TABLE OF CONTENTS

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PART I

     ThisSome of the information set forth in this annual report includes forward-lookingare “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, including statements as to industry trends, our future expectations and other matters that reflectdo not relate strictly to historical facts, are based on certain assumptions made by management. These statements are often identified by the use of words such as “may,” “will,” “expect,” “plans,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue” and similar expressions or variations, and are based on the beliefs and assumptions of our current views with respectmanagement based on information then currently available to future events and our potential financial performance. Thesemanagement. Such forward-looking statements are subject to certain risks, uncertainties and uncertainties, including those discussed in “Business”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and elsewhere in this report,other factors that could cause actual results to differ materially from historicalfuture results expressed or those anticipated. In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future” and similar expressions identifyimplied by such forward-looking statements. Forward-looking statements also includeImportant factors that could cause actual results to differ materially from the assumptions that underlie such statements, Readers are cautioned not to place undue reliance on these forward-looking statements whichinclude, among others, the risks discussed below under “Risks Related to Our Business.” These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, may be significant, presently or in the future, and may affect us to a greater extent than indicated. Such forward-looking statements speak only as of the date on which such statements are made; except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of this report.such statements.

     We design, develop, manufacture and distribute high-performance compound semiconductor substrates as well as opto-electronic semiconductor devices, such as high-brightness light emitting diodes, or HBLEDs,comprising gallium arsenide (GaAs), indium phosphide (InP) and laser diodes including vertical cavity surface emitting lasers, or VCSELs, and Fabry-Perot laser diodes.germanium (Ge). Our substrate products are used primarily in wireless communications, lighting display applications, and fiber optic communications. We believe our proprietary vertical gradient freeze, or VGF, technique for manufacturing compound semiconductor substrates provides significant benefits over other methods and has enabled us to become a leading manufacturer of compound semiconductor substrates. We pioneered the commercial use of VGF technology to manufacture gallium arsenide, or GaAs substrates and subsequently used VGF technology to manufacture substrates from other materials, including indium phosphide, or InP, and germanium, or Ge. Some of our competitors followed our lead by developing their own versions of VGF technology. Customers for our substrates include Skyworks Solutions,United Epitaxy Company, Motorola, Agilent Technologies, Samsung, EMCORE, Kopin, IQE, Nortel Networks, and Sumitomo Chemical. Our acquisition of Lyte Optronics in 1999 provided us with expertise in epitaxial processes for manufacturing opto-electronic semiconductor devices. We use these capabilities to make blue, green and cyan HBLEDs and laser diodes. Our opto-electronic semiconductor devices are used in a wide range of applications, such as solid-state lighting and fiber optic communications.Sumika. Over the past four years, we have implemented an initiative, which is now largely complete, to reduce the cost of manufacturing our substrates by moving most of our operations to China and by investing in sources of low cost raw materials. We also expanded our HBLED manufacturing capacity in response

     On June 24, 2003, the Company’s Board of Directors approved management’s plan to an increase in customer demand.exit the Company’s unprofitable opto-electronics business. The disposition was a result of continuing operating losses and negative cash flows from the division and significant uncertainty regarding future profitability.

     We were incorporated in California in December 1986 and reincorporated in Delaware in May 1988. We changed our name from American Xtal Technology, Inc. to AXT, Inc. in July 2000. Our principal offices are located at 4281 Technology Drive, Fremont, California 94538, and our telephone number at this address is (510) 683-5900. Our web site iswww.axt.com; www.axt.com; however, the information on our web site does not constitute a part of this annual report on Form 10-K and is not incorporated herein. We make available, free of charge, on or through our web site, our annual, quarterly and current reports, and any amendments to those.those reports.

Industry Background

     Historically, most semiconductor devicessemiconductors were created on a single crystal base material, or substrate, of silicon. Today, however, many electronic and opto-electronics devicessemiconductors are being developed with requirements that exceed the capabilities of silicon. These devicessemiconductors address the continually increasing demand to send, receive and display information on high-speed wireless and wireline networks. This demand createdcreates a growing need for power-efficient high-performance systemssemiconductors that can operate at high frequencies and can be produced cost-effectively in large volumes. These systemssemiconductors enable the growth and development of a wide range of end-userend user applications. For example, Dataquest,Gartner, Inc., an independent research firm, expects

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     Other examples of applications for these systems include:

	•	voice and high-speed wireless data systems;
	•	infrared emitters and optical detectors in computer systems;
	•	fiber optic networks and optical systems within these networks;

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	•	selected wi-fi networks
	•	solid-state lighting, including exterior and interior automobile lighting; and
	•	satellite communications systems.

     As a result of the limitations of silicon-based technologies, semiconductor device manufacturers use compound semiconductor substrates to improve the performance of semiconductor devices and to enable these new applications. This use occurs even though these compound semiconductor substrates are more expensive than silicon. Compound semiconductor substrates are composed of multiple elements that include a metal, such as gallium, aluminum or indium, and a non-metal, such as arsenic, phosphorus or nitrogen. The resulting compounds include gallium arsenide, indium phosphide and gallium nitride. Advantages of devices manufactured on compound substrates over devices manufactured using silicon substrates include:

	•	operation at higher speeds;
	•	lower power consumption;
	•	less noise and distortion; and
	•	opto-electronic properties that enable devices to emit and detect light.

     A key step in producing a compound semiconductor substrate is to grow a crystal of the materials. Historically, two processes were used to grow crystals: the Liquid Encapsulated Czochralski, or LEC, technique and the Horizontal-Bridgeman, or HB, technique. We believe two trends reduced the appeal of these techniques: more semiconductor devices are being formed using an epitaxial process and semiconductor device manufacturers are switching their production lines to larger diameter substrates, including six-inch diameter substrates.diameters for electronic device applications and three- and four-inch for opto-electronic device applications. The LEC and HB techniques each have difficulties producing high quality, low-cost compound semiconductor substrates for epitaxial processing and substratesprocessing. Substrates produced using thisthe LEC technique have a high volume of defects as size increases beyond four-inches in diameter. The HB technique has been unable to reliably produce substrates more than three-inches in diameter.

     We introduced our VGF technique in 1986 to respond to the limitations inherent in the LEC and HB techniques, and, in recent years, some of our competitors who previously relied on the LEC or HB methods have also developed their own versions of VGF. We believe that a majority of the substrates sold commercially in 2003 for electronic device applications were manufactured using the VGF or similar techniques.

     Compound semiconductor substrates enable the development of a wide range of electronic products including power amplifiers and radio frequency integrated circuits used in wireless handsets. Compound substrates can also be used to create opto-electronic products including high brightness light emitting diodes, or HBLEDs, and vertical cavity surface emitting lasers, or VCSELs, used in solid-state lighting and fiber optic communications.communications, respectively.

     HBLEDs are solid-state compound semiconductor devices that emit light. The global demand for HBLEDs is experiencing rapid growth because HBLEDs have a long useful life, consume approximately 10% of the power consumed by incandescent or halogen lighting and improve display visibility. Applications where HBLEDs are increasingly used include wireless handset displays, automotive displays, full color video and sign displays, traffic lights and various consumer applications. According to Strategies Unlimited, an independent industry analyst, the market for HBLEDs is expected to grow from $1.8 billion in 2002 to approximately $3.9 billion by 2006.2

The AXT Advantage

     We are a leading developer and supplier of high-performance compound semiconductor substrates and opto-electronic semiconductor devices, including HBLEDs.substrates. There are fourthree key causes of our success:

     Our VGF technology is a competitive advantage.We pioneered the commercial use of VGF technology to manufacture GaAs substrates and we believe that through the use of VGF we have becomebecame a leading worldwide supplier of GaAs substrates, particularly for six-inch diameter substrates. Our VGF process produces substrates with high mechanical strength and physical and chemical uniformity, as well as a low crystal defect rate.densities. The following changes in our customers’ technologies are increasing the share of substrates sold with these features:

	•	Greater use of epitaxy rather than ion implantation.Many of the newest generation of high-performance semiconductor devices for fiber optic and wireless communications applications, including heterojunction bipolar transistors, or HBTs, and pseudomorphic high electron mobility transistors, or

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		PHEMTs, are popular because they offer lower power consumption and better device linearity than their predecessors. These devices are created using epitaxial processed substrates. Our VGF substrates are more suitable for these applications than are our competitors’ products manufactured using LEC and HB technologies, and competing materials such as silicon germanium, or SiGe.
	•	Switch to six-inch diameter wafers.Many of our semiconductor device manufacturing customersmanufacturers switched their GaAs production lines to six-inch diameter substrates in order to reduce unit costs and increase capacity. We were among the first competitors able to deliver large volumes of six-inch diameter VGF substrates and retain a significant amount of manufacturing capacity for this product.
	•	Introduction of InP substrates.Even GaAs cannot meet the requirements for system performance and network bandwidth of some potential applications, including SONET OC-768 applications that will operate at speeds up to 40 gigabits per second. While the date of introduction of these applications is uncertain, they are likely to use Indium Phosphide (InP) substrates. We successfully used our VGF technique to develop InP and we were among the first to offer four- and six-inch diameter InP substrates.

     In addition, VGF technology gives us further benefits.

	•	Customer technology independence.Our semiconductor device manufacturing customers often compete among themselves. For example, several of our customers compete for technological leadership in the wireless handset market. These customers or end-users all manufacture their devices on GaAs substrates. We are, therefore, largely immune from the effects of such competition and benefit from an overall need for faster, more power efficient electronic and opto-electronic devices.

     Some customers specify VGF substrates.Our wafers are qualified with many of the key suppliers of GaAs and InP semiconductor devices. The qualification process, which is lengthy and must be repeated for each customer, can be a barrier to entry for a new material or supplier. Furthermore, certain of our customers now effectively specify that they will only accept VGF-grown or equivalent substrates for their manufacturing processes. As the businesses of theseThe lengthy qualification period benefits us when we are already qualified with a customer, but acts as a barrier to entry for those customers grow,with which we and those competitors that developed a technology similar to VGF, are well positioned to capture their business.not qualified.

     Our low-cost manufacturing is an advantage.In 1998, we began moving portions of our substrate manufacturing operations to China, to benefit from a combination of lower costs for facilities, labor and materials than we encounter in the United States. That move continued and atas of the end of 20022003, most of our substrate manufacturing activities occur in China. We have also made some strategic investments in raw materials producers, including one that produces gallium, that assureprovide us ofwith a secured and low cost source of theseimportant materials and enables us to market surplus production to others. By the end of 2003, we anticipate that almost all of our substrate production will be located in China. We believe this provides us with a cost advantage vis-à-vis our competitors.competitors, which do not enjoy similar arrangements.

We entered the opto-electronic semiconductor device market quickly through our acquisition of Lyte Optronics.Our acquisition of Lyte Optronics provided us with expertise in epitaxial processes for manufacturing high-volumes of opto-electronic semiconductor devices. High-quality epitaxy is a key requirement for most of today’s advanced opto-electronic semiconductor devices, such as HBLEDs and VCSELs. Since acquiring Lyte Optronics, we developed opto-electronic products that are among the more difficult to create using epitaxy, including blue and green HBLEDs and VCSELs. We have received three United States patents and filed eight additional patent applications for our approach to fabricating HBLEDs.

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The AXT Strategy

     Our goals are to strengthen our position as a leading developer and supplier of selected high-performance compound semiconductor substrates and to develop a leading position in the market for opto-electronic semiconductor devices. Key elements of our strategy include:

Decrease our substrate manufacturing cost structure.We will continue to shift our substrate manufacturing operations to China and invest in joint ventures to obtain key raw material supplies in order to lower unit production costs.

Advance VGF technology leadership.As some of our competitors have introduced production technologies similar to VGF, customers seeking VGF material have had more choice and some have allocated their orders among multiple suppliers. Given the current industry oversupply, customers are rejecting previously approved products if they can obtain higher yields from another supplier. We commit much of our research and development effort to improve the surface characteristics of our substrates and our recently produced substrates do increase customers’ yields compared with our previous products.

Strengthen our leadership position in the InP market.We believe that there will be growth in demand for the next generation of high-speed fiber optic devices, such as devices used in SONET OC-768 applications. These products are manufactured on InP substrates and we are positioning ourselves to be the leading supplier of InP substrates.

Enhance our opto-electronic semiconductor devices.We intend to further penetrate the HBLED market through continued investment in research and development and selected expansion of production capacity. We expanded our manufacturing capacity by adding metal-organic chemical vapor deposition, or MOCVD, reactors and are modifying our epitaxial process to improve device performance and yield. We invested in the research and infrastructure required to grow our own sapphire substrates, which are used in producing blue, green and cyan HBLEDs.

Technology

     Our core technologies include our proprietary VGF technique used to produce high quality crystals that are processed into compound substrates, and our epitaxy technologies that enablegallium extraction technology which allows us to manufacture blue, green and cyan HBLEDs, VCSELs and edge-emitting laser diodes.extract raw gallium from aluminum ore.

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     Our VGF technique is designed to control the crystal-growth process with minimal temperature variation and is the technique we use to produce our GaAs, InP and Ge substrates. Unlike traditional techniques, our VGF technique places the hot compound melt above the cool crystal, thereby reducing the turbulence at the interface of the melt and the solid crystal, compared with the LEC technique in which the melt and crystal are inverted. The temperature gradient between the melt and the crystal in the VGF technique is significantly lower than in traditional techniques. These aspects of the VGF technique enable us to grow crystals that have a relatively low defect density and high uniformity. The crystal and the resulting substrate are mechanically strong, resulting in lower breakage rates during a customer’s manufacturing process. Since the temperature gradient is controlled electronically rather than by physical movement, the sensitive crystal is not disturbed as it may be during some competitors’ VGF-like growth processes. In addition, the melt and growing crystal are contained in a closed chamber, which isolates the crystal from the outside environment to reduce potential contamination. This substrate isolation allows for more precise control of the gallium-to-arsenic ratio, resulting in better consistency and uniformity of the crystals.

     Our VGF technique offers several benefits when compared to traditional crystal growing technologies. The Liquid Encapsulated Czochralski, or LEC, technique is the traditional method for producing semi-insulating GaAs substrates for electronic applications. During the LEC process, the crystal is grown by dipping a seed crystal through molten boric oxide into a melt and slowly pulling the seed up into the cool zone above the boric oxide where the crystal hardens. Unlike the VGF technique, the LEC technique is designed so that the hotter GaAs melt is located beneath the cooler crystal, resulting in greater turbulence in the melt, and at a temperature gradient that is significantly higher than the VGF technique. The turbulence and high temperature cause LEC-grown crystals to have a higher dislocation density than VGF-grown crystals, resulting in a higher rate of breakage during the device manufacturing process. As an open process, the LEC technique also results in greater propensity for contamination and difficulty controlling the ratio of gallium to

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     Our VGF technique also offers advantages over the Horizontal-Bridgeman, or HB, technique, for producing semi-conducting GaAs substrates for opto-electronic applications. The HB technique holds the GaAs melt in a semi-cylindrical container, causing crystals grown using the HB method to have a semi-circular, or D-shaped, cross-section. Accordingly, more crystal material is discarded when the D-shaped substrate is subsequently trimmed to a round shape. In addition, crystals grown using the HB technique have a higher defect density than VGF-grown crystals. The HB technique cannot be used cost-effectively to produce substrates greater than three inches in diameter. The HB technique houses the GaAs melt in a quartz container during the growth process, which can contaminate the GaAs melt with silicon impurities, making it unsuitable for producing semi-insulating GaAs substrates.

     The following table provides a comparison of these three techniques: LEC remains about 40% of the semi-insulating market and HB is still present in the semi-conducting market.

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     Many major substrate purchasers have adjusted their product specifications to effectively allow only VGF or equivalent material. Some have simultaneously tightened their specifications for surface characteristics that causes them to reject material they had previously approved. We are improving our surface characteristics so that we fully comply with customer requirements.

     We create our opto-electronic semiconductor devices using MOCVD, which is an epitaxial technique to synthesize compound semiconductor thin films onto substrates. MOCVD reactors are available from multiple sources and wafers fabricated using MOCVD generally possess a better combination of uniformity and optical and electronic properties and are easier to produce cost-effectively in high volumes than wafers manufactured by other methods, such as molecular beam epitaxy, vapor phase epitaxy or liquid phase epitaxy. As a result, MOCVD reactors have become the choice of the opto-electronics industry for fabricating devices such as LEDs, VCSELs and laser diodes. We modify our MOCVD reactors to improve their performance and use a proprietary growth recipe that controls temperature, material impurity, defect density, material thickness and layer composition while allowing for multiple wafer batch replication.

Products

     We design, develop, manufacture and distribute high-performance semiconductor substrates, as well as opto-electronic devices, such as HBLEDs, VCSELs and laser diodes.substrates. The table below sets forth our products and selected applications:

     Substrates.We currently sell compound substrates manufactured from GaAs and InP, as well as single-element substrates manufactured from Ge. We supply GaAs substrates in two-, three-, four-, five- and six-

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     Opto-electronics.Materials.We sell blue, green and cyan HBLED products in wafer and chip form.99.99% pure gallium. We began selling blue HBLED products in the first quarter of 2000 andGa in 2001, began shipping green and cyan HBLEDs.primarily through our majority owned subsidiary, Beijing Ji Ya Semiconductor Material Company, Ltd. We introduced our first VSCEL product in August 2000 and introduced a rangesell primarily to re-processors who improve the purity of Fabry-Parot laser products beginning in 2001 and early 2002.the gallium. In 2003 sales of gallium were approximately $3.3 million.

Customers

     We sell our compound semiconductor substrates worldwide to leading semiconductor device manufacturers.and materials worldwide. Our substrate customers include:

     We sell our HBLED products primarily to customers that incorporate them into lighting products. Our HBLED customers include Agilent, Metairie, Harvatek, Liteon, Kindwin, and Seoul Semiconductor.

     Historically, we have sold a significant portion of our products in any particular period to a limited number of customers. Our five largest customers accountedNo customer represented greater than 10% of product revenues for 35.6% of our total revenue from continuing operations in 2002, 28.3 % in 2001, and 26.1% in 2000. One customer accounted for 10.7% of our revenue inthe years ended December 31, 2003, 2002 and no customer accounted2001. The company’s top five customers represented 28.9% of product revenue for more than 10% percentthe year ended December 31, 2003, 31.4% of our totalproduct revenue in 2001 or 2000.for the year ended December 31, 2002, and 31.1% of product revenue for the year ended December 31, 2001. We expect that sales to certain customers will continue to comprise a significant portion of our revenue in the future.

Manufacturing, Raw Materials and Supplies

     We believe that our success isresults are partially due to our manufacturing efficiency and high product yields and we continually emphasize quality and process control throughout our manufacturing operations. We perform our substrate manufacturing operations at our facilities in Beijing, China and Fremont, California. As part of our plan to reduce substrate manufacturing costs, we shifted mostthe vast majority of our manufacturing processes to our facilities in China, where costs are generally lower. We intend to transfer the vast majority, if not all, of our substrate manufacturing operations to Chinalower, by the end of 2003. We currently perform research and development and limited manufacturing in our Fremont, California facilities. We believe that our capital investment and subsequent operating costs are lower for our manufacturing facilities in China relative to the U.S. Many of our manufacturing operations are fully automated and computer monitored or controlled, enhancing reliability and yield. We use proprietary equipment in our substrate manufacturing operations to protect our intellectual property and control the timing and pace of capacity additions. Our epitaxial wafer production is located in El Monte, California and our wafer fabrication and die fabrication activities for our opto-electronics products are located in Monterey Park, California, Beijing, China, and Xiamen, China. All of our manufacturing facilities are ISO 9001 or 9002 certified.

     Although we purchase supply parts, components and raw materials from several domestic and international suppliers, we depend on a single or limited number of suppliers for certain critical materials used in the production of our substrates, such as quartz tubing, polishing solutions, and opto-electronics products.paralytic boron nitride. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts. Although we seek to maintain sufficient inventory levels of certain materials to guard against interruptions in supply and to meet our near term needs, and have to date been able to obtain sufficient supplies of materials in a timely manner, there may be shortages of certain key materials, such as gallium. Accordingly, to help ensure continued supply of materials, we formed strategic alliancesjoint ventures with and made investments in some suppliers of key raw materials required to manufacture our products.products, including gallium. We believe that these alliancesjoint ventures and investments will be advantageous in procuring materials to support our growth. In addition, excess capacity is marketed to others, enabling us to expand our markets and discouraging our alliance partners from becoming too dependent upon us.others.

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     We use MOCVD equipment to manufacture our opto-electronics devices. We qualified two new MOCVD reactors during the past twelve months and have one reactor awaiting qualification. The substrate materials and raw wafers used in our opto-electronics products are purchased from our substrate division and other sources.

Sales and Marketing

     Each of our divisions is responsible for its own sales and marketing activities, and each maintains its own sales and marketing personnel. In addition, each of our divisions advertisesWe advertise in trade publications, distributesdistribute promotional materials, publishes technical articles, conductsconduct marketing and sales programs, and participatesparticipate in industry trade shows and conferences in order to raise market awareness of our products.

Substrates.We sell our substrate products through our direct sales force in the U.S. and Japan and through independent sales representatives in France, Japan, South Korea, Taiwan and the United Kingdom. Our direct sales force consists of sales engineers who are knowledgeable in the manufacture and use of compound and single-element substrates. Our sales engineers work with customers during all stages of the substrate manufacturing process, from developing the precise composition of the substrate through manufacturing and processing the substrate to the customer’s exact specifications. We believe that maintaining a close relationship with customers and providing them with ongoing technical support improves customer satisfaction and will provide us with a competitive advantage in selling other substrates to our customers. The substrate division launched a program in late 2000 with selected customers in which we guaranteed that certain volumes of six-inch GaAs and other substrates would be delivered on specific dates and the customer made a prepayment for part of the value of its order. Several major customers participate in this program which we expect will conclude during 2003.program. At December 31, 2002,2003, the unearned pre-payments we retained under this program equaled $2.2$1.0 million.

Opto-electronics.We sell our HBLED products through our direct sales forcedo not expect to continue this program after the pre-payments currently in the U.S. and Taiwan and through independent sales representatives to lamp package manufacturers in Asia. We intend to expand sales of these products in the U.S. and Europe primarily using our direct sales force. We sell our VCSEL and edge emitting laser diodes through our direct sales force and through independent sales representatives.hand are utilized by customers.

     International Sales.International sales are an important part of our business. In the year ended December 31, 2002,2003, sales to customers outside of the United States accounted for 58.2%65.9% of our revenue, as compared with 50.4%43.9% in 20012002 and with 48.2%47.5% in 2000.2001. The primary markets for sales of our products outside of the United States include countries in Asia and Western Europe. Our ability to sustain and increase our international sales involves significant risks, including volatile political, social and economic instabilities abroad, possible fluctuations in currency exchange rates, and changes in tariffs, import restrictions or other trade barriers.

Research and Development

     To maintain and improve our competitive position, we focus our research and development efforts on designing new proprietary processes and products, improving the performance of existing products and reducing manufacturing costs. We have assembled a multi-disciplinary team of highly skilled scientists, engineers and technicians to meet our research and development objectives.

     Our current substrate research and development activities focus on continued development and enhancement of six-inch GaAs, crystals,InP and Ge substrates, including improved yield, enhanced surface characteristics and uniformity, greater substrate strength and increased crystal length. We developed and intend to initiate production of sapphire substrates.

     We are focusing on all three major stages of HBLED development: epitaxy, wafer fabrication and die fabrication. Our goal is to improve brightness and yield, create productsDuring 2003 we experienced surface quality problems with a narrowly banded range of features including,our GaAs substrates for example, wavelength, brightness, and forward voltage, and enhance uniformity of product, both within and across production runs. Specific colors are created by controlling the indium content of the epitaxial layers, which we achieve, in part, from modifications that we make to our MOCVD reactors.

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     Research and development expenses were $4.9$1.3 million in 2003, compared with $2.3 million in 2002, compared with $8.2and $3.9 million in 2001,2001. We believe that our current rate of expenditure can enable us to achieve our research and $8.8 million in 2000.development goals.

Competition

     The semiconductor substrate industry is characterized by rapid technological change and price erosion, as well as intense foreign and domestic competition. We believe we currently have a leading position in the existing markets for compound semiconductor substrates primarily as a result of our expertise in VGF technology. However, we believe we face actual and potential competition from a number of established domestic and international companies.companies who have advantages not available to us.

     We believe that the primary competitive factors in the markets in which our substrate products compete are:

	•	quality;
	•	price;
	•	performance;

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	•	meeting customer specifications; and
	•	customer support and satisfaction; and
	•	customer investment in competing technologies.satisfaction.

     Our ability to compete in target markets also depends on factors such as:

	•	the timing and success of the development and introduction of new products and product features by us and our competitors;
	•	the availability of adequate sources of raw materials; and
	•	protection of our products by effective use of intellectual property laws and general economic conditions.

     Our primary competition in the market for compound semiconductor substrates includes Freiberger, Japan Energy and Sumitomo Electric. In addition, we also face competition from compound semiconductor device manufacturers that produce substrates for their own internal use, including Hitachi, and from companies such as IBM and Motorola that are actively developing alternative compound semiconductor materials.

     Our primary competitors in the market for HBLED products include Arima, Cree, LumiLED, Nichia Chemicals, Toyoda Gosei and United Epitaxy. In general, HBLED manufacturers in Taiwan and China have a competitive pricing advantage due to low overhead and small research and development investments. Cree, Nichia Chemicals, Sony and Toyoda Gosei have significant patent portfolios that other competitors, including us, must either design around or license.

     We primarily compete with EMCORE, Honeywell, Trulight, Picolight, Zarlink, Infineon, Cielo and E2O in the market for VCSEL devices.

Protection of our Intellectual Property

     Our success and the competitive position of our VGF technique depend on our ability to maintain trade secrets and other intellectual property protections. 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. 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 depends as much on the skills of our development personnel as upon the legal protections afforded our existing technologies. To protect our trade secrets, we take certain measures to ensure their secrecy, such as executing non-disclosure agreements with our employees, customers and suppliers. However, reliance on trade secrets is only an

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     To date, we have been issued one4 U.S. patents and have three4 U.S. patent applications pending, which relate to our VGF products and processes. We have three U.S. patents and eight U.S.9 patent applications pending which relate to our HBLED or laser diode technology, and have patent applications pending(in PCT/national stage process) in Europe, Canada, China, Japan and South Korea which are based on one of our U.S. patents that relatesrelate to our VGF and opto-electronic processes. We have no1 issued foreign patents.patent.

Environmental Regulations

     We are subject to federal, state and local environmental laws and regulations. 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. We cooperated with the California Occupational Safety 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. In May 2000, Cal-OSHA levied a fine against us in the amount of $313,655 for alleged health and safety violations. In March 2001, we settled this claim in the amount of $200,415, and have put in place engineering, administrative and personnel protective equipment programs to address these issues. On May 1, 2001, the Santa Clara Center for Occupational Safety and Health (SCCOSH) filed a complaint for injunctive relief and civil penalties against us alleging violations of California Business Professions Code 17200 et seq., and Health and Safety Code section 25249 et seq. as a result of our use of arsenic and inorganic arsenic compounds in our workplace. We reached a settlement with SCCOSH during 2002. See “Legal Proceedings” below.

Employees

     As of December 31, 2002,2003, we had 1,306972 employees, of whom 1,075818 were principally engaged in manufacturing, 197141 in sales and administration, and 3413 in research and development. Of these employees, 317 119

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     Our principal properties as of March 15, 20032004 are as follows:

     We consider each facility to be in good operating condition and adequate for its present use, and believe that each facility has sufficient plant capacity to meet its current and anticipated operating requirements.

     From time to time we are involved in judicial or administrative proceedings concerning matters arising in the ordinary course of our business. We do 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.

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     On May 1, 2001, the Santa Clara Center for Occupational Safety and HealthApril 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint for injunctive relief and civil penaltiesin 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 Superioramount 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.

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California County of Alameda, Hayward Division, Case No. H218237-5.against us alleging patent infringement. The complaint alleged violationssought damages and injunction against infringement. On July 23, 2003, we filed a counter complaint in the United States Court for Northern District of California, Businessdenying any patent infringement and Professions Code section 17200 et seq.,alleging that Cree’s actions were intentionally designed to interfere with our prospective business relationships. We reached an agreement with Cree resolving the disputes between us and violations under Proposition 65 and California Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. On June 24, 2002, we participated in a private mediation, and as a result, reached a settlement of all claims, pursuant to which we agreed to pay the Santa Clara Center for Occupational Safety and Health an amount equal to $175,000. The parties have executedsigned a settlement agreement and the court approved the settlement on December 31, 2002, and dismissalMarch 5, 2004. The resolution of the case is pending.disputes did not have a material adverse impact on the Company’s consolidated financial position or results of operations.

     None

PART II

     Our common stock has been trading publicly on the Nasdaq National Market under the symbol “AXTI” since May 20, 1998, the date we consummated our initial public offering. The following table sets forth, for the periods indicated, the range of quarterly high and low closing sales prices for our common stock on the Nasdaq National Market.

     As of December 31, 2002,2003, there were 89 registered121 holders of record of our common stock. Because many shares of AXT’s common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these registered holders.stockholders.

     We have never paid or declared any cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future. We are restricted in our ability to pay dividends under the terms of our credit facility with our bank. Dividends accrue on our outstanding Series A preferred stock at the rate of $0.20 per annum per share of Series A preferred stock.

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     The following selected consolidated financial data are derived from and should be read in conjunction with and are referenced to, our consolidated financial statements and related notes set forth in Item 8 below, and in our previously filed reports on Form 10-K. See also Item 7.7 “Management’s Discussion and Analysis of Financial Condition

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Income statement data from our substrate division and discontinued consumer products division is included in all periods presented. Income statement data from our opto-electronics division is included from the time of the acquisition of Alpha Photonics by Lyte Optronics on September 29, 1998.     All periods have been restated to reflect the accounting for discontinued operations. As a result, the discontinued opto-electronics and consumer products division hasdivisions have been eliminated from continuing operations in the income statements.

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     The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Form 10-K. In addition to historical information, the discussion in this Form 10-K contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially from those projected. The statements contained in the Report on Form 10-K that are not purely historical are forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-K are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue”“continues” or the negative of these terms or other comparable terminology. Factors that might cause or contribute to such differences include, but are not limited to, those set forth under “Risks Related to Our Business” and elsewhere in this Form 10-K.

Overview

     We were founded in 1986 to commercialize and enhance our proprietary VGFvertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. We currently operate two divisions:Upon the discontinuance of our substrateopto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating segment: our opto-electronicssubstrate division. We made our first substrate sales in 1990 and our substrate division currently sells GaAsgallium arsenide (GaAs) and InPindium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, LEDslight 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.cells but withdrew from this business during 2000 so that we could more profitably use our then constrained capacity. We acquired Lyte Optronics, Inc., on May 28, 1999, and currently operate part of Lyte’s historical business asare now trying to re-qualify our opto-electronics division. The opto-electronics division manufactures HBLEDs, VCSELs and laser diodes forgermanium substrates with the illumination markets, including full-color displays, automobile lighting and traffic signals, as well as fiber optic communications. We previously operated the consumer products division, discontinued in December 2000, which had focused on the design and manufacture of laser-pointing and alignment products for the consumer, commercial and industrial markets.

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few existing satellite solar cell system manufacturers.

     Our total revenue from continuing operations was $63.2$34.7 million for 2003, $44.9 million for 2002 $119.5and $108.8 million for 2001 and $121.5 million for 2000.2001. In 20022003 we incurred a loss from continuing operations of $81.2$9.6 million compared to a loss of $5.0$39.7 million for 20012002 and income of $24.4$20.2 million for 2000.2001.

     Several non-recurring events occurred that had a substantial impact onOn June 24, 2003, we announced the discontinuation of our performance and financial results for the years-ended December 31, 2002, 2001 and 2000. In 2002,opto-electronics division, which we recorded excess inventory impairment chargesestablished as part of $9.7 million that are included in cost of revenue, equipment impairment charges of $38.0 million and goodwill impairment charges of $1.1 million that are included in operating expenses, a write-down in our investment in Finisar Corporation of $10.8 million and a loss on a building held for sale of $3.1 million that are included in other expense. In 2001, we realized a net $15.6 million non-cash loss as a result of writing down our investment in Finisar Corporation common stock. This loss is included in other expense. In 2000, we realized a $27.3 million non-cash gain as a result of acquiring Finisar Corporation common stock in connection with Finisar Corporation’s acquisition of Demeter Technologies, a companyLyte Optronics, Inc. in which we held warrants to purchase preferred stock. This gain is included in other income. On December 14, 2000,May 1999. Accordingly, the Board of Directors approved our plan to discontinue our unprofitable consumer products division. As a result of discontinuing the consumer products division, we incurred a pre-tax loss on disposal of $2.2 million. The results of operations of the consumer productsopto-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 2 to our consolidated financial statements for details regarding the income statements. In 2000accounting 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 exitedcompleted a sale of substantially all of the assets of our unprofitable 650nm laser diode product line atopto-electronics business to Lumei Optoelectronics, Corp. and Dalian Luming Science and Technology Group, Co., Ltd. for the opto-electronics division. AsChinese Renminbi (RMB) equivalent of $9.6 million. Sale 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. If unclaimed, up to $250,000 of the sale proceeds will be held in escrow for a result of exiting this product line,second year and will not be recorded until all claims, if any, are settled. We retain a building located in Monterey Park, CA, that we incurred a restructuring charge of $8.2 million, of which $1.8 million has beenexpect to sell in 2004. This asset is classified as cost of goods sold and $6.4 million has been classified as operating expense.Held for Sale on our consolidated balance sheet at December 31, 2003.

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     Our continuing business, particularlyprimarily sales of our substrate products, areis dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both as a result of economic changes and of overcapacity. FollowingWe experienced a stronggrowth period duringthat lasted from our initiation of sales in 1990 through the first half of 2001. In the second half of 2001, we are nowexperienced a $44.9 million, or 58.5% decrease in revenue compared to the first half as a result of the rapid decline in the midst of a significantmobile and prolonged downturn, and, togetherfiber optic telecommunications markets. Together with other industry participants, havewe 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 to 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 losses in each quarter of 2003. During the year we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

We cannot predict the severitylevel of future industry demand or duration of the downturn,our ability to regain lost market share, but it hasthey 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.

     In 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 second half of 2001, we experienced a $43.2 million, or 53.1% decrease in revenue comparedquality provided by competitors, product pricing, our ability to the first half as a result of the rapid decline in the mobile and fiber optic telecommunications markets. As such, we recorded losses in the third and fourth quarters. In 2002, the downward revenue trend that began in the second half of 2001 continued and full year 2002 revenue declined $56.4 million, or 47.1% compared to 2001. We recorded losses in each quarter of 2002. In reaction to the economic downturn, we have initiated an aggressive effort to reduce substrate manufacturing costs. This includes moving muchshift more of our substrate manufacturing operationsproduction to China, reducing capacity inand our Fremont, CA facilityability to create and developing and investing in key low cost raw material sources. We are hopeful thatdefend our intellectual property while not infringing on the cost reduction efforts should allow us to operate profitably again by the endintellectual property of 2003 and will position us well for future growth. During the second half of 2002, we experienced certain manufacturing and quality problems that had a negative impact in obtaining orders from several large customers for HBLEDs at the opto-electronics division, as well as on our substrates, which resulted in decreased orders at our substrate division. As a result, the divisions continued to experience losses in each quarter of 2002. We have initiated measures to improve our manufacturing and quality issues and have taken measures to reduce operating costs. As a result, we are hopeful that the opto-electronics division will also be profitable by the end of 2003.

     During 2002 and 2001, we raised approximately $850,000 and $4.8 million, respectively, from the exercise of options by employees to purchase our common stock under our employee stock option plan. During 2000, we raised approximately $96.0 million from the sale of common stock in a private offering, a registered public offering and the exercise of options by employees to purchase our common stock under our employee stock option plan.

     Our five largest customers accounted for 35.6% of our total revenue from continuing operations in 2002, 28.3% in 2001 and 26.1% in 2000. One customer accounted for 10.7% of our revenue in 2002 and no customer accounted for more than 10% of our total revenue in 2001 or 2000.

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     Each of our divisions is responsible for its own sales and marketing activities, and each maintains its own sales and marketing personnel. We sell our substrate products through our direct sales force in the U.S. and through independent sales representatives in France, Japan, South Korea, Taiwan and the United Kingdom. We sell our HBLED and laser diode products through our direct sales force and through independent sales representatives.others.

Critical Accounting Policies and Estimates

     We have prepared our consolidated financial statements in accordance with accounting principalsprinciples 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.

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     We believe that the following are our critical accounting policies:

     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 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. 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. We do not provide for warranty related exposure as such exposure has historically been immaterial.

     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. At December 31, 20022003 our accounts receivable balance was $7.2$6.3 million net of an allowance for doubtful accounts of $6.7$4.3 million.

     Inventories are stated at the lower of cost or net realizable value.market. Cost is determined using the weighted averagestandard 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. The livesCompetitive 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 our substrateorders. If orders are not obtained for the product built, the products are relatively longwill ultimately be deemed obsolete and accordingly, obsolescence has historically not beenwe will establish a significant factor.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

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     We reviewevaluate 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 ourthe long-lived assets to the projection of future undiscounted cash flows attributable to such assets and investments in order to identify any impairment. Long-lived assets are written down to their current fair market value whenthe event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of an asset exceeds their related undiscounted future cash flows. To determine the carrying value over the asset’s fair market value of our long-lived assets, we obtain appraisals from outside consultants. During 2002, we recorded long-lived asset and goodwill impairment charges of $42.2 million.value.

     The Company classifies itsWe determine the appropriate classification of investments in marketable securities as available-for-sale securities as prescribed in Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Allat the time of purchase. Available-for-sale investments are carried at their fair market value which is determined based on quoted market prices with netas 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 andor losses includedare recorded directly in comprehensive income, net of tax. If a decline in fair value is judgedstockholders’ 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 ofbasis. These investments are reviewed for other

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     The Company accountsWe 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.

18Voluntary Stock Option Exchange Program

     On May 27, 2003, we announced a voluntary stock option exchange program for our employees. Under the program, our option holders, excluding our executive officers and independent directors, had the opportunity to cancel outstanding options with an exercise price in excess of $2.10 per share in exchange for new options to be granted at a future date that was at least six months and one day after the cancellation date. The number of shares of common stock subject to the new options was equal to 75% of the number subject to the exchanged options. Under the exchange program, options to purchase an aggregate of 738,027 shares of our common stock, representing approximately 48% of the options that were eligible to be tendered in the Offer were tendered and cancelled. New options will vest at the same rate as the exchanged options and have an exercise price equal to the fair market value of our common stock at the new grant date, which was $3.11 per share. On December 31, 2003, we granted options to purchase an aggregate of 522,754 shares of our common stock in exchange for such tendered options.

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Results of Operations

     The following table sets forth certain operating data as a percentage of total revenues for the periods indicated.

     Revenue from continuing operations.Revenue from continuing operations decreased $56.4$10.2 million, or 47.1%22.6%, to $63.2$34.7 million in 2003 compared to $44.9 million in 2002. Total GaAs substrate revenue decreased $4.6 million, or 13.9%, to $28.3 million in 2003 compared to $32.9 million in 2002. Sales of 5 inch and 6 inch diameter GaAs substrates, which are used exclusively to manufacture electronic devices, decreased $3.4 million, or 38.9%, to $5.4 million in 2003 compared to $8.8 million in 2002. InP substrate revenue decreased $4.4 million, or 68.0%, to $2.1 million in 2003 compared to $6.5 million in 2002. InP substrates are used almost exclusively for telecommunications applications. The decrease in GaAs and InP substrate revenue is due to decreased volume and lower average sales prices as a result of the slowdown in our target markets including telecommunications, high speed electronic devices, and short wavelength lasers, and the introduction of VGF-like substrates from our competitors that caused some customers to purchase substrates from our competitors rather than from us.

     International revenue increased to 65.9% of total revenue from continuing operations in 2003 compared to 43.9% in 2002. 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 6.4% of revenue in 2003 compared to negative 19.8% in 2002. The increase was primarily due to reduced costs associated with moving most of our production to China. In addition, we incurred a charge of $9.7 million in 2002 related to the write-down of certain inventory that we concluded was obsolete.

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Selling, general and administrative expenses. Selling, general and administrative expenses decreased $3.4 million, or 24.4%, to $10.5 million in 2003 compared to $119.5$13.9 million in 2001. Revenue from our substrate division, which represents 71.0%2002. As a percentage of total revenue, selling, general and administrative expenses were 30.2% in 2003 compared to 30.9% in 2002. The decrease in selling, general and administrative expenses is the result of our efforts to adjust costs in line with our current business and of our ability to shift some of these activities to China where our costs are lower.

Research and development expenses. Research and development expenses decreased $1.0 million or 42.8%, to $1.3 million in 2003 compared to $2.3 million in 2002. As a percentage of total revenue, research and development expenses were 3.9% in 2003 compared to 5.2% in 2002. Although we reduced research and development expenses in 2003 as part of our effort to reduce costs, 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 in future periods. Research and development efforts during 2003 were focused primarily on improving the yield and surface quality of our GaAs substrates.

Interest expense. Interest expense increased $29,000, or 6.6%, to $466,000 in 2003 compared to $437,000 in 2002. By the end of 2003, we had repaid $10.1 million in equipment lease and loan debt which will reduce future interest payments.

Other income and expense, net. Other expense was $1.1 million in 2003 compared to $12.7 million in 2002. The amount in 2003 includes charges of $2.1 million related to the write-down of investments we hold in two privately held U.S. companies. The amount in 2002 includes non-cash charges of $10.8 million related to the write-down to market value of our investment in Finisar Corporation common stock and $3.1 million to write-down a building held for sale to net realizable value.

Provision for income taxes. Due to our continuing operating losses and uncertainty regarding future profitability, we recorded a full valuation allowance against our net deferred tax assets of $31.2 million in 2002. During 2003, we continued to record a full valuation allowance against our net deferred tax assets and as a result, our effective tax rate decreased to 0.0% for 2003.

Loss from discontinued operations. Loss from our discontinued opto-electronics division for the year ended December 31, 2003 was $15.6 million, which included a loss on disposal of $9.5 million and the operating loss from our discontinued opto-electronics division of $6.1 million.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenue from continuing operations. Revenue from continuing operations decreased $63.9 million, or 58.8%, to $44.9 million in 2002 compared to $108.8 million in 2001. Total GaAs substrate revenue decreased $42.5 million, or 56.4%, to $32.9 million in 2002 compared to $75.4 million in 2001. Sales of 5” and 6” diameter GaAs substrates decreased $12.8 million, or 59.2%, to $8.8 million in 2002 compared to $21.6 million in 2001. InP substrate revenue decreased $21.7 million, or 77.0%, to $6.5 million in 2002 compared to $28.2 million in 2001. The decrease in GaAs and InP substrate revenue iswas due to decreased volume and sales prices as a result of the slowdown in our markets including telecommunications, high speed electronic devices, and short wavelength lasers.

     Revenue from our opto-electronics division, which represents 29.0% of total revenue for 2002, increased $7.6 million, or 70.6%, to $18.3 million in 2002, compared to $10.7 million in 2001. The increase was a result of higher sales volume of HBLED products. HBLED revenue increased $8.4 million, or 114.0%, to $15.8 million in 2002 compared to $7.4 million in 2001. While revenue earned from HBLED products increased, the per unit price declined during 2002 and we may face further reductions in market prices in the future.

     VCSELInternational revenue decreased $392,000, or 38.8% to $619,000 in 2002 compared to $1.0 million in 2001. The decrease in VCSEL revenue was primarily due to a weakening in consumer demand. Laser diode sales decreased $437,000, or 18.7%, to $1.9 million in 2002 compared to $2.3 million in 2001. The decrease in laser diode sales was primarily due to the exit of our unprofitable 650 nm laser diode product line in 2001.

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     International revenue increased to 58.2%43.9% of total revenue in 2002 compared to 50.4%47.5% of total revenue in 2001. The increase was primarily due to increased sales of HBLED products to customers in Asia.

     Gross margin.Gross margin decreased to negative 17.2% of revenue in 2002 compared to 31.2% in 2001. Gross margin at the substrate division decreased to negative 19.8% of revenue in 2002 compared to positive 38.0% in 2001. The decrease was primarily due to lower unit sales and average sales prices of GaAs and InP substrates spread over a relatively fixed manufacturing overhead base and a $9.7 million charge to write-down excess inventory. As a result, we have initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We are currently shifting mostshifted much of our substrate manufacturing to China and reducingreduced capacity in our Fremont, California facility. Gross margin at the opto-electronics division increased to negative 10.7% of revenue for 2002 compared to negative 37.0% for 2001. The increase was primarily due to increased unit sales of blue HBLED products.

     Selling, general and administrative expenses.Selling, general and administrative expenses decreased $2.8$3.3 million, or 13.2%19.5%, to $18.6$13.8 million in 2002 compared to $21.5$17.2 million in 2001. As a percentage of total

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     Research and development expenses.Research and development expenses decreased $3.3$1.5 million or 40.7%39.7%, to $4.9$2.3 million in 2002 compared to $8.2$3.9 million in 2001. As a percentage of total revenue, research and development expenses were 7.7%5.2% in 2002 compared to 6.9%3.6% in 2001. Although we reduced research and development expenses in 2002 as part of our effort to reduce costs, 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 in future periods. Research and development efforts during 2002 were focused primarily on improving the yield and surface quality of our GaAs substrates, and improving the brightness, reliability, and yield of our HBLED products.substrates.

     Interest expense.Interest expense decreased $755,000,$394,000, or 36.3%47.4%, to $1.3 million$437,000 in 2002 compared to $2.1 million$831,000 in 2001. The decrease was primarily due to the repayment of certain long-term real estate notes and capital equipment leases.

     Other income and expense.Other expense was $12.7 million in 2002 compared to $13.4 million in 2001. The amount in 2002 includes non-cash charges of $10.8 million related to the write-down to market value of our investment in Finisar Corporation common stock and $3.1 million to write-down a building held for sale to net realizable value. The 2001 balance includes a non-cash charge of $15.6 million to write-down to market value our investment in Finisar common stock.

     Provision for income taxes.Due to our continuing operating losses during 2002 and uncertainty regarding future profitability, we recorded a full valuation allowance against our net deferred tax assets of $31.2 million in 2002. As a result, our effective tax rate decreased to 7.2% in 2002 and will be 0% in the foreseeable future.2002. Our effective tax rate in 2001 was 36%.

     RevenueLoss from continuingdiscontinued operations.Revenue decreased $2.0 million, or 1.6%, to $119.5 million in 2001 compared to $121.5 million in 2000. Revenue Loss from our substratediscontinued opto-electronics division which represents 91.0% of total revenue for the year ended 2001, decreased $4.6December 31, 2002 was $26.2 million or 4.0%, to $108.8 million compared to $113.4 million in 2000. Total GaAs substrate revenue decreased $22.6 million, or 23.1%, to $75.4 million in 2001 compared to $97.9 million in 2000. Salesnet of 5” and 6” diameter GaAs substrates was unchanged at $21.6 million for 2001 and 2000. InP substrate revenue increased $14.3 million, or 102.0%, to $28.2 million in 2001 compared to $14.0 million in 2000. While our substrate division experienced sequential quarter over quarter revenue growth during the first halfincome tax benefit of 2001, substrate revenue declined substantially in the second half due to a decline in the wireless and fiber optic telecommunication markets. Substrate revenue in the first half of 2001 was $76.9 million compared to $31.9 million in the second half of 2001, as the global economic

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     Revenue from our opto-electronics division, which represents 9.0% of total revenue for 2001, increased $2.6 million, or 32.0%, to $10.7 million in 2001, compared to $8.1 million in 2000. The increase was a result of higher sales volume of HBLED products. HBLED revenue increased $5.4 million, or 263.9%, to $7.4 million in 2001 compared to $2.0 million in 2000. VCSEL revenue increased $816,000, or 418.5% to $1.0 million in 2001 compared to $195,000 in 2000. Laser diode sales decreased $3.8 million, or 61.9%, to $2.3 million in 2001 compared to $6.2 million in 2000. The decrease in laser diode sales was primarily due to the exit of our unprofitable 650 nm laser diode product line.

     International revenue increased to 50.4% of total revenue in 2001 compared to 48.2% of total revenue in 2000. The increase was primarily due to increased sales of HBLED products to customers in Asia.

Gross margin.Gross margin decreased to 31.2% of revenue in 2001 compared to 39.4% in 2000. Gross margin at the substrate division decreased to 38.0% of revenue in 2001 compared to 45.9% in 2000. The decrease was primarily due to lower unit sales and average sales prices of GaAs substrates in the second half of 2001. As a result, we initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We began shifting much of our substrate manufacturing to China and reducing capacity in our Fremont, California facility. Gross margin at the opto-electronics division increased to negative 37.0% of revenue for 2001 compared to negative 51.6% for 2000. The increase was primarily due to increased unit sales of blue HBLED products.

Selling, general and administrative expenses.Selling, general and administrative expenses increased $3.5 million, or 19.1%, to $21.5 million in 2001 compared to $18.0 million in 2000. As a percentage of total revenue, selling, general and administrative expenses were 18.0% in 2001 compared to 14.8% in 2000. The increase was due to the addition of personnel and facilities in anticipation of increased revenues after the expansion of orders experienced in 2000. Due to the decline in substrate revenue in the second half of 2001, we initiated cost reductions in this area.

Research and development expenses.Research and development expenses decreased $565,000, or 6.4%, to $8.2 million in 2001 compared to $8.8 million in 2000. As a percentage of total revenue, research and development expenses were 6.9% in 2001 compared to 7.2% in 2000.

Interest expense.Interest expense decreased $1.5 million, or 42.5%, to $2.1 million in 2001 compared to $3.6 million in 2000. The decrease was primarily due to the repayment of outstanding short-term debt with equity financing proceeds in September 2000.

Other income and expense.Other expense was $13.4 million in 2001 compared to income of $28.4 million in 2000. The balance in 2001 includes the realization of a net $15.6 million non-cash loss from the write-down to market value of our investment in Finisar Corporation common stock in accordance with SFAS 115. The balance in 2000 includes the realization of a $27.3 million non-cash gain on Demeter Technology warrants that were exchanged for Finisar Corporation common stock as a result of Finisar Corporation’s acquisition of Demeter Technology in 2000.

Provision for income taxes.Our effective tax rate decreased to 36.0% in 2001 compared to 38.0% in 2000. The decrease was primarily the result of shifting certain substrate manufacturing operations to China.$8.4 million.

Liquidity and Capital Resources

     We consider cash and cash equivalents, short-term investments and long-termshort-term investments as liquid and available for use. Short and long-termShort-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.

     Cash and cash equivalents, short-term investments and long-term investments, excluding $1.1$3.7 million and $11.7$1.1 million for our investment in Finisar common stock at December 31, 2003 and 2002 and 2001 respectively, decreased $33.5increased $8.9 million to $24.5$44.6 million at December 31, 20022003 compared to $58.1$35.7 million at December 31,

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     Cash and cash equivalents decreased $23.7increased $10.5 million to $24.3 million at December 31, 2003 compared to $13.8 million at December 31, 2002 compared to $37.5 million at December 31, 2001.2002.

     Net cash provided by operating activities of $725,000$6.3 million for the year ended December 31, 20022003 was comprised primarily of our net loss adjusted for non-cash items of $65.5$18.0 million, consisting primarily of the equipment and goodwill impairment charges of $39.1 million, the write-down to market valueloss on disposal of our investment in Finisar Corporation common stockopto-electronics division of $10.6$9.5 million, and depreciation of $9.5$5.8 million, and by a $16.4$15.0 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in inventory, prepaid expenses and accountsincome tax receivable, an increaseoffset by decreases in accounts payable offset by increases in income tax receivables and a decrease in accrued liabilities.

     Accounts receivable decreased $8.5$898,000, or 12.5%, to $6.3 million or 54.1%,at December 31, 2003 compared to $7.2 million at December 31, 2002 compared to $15.7 million at December 31, 2001.2002. The change reflects lower sales volume, collections of $71.7$32.5 million and no changea decrease in our allowance for doubtful accounts of $6.7 million.$2.4 million due to the collection of previously written-down receivables. It also included a $666,000 write-down of accounts receivable from our discontinued opto-electronics division, which is included in “loss on disposal” in our consolidated statement of operations for the year ended December 31, 2003.

     Inventories decreased $18.0$13.5 million, or 32.4%35.9% to $24.1 million at December 31, 2003 compared to $37.6 million at December 31, 2002 compared to $55.6 million at December 31, 2001.2002. The decrease in inventory included an increasea $2 million write-down of inventory from our discontinued opto-electronics division, which is included in “loss on disposal” in our consolidated

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     Net cash used inprovided by investing activities of $16.0$13.7 million for the year ended December 31, 20022003 includes proceeds from the sale of property and equipment, and high grade investment securities totaling $27.7 million, offset by purchases of property and equipment of $14.2$2.2 million primarily used to transfer production capacity to China for the substrate division, and to increase HBLED epitaxy growth and wafer processing capacity at the opto-electronics division. It also includes $799,000 in purchases of high grade investment securities with maturities of less than two years and a transfertotaling $5.9 million. It also includes an increase in restricted cash of $1.0$5.8 million to restricted deposits to collateralize a letter of credit with a bank that supports our long-term debt and workers’ compensation insurance policy.

     We do not have any plans to initiate any major new capital spending projects through 2003.2004. We are currently completing certain projects at our China facilities and are continuously constructing minor improvements to our existing production facilities in China and California. We expect to invest approximately $6.0$5.0 million in capital projects in 2003.2004. 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 $8.1$9.6 million consisted of proceeds of $850,000$480,000 from the exercise of options by our employees, additional long-term borrowings of $3.9 million, offset by payments of $6.9$10.1 million to reduce long-term borrowings and $6.0 million for capital lease payments.leases.

     We generally finance equipment purchases through secured equipment loans and capital leases over four or five-year terms at interest rates ranging from 3.6% to 8.8% per annum.     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 1.6%1.35% at December 31, 2002.2003. 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. At December 31, 2002, $9.12003, $8.5 million was outstanding under these bonds.

     At June 30, 2002,December 31, 2003 the credit facility maintained by the Companyus with a bank included a $5 million line of credit with no balance outstanding, term loans in the amount of $4.8 million and a letter of credit supporting repayment of the Company’sour industrial revenue bonds with an outstanding amount of $9.4 million. The credit facility is collateralized by all corporate personal and real property owned by the Company. As of June 30, 2002, the Company was in default of the credit facility by failure to maintain certain financial covenants required under the terms of the facility. As a result, on September 30, 2002 we modified the credit agreement with our bank, which waived the covenant default, terminated the credit line, amended the financial covenants

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     As a result of the significant revenue declinesWe believe that we have experienced over the past six quarters, we have taken cost reduction measures and continue to pursue additional measures to reduce our costs and increase our cash flows. At December 31, 2002, we had availableadequate cash and cash equivalents of $13.8 million. We believe that our existing cash and cash equivalents, and cash generated from operations, coupled with additional efforts to reduce our expenditures in support of our substrate and opto-electronic businesses, will be sufficientinvestments to meet our working capital expenditure requirements for the next 12 months. However, our existing cashCompany’s short- and cash equivalents could continue to decline during 2003 due to a continued or further weakening of the economy or changes in our planned cash outlay.

long-term needs. If our sales continue to 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.”

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     Outstanding contractual obligations as of December 31, 20022003 are summarized below (in thousands):

Recent Accounting Pronouncements

In June 2002,     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 was approximately $1.2 million for the Financial Accounting Standards Board (FASB) issued Statement of Accounting Standards No. 146,“Accounting for Costs Associated with Exit or Disposal Activities.”SFAS No. 146 addresses the timing and amount of costs recognized as a result of restructuring and similar activities. The company will apply SFAS No. 146 to activities initiated afteryear ended December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the Company’s consolidated statements of income or financial position.

In December2003, $947,000 in 2002 the FASB issued Statement of Financial Accounting Standards No. 148 (“SFAS No. 148”),“Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment to FASB Statement No. 123, Accounting for Stock-Based Compensation.”SFAS No. 148 provides alternative

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In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45),“Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”FIN No. 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN No. 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN No. 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. Our adoption of FIN No. 45 did not have a material effect on our consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46),“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We are currently evaluating the impact that the adoption of this standard will have on our financial statements.2001.

Risks Related to Our Business

     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 highly cyclical.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 in the past, and will likely in the future, experiencepreviously 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 decliningweak demand such as those experienced over the past year,years, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition may result,has resulted, causing pressure on our net sales, gross margin and net income. We have over the past year experienced cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn continues,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. Although we have taken actionsActions to reduce our costs, if our actions aresuch as those we have recently taken, may be insufficient to align our structure with prevailing business conditions, weconditions. 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. In addition,

     During periods of increasing demand for semiconductor devices, we may continuemust have sufficient manufacturing capacity and inventory to experiencemeet 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 declinerecovery, if any, and the industry’s rate of growth in this recovery, if it occurs. If we are unable to effectively manage our cashresources and cash equivalents and therefore we may be required to seek additional sources of cash, which may not be available on acceptable terms or at all.production

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     Our operating results can vary significantly based uponIt appears that the impact of changesindustry may be in global economic conditions on our customers. More specifically, the macro-economic environment that we facedan upturn, which may cause demand to increase rapidly as it has in prior years after other cyclical downturns in the second half of 2001economy and continuedthe industries in which we operate. If this happens, in order to face in 2002 is more uncertain than in prior periods, has lasted longer than expectedmeet increased demand and has materiallymaintain 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 affected usimpact our ability to meet increased production demand while reducing unit costs, margins and improving our operating resultsresults.

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;
	•	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 continuebe costlier than anticipated and completion could be delayed, which could hurt our ability to do so. The revenue growthexpand capacity and profitabilityincrease 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 business depends onpreviously planned capacity expansion. To offset the overalladditional fixed operating expenses, we must increase our revenue by increasing production and improving yields. If demand for our substrates, LED’s and laser diodes, andproducts does not grow, if prices decline significantly, or if our yields do not improve as anticipated, we are particularly dependant on the market conditions for the wireless, fiber optics and telecommunications industries. Becausemay be unable to offset these costs against increased revenue, which would adversely impact 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, LEDs and laser diodes 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.operating results.

     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 iswas the largest in our history.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;

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	•	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 a meaningful indicatorindicators of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock would likelycould 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.

     The lead-time for customer orders is generally shorter than it was eighteen year ago. As a result, our visibility regarding future financial performance is uncertain and we have and may continue to provide investors with financial guidance that we cannot meet. As a result, our operating results could be below the expectations of market analysts or investors, which could also cause our stock price to fall.

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     Although we are currently in a period of overcapacity, reduced sales, and decreased margins, if the economy recovers, demand may 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;
	•	delays in completing new facilities;
	•	delays in bringing production equipment on-line;
	•	work stoppages or delays; inability to recruit and train qualified staff;
	•	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 might 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 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.

     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. On October 1, 2003, we implemented a new inventory control system that may experience unexpected difficulties.

     We may need additional capital to fund expansionnot obtain the benefits we expect as a result of discontinuation of our manufacturing and production capacity andopto-electronics business, such as greater strategic focus on our future operations or acquisitions. If we raise additional capital through the sale of equity or debt securities, the issuance of such securities could result in dilution to existing stockholders. These securities could have rights, preferences and privileges that are senior to those of holders of our common stock. For example, in December 1998 we issued debt securities for the purchase and improvement of our facilities in Fremont, California.

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If we require additional capital in the future, it might not be available on acceptable terms, or at all. If we are unable to obtain additional capital when needed, wecore businesses. We may be required to reducereturn to the scopebuyer 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 product line,balance sheet. We may incur additional costs associated with the planned expansion of our manufacturing capacity or of our product development and marketing efforts,discontinued operations which could adversely affectmaterially reduce our business and operating results.short term earnings.

     Much of our cash resources are denominated in Chinese Renminbi and held in accounts in China and, under some circumstances, may not be easily exchanged for US dollars. The value of our Chinese cash holdings are also subject to changes in the exchange rate between Chinese Renminbi and US dollars. If our US dollar commitments were to exceed the cash we have available in the United States, we may be unable to access cash held in China to satisfy these commitments.

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     We have experienced declining revenue for bothThe majority of our HBLED and laser diode products as a result of a loss of revenuesubstrate manufacturing activities are conducted in China. In addition, we source key raw materials, including gallium, from our leading LED customerjoint ventures and other suppliers in China. The 2003 SARS outbreak was most notable in China and a declinesmall 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 marketfacility for ten days. There was no significant impact to our laser diode products, as well as dueability to quality control problems experienced on these products. Wefill 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 unablerequired to successfully market and increase sales of these products. To market and increase salestemporarily close our manufacturing operations. Similarly, if one of our HBLED and VCSEL products,key suppliers is required to close for an extended period, we willmay 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 develop additional distribution channelsmaintain 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 achieve certain product and reliability specifications. We may be unable to obtainthe 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 increases inperiod, 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 seek potential investors fornot be able to ship product to them, our opto-electronics business. We must also continuerevenue would decline and our research and development efforts to apply our proprietary VGF technique to new substrate products and successfully introduce and market new opto-electronic semiconductor devices, including enhancements to our HBLED and VCSEL products.financial performance would suffer.

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 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.

     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 IBM and Motorola,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-basedGaAs- and InP-based devices at competitive prices. In addition, some of our competitors have developed VGF technology similar to ours. 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. Similarly, other companies, including Kopin, are developing alternative production technologies for HBLEDs. If they are successful, demand for our HBLEDs could drop and our revenue could decline.

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     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.

     Some of our competitors have developed a crystal growth technique similar to our VGF technology. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and we believe that we may 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.

     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

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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.

     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 IBM and Motorola,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, particularly in our compound semiconductor device products, including:

	•	greater experience in the business;
	•	more manufacturing experience;
	•	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 theour products that we have developed or may develop. For example, some competitors in the HBLED market offer devices that are brighter than our HBLEDs and have other desirable features. Some of our competitors may also develop technologies that enable the production of commercial products with characteristics similar to or better than ours, but at a lower cost.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 some 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.

     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

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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.

     Our products are manufactured using complex technologies, and the number of usable substrates and devices 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.

     BecauseIf our yields decrease, our revenue could decline because many of our manufacturing costs are fixed, our revenue could decline if our yields decrease but our costsor would change little, if at all.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, as have quality control problems experienced on both our substrate and LED products.results. We may experience similar problems in the future and we cannot predict when they may occur or their

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