended June 30, 2004.

 

The Company’s financial statements have been presented to reflect the opto-electronics business as a discontinued operation for all periods presented. Operating results of the discontinued operation are as follows (in thousands):

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

 

$

2,897

 

$

 

$

7,019

 

Cost of revenue

 

 

4,443

 

 

9,119

 

 

 

 

 

 

 

 

 

 

 

Gross loss

 

 

(1,546

)

 

(2,100

)

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

(222

)

750

 

(222

)

1,536

 

Research and development

 

 

342

 

 

707

 

Impairment costs

 

 

 

 

 

Total operating expenses

 

(222

)

1,092

 

(222

)

2,243

 

Gain (loss)  from operations

 

222

 

(2,638

)

222

 

(4,343

)

Interest expense

 

 

109

 

 

231

 

Gain (loss) before benefit for income taxes and loss on disposal

 

222

 

(2,747

)

222

 

(4,574

)

Income tax (benefit)

 

 

 

 

 

Loss on disposal

 

 

(11,100

)

 

(11,100

)

Net gain (loss)

 

$

222

 

$

(13,847

)

$

222

 

$

(15,674

)

 

The carrying value of the assets and liabilities of the discontinued opto-electronics business included in the consolidated balance sheets are as follows (in thousands):

 

 

 

June 30, 2004

 

December 31, 2003

 

Current assets:

 

 

 

 

 

Cash

 

$

560

 

$

539

 

Accounts receivable, net

 

19

 

250

 

Assets held for sale

 

1,000

 

1,000

 

Total current assets

 

1,579

 

1,789

 

Other assets

 

200

 

200

 

Total assets

 

$

1,779

 

$

1,989

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

 

$

43

 

Accrued liabilities

 

462

 

1,232

 

Total liabilities

 

462

 

1,275

 

Net assets

 

1,317

 

714

 

Total liabilities and net assets

 

$

1,779

 

$

1,989

 

 

Assets held for sale consist of a building and are carried at management’s estimated fair value less costs to sell.

 

7



 

Note 3 . Accounting for Stock Options

 

The Company records compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees” and has adopted the disclosure-only alternative of Statement of Financial Accounting Standards No. 123 (SFAS 123) “Accounting for Stock-Based Compensation”. Because the Company establishes the exercise price based on the fair market value of the Company’s stock at the date of grant, the options have no intrinsic value upon grant, and therefore no expense is recorded. Each quarter, the Company reports the potential dilutive impact of stock options in its diluted earnings per share using the treasury-stock method. Out-of-the-money stock options (i.e., options where the average sales price of our common stock as reported on the Nasdaq National Market during the period is below the exercise price of the option) are not included in diluted earnings per share.

 

As required under SFAS 123 and Statement of Financial Accounting Standards No. 148 (SFAS 148), “Accounting for Stock-Based Compensation Transition and Disclosure,” the pro forma effects of stock-based compensation on net income (loss) and net income (loss) per common share had the Company applied the fair value recognition principles of SFAS 123 to employee stock options have been estimated at the date of grant using the Black-Scholes option-pricing model.

 

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market. Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Company’s employee options. Use of an option valuation model, as required by SFAS 123, includes highly subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant. Because the Company’s employee options have characteristics significantly different from those of freely traded options, and because changes in the assumptions underlying the option-pricing model can materially affect the Company’s estimate of the fair value of those options, in the Company’s opinion, the existing valuation models, including Black-Scholes, are not reliable single measures and may misstate the fair value of the Company’s employee options.

 

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS 123 using the following assumptions:

 

 

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

Weighted average risk free interest rate

 

1.6

%

2.7

%

Expected life (in years)

 

5.0

 

5.0

 

Dividend yield

 

 

 

Volatility

 

85.3

%

114.0

%

 

The weighted average fair value as of the date of grant of options granted during the six months ended June 30, 2004 and 2003 were $1.97 and $1.05, respectively.

 

8



 

Had compensation cost for the Company’s options been determined based on the fair value at the grant dates, as prescribed in SFAS 123 and SFAS 148, the Company’s pro forma net loss and net loss per share would have been summarized as follows (in thousands , except per share data):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net loss :

 

 

 

 

 

 

 

 

 

As reported

 

$

(3,847

)

$

(17,736

)

$

(6,407

)

$

(22,053

)

Stock-based compensation determined under fair value method

 

(253

)

(1,743

)

(846

)

(3,566

)

Pro forma net loss

 

$

(4,100

)

$

(19,479

)

$

(7,253

)

$

(25,619

)

Net loss per share:

 

 

 

 

 

 

 

 

 

As reported:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

$

(0.17

)

$

(0.78

)

$

(0.28

)

$

(0.97

)

Pro forma net loss :

 

 

 

 

 

 

 

 

 

Basic and diluted

 

$

(0.18

)

$

(0.86

)

$

(0.32

)

$

(1.13

)

Shares used in per share calculation:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

23,045

 

22,702

 

23,020

 

22,665

 

 

Because additional option grants are expected to be made each quarter, the above pro forma disclosures are not representative of pro forma effects on reported net income (loss) for future quarters.

 

Note 4 . Investments

 

The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115 (SFAS 115) “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. A decline in the market value of the security below cost that is deemed other than temporary is charged to earnings, resulting in the establishment of a new cost basis for the security. The components of investments as of June 30, 2004 are summarized as follows (in thousands):

 

Available for sale

 

Cost

 

Unrealized
Gain /(loss)

 

Aggregate
Fair value

 

Money market

 

$

8,898

 

$

 

$

8,898

 

Corporate bonds

 

17,103

 

(67

)

17,036

 

Government agency bonds

 

5,275

 

(1

)

5,274

 

Corporate equity securities

 

1, 464

 

1,210

 

2, 674

 

 

 

$

32,740

 

$

1,142

 

$

33,882

 

Recorded as :

 

 

 

 

 

 

 

Cash equivalents

 

$

5,409

 

 

 

 

 

Short-term investments

 

19,858

 

 

 

 

 

Restricted deposits

 

8,615

 

 

 

 

 

 

 

$

33,882

 

 

 

 

 

 

Note 5 . Assets Held for Sale

 

Assets held for sale at June 30, 2004 consist of a building located in Monterey Park, California, which is part of the Company’s discontinued opto-electronics division (see Note 2). This building is carried at management’s estimated fair value less costs to sell, totaling $1.0 million as of both June 30, 2004 and December 31, 2003.

 

9



 

Note 6 . Inventories

 

The components of inventory are summarized as follows (in thousands):

 

 

 

June 30,
2004

 

December 31,
2003

 

Inventories:

 

 

 

 

 

Raw materials

 

$

5,951

 

$

7,086

 

Work in process

 

14,724

 

16,027

 

Finished goods

 

1,147

 

970

 

 

 

$

21,822

 

$

24,083

 

 

Note 7 . Restructuring Charge

 

The Company’s restructuring accrual is summarized as follows (in thousands):

 

For the three month period ended
June 30, 2004

 

Restructuring
Accrual as of
March 31,
2004

 

Additions/
Reversals

 

Payments

 

Restructuring
Accrual as of
June 30, 2004

 

Future lease payments related to abandoned facilities

 

$

 

$

690

 

$

 

$

690

 

Workforce reduction

 

 

387

 

(37

)

350

 

Total

 

$

 

$

1,077

 

$

(37

)

$

1,040

 

 

For the six month period ended
June 30, 2004

 

Restructuring
Accrual as of
December 31, 2003

 

Additions/
Reversals

 

Payments

 

Restructuring
Accrual as of
June 30, 2004

 

Future lease payments related to abandoned facilities

 

$

 

$

690

 

$

 

$

690

 

Workforce reduction

 

 

387

 

(37

)

350

 

Total

 

$

 

$

1,077

 

$

(37

)

$

1,040

 

 

During the three and six month period ended June 30, 2004, the Company recorded a restructuring charge of $1.1 million related to the reduction in force effected in June 2004, and to leas e costs associated with facilities located in California that are no longer required to support production.

 

The remaining restructuring accrual for future lease payments related to abandoned facilities of $0.7 million and workforce reduction of $0.4 million is expected to be paid out through calendar 2004, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.

 

10



 

Note 8 . Net Loss Per Share

 

Basic net loss per common share is calculated by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net loss per common and common equivalent shares include the dilutive effect of common stock equivalents outstanding during the period calculated using the treasury stock method. Common stock equivalents consist of the shares issuable upon the exercise of stock options.

 

A reconciliation of the numerators and denominators of the basic and diluted net loss per share calculations is summarized as follows (in thousands , except per share data):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Numerator:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(3,847

)

$

(17,736

)

$

(6,407

)

$

(22,053

)

Less : Preferred stock dividends

 

(44

)

(44

)

(88

)

(88

)

Net loss available to common stockholders

 

$

(3,891

)

$

(17,780

)

$

(6,496

)

$

(22,141

)

Denominator:

 

 

 

 

 

 

 

 

 

Denominator for basic net loss per share - weighted average common shares

 

23,045

 

22,702

 

23,020

 

22,665

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Common stock options

 

 

 

 

 

Denominator for dilutive net loss per share

 

23,045

 

22,702

 

23,020

 

22,665

 

Basic and diluted net loss per share

 

$

(0.17

)

$

(0.78

)

$

(0.28

)

$

(0.97

)

Options excluded from diluted net loss per share as the impact is antidilutive

 

1,916

 

3,124

 

1,916

 

3,231

 

 

Note 9 . Comprehensive Loss

 

The components of comprehensive loss are summarized as follows (in thousands):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(3,847

)

$

(17,736

)

$

(6,407

)

$

(22,053

)

Foreign currency translation gain (loss)

 

1

 

1

 

(57

)

(45

)

Unrealized gain (loss) on available for sale investments

 

(296

)

921

 

(1,452

)

677

 

Comprehensive loss

 

$

(4,142

)

$

(16,814

)

$

(7,916

)

$

(21,421

)

 

Note 1 0 . Segment Information

 

The Company has one operating segment comprising the design, development, manufacture and distribution of high-performance compound semiconductor substrates. The Company’s operating segment reports to the Interim Chief Executive Officer.

 

The Company sells its substrates products in the United States and in other parts of the world, and maintains operations in the United States, Japan and China. Revenues by geographic location based on the country where the customer is located are summarized as follows (in thousands):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net revenues:

 

 

 

 

 

 

 

 

 

United States

 

$

2,142

 

$

2,013

 

$

4,199

 

$

5,917

 

Europe

 

2,287

 

1,731

 

3,702

 

3,040

 

Canada

 

35

 

84

 

89

 

107

 

Japan

 

1,023

 

1,298

 

2,259

 

1,786

 

Taiwan

 

2,539

 

1,655

 

5,683

 

3,144

 

Asia Pacific and other

 

1,498

 

1,738

 

3,368

 

3,060

 

Consolidated

 

$

9,524

 

$

8,519

 

$

19,300

 

$

17,054

 

 

11



 

Note 1 1 . Corporate Affiliates

 

The Company’s investments in its corporate affiliates are summarized as follows (in thousands):

 

Affiliate

 

Investment
Balance
June 30,
2004

 

Investment
Balance
December 31,
2003

 

Accounting
Method

 

Ownership
Percentage

 

Xilingol Tongli Ge Co. Ltd.

 

$

820

 

$

822

 

Equity

 

25

%

Emeis han Jia Mei High Pure Metals Co., Ltd.

 

599

 

603

 

Equity

 

25

%

Beijing Ji Ya Semiconductor Material Co., Ltd.

 

1,071

 

1,071

 

Consolidated

 

51

%

Nanjing Jin Mei Gallium Co., Ltd.

 

616

 

616

 

Consolidated

 

88

%

Beijing BoYu Manufacturing Co., Ltd.

 

409

 

409

 

Consolidated

 

70

%

 

The investment balances for those affiliates accounted for under the equity method are included within “Other assets” in the condensed consolidated balance sheets. The minority interest for those affiliates that are consolidated is included within “Other long-term liabilities” in the condensed consolidated balance sheets and within “Other income, net” on the condensed consolidated statements of operations.

 

Undistributed retained earnings relating to the Company’s corporate affiliates was $1,380,000 as of June 30, 2004 and $794,000 as of June 30, 2003. Net income recorded from the Company’s corporate affiliates were $382 ,000 and $612,000 for the three month and six month periods ended June 30, 2004, respectively. Net loss recorded from the Company’s corporate affiliates were $41,000 and $67,000 for the three and six month periods ended June 30, 2003, respectively.

 

The Company invested in these companies because each provides materials that are important to the Company’s substrate business, each can provide products at lower cost than other suppliers, and each has a market beyond that provided by the Company. As of June 30, 2004, the Company had no obligations to make further investments in any of these companies, although it may choose to do so under certain conditions.

 

Note 1 2 . Commitments and Contingencies

 

From time to time the Company is involved in judicial or administrative proceedings concerning matters arising in the ordinary course of our business. The Company does not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition, cash flows or results of operation.

 

On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the Tokyo District Court, Civil Division against us and our Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from AXT in the amount of $1.67 million plus interest and court costs and the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXT intends to defend itself vigorously in these lawsuits and continues to sell its products in Japan. Both parties have completed submitting arguments and evidence in litigation in Japan. The Company retains all of its options which include appealing any court decision and launching an effort to have Sumitomo’s patent invalidated in Japan.

 

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California against the Company alleging patent infringement. The complaint sought damages and injunction against infringement. On July 23, 2003, the Company filed a counter complaint in the United States Court for Northern District of California, denying any patent infringement and alleging that Cree’s actions were intentionally designed to interfere with the Company’s prospective business relationships. The Company reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolution of the disputes did not have a material adverse impact on the Company’s consolidated financial position or results of operations. All parties signed a final release regarding all disputes between them on April 15, 2004.

 

12



 

The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of $1.0 million. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. The Company has not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling $793,000 and $994,000 are included in accrued liabilities in the accompanying condensed consolidated balance sheets as of June 30, 2004 and December 31, 2003. As of June 30, 2004, the Company has met all of its current delivery obligations under these contracts and expects to continue to meet delivery requirements during the remainder of the contract terms.

 

The Company indemnifies certain customers for attorney fees and damages and costs awarded against these parties in certain circumstances if its products are found to infringe certain patents and they are sued by the patent holder and awarded damages. There are limits on and exceptions to its potential liability for indemnification relating to intellectual patent infringement claims. The Company cannot estimate the amount of potential future payments, if any, that it might be required to make as a result of these agreements. To date, the Company has not paid any claim or been required to defend any action related to its indemnification obligations, and accordingly, the Company has not accrued any amounts for such indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations.

 

The Company’s financial statements include accruals for potential product liability and warranty claims based on the Company’s claims experience. Such costs are accrued at the time revenue is recognized. As of June 30, 2004 and December 31, 2003, accrued product warranties totaled $135,000 and $0 respectively, and are included in “accrued liabilities” in the accompanying condensed consolidated balance sheets. If there is a material increase in customer claims compared with our historical experience, or if costs of servicing claims are greater than expected, we may record a charge against cost of sales.

 

The following table reconciles changes in the Company’s accrued product warranties which is included in accrued liabilities for the three and six month periods ended June 30, 2004 and 2003, respectively (in thousands):

 

 

 

Three Months Ended June 30 ,

 

Six Months Ended June 30 ,

 

 

 

200 4

 

200 3

 

200 4

 

200 3

 

 

 

 

 

 

 

 

 

 

 

Beginning accrued warranty and related costs

 

$

135

 

$

 

$

 

$

 

Charged to cost of revenue

 

 

 

135

 

 

Actual warranty expenditures

 

 

 

 

 

Ending accrued warranty and related costs

 

$

135

 

$

 

$

135

 

$

 

 

In April 2004, the Company determined that it ha d not followed requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. Since April 2004, the Company has continued to notify the affected customers concerning its findings. The Company has established a reserve based on its best estimate of future returns related to this matter. Although actual returns may differ, the Company does not believe future claims in the aggregate will be material. One of the customers has cancelled outstanding orders for scheduled future deliveries totaling approximately $352,000. This customer represented approximately 2.8% of the Company’s total consolidated revenue for the three month period ended June 30, 2004 and 3.7% of the Company’s total consolidated revenue for the six month period ended June 30, 2004. The Company has recorded a reserve for sale returns of $745,000 and believes this is adequate to cover any product returns related to this matter, however, the Company is unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately $125,000 of the $745,000 sales returns reserve has been utilized in July 2004.  Refer to “Item 4 Controls and Procedures” for further information.

 

13



 

Note 13. Foreign Exchange Contracts and Transaction Gains/Losses

 

The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of June 30, 2004, the Company had no outstanding commitments with respect to foreign exchange contracts.

 

The Company incurred foreign currency transaction exchange losses of $(75,000) and $(11,000) for the three and six month periods ended June 30, 2004, respectively, and foreign currency transaction exchange gains of $1 3,000 and $65,000 for the three and six month periods ended June 30, 2003, respectively.

 

Note 14. Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board  (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities , which addresses consolidation by business enterprises of variable interest entities, or VIEs, either that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46, or FIN 46(R), resulting in an effective date of no later than the first interim or annual period ending after March 15, 2004. The Company’s adoption of FIN 46(R) did not have an impact on our results of operations or financial position.

 

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, (EITF 03-06), Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share . EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 was effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have a material effect on the Company’s results of operations or financial position.

 

14



 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions. Statements concerning our financial position, business strategy and plans or objectives for future operations are forward-looking statements.

 

These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and the condensed consolidated financial statements included elsewhere in this report.

 

Overview

 

We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. As a result of the discontinuance of our opto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating segment: our substrate division. We made our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell raw materials including gallium and germanium through our participation in majority- and minority-owned joint ventures. We have the capability to manufacture germanium substrates for use in satellite solar cells but withdrew from this business during 2000 so that we could more profitably use our then constrained capacity. We are now trying to requalify our germanium substrates with the few existing satellite solar cell system manufacturers.

 

Our total revenue from continuing operations was $9.5 million for the second quarter of 2004, $8.5 million for the second quarter of 2003 and $9.8 million for the first quarter of 2004. In the second quarter of 2004 we incurred a loss from continuing operations of $4.1 million compared with a loss of $3.9 million for the second quarter of 2003 and a loss of $2.6 million for the first quarter of 2004.

 

On June 24, 2003, we announced the discontinuation of our opto-electronics division, which we established as part of our acquisition of Lyte Optronics, Inc. in May 1999. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our consolidated statements of operations for all periods presented (see Note 3 of the notes to our condensed consolidated financial statements for details regarding the accounting for discontinued operations). The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks.

 

On September 27, 2003 we completed a sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics, Corp. and Dalian Luming Science and Technology Group, Co., Ltd. for the China Renminbi (RMB) equivalent of $9.6 million. During the first quarter of 2004, $7.8 million was converted to US dollars. The remaining funds were converted to US dollars in early April 2004. $1.0 million of the sales proceeds is maintained in an escrow account for up to one year after the sale date and will not be recorded until all claims made against the escrow, if any, are settled. We expect this escrow to be released, if no claims are made against it, on or about September 28, 2004. Of this $1.0 million escrow, up to $250,000 will be held in escrow for a second year and will not be recorded until all claims made against the escrow, if any, are settled. We retain a building located in Monterey Park, CA, that we intend to sell in 2004. This asset is classified as held for sale on our condensed consolidated balance sheets as of December 31, 2003 and June 30, 2004.

 

15



 

Our continuing business, primarily sales of our substrate products, is dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both as a result of economic changes and of overcapacity. We experienced a growth period that lasted from our initiation of sales in 1990 through the first half of 2001. In the second half of 2001, we experienced a $44.9 million, or 58.5% decrease in revenue compared with the first half as a result of the rapid decline in the mobile and fiber optic telecommunications markets. Together with other industry participants, we experienced lower revenues, slower bookings, push outs and cancellation of orders. As such, we recorded losses in the third and fourth quarters of 2001.

 

During the first half of 2002 our revenues grew due to improvements in the wireless market. In the second half of 2002 our revenue fell, however, because the substrate industry was still facing excess capacity that caused prices to decline, and because we experienced a loss of market share after two competitors developed technologies similar to ours. In addition, certain customers selected competitors’ products in order to diversify their supply sources and due to the belief that the competitors’ substrates offered better surface qualities. Full year 2002 revenue declined $63.9 million, or 58.8% compared with 2001. We recorded losses in each quarter of 2002 and incurred impairment charges against fixed assets and inventory due to the decline in demand and prices. In reaction to the economic downturn, we initiated an aggressive effort to reduce substrate manufacturing costs. This included moving much of our substrate manufacturing operations to China, reducing capacity in our Fremont, CA facility and developing and investing in key low-cost raw material sources.

 

In 2003, we believe that the wireless communications and HBLED markets grew, but our revenue did not increase until the fourth quarter of 2003 due to continued reductions in prices and the time required to improve our substrate surface quality and regain some lost customers. Revenue for 2003 fell by $10.2 million, or 22.6% compared with 2002. We recorded net losses in each quarter of 2003. During 2003 we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

 

During the first half of 2004, our revenue increased compared with the fourth quarter of 2003, primarily as a result of increased demand for HBLEDs. We recorded net losses in the first two quarters of 2004. During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China.

 

We cannot predict the level of future industry demand or of our ability to regain lost market share, but they have impacted our ability to sell our products and operate profitably. If demand for our products remains depressed for an extended period, our business will be harmed as a result. Our business performance will be most influenced by market demand for compound semi-conductor substrates, our ability to offer products that equal or exceed the quality provided by competitors, product pricing, our ability to shift more of our manufacturing production to China, and our ability to create and defend our intellectual property while not infringing on the intellectual property of others.

 

In April 2004, we determined that we ha d not followed requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. We have notified the affected customers concerning our findings. We have established a reserve based on our best estimate of future returns related to this matter. Although actual returns may differ, we do not believe future claims in the aggregate will be material. One of our customers has cancelled outstanding orders for scheduled future deliveries totaling approximately $352,000. This customer represented approximately 2.8% of our total consolidated revenue for the three month period ended June 30, 2004 and 3.7% of our total consolidated revenue for the six month period ended June 30, 2004. We have recorded a reserve for sales returns of $745,000 and believe this is adequate to cover any product returns related to this matter, however, we are unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately $125,000 of the $745,000 sales returns reserve has been utilized in July 2004.  See “Item 4. Controls and Procedures” for further information.

 

In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down the remaining manufacturing facilities in the US.  This charge is comprised of costs related to the reduction in force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. See Note 8 of the notes to our condensed consolidated financial statements for further details.

 

For the second quarter of 2004, our revenue from continuing operations increased to $9.5 million from $8.5 million in the second quarter of 2003, primarily due to greater sales of GaAs substrates, which benefited from increasing demand from our key end-use markets, red and amber HBLEDs and wireless handsets. Our gross margin also increased from the second quarter of 2003 to 8.7 percent due to higher yields and a greater share of our production being completed in China.

 

16



 

Critical Accounting Policies and Estimates

 

We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, we have had to make estimates, assumptions and judgments that affect the amounts reported on our financial statements. These estimates, assumptions and judgments about future events and their effects on our results cannot be determined with certainty, and are made based upon our historical experience and on other assumptions that are believed to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. The discussion and analysis of our results of operations and financial condition are based upon these consolidated financial statements. We have identified the policies below as critical to our business operations and understanding of our financial condition and results of operations. A critical accounting policy is one that is both material to the presentation of our financial statements and requires us to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations. They may require us to make assumptions about matters that are highly uncertain at the time of the estimate, and different estimates that we could have used, or changes in the estimate that are reasonably likely to occur, may have a material impact on our financial condition or results of operations.

 

We believe that the following are our critical accounting policies:

 

Revenue Recognition

 

We recognize revenue upon shipment of products to our customers provided that we have received a signed purchase order, the price is fixed or determinable, title has transferred, collection of resulting receivables is probable, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining obligations. We establish a reserve when there is uncertainty regarding customer acceptance. We assess the probability of collection based on a number of factors including past history with the customer and credit worthiness. We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. During the first quarter of 2004, we increased our reserve for sales returns by $745,000 related to our failure to follow certain testing requirements and provision of testing data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific shipments made during the quarter. Except for sales in Japan and some sales in Taiwan, which in both cases are denominated in Japanese yen, we denominate and collect our international sales in U.S. dollars.

 

Allowance for Doubtful Accounts

 

We periodically review the likelihood of collecting our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. As of June 30, 2004 our accounts receivable balance was $4.4 million, which is net of an allowance for doubtful accounts of $4.9 million.

 

Warranty Reserve

 

We maintain a warranty reserve based upon our claims experience during the prior twelve months. Such costs are accrued at the time revenue is recognized. As of June 30, 2004, accrued product warranties totaled $135,000.

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the standard cost method. Finished goods and work-in-process inventories include material, labor and manufacturing overhead costs. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and we provide a valuation allowance for certain inventories based upon the age and quality of the product. Competitive delivery times are frequently less than the time required for us to manufacture a product, requiring us to build some work-in-process inventories in anticipation of orders. If orders are not obtained for the products built, the products will ultimately be deemed obsolete and we will establish a reserve for their value. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in ending inventory exceeds the sales value less any related selling costs, a reserve is established for the difference.

 

17



 

Impairment of Long-Lived Assets

 

We evaluate the recoverability of property, equipment, and intangible assets in accordance with Statement of Financial Accounting Standards No. 144, or SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” When events and circumstances indicate that long-lived assets may be impaired, we compare the carrying value of the long-lived assets to the projection of future undiscounted cash flows attributable to such assets and in the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value.

 

Investments

 

We determine the appropriate classification of investments at the time of purchase. Available-for-sale investments are carried at their fair value based on quoted market prices as of the balance sheet date. The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in “other (income) and expense, net.” Realized gains or losses are determined on the specific identification method and are reflected in “other (income) and expense, net.” Net unrealized gains or losses are recorded directly in stockholders’ equity. Those unrealized losses that are deemed to be other than temporary are reflected in “interest and other income, net.” We also maintain minority investments in private companies which are accounted for under the cost basis. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions.

 

Income Taxes

 

We account for deferred income taxes using the liability method, under which the expected future tax consequences of timing differences between the book and tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. Valuation allowances are established when necessary to reduce net deferred tax assets when management estimates, based on available objective evidence, that it is more likely than not that the future income tax benefit represented by the net deferred tax asset will not be realized.

 

Results of Operations

 

The following table sets forth certain information relating to the operations of the Company expressed as a percentage of total revenues for the periods indicated:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Revenues

 

100.0

%

100.0

%

100.0

%

100.0

%

Cost of revenues

 

91.3

 

92.1

 

92.9

 

94.4

 

Gross profit

 

8.7

%

7.9

%

7.1

%

5.6

%

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

33.6

 

33.1

 

30.9

 

31.2

 

Research and development

 

3.7

 

4.3

 

3.6

 

4.4

 

Restructuring charge

 

11.3

 

 

5.6

 

 

Total operating expenses

 

48.6

 

37.4

 

40.1

 

35.6

 

Loss from operations

 

(39.9

)

(29.5

)

(33.0

)

(30.0

)

Interest expense

 

(0.6

)

1.3

 

(0.9

)

1.3

 

Other (expense) income, net

 

(1.2

)

14.9

 

0.3

 

6.1

 

Loss before provision for income taxes

 

(41.7

)

(45.7

)

(33.6

)

(37.4

)

Provision for incomes taxes

 

(1.0

)

 

(0 .7

)

 

Loss from continuing operations

 

(42.7

)

(45.7

)

(34.3

)

(37.4

)

Discontinued operations:

 

 

 

 

 

 

 

 

 

Gain (loss) from discontinued operations, net of tax

 

2.3

 

(162.5

)

1.1

 

(91.9

)

Gain (loss) from disposal

 

 

 

 

 

Net loss

 

(40.4

)%

(208.2

)%

(33.2

)%

(129.3

)%

 

18



 

Three months ended June 30, 2004 compared with three months ended June 30, 2003

 

Revenue from continuing operations. Revenue from continuing operations increased $1.0 million, or 11.8%, to $9.5 million for the three months ended June 30, 2004 compared with $8.5 million for the three months ended June 30, 2003.

 

Total GaAs substrate revenue increased $ 0.5 million, or 6.5%, to $7.5 million for the three months ended June 30, 2004 compared with $7.0 million for the three months ended June 30, 2003. Sales of 5” and 6” diameter GaAs substrates were $1.3 million for the three months ended June 30, 2004 compared with $0.8 million for the three months ended June 30, 2003. InP substrate revenue increased $30,000, or 6.0%, to $533,000 for the three months ended June 30, 2004 compared with $503,000 for the three months ended June 30, 2003. The increase in GaAs substrate revenue during the past year is due to market growth in the HBLED and wireless handset markets and to our ability to gain share among some Asian customers.

 

International revenue increased to 77.1% of total revenue from continuing operations for the three months ended June 30, 2004 compared with 76.4% of total revenue from continuing operations for the three months ended June 30, 2003. The increase was primarily due to a greater share of our GaAs substrates being used in opto-electronics applications and the majority of our customers for these applications being in Asia.

 

Gross margin. Gross margin increased to 8.7% of total revenue for the three months ended June 30, 2004 compared with 7.9% of total revenue for the three months ended June 30, 2003. The increase was primarily due to a larger sales volume that enabled us to cover more fixed costs as well as reduced costs that we incurred as a result of moving most of our production to China, where we incur lower production costs than in our California operations.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased to $3.2 million for the three months ended June 30, 2004 compared with $2.8 million for the three months ended June 30, 2003. The increase is due to an additional accrual of $350,000 for legal fees related to an investigation by our Audit Committee into product testing and compliance practices in second quarter of  2004. As a percentage of revenue, selling, general and administrative expenses were 33.6% for the three months ended June 30, 2004 compared with 33.1% for the three months ended June 30, 2003.

 

Research and development expenses. Research and development expenses decreased $18,000, or 4.9%, to $350,000 for the three months ended June 30, 2004 compared with $368,000 for the three months ended June 30, 2003. As a percentage of total revenue, research and development expenses were 3.7% for the three months ended June 30, 2004 compared with 4.3% for the three months ended June 30, 2003. Although we reduced research and development expenses as part of our effort to adjust costs in line with our current business, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels or increase in future periods. Research and development efforts during the first quarter of 2004 were focused primarily on improving the yield and surface quality of our GaAs substrates.

 

Interest expense. Interest expense decreased $50,000, or 46.3%, to $58,000 for the three months ended June 30, 2004 compared with $108,000 for the three months ended June 30, 2003. Interest expense decreased due to lower debt levels as we continue to pay down our debt.

 

Other income and expense, net. Other expense decreased $1.2 million to $113,000 for the three months ended June 30, 2004 compared with other expense of $1.3 million for the three months ended June 30, 2003. The decrease was mainly due to an impairment charge in 2003 related to a non-consolidated subsidiary for $1.3 million.

 

Provision for income taxes. Due to our continuing operating losses in the United States and uncertainty regarding future profitability, we recorded a full valuation allowance for our US losses against our net deferred tax assets of $34.6 million in 2003. We incurred a tax liability of $97,000 for our overseas businesses for the three months ended June 30, 2004.

 

Six months ended June 30, 2004 compared with six months ended June 30, 2003

 

Revenue from continuing operations. Revenue from continuing operations increased  $2.2 million, or 13.2%, to $19.3 million for the six months ended June 30, 2004 compared with $17.1 million for the six months ended June 30, 2003.

 

Total GaAs substrate revenue increased $1.5 million, or 11.0%, to $15.5 million for the six months ended June 30, 2004 compared with $14.0 million for the six months ended June 30, 2003. Sales of 5” and 6” diameter GaAs substrates were $2.8 million for the six

 

19



 

months ended June 30, 2004 compared with $ 2.1 million for the six months ended June 30, 2003. InP substrate revenue decreased $18,000, or 1.7%, to $1.1 million for the six months ended June 30, 2004 compared with $1.1 million for the six months ended June 30, 2003. The increase in GaAs substrate revenue during the past year is due to market expansion in the HBLED and wireless handset markets and to our ability to gain share among Asian customers.

 

International revenue increased to 77.8% of total revenue from continuing operations for the six months ended June 30, 2004 compared with 64.6% of total revenue from continuing operations for the six months ended June 30, 2003. The increase was primarily due to a greater share of our GaAs substrates being used in opto-electronics applications and the majority of our customers for these applications being in Asia.

 

Gross margin. Gross margin increased to 7.1% of total revenue for the six months ended June 30, 2004 compared with 5.6% of total revenue for the six months ended June 30, 2003. The increase was primarily due to a larger sales volume that enabled us to cover more fixed costs as well as reduced costs that we incurred as a result of moving most of our production to China, where we incur lower production costs than in our California operations.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased to $6.0 million for the six months ended June 30, 2004 compared with $5.3 million for the six months ended June 30, 2003. The increase is due to an additional accrual of $350,000 for legal fees related to the investigation by our Audit Committee into product testing and compliance practices in second quarter of 2004, and $300,000 for auditing and Sarbanes-Oxley related expenses for 2004. As a percentage of revenue, selling, general and administrative expenses were 30.9% for the six months ended June 30, 2004 compared with 31.2% for the six months ended June 30, 2003.

 

Research and development expenses. Research and development expenses decreased $56,000, or 7.5%, to $691,000 for the six months ended June 30, 2004 compared with $747,000 for the six months ended June 30, 2003. As a percentage of total revenue, research and development expenses were 3.6% for the six months ended June 30, 2004 compared with 4.4% for the six months ended June 30, 2003. Although we reduced research and development expenses as part of our effort to adjust costs in line with our current business, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels or increase in future periods. Research and development efforts during the first quarter of 2004 were focused primarily on improving the yield and surface quality of our GaAs substrates.

 

Interest expense. Interest expense decreased $56,000, or 25.1%, to $167,000 for the six months ended June 30, 2004 compared with $223,000 for the six months ended June 30, 2003. Interest expense includes a prepayment penalty incurred by voluntarily repaying off a loan before it was due with an outstanding principal balance of $781,000, which we acquired in 1996.  Interest expense decreased due to lower debt levels as we continue to pay down our debt.

 

Other income and expense, net. Other income increased $1.1 million to $54,000 for the six months ended June 30, 2004 compared with other expense of $1.0 million for the six months ended June 30, 2003. The increase was mainly due to an impairment charge in 2003 related to a non-consolidated subsidiary for $1.3 million.

 

Provision for income taxes. Due to our continuing operating losses in the United States and uncertainty regarding future profitability, we recorded a full valuation allowance for our US losses against our net deferred tax assets of $34.6 million in 2003. We incurred a tax liability of $137,000 for our overseas businesses for the six months ended June 30, 2004.

 

Liquidity and Capital Resources

 

We consider cash and cash equivalents, and short-term investments as liquid and available for use. Short-term investments are comprised of government bonds and high-grade commercial debt instruments. Also included in short-term investments is our common stock investment in Finisar Corporation. As of June 30, 2004, our principal sources of liquidity were $34.6 million in cash and cash equivalents and short-term investments, excluding restricted deposits.

 

Cash and cash equivalents and short-term investments, excluding $2.3 million and $3.7 million for our investment in Finisar common stock as of June 30, 2004 and December 31, 2003, respectively, decreased $3.0 million to $32.3 million as of June 30, 2004 compared with $35.3 million as of December 31, 2003.

 

20



Cash and cash equivalents decreased $9.6 million to $14.8 million as of June 30, 2004 compared with $24.3 million as of December 31, 2003. Short-term investments increased by $ 5.2 million to $19.9 million as of June 30, 2004 compared with $14.7 million as of December 31, 2003. We converted approximately $7.8 million of the total $9.6 million of Chinese Renminbi from the sale of our opto-electronic assets into United States dollars during the first quarter of 2004 and invested most of that into short-term investments. The remaining funds were converted in early April 2004.

 

Net cash used by operating activities of $185,000 for the six month period ended June 30, 2004 was comprised primarily of our net loss adjusted for non-cash items which netted to $2.8 million, consisting primarily of depreciation of $2.4 million, and by a $2.6 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in accounts receivable and inventory partially offset by an increase in prepaid expenses and a decrease in accrued liabilities.

 

Net accounts receivable decreased by $1.9 million, or 30.3%, to $4.4 million as of June 30, 2004 compared with $6.3 million as of December 31, 2003. The decrease reflects better collections from customers and an additional sales returns reserve of $745,000 recorded in the first quarter of 2004.

 

Net inventories decreased $2. 3 million, or 9.4% to $21.8 million as of June 30, 2004 compared with $24.1 million as of December 31, 2003. The Company adopted a strategy of using inventory to conserve cash during the first half of 2004. During the second half of 2004, we do not expect to maintain the same rate of net inventory decrease as we experienced in first half of 2004.

 

Net cash used by investing activities of $6.8 million for the quarter ended June 30, 2004 includes purchases of property and equipment of $0.7 million primarily used to transfer production capacity to China for the substrate division, and purchases of high grade investment securities with maturities of less than two years totaling $20.7 million, partially offset by sales of high grade investment securities totaling $10.4 million and a change in the investments providing our restricted cash of $4.2 million.

 

We do not have any plans to initiate any major new capital spending projects through 2004. We are currently completing certain projects at our China facilities and closing our remaining manufacturing facilities in Fremont, California. We expect to invest approximately $2.0 million in capital projects in 2004. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

 

Net cash used in financing activities of $2.5 million consisted of scheduled payments of $2.7 million related to long-term borrowings, partially offset by proceeds of $0.2 million through our employee stock compensation programs.

 

Our main Fremont, California manufacturing facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at a variable rate that was 1.4% as of June 30, 2004. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. As of June 30, 2004, $8.5 million was outstanding under these bonds.

 

As of June 30, 2004 , the credit facility maintained by us with a bank included a letter of credit supporting repayment of our industrial bonds with an outstanding amount of $8.6 million. The Company has pledged and placed certain investment securities with an affiliate of the bank as additional collateral for this facility. We have also pledged certain investments for a credit facility for our workers compensation insurance. As a result, $8.6 million of our cash and short-term investments are restricted.

 

We currently hold a note payable secured by certain buildings and land in China totaling $1.5 million as of June 30, 2004. The balance on this note is due in December 2004.

 

We believe that we have adequate cash and investments to meet the Company’s needs over the next 12 months. If our sales decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use more cash at a more rapid rate than expected, and require us to seek additional capital. There can be no assurance that such additional capital will be available or, if available it will be at terms acceptable to the Company. Cash from operations could be affected by various risks and uncertainties, including, but not limited to those set forth below under “Risks Related to Our Business.”

 

Outstanding contractual obligations as of June 30, 2004 are summarized as follows (in thousands):

 

21



 

 

 

Debt

 

Operating
Leases

 

Total

 

2004 (remaining six months)

 

$

1,818

 

$

717

 

$

2,535

 

2005

 

420

 

1,222

 

1,642

 

2006

 

420

 

901

 

1,321

 

2007

 

420

 

681

 

1,101

 

2008

 

385

 

681

 

1,066

 

Thereafter

 

6,345

 

2,855

 

9,200

 

 

 

$

9,808

 

$

7,057

 

$

16,865

 

 

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Total rent expense under these operating leases w as approximately $352,000 and $705,000 for the three month and six month periods ended June 30, 2004, respectively.

 

Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, or FIN 46, Consolidation of Variable Interest Entities , which addresses consolidation by business enterprises of variable interest entities, or VIEs, either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46, or FIN 46(R), resulting in an effective date of no later than the first interim or annual period ending after March 15, 2004. The Company’s adoption of FIN 46(R) did not have an impact on our results of operations or financial position.

 

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, (EITF 03-06), Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share . EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 was effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have a material effect on the Company’s results of operations or financial position.

 

Risks Related to Our Business

 

We may incur claims or other liabilities or obligations related to our failure to follow requirements for testing of products and provision of testing data and information relating to customer requirements. Additionally, customers may cancel or reduce future shipments in response to these failures.

 

We have recently determined that we ha d not followed requirements for testing of products and provision of testing data and information relating to customer requirements. See preceeding “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Overview” and “Item 4. Controls and Procedures” below for further information. Although we are notifying affected customers concerning our findings, there can be no assurance that we will not incur customer claims or other liabilities or obligations in connection with this matter, nor, if we receive any such claims, that we will not have to restate results from prior periods. In addition, revenue in future periods may be adversely impacted if customers cancel or reduce orders or decide not to continue ordering from us as a result of this disclosure. We have been notified of several cancellations of future orders by customers pending further information regarding enhancements to our product testing and quality control systems. We cannot be sure that we will not receive additional cancellations of orders by other customers, or fail to win expected future orders from customers, as a result of our disclosure of our investigation conclusions.

 

22



 

Because of power shortages in China, we may have to temporarily close our China operations, which would adversely impact our ability to manufacture our products, meet customer orders, and result in reduced revenues for the period.

 

The Chinese government has indicated that the country faces a power crunch this summer and that power demand in 24 provinces outstripped supply in peak periods during the first four months of 2004. Instability in electrical supply has caused sporadic outages among residential consumers. As a result, the Chinese government has called for tough measures to ease the energy shortage which is expected to last at least through 2005.  Provinces have imposed power brownouts to reduce electricity demand and some companies in Beijing have been ordered to give their employees a week off to ease the pressure on power supply.  It is anticipated that the plants, most of which are state-owned, will be closed and reopened on a staggered schedule to reduce power consumption during the capital’s hottest months, with the first closings occurring in early July.  The policy is expected to continue until the end of August.  We closed most of our operations for a week in late July 2004 in conformance with this policy.  If we are required to make additional temporary closures of our Beijing operations, we will be unable to manufacture our products, and will be unable to meet customer orders except from inventory on hand.  As a result, we could lose sales, adversely impacting our revenues, and our relationships with our customers could suffer, impacting our ability to generate future sales.  In addition, if power is shut off at our Beijing operations at any time, either voluntarily or as a result of unplanned brownouts, during certain phases of our manufacturing process including our crystal growth phase, the work in process may be ruined and rendered unusable, causing us to incur expense that will not be covered by revenue, and negatively impacting our cost of goods sold and gross margins.

 

Intellectual property infringement claims may be costly to resolve and could divert management attention.

 

Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others, and have been sued by a substrate competitor concerning alleged patent infringement. On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the Tokyo District Court, Civil Division against the Company and its Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from us in the amount of $1.67 million plus interest and court costs and the cessation of our sales of gallium arsenide substrates in Japan. We intend to defend ourself vigorously in these law suits. Both parties have completed submitting arguments and evidence in litigation in Japan and we currently retain all of our options which include appealing any court decision and launching an effort to have Sumitomo’s patent invalidated in Japan. However, there can be no assurance that the court will not rule against us on the infringement claim, or that we can settle this matter on terms acceptable to us, if at all.

 

Litigation to determine the validity of alleged claims, such as that between us and Sumitomo, could be time-consuming and result in significant expense to us and divert the efforts of our technical and management personnel, whether or not the litigation is ultimately determined in our favor. If a law suit is decided against us, including the lawsuit with Sumitomo, we could be subject to significant liabilities, requiring us to seek costly licenses or preventing us from manufacturing and selling our products. We may not be able to obtain required licensing agreements on terms acceptable to us or at all. If we lose the litigation with Sumitomo, we may have to pay royalties to Sumitomo on products sold in Japan, or cease sales of our products to customers in Japan.

 

If we fail to comply with environmental and safety regulations, we may be subject to significant fines or cessation of our operations; in addition, we could be subject to suits for personal injuries caused by hazardous materials.

 

We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development, and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational Saftey and Health Administration, or Cal-OSHA, in an investigation primarily regarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California for $200,415, and we have recently been the target of press allegations concerning our environmental compliance programs and exposure of our employees to hazardous materials, and there is a possibility that former employees may file litigation against us. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. Existing or future changes in laws or regulations in the United States and China may require us to incur significant expenditures or liabilities, or may restrict our operations. In addition, our employees could be exposed to chemicals or other hazardous materials at our facilities and we may be subject to lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicals or

 

23



 

hazardous materials at our facilities.

 

If litigation is brought against us, litigation is inherently uncertain and while we would expect to defend ourself vigorously, it is possible that our business, financial condition, results of operations or cash flows, could be affected in any particular period by such litigation if brought against us.

 

The semiconductor industry is cyclical and has experienced a downturn which has adversely impacted our operating results.

 

Our continuing business depends in significant part upon manufacturers of electronic and opto-electronic semiconductor devices, as well as the current and anticipated market demand for such devices and products using such devices. As a supplier to the semiconductor industry, we are subject to the business cycles that characterize the industry. The timing, length and volatility of these cycles are difficult to predict. The semiconductor industry has historically been cyclical because of sudden changes in demand for semiconductors and capacity requirements, including capacity utilizing the latest technology. The rate of changes in demand, including end demand, is high, and the effect of these changes upon us occurs quickly, exacerbating the volatility of these cycles. These changes have affected the timing and amounts of customers’ capital equipment purchases and investments in new technology. These industry cycles create pressure on our net sales, gross margin and net income.

 

The industry has previously experienced periods of oversupply that result in significantly reduced demand for semiconductor devices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur, our operating results and financial condition are adversely affected, and create pressure on our revenue, gross margins and net income. Inventory buildups in telecommunications products and slower than expected sales of computer equipment resulted in overcapacity and led to reduced sales by our customers, and therefore reduced purchases of our products. During periods of weak demand such as those experienced over the past years, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition has resulted, causing pressure on our net sales, gross margin and net income. We experienced cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn were to continue, or occur again in the future, further order cancellations, reductions in order size or delays in orders will materially adversely affect our business and results of operations. Actions to reduce our costs, such as those we have recently taken, may be insufficient to align our structure with prevailing business conditions. We may be required to undertake additional cost-cutting measures, and may be unable to invest in marketing, research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investments could seriously harm our business.

 

During periods of increasing demand for semiconductor devices, we must have sufficient manufacturing capacity and inventory to meet customer demand, and must be able to attract, hire, train and retain qualified employees to meet demand. It appears that the semiconductor industry is in the early stages of an upturn and increasing demand. However, we cannot predict the sustainability of a recovery, if any, and the industry’s rate of growth in this recovery, if it occurs. If we are unable to effectively manage our resources and production capacity during an industry upturn, there could be a material adverse effect on our business, financial condition and results of operations.

 

If the economy recovers and we are again in a period of high demand for our products, we may be unable to expand our manufacturing capacity quickly enough to meet increased demand, we may make decisions to expand capacity that are not profitable, and we may be unable to lower our costs or increase revenue.

 

It appears that the industry may be in an upturn, which may cause demand to increase rapidly as it has in prior years after other cyclical downturns in the economy and the industries in which we operate. If this happens, in order to meet increased demand and maintain our market share, we may need to increase production, which could require us to build new facilities, expand and modify our existing facilities, purchase additional manufacturing equipment, and add qualified staff. If we are not at that time able to expand our manufacturing capacity, we will be unable to increase production, which may adversely impact our ability to meet increased production demand while reducing unit costs, margins and improving our operating results.

 

We are currently constructing and modifying facilities in California and China. Our construction activities subject us to a number of risks, including:

 

    unforeseen environmental or engineering problems;

 

    unavailability or late delivery of production equipment;

 

24



 

    delays in completing new facilities;

 

    delays in bringing production equipment on-line;

 

    work stoppages or delays;

 

    inability to recruit and train qualified staff; and

 

    unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the   United States and China.

 

If any of these risks occurs, construction may be costlier than anticipated and completion could be delayed, which could hurt our ability to expand capacity and increase our sales. In addition, if we experience delays in expanding our manufacturing capacity, we may not be able to timely meet customer requirements, and we could lose future sales. We are also completing selective investments in equipment and facilities as part of our previously planned capacity expansion. To offset the additional fixed operating expenses, we must increase our revenue by increasing production and improving yields. If demand for our products does not grow, if prices decline significantly, or if our yields do not improve as anticipated, we may be unable to offset these costs against increased revenue, which would adversely impact our operating results.

 

Unpredictable fluctuations in our operating results could disappoint analysts or our investors, which could cause our stock price to decline.

 

We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our net loss in 2002 was the largest in our history and our losses continued during 2003. We believe we will endure losses for at least part of 2004.

 

We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:

 

      decline in general economic conditions or downturns in the industry in which we compete;

 

      fluctuations in demand for our products;

 

      expansion of our manufacturing capacity;

 

      expansion of our operations in China;

 

      limited availability and increased cost of raw materials;

 

      the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;

 

      fluctuation of our manufacturing yields;

 

      decreases in the prices of our competitors’ products;

 

      costs incurred in connection with any future acquisitions of businesses or technologies;

 

      increases in our expenses, including expenses for research and development; and

 

      our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.

 

Due to these factors, we believe that period-to-period comparisons of our operating results may not be meaningful indicators of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or

 

25



 

investors. If this occurs again in future periods, the price of our common stock could decline or fluctuate.

 

A substantial percentage of our operating expenses are fixed in the short term and we may be unable to adjust spending to compensate for an unexpected shortfall in revenues. As a result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors, which could also cause our stock price to fall.

 

Our results of operations may suffer if we do not effectively manage our inventory.

 

We must manage our inventory of component parts, work-in-process, and finished goods effectively to meet changing customer requirements, while keeping inventory costs down and improving gross margins. Some of our products and supplies have in the past and may in the future become obsolete while in inventory due to changing customer specifications, or become excess inventory due to decreased demand for our products and an inability to sell the inventory within a foreseeable period. Furthermore, if current costs of production increase or sales prices drop below the standard prices at which we value inventory, we may need to take a charge for a reduction in inventory values. We have in the past had to take inventory valuation and impairment charges. If we are not successfully able to manage our inventory, we may need to write off unsaleable, obsolete or excess inventory, which could adversely affect our results of operations.

 

Decreases in average selling prices of our products may reduce gross margins.

 

The market for compound semiconductor substrates is characterized by pressures on average selling prices resulting from factors such as increased competition or overcapacity. We may experience price pressures on our products, and if average selling prices decline in the future, our revenues and gross margins could decline. We may be unable to reduce the cost of our products sufficiently to counter the effect of lower selling prices and allow us to keep pace with competitive pricing pressures and our margins could be adversely affected.

 

The disposal of our opto-electronics business may fail to result in the benefits we anticipate.

 

We may not obtain the benefits we expect as a result of discontinuation of our opto-electronics business, such as greater strategic focus on our core businesses. We may be required to return to the buyer some or all of the $1 million of the sale proceeds which will be held in escrow should the buyer successfully claim that we breached one of the representations or warranties made to it. Our building in Monterey Park may not be sold for the $1 million at which we are carrying it on our balance sheet. We may incur additional costs associated with the discontinued operations which could materially reduce our short term earnings.

 

A reoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of a different contagious disease may adversely impact our manufacturing operations and some of our key suppliers and customers.

 

The majority of our substrate manufacturing activities are conducted in China. In addition, we source key raw materials, including gallium, from our joint ventures and other suppliers in China. The 2003 SARS outbreak was most notable in China and a small number of cases have been reported to date in 2004. One employee at our LED production facility in China contracted SARS in late April 2003 prompting us to close the facility for ten days. There was no significant impact to our ability to fill customer orders. If there were to be another outbreak of SARS or a different contagious disease and if our employees contracted the disease, we may be required to temporarily close our manufacturing operations. Similarly, if one of our key suppliers is required to close for an extended period, we may not have enough raw material inventory to continue manufacturing operations. In addition, while we possess management skills among our China staff that enable us to maintain our manufacturing operations with minimal on-site supervision from our US-based staff, our business could also be harmed if travel to or from Asia and the United States is restricted or inadvisable, as it was during parts of 2003. None of our substrate competitors is as dependent on manufacturing facilities in China as we are. If our manufacturing operations were closed for a significant period, we could lose revenue and market share during that period which would depress our financial performance and could be difficult to recapture. Finally, if one of our key customers is required to close for an extended period, we may not be able to ship product to them, our revenue would decline and our financial performance would suffer.

 

The impact of changes in global economic conditions on our customers may cause us to fail to meet expectations, which would negatively impact the price of our stock.

 

Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we faced in 2003 was more uncertain than in some prior periods, lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue

 

26



 

growth and profitability of our business depends on the overall demand for our substrates, and we are particularly dependant on the market conditions for the wireless, solid-state illumination, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

 

If we do not successfully develop new products to respond to rapidly changing customer requirements, our ability to generate sales and obtain new customers may suffer.

 

Our success depends on our ability to offer new products and product features that incorporate leading technology and respond to technological advances. In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industry standards. If our competitors introduce products employing new technologies or performance characteristics, our existing products could become obsolete and unmarketable. During the past year, we have seen our competitors selling more substrates manufactured using a crystal growth technology similar to ours, which has eroded our technological differentiation. If we fail to offer new products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements. Other companies, including Triquent, are actively developing substrate materials that could be used to manufacture devices that could provide the same high-performance, low-power capabilities as GaAs- and InP-based devices at competitive prices. If these substrate materials or VGF derived products are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer.

 

The development of new products can be a highly complex process, and we may experience delays in developing and introducing new products. Any significant delays could cause us to fail to timely introduce and gain market acceptance of new products. Further, the costs involved in researching, developing and engineering new products could be greater than anticipated.

 

Our operating results depend in large part on further customer acceptance of our existing substrate products manufactured in China.

 

To shift more of our substrate manufacturing operations to China successfully, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. We may lose sales of our products to competitors who are not manufacturing in China, or whose operations in China have already been qualified by customers. All of these events could reduce our revenue but increase our cost structure. In addition, we announced a plan to stop producing products in China during the third quarter of 2004. If customers do not fully qualify our China production by the time we cease our California production, we may lose additional customers.

 

Furthermore, some customers have reduced their orders from us until our surface quality is as good and consistent as that offered by competitors. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and we believe that we have lost revenue and market share as a result of these customer decisions, which we may be unable to recover. If we are unable to retain our market share, our revenue and performance will decline.

 

Intense competition in the markets for our products could prevent us from increasing revenue and sustaining profitability.

 

The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as Triquent, that are actively developing alternative materials to GaAs and some semiconductor devices are being marketed using these materials. We believe that at least two of our competitors are shipping high volumes of GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase and we may be unable to be profitable. We face many competitors that have a number of significant advantages over us, including:

 

      greater experience in the business;

 

      more manufacturing experience;

 

27



 

      extensive intellectual property;

 

      broader name recognition; and

 

      significantly greater financial, technical and marketing resources.

 

Our competitors could develop new or enhanced products that are more effective than our products are.

 

The level and intensity of competition has increased over the past year and we expect competition to continue to increase in the future. Competitive pressures caused by the current economic conditions have resulted in reductions in the prices of our products, and continued or increased competition could reduce our market share, require us to further reduce the prices of our products, affect our ability to recover costs or result in reduced gross margins.

 

Defects in our products could diminish demand for our products.

 

Our products are complex and may contain defects. We have experienced quality control problems with some of our products over the past two years, which caused customers to return products to us, reduce orders for our products, or both. If we continue to experience quality control problems, or experience these or other problems in new products, customers may cancel or reduce orders or purchase products from our competitors and sales of our products could decline. Defects in our products could cause us to incur higher manufacturing costs and suffer product returns and additional service expenses, all of which could adversely impact our operating results.

 

If new products developed by us contain defects when released, our customers may be dissatisfied and we may suffer negative publicity or customer claims against us, lose sales or experience delays in market acceptance of our new products.

 

If we have low product yields, the shipment of our products may be delayed and our operating results may be adversely impacted.

 

Our products are manufactured using complex technologies, and the number of usable substrates we can produce can fluctuate as a result of many factors, including:

 

      impurities in the materials used;

 

      contamination of the manufacturing environment;

 

      substrate breakage;

 

      equipment failure, power outages or variations in the manufacturing process; and

 

      performance of personnel involved in the manufacturing process.

 

If our yields decrease, our revenue could decline because many of our manufacturing costs are fixed, or would increase. We have experienced product shipment delays and difficulties in achieving acceptable yields on both new and older products, and delays and poor yields have adversely affected our operating results. We may experience similar problems in the future and we cannot predict when they may occur or their severity. In particular, many of our manufacturing processes are new and are still being refined, which can result in lower yields.

 

We derive a significant portion of our revenue from international sales, and our ability to sustain and increase our international sales involves significant risks.

 

Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 77.8% of our total revenue for the six months ended June 30, 2004 and 64.6% for the six months ended June 30, 2003. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue, particularly sales to customers in Asia.

 

Currently, an increasing percentage of our sales are to customers headquartered in Asia. Certain manufacturing facilities and

 

28



 

suppliers are also located outside the U.S. Managing our global operations presents challenges, including periodic regional economic downturns, trade balance issues, varying business conditions and demands, political instability, variations in enforcement of intellectual property and contract rights in different jurisdictions, differences in the ability to develop relationships with suppliers and other local businesses, changes in U.S. and international laws and regulations including U.S. export restrictions, fluctuations in interest and currency exchange rates, the ability to provide sufficient levels of technical support in different locations, cultural differences, shipping delays and terrorist acts or acts of war, among other risks. Many of these challenges are present in China, which represents a large potential market for semiconductor equipment and where AXT anticipates significant opportunity for growth. Global uncertainties with respect to: (i) economic growth rates in various countries; (ii) sustainability of demand for electronics products; (iii) capital spending by semiconductor manufacturers; (iv) price weakness for certain semiconductor devices; and (v) political instability in regions where we have operations may also affect our business, financial condition and results of operations.

 

Our dependence on international sales involves a number of risks, including:

 

      changes in tariffs, import or export restrictions and other trade barriers;

 

      unexpected changes in regulatory requirements;

 

      longer periods to collect accounts receivable;

 

      changes in export license requirements;

 

      political and economic instability;

 

      unexpected changes in diplomatic and trade relationships; and

 

      foreign exchange rate fluctuations.

 

Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen. Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive than competitors’ products in these markets. Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. The functional currencies of our Japanese and Chinese subsidiaries are the local currencies. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. If we do not effectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.

 

Demand for our products may decrease if our customers experience difficulty manufacturing, marketing or selling their products.

 

Our products are used as components in our customers’ products. Accordingly, demand for our products is subject to factors affecting the ability of our customers to successfully introduce and market their products, including:

 

      the competition our customers face in their particular industries;

 

      the technical, manufacturing, sales and marketing and management capabilities of our customers;

 

      the financial and other resources of our customers; and

 

      the inability of our customers to sell their products if they infringe third party intellectual property rights.

 

If demand for the end user applications for which our products are used decreases, or our customers are unable to develop, market and sell their products, demand for our products will decrease.

 

29



 

The financial condition of our customers may affect their ability to pay amounts owed to us.

 

Many of our customers are facing business downturns that have reduced their cash balances and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 120 days after delivery. Subsequent to our shipping a product, some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. At least three customers that owed us a significant amount have filed for bankruptcy protection and we are unlikely to receive a substantial portion or any of the amounts owed to us as part of a bankruptcy settlement. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.

 

We purchase critical raw materials and parts for our equipment from single or limited sources, and could lose sales if these sources fail to fill our needs.

 

We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as quartz tubing, polishing solutions, and paralytic boron nitride. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and no supplier guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules and our revenue and operating results could suffer.

 

The loss of one or more of our key substrate customers would significantly hurt our operating results.

 

A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 35.6% and 34.6% of our total revenue for the three month and six month periods ended June 30, 2004, respectively. One customer accounted for 5.8% and 9.5% of our revenue for the three month and six month periods ended June 30, 2004. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders from some customers. In addition, due to the difficult economic environment, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.

 

Our substrate products have a long qualification cycle that makes it difficult to plan our expenses and forecast our results.

 

Customers typically place orders with us for our substrate products three months to a year or more after our initial contact with them. The sale of our products may be subject to delays due to our customers’ lengthy internal budgeting, approval and evaluation processes. During this time, we may incur substantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result in sales of our products. If we do not achieve anticipated sales in a period as expected, we may experience an unplanned shortfall in our revenue. As a result, we may not be able to cover expenses, causing our operating results to vary. In addition, if a customer decides not to incorporate our products into its initial design, we may not have another opportunity to sell products to this customer for many months or even years. In the current competitive and economic climate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to accurately forecast our future sales. We anticipate that sales of any future substrate products will also have lengthy sales cycles and will, therefore, be subject to risks substantially similar to those inherent in the lengthy sales cycle of our current substrate products.

 

If we are unable to protect our intellectual property, we may lose valuable assets or incur costly litigation.

 

We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. However, we believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership also depends on

 

30



 

the skills of our development personnel.

 

Despite our efforts to protect our intellectual property, a third party could develop products or processes similar to ours. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around our patents. We believe that at least two of our competitors have begun to ship GaAs substrates produced using a process similar to our VGF technique. Our competitors may also develop and patent improvements to the VGF technology upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents or trade secrets.

 

It is possible that pending or future United States or foreign patent applications made by us will not be approved, that our issued patents will not protect our intellectual property, or that third parties will challenge the ownership rights or the validity of our patents. In addition, the laws of some foreign countries may not protect our proprietary rights to as great an extent as do the laws of the United States and it may be more difficult to monitor the use of our intellectual property. Our competitors may be able to legitimately ascertain non-patented proprietary technology embedded in our systems. If this occurs, we may not be able to prevent the development of technology substantially similar to ours.

 

We may have to resort to costly litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope, validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause us to divert resources and may not prove successful. Our protective measures may prove inadequate to protect our proprietary rights, and if we fail to enforce or protect our rights, we could lose valuable assets.

 

We need to continue to improve or implement our systems, procedures and controls and may not receive favorable attestation of our internal control systems by our independent auditors.

 

The new requirements adopted by the Securities and Exchange Commission in response to the passage of the Sarbanes-Oxley Act of 2002 will require annual review and evaluation of our internal control systems, and attestation of these systems by our independent accountants. We are currently reviewing our internal control procedures and considering further documentation of such procedures that may be necessary. Although the guidelines for the evaluation and attestation of internal control systems have been finalized, the evaluation and attestation processes are new and untested. Therefore, we can give no assurances that our systems will satisfy the new requirements of the Securities and Exchange Commission or that we will receive a favorable review and attestation by our independent auditors.

 

In the past, periods of rapid growth and expansion has strained our management and other resources. The expansion of our manufacturing capacity and the shift of manufacturing operations to China placed and continue to place a significant strain on our operations and management resources. We recently upgraded our inventory control systems and may implement additional systems relating to consolidation of our financial results. If we fail to manage these changes effectively, our operations may be disrupted.

 

To manage our business effectively, we may need to implement additional and improved management information systems, further develop our operating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.

 

If we fail to manage periodic contractions, we may utilize our cash balances and our existing cash and cash equivalent balances could decline.

 

We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. However, our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production, and other factors related to the uncertainties of the industry and global economies. If we fail to manage our contractions successfully we may draw down our cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity funding in the future, at a time when we may be required to raise additional cash. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital, or, if so required, that such capital will be available on terms acceptable to us, if at all. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.

 

We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. Our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production efforts, and other factors related to the

 

31



 

uncertainties of the industry and global economies. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital sooner, or, if so required, that such capital will be available on terms acceptable to us if at all.

 

We have made and may continue to make strategic investments in raw materials suppliers, which may not be successful and may result in the loss of all or part of our investment.

 

Through fiscal 2003, we have recorded minority investments in raw material suppliers in China, that provide us with opportunities to gain supply of key raw materials that are important to our substrate business, and other products at lower cost than other suppliers. These affiliates each have a market beyond that provided by us. As of June 30, 2004, we had no obligations to make further investments in any of these companies, although we may choose to do so under certain conditions. We do not have influence over all of these companies, each of which is located in China, and in some we have made only a strategic, minority investment. We may not be successful in achieving the financial, technological or commercial advantage upon which any given investment is premised, and we could end up losing all or part of our investment.

 

Any future acquisitions may disrupt our business, dilute stockholder value or distract management attention.

 

As part of our strategy, we may consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Acquisitions entail numerous risks, including:

 

      we may have difficulty assimilating the operations, products and personnel of the acquired businesses;

 

      our ongoing business may be disrupted;

 

      we may incur unanticipated costs;

 

      our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;

 

      we may be unable to maintain uniform standards, controls, procedures, and policies; and

 

      our relationships with employees and customers may be impaired as a result of any integration.

 

For example, we incurred substantial costs in connection with our acquisition of Lyte Optronics in May 1999, including the assumption of approximately $10.0 million of debt, which was subsequently repaid, resulting in a decline of cash available. We also incurred consistent operating losses for the business following the acquisition, and have discontinued all operations and sold the related assets acquired in our acquisition of Lyte Optronics during 2003.

 

To the extent that we issue shares of our stock or other rights to purchase stock in connection with any future acquisitions, dilution to our existing stockholders will result and our earnings per share may suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business.

 

If any of our facilities is damaged by actions such as fire, explosion, or natural disaster, we may not be able to manufacture our products.

 

The ongoing operation of our manufacturing and production facilities in California and China is critical to our ability to meet demand for our products. If we are not able to use all or a significant portion of our facilities for prolonged periods for any reason, we will not be able to manufacture products for our customers. For example, a natural disaster, fire or explosion caused by our use of combustible chemicals and high temperatures during our manufacturing processes would render some or all of our facilities inoperable for an indefinite period of time. Actions outside of our control, such as earthquakes, could also damage our facilities, rendering them inoperable. Some of our manufacturing and research and development is currently performed at our Fremont, California facilities, which are located near an active seismic fault line. If we are unable to operate our facilities and manufacture our products, we will lose customers and revenue and our business will be harmed.

 

32



 

Changes in China’s political, social and economic environment may affect our financial performance.

 

Our financial performance may be affected by changes in China’s political, social and economic environment. The role of the Chinese central and local governments in the Chinese economy is significant. Chinese policies toward economic liberalization, and laws and policies affecting technology companies, foreign investment, currency exchange rates and other matters could change, resulting in greater restrictions on our ability to do business and operate our manufacturing facilities in China. Any imposition of surcharges or any increase in Chinese tax rates could hurt our operating results. The Chinese government could revoke, terminate or suspend our license for national security and similar reasons without compensation to us. If the government of China were to take any of these actions, we would be prevented from conducting all or part of our business. Any failure on our part to comply with governmental regulations could result in the loss of our ability to manufacture our products in China.

 

China has from time to time experienced instances of civil unrest and hostilities. Confrontations have occurred between the military and civilians. Events of this nature could influence the Chinese economy, result in nationalization of foreign-owned operations such as ours, and could negatively affect our ability to operate our facilities in China.

 

The effect of terrorist threats and actions on the general economy could decrease our revenues.

 

The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to our suppliers, customers and markets for our products and the U.S. economy are uncertain. There may be embargos of ports or products, or destruction of shipments or our facilities, or attacks that affect our personnel. There may be other potential adverse effects on our operating results due to a significant event that we cannot foresee. Since we perform substantially all of our manufacturing operations in China, and a significant portion of our customers are located outside of the Untied States, terrorist activity or threats against US-owned enterprise are a particular concern to us.

 

Our stock price has been and may continue to be volatile.

 

Our stock price has fluctuated significantly since we began trading on the NASDAQ National Market. For the twelve months ended June 30, 2004, the high and low closing sales prices of our common stock were $4.58 and $1.20, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

 

      actual or anticipated fluctuations in our quarterly or annual operating results;

 

      changes in expectations about our future financial performance or changes in financial estimates of securities analysts;

 

      announcements of technological innovations by us or our competitors;

 

      new product introduction by us or our competitors;

 

      large customer orders or order cancellations; and

 

      the operating and stock price performance of comparable companies.

 

In addition, the stock market in general has experienced extreme volatility that often has been unrelated to the operating performance of particular companies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance.

 

We have adopted certain anti-takeover measures that may make it more difficult for a third party to acquire us.

 

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock.

 

On April 24, 2001, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover

 

33



 

tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.

 

In addition, provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a merger, acquisition or change of control of us, or changes in our management, including:

 

      the division of our board of directors into three separate classes, each with three year terms;

 

      the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;

 

      the ability of our board to alter our bylaws;

 

      the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and

 

      the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.

 

Furthermore, because we are incorporated in Delaware, we are subject to the provisions of Section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless:

 

      66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or

 

      the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.

 

Legislative actions, higher insurance costs and potential new accounting pronouncements are likely to cause our general and administrative expenses to increase and impact our future financial position and results of operations.

 

In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by NASDAQ, and proposed accounting changes by the Securities and Exchange Commission, we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year, and our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, increased during 2003. Proposed changes in the accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.

 

ITEM 3 . QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

 

Foreign Currency Risk

 

We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of June 30, 2004, we had no outstanding commitments with respect to foreign exchange contracts.

 

34



 

Interest Rate Risk

 

Cash and cash equivalents earning interest and certain variable rate debt instruments are subject to interest rate fluctuations. The following table sets forth the probable impact of a 10% change in interest rates (in thousands):

 

Instrument

 

Balance
June 30,
2004

 

Current
Interest
Rate

 

Current
Interest
Income/
(Expense)

 

Proforma
10% Interest
Rate Decline
Income/(Expense)

 

Proforma
10% Interest
Rate Increase
Income/(Expense)

 

Cash and cash equivalents

 

$

14,783

 

1.00

%

$

148

 

$

133

 

$

163

 

Bonds

 

8,300

 

1.42

%

(118

)

(106

)

(130

)

 

 

 

 

 

 

$

30

 

$

27

 

$

33

 

 

Equity Risk

 

We also maintain minority investments in private and publicly traded companies. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions. In 2003, we recorded $2.0 million in charges to other expense to write down our investment in two private US companies. As of June 30, 2004, the minority investments we continue to hold amounted to $2.0 million.

 

ITEM 4 . CONTROLS AND PROCEDURES

 

(a) Under the supervision and with the participation of our management, our Interim Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Interim Chief Executive Officer and our Chief Financial Officer concluded that the our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report, except as described below relating to certain product testing procedures, as of the end of the period covered by this quarterly report.

 

In March 2004, as part of the Company’s implementation of our Code of Business Conduct and Ethics, we learned of certain failures to comply with requirements for product testing and the provision of testing data and information relating to requirements of certain customers. The Audit Committee of the Company’s Board of Directors conducted an investigation into our product testing practices and procedures, with the assistance of outside counsel.

 

The investigation confirmed that certain requirements for product testing and the provision of testing data and information relating to certain customer requirements were not being complied with. We implemented measures to ensure greater operational controls and compliance with customer requirements. As a result of the investigation, the Audit Committee concluded that certain executive management changes should be implemented. Donald L. Tatzin, formerly Chief Financial Officer, has been appointed Interim Chief Executive Officer, Wilson W. Cheung, our Vice President, Corporate Controller, has been promoted to Chief Financial Officer. Morris Young, Ph.D., formerly our Chairman, President and Chief Executive Officer, will be responsible for improving and expanding the Company’s China operation. He will also remain a director. The Board of Directors has also determined to separate the role of Chairman and Chief Executive Officer, and accordingly, Jesse Chen, a current AXT board member, has become Chairman of the Board. In addition, the Audit Committee concluded that additional review of the organization and performance of operations, quality control and product testing would be conducted, resulting in possible additional changes in management and non-management functions. The Audit Committee also instructed management to implement additional training programs for employees involved in production, testing and quality assurance. The Audit Committee believes that these measures will address the issues raised above and provide the necessary operational oversight and assurance that the Company is complying with the requirements for product testing and the provision of testing data and other customer information.

 

(b) No significant changes in internal controls over financial reporting were made during the quarter ended June 30, 2004, although as described above, we implemented executive management changes, including a change in our Chief Executive Officer and Chief Financial Officer roles, during the quarter, and are implementing operational changes and measures to improve our operational controls over product testing, provision of testing and other customer data and quality assurance.

 

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PART II OTHER INFORMATION

 

Item 1. Legal Proceedings

 

From time to time the Company is involved in judicial or administrative proceedings concerning matters arising in the ordinary course of business. The Company does not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on its business, financial condition, cash flows or results of operation.

 

On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the Tokyo District Court, Civil Division against the Company and its Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from AXT in the amount of $1.67 million plus interest and court costs and the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXT intends to defend itself vigorously in these lawsuits and continues to sell its products in Japan. Both parties have completed submitting arguments and evidence in litigation in Japan. We retain all of our options which include appealing any court decision and launching an effort to have Sumitomo’s patent invalidated in Japan.

 

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California against the Company alleging patent infringement. The complaint sought damages and injunction against infringement. On July 23, 2003, the Company filed a counter complaint in the United States Court for Northern District of California, denying any patent infringement and alleging that Cree’s actions were intentionally designed to interfere with the Company’s prospective business relationships. The Company reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolution of the disputes did not have a material adverse impact on the Company’s consolidated financial position or results of operations. All parties signed a final release regarding all disputes between them on April 15, 2004.

 

Item 2. Changes in Securities and Use of Proceeds

 

None

 

Item 3. Defaults upon Senior Securities

 

None

 

Item 4. Submission of Matters to a Vote of Security Holders

 

AXT held its annual meeting of stockholders at its headquarters in Fremont, California on May 18, 2004.  Of the 23,042,982 shares outstanding as of the record date, 20,907,474 shares were represented by proxy at the meeting.  Proxies were solicited by the Company pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.  At the meeting, AXT’s stockholders voted on the following matters:

 

(1)    Proposal to elect one class III director to hold office for a three-year term, and until his successor is elected and qualified.

 

 

 

For

 

Against

 

Leonard J. LeBlanc

 

20,732,335

 

175,139

 

 

(2)    Proposal to ratify the selection of PricewaterhouseCoopers LLP as our independent auditors for the year ending December 31, 2004.

 

 

 

For

 

Against

 

Abstain

 

PricewaterhouseCoopers LLP

 

20,825,550

 

77,174

 

4,750

 

 

Item 5. Other Information

 

None

 

36



 

Item 6. Exhibits and Reports on Form 8-K

 

a. Exhibits

 

Exhibit
Number

 

Description

3.1(1)

 

Restated Certificate of Incorporation

 

 

 

3.2(2)

 

Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference

 

 

 

3.3(3)

 

Second Amended and Restated Bylaws

 

 

 

3.4

 

Certificate of Amendment to the Restated Certificate of Incorporation

 

 

 

31.1

 

Certification by Interim Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification by Interim Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


(1)   Incorporated by reference to the exhibit of the same number filed with the SEC with our Annual Report on Form 10-K for the year ended December 31, 1998.

 

(2)   Incorporated by reference to Exhibit 2.1 to registrant’s Form 8-K filed with the SEC on June 14, 1999.

 

(3)   Incorporated by reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30, 2001.

 

b. Reports on Form 8-K

 

We filed or furnished the following reports on Form 8-K during the quarter ended June 30, 2004:

 

On May 24, 2004 we furnished a report on Form 8-K announcing our earnings for the quarter ended March 31, 2004.

 

On May 24, 2004, we filed a report on Form 8-K announcing our executive management changes.

 

On June 24, 2004, we filed a report on Form 8-K announcing our change in certifying accountant s and a workforce reduction at our Fremont manufacturing facility.

 

37



 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

AXT, INC.

 

 

Dated: August 5, 2004

By:

/s/ Donald L. Tatzin

 

 

Donald L. Tatzin

 

 

Interim Chief Executive Officer

 

 

(Principal Executive Officer)

 

 

 

 

 

/s/ Wilson W. Cheung

 

 

Wilson W. Cheung

 

 

Chief Financial Officer

 

 

(Principal Financial and Accounting Officer)

 

38



 

EXHIBIT INDEX

 

Exhibit
Number

 

Description

3.1(1)

 

Restated Certificate of Incorporation

 

 

 

3.2(2)

 

Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference

 

 

 

3.3(3)

 

Second Amended and Restated Bylaws

 

 

 

3.4

 

Certificate of Amendment to the Restated Certificate of Incorporation

 

 

 

31.1

 

Certification by Interim Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification by Interim Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


(1)   Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998.

 

(2)   Incorporated by reference to Exhibit 2.1 to registrant’s Form 8-K filed with the SEC on June 14, 1999.

 

(3)   Incorporated by reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30, 2001.

 

39


EXHIBIT 3.4

 

CERTIFICATE OF AMENDMENT
TO THE
RESTATED CERTIFICATE OF INCORPORATION
OF
AXT, INC.

 

Morris S. Young and Donald L. Tatzin certify that:

 

1.              They are the duly elected and acting President and Secretary, respectively, of AXT, Inc. (the “Corporation”), a corporation duly organized and existing under the General Corporation Law of the State of Delaware, in accordance with the provisions of Sections 228 and 242 thereof, DO HEREBY CERTIFY:

 

2.              That the amendment to the Corporation’s Restated Certificate of Incorporation set forth in the following resolution has been approved in accordance with the provisions of Sections 228 and 242 of the General Corporation Law of the State of Delaware.

 

“RESOLVED, that the first Paragraph of the FOURTH Article of the Corporation’s Restated Certificate of Incorporation is hereby amended to read in its entirety as follows:

 

FOURTH:

 

STOCK

 

The Corporation is authorized to issue two classes of stock to be designated, respectively, “Preferred Stock” and “Common Stock.”  The total number of shares of Preferred Stock the Corporation shall have authority to issue is 2,000,000, $.001 par value per share, and the total number of shares of Common Stock the Corporation shall have authority to issue is 70,000,000, $.001 par value per share.  The shares of Preferred Stock shall initially be undesignated as to series.”

 

IN WITNESS WHEREOF, this Certificate of Amendment to the Restated Certificate of Incorporation has been executed on behalf of the Corporation by its President and attested by Donald L. Tatzin, its Secretary, this 24th day of May, 2001.

 

 

 

AXT, INC.

 

 

 

 

 

By:

 

/s/ Morris S. Young

 

 

 

Morris S. Young, President

 

 

ATTEST:

 

 

By:

 

/s/ Donald L. Tatzin

 

 

Donald L. Tatzin, Secretary

 


EXHIBIT 31.1

 

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

I, Donald L. Tatzin, certify that:

 

1.      I have reviewed this report on Form 10-Q of AXT, Inc.;

 

2.      Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.      Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.      The registrant’s other certifying officer and I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

 

(a)    Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this report is being prepared;

 

(b)    Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

(c)    Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.      I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

 

(a)    All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

(b)    Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Dated: August 5, 2004

By:

/s/ Donald L. Tatzin

 

 

Donald L. Tatzin

 

 

Interim Chief Executive Officer

 


EXHIBIT 31.2

 

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

I, Wilson W. Cheung, certify that:

 

1.      I have reviewed this report on Form 10-Q of AXT, Inc.;

 

2.      Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.      Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.      The registrant’s other certifying officer and I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

 

(a)    Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this report is being prepared;

 

(b)    Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

(c)    Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.      I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

 

(a)    All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

(b)    Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Dated: August 5, 2004

By:

/s/ Wilson W. Cheung

 

 

Wilson W. Cheung

 

 

Chief Financial Officer

 


EXHIBIT 32.1

 

Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

In connection with the Quarterly Report of AXT, Inc. (the “Company”) on Form 10-Q for the quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Donald L. Tatzin, Interim Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (“Section 906”), that, to the best of my knowledge:

 

(1)    The Report fully complies with the requirements of section 13(a) of the Securities and Exchange Act of 1934 (15 U.S.C. 78m); and

 

(2)    The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

 

Dated: August 5, 2004

By:

/s/ Donald L. Tatzin

 

 

Donald L. Tatzin

 

 

Interim Chief Executive Officer

 


EXHIBIT 32.2

 

Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

In connection with the Quarterly Report of AXT, Inc. (the “Company”) on Form 10-Q for the quarter ended June 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Wilson W. Cheung, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (“Section 906”), that, to the best of my knowledge:

 

(1)    The Report fully complies with the requirements of section 13(a) of the Securities and Exchange Act of 1934 (15 U.S.C. 78m); and

 

(2)    The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

 

Dated: August 5, 2004

By:

/s/ Wilson W. Cheung

 

 

Wilson W. Cheung

 

 

Chief Financial Officer