UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)
þANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

(Mark One)

x                              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

OR

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                           to                          

For the fiscal year ended December 31, 2003
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from           to

Commission file number:  0-24085000-24085

AXT, Inc.

(Exact name of registrant as specified in its charter)

Delaware

94-3031310

(State or other jurisdiction of
incorporation or organization)

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

4281 Technology Drive,
Fremont, California

94538

(Address of principal executive offices)

94538

(Zip Code)

Registrant’s telephone number, including area code:

(510) 683-5900

Securities registered pursuant to Section 12(b) of the Act:

None

Title of each class

Name of each exchange on which registered

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001$0.001 par value

(Title of class)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. xYes     þo Noo

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes o          No þ

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.). Yes o Yes     xNoþ

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the common stock on June 30, 20032004 as reported on the Nasdaq National Market, was approximately $20,120,644.$35,305,807. Shares of common stock held by each officer, director and by each person who owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes.

As of January 31, 2003, 22,960,606March 10, 2005, 23,175,126 shares, $.001$0.001 par value, of the registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement for the registrant’s 20042005 annual meeting of stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this form are incorporated by reference into Part III of this Form 10-K report.



TABLE OF CONTENTS

PART I

Item 1.

Business

1

2

Item 2.

Properties

9

11

Item 3.

Legal Proceedings

9

11

Item 4.

Submission of Matters to a Vote of Security Holders

10

12

PART II

Item 5.

Market for Registrant’s Common Equity, and Related Stockholder Matters and Issuer Purchases of Equity Securities

10

13

Item 6.

Selected Consolidated Financial Data

10

14

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

13

16

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

34

45

Item 8.

Consolidated Financial Statements and Supplementary Data

34

46

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial DisclosuresDisclosure

36

47

Item 9A.

Controls and Procedures

36

47

PART IIIItem 9B.

Other Information

48

PART III

Item 10.

Directors and Executive Officers of the Registrant

37

49

Item 11.

Executive Compensation

37

49

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

37

49

Item 13.

Certain Relationships and Related Transactions

37

49

Item 14.

Principal Accountant Fees and Services

38

50

PART IV

Item 15.

Exhibits and Financial Statement Schedules and Reports on Form 8-K

39
EXHIBIT 10.17
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

51

1



PART I

SomeThis Annual Report (including the following section regarding Management’s Discussion and Analysis of the information set forth in this annual report are “forward-looking statements” within the meaningFinancial Condition and Results of the Private Securities Litigation Reform ActOperations) contains forward-looking statements regarding our business, financial condition, results of 1995. Forward-looking statements, including statements as to industry trends, our future expectationsoperations and other matters that do not relate strictly to historical facts, are based on certain assumptions made by management. These statements are often identified by the use of wordsprospects. Words such as “may,“expects,” “will,“anticipates,” “expect,“intends,” “plans,” “believe,“believes,” “anticipate,“seeks,” “intend,” “could,” “estimate,” or “continue”“estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Annual Report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, sales levels, expense levels and other statements regarding matters that are based onnot historical are forward-looking statements.

Although forward-looking statements in this Annual Report reflect the beliefs and assumptionsgood faith judgment of our management, such statements can only be based on information thenfacts and factors currently available to management. Suchknown by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Important factors that could cause actual results toand outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statementsstatements. Factors that could cause or contribute to such differences in results and outcomes include among others,without limitation those discussed under the risks discussed below underheading “Risks Related to Our Business.” These factorsBusiness” below, as well as those discussed elsewhere in this Annual Report. Readers are urged 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. Suchplace undue reliance on these forward-looking statements, which speak only as of the date on which such statements are made; except as required by law, weof this Annual Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect eventsany event or circumstancescircumstance that may arise after the date of such statements.this Annual Report. Readers are urged to carefully review and consider the various disclosures made in this Annual Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

Item 1.   Business Overview

Item 1.Business — Overview

We design, develop, manufacture and distribute high-performance compound and single element semiconductor substrates comprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). Our substrate products are used primarily in wireless communications, lighting display applications, wireless communications, 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 semiconductorsuch substrates. We pioneered the commercial use of VGF technology to manufacture GaAs substrates and subsequently used VGF technology to manufacture substrates from InP and Ge. Some of our competitors followed our lead by developing their own versions of VGF technology. Customers for our substrates include United Epitaxy Company, Motorola, Agilent Technologies, Samsung, EMCORE, Kopin, IQE, Osram, MBE Technologies, and 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 manufacturing operations to China, which is now complete, and by investing in sources of low cost raw materials.

We also manufacture and sell raw materials related to our substrate business through five joint ventures located in China. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. AXT’s ownership interest in these entities ranges from 25 percent to 88 percent. We consolidate the three ventures in which we own a majority interest and employ equity accounting for the two joint ventures in which we have a 25 percent interest. We purchase the materials produced by these ventures for our use and sell other portions of their production to third parties.

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


We were incorporated in California in December 1986 and reincorporated in Delaware in May 1988.1998. We changed our name from American Xtal Technology, Inc. to AXT, Inc. in July 2000. Our principal offices arecorporate office is located at 4281 Technology Drive, Fremont, California 94538, and our telephone number at this address is (510) 683-5900. Our web site is www.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 reports.

Industry Background

     Historically, mostMost semiconductors wereare created on a single crystal base material, or substrate, of silicon. Today, however, manySome electronic and opto-electronics semiconductors are being developed withhave requirements that exceed the capabilities of silicon. These semiconductors 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. Devices made on such semiconductors are power efficient, operate at high frequencies, and can be produced cost effectively.

These properties address the continually increasing demand to send, receive and display information on high-speed wireless and wirelinefiber optic networks. This demand creates a growing need for power-efficient high-performance semiconductors thatThe products made using semiconductor substrates include power amplifiers and radio frequency integrated circuits used in wireless handsets. Compound semiconductor substrates can operate atalso be used to create opto-electronic products including high frequenciesbrightness light emitting diodes, or HBLEDs, and can be produced cost-effectivelyvertical cavity surface emitting lasers, or VCSELs, used in large volumes. solid-state lighting and fiber optic communications, respectively.

These semiconductors enable the growth and development of a wide range of end user applications. Forapplications, including:

·       mobile terminals;

·       voice and high-speed wireless data systems;

·       infrared emitters and optical detectors in computer systems;

·       fiber optic networks and optical systems within these networks;

·       selected wi-fi networks;

·       solid-state lighting, including full color displays, automobile lighting, traffic lights, and channel lighting; and

·       satellite communications systems.

The markets for several of these end-user applications are expected to grow; for example, Gartner, Inc.,iSuppli Corporation, an independent research firm, expects

1

worldwide mobile terminaltelephone production to grow from approximately 510 million units in 2003 to approximately 560740 million units in 2004.
2005.

     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;
• 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.

·       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 diameters for electronic device applications and three- and four-inch diameters for opto-electronic device applications. The LEC and HB techniques each have difficulties producing high quality, low-cost compound semiconductor substrates for epitaxial processing.processing, especially for larger sizes. Substrates produced using the 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 insince 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, respectively.

2

The AXT Advantage

We are a leading developer and supplier of high-performance compound semiconductor substrates. There are three key causes of our success:We believe that we benefit from the following advantages:

Our VGF technology is a competitive advantage.advantage for our current and prospective markets.We pioneered the commercial use of VGF technology to manufacture GaAs substrates and we believe that through the use of VGF we became a leading worldwide supplier of GaAs substrates.substrates, particularly for HBLED applications. Our VGF process produces substrates with high mechanical strength and physical and chemical uniformity, as well as low crystal defect densities. The following

While we sold relatively few substrates for wireless and other electronic device applications in 2004, our VGF technology helps qualify us to compete for these markets because changes in our customers’ technologies are increasing the share of substrates sold withthat are manufactured using VGF or comparable technology:

·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 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 features:applications than are products manufactured using LEC and HB technologies, and competing materials such as silicon germanium, or SiGe.

• Greater use of epitaxy rather than ion implantation.·Switch to six-inch diameter wafers.   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 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 products manufactured using LEC and HB technologies, and competing materials such as silicon germanium, or SiGe.
• Switch to six-inch diameter wafers.Many semiconductor device manufacturers switched their GaAs production lines to six-inch diameter substrates from three and four 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. Although we encountered surface morphology problems causing our 2004 sales of six-inch diameter GaAs substrates to be lower than in previous years, we believe that we are well-positioned to take advantage of the growth in this product.
• 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. The lengthy qualification period benefits us when we are already qualified with a customer, but acts as a barrier to entry for those customers with which we are 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 after 1998 and asduring 2004, we completed the transfer of the end of 2003, mostall of our substrate manufacturing activities occur into China. We have also made somefive strategic investments in raw materials producers including one that produces gallium, that provide us with a secured and low cost sourcesources of important materials and enablesenable us to market surplus production to others. We believe this provides us with a cost advantage vis-à-vis our competitors whichwho do not enjoy similar arrangements.

3

Customer technology independence protects us from dependence on a small number of customers.Our semiconductor device manufacturing customers often compete among themselves. For example, several of our customers compete for technological leadership and market share in the HBLED market. These customers or end-users all manufacture some of their devices on GaAs substrates. Because we supply many HBLED manufacturers, we are, therefore, largely immune from the effects of such competition and benefit from an overall need for better and more efficient solid-state lighting.

Technology

Our core technologies include our proprietary VGF technique used to produce high quality crystals that are processed into compound substrates, and the technologies of our gallium extraction technologyjoint venture companies, which allowsenable us to extract raw gallium from aluminum ore.manufacture a range of products that are used in the manufacture of compound semiconductor substrates or can be sold to third parties.

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 reducingand minimizes the temperature gradient between the crystal and the melt which reduces the turbulence at the interface of the melt and the solid crystal, compared withcrystal. In comparison, in the LEC technique in which the melt and crystal are inverted. Theinverted, there is a higher temperature gradient between the melt and the crystal, inand more turbulence at the VGF technique is significantly lower than in traditional techniques.interface of the melt and solid crystal. 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,Horizontal-Bridgeman, or LEC,HB, 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

4

arsenic. It requires large, complex electro-mechanical systems that are expensive and require highly skilled personnel to operate. Strategy Analytics, a third-party market research firm, estimated that approximately 60 percent of the GaAs substrates sold in 2002 by all competitors to customers that manufacture electronic devices were manufactured using VGF or similar techniques. They projected that VGF’s share would increase to approximately 70 percent by 2007.

     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.

Our VGF technique also offers advantages over the Liquid Encapsulated Czochralski, or LEC, technique 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 of gallium and arsenic poly-crystal material and slowly pulling the seed up into the cool zone above the boron 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 arsenic. It requires large, complex electro-mechanical systems that are expensive and require highly skilled personnel to operate. Strategy Analytics, a third-party market research firm, estimated that approximately 60 percent of the GaAs substrates sold in 2003 by all competitors to customers that manufacture electronic devices were manufactured using VGF or similar techniques. They projected that VGF’s share would increase to approximately 70 percent by 2007.

The following table provides a comparison of these three techniques: in 2003, LEC remainsretains about 40% of the semi-insulating market and HB is still present in the semi-conducting or opto-electronics market.

VGF

HB

LEC

Substrate applications

Electronic and opto-electronic

Opto-electronic

Electronic

Largest wafer size availablein commercial use

6”

3”

6”

Stress/defect levels

Very Low

Low

High

Crystal purity

Good

Poor

Good

Applicability to multiple materials

GaAs, InP, Ge

GaAs

GaAs, InP, GaP

Equipment and labor cost

Very Low

Low

High

Amount of waste material

Very Low

High

Low

Equipment flexibility

Versatile

Limited

Limited

Equipment downtime

Minimal

Moderate

High

Number of competitors

Several

Declining

Declining


Products

We design, develop, manufacture and distribute high-performance semiconductor substrates. The table below sets forth our products and selected applications:

Product

Product

Applications

Substrates

Electronic

Opto-electronic

GaAs

•

· Cellular phones

•

· LEDs

•

· Direct broadcast television

•

· Lasers

•

· High-performance transistors

•

· Optical couplers

•

· Satellite communications

InP

•

· Fiber optic communications

•

· Lasers

•

· Satellite communications

•

· High-performance transistors

•

· Automotive collision avoidance radarsradar

Ge

•

· Satellite solar cells

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

5

six-inch diameters. We manufacture InP substrates in two-, three- and four-inch diameters and Ge substrates in two- and four-inch diameters.

Materials.We participate in five joint ventures in China that sell raw materials used by us in substrate manufacturing and by others. These joint ventures produce products including 99.99% pure gallium. We began selling Ga in 2001, primarily through our majority owned subsidiary, Beijing Ji Ya Semiconductor Material Company, Ltd. We sell primarily to re-processors who improve thegallium (4N Ga), high purity of the gallium.gallium, arsenic, and germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. In 20032004, sales of gallium to parties other than us were approximately $3.3 million.

Customers

We sell our compound semiconductor substrates and materials worldwide. Our customers include:

Advanced Epitaxy Technology

Kingmax

EMCORE

Sumika

Sogem

Agilent Technologies

Kopin

IQE, Inc.

Triquent Semiconductor

Sumika

Coherent Tutcore

Arima Optoelectronic Corp.

Motorola

MCP

Uni Light Technology

United Epitaxy Company

EMCORE

Bookham

Osram

Motorola

Visual Photonics Epitaxy

Honeywell

Coherent Tutcore

Opto-Power

Nippon Sheet Glass

United Epitaxy Company
IQE, Inc.Procomp Informatics

Xiamen Shanan Electronics

Isotech

Dowa

Recapture Metals

Osram

Historically, we have sold a significant portion of our products in any particular period to a limited number of customers. No customer represented greater than 10% of product revenues for the years ended December 31, 2004, 2003, 2002 and 2001.2002. The company’s top five customers represented 30.1% of revenue for the year ended December 31, 2004, 28.9% of product revenue for the year ended December 31, 2003, and 31.4% of product revenue for the year ended December 31, 2002, and 31.1% of product revenue for the year ended December 31, 2001.2002. We expect that sales to certaina small number of customers will continue to comprise a significant portion of our revenue in the future.

7



Manufacturing, Raw Materials and Supplies

We believe that our results 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,China. During 2004, we shifted the vast majority ofdiscontinued our manufacturing processes to our facilities in China, where costs are generally lower, by the end of 2003. We currently performand research and development and limited manufacturing inactivities at our Fremont, California facilities.facility. 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. 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, and polishing solutions, and paralytic boron nitride.solutions. 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 five joint ventures with and made investments in some suppliers of key raw materials required to manufacture our products, including gallium.gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride crucibles, and boron oxide. We believe that these joint ventures and investments will be advantageous in procuring materials to support our growth. In addition, excess capacity is marketed to others.growth and cost management goals.

6

Sales and Marketing

We advertise in trade publications, distribute promotional materials, conduct marketing and sales programs, and participate in industry trade shows and conferences in order to raise market awareness of our products. We sell our substrate products through our direct sales force in the U.S. and Japan and through independent sales representatives in France, Germany, Japan, South Korea, Taiwan and the United Kingdom. Our direct sales force consists of sales engineers who areis knowledgeable in the manufacture and use of compound and single-element substrates. Our salesapplications 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 technicalengineering 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 itsthe entire order. Several major customers participateparticipated in this program. AtAs of December 31, 2003,2004, the unearned pre-payments we retained under this program equaled $1.0 million.$130,000. We do not expect to continue this program after the pre-payments currently in hand are utilized by customers.

International Sales.International sales are an important part of our business. InFor the year ended December 31, 2003,2004, sales to customers outside of the United States accounted for 65.9%79.2% of our revenue, as compared with 65.9% in 2003, and with 43.9% in 2002 and with 47.5% in 2001.2002. 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 GaAs, InP and Ge substrates, including haze reduction, improved yield, enhanced surface and electrical characteristics and uniformity, greater substrate strength and increased crystal length. During 2003In addition, during 2004 we experiencedspent some research and development resources to reduce surface quality problems we experienced with our GaAs and InP substrates for some customers.customers, particularly related to surface morphology. We continue to work on issues related to surface quality.

Research and development expenses were $1.5 million in 2004, compared with $1.3 million in 2003 comparedand with $2.3 million in 2002, and $3.9 million in 2001.2002. We believe thatexpect to increase our current rate of expenditure can enable us to achieve ouron research and development goals.costs by approximately 15% in 2005.

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 marketsmarket for compound semiconductorGaAs substrates for HBLED applications primarily as a result of our expertise in VGF technology.technology, overall product quality, response times and prices. However, we believe we face actual and potential competition from a number of established domestic and international 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;

7·       price;

·       performance;

·       meeting customer specifications; and

·       customer support and satisfaction.

• meeting customer specifications; and
• customer support and satisfaction.

     Our·       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.

·       the availability of adequate sources of raw materials;

·       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 Crystal Technologies, Freiberger Compound Materials, Japan Energy, Mitsubishi Chemical Corporation, and Sumitomo Electric.Electric Industries. 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. In addition, as a result of quality problems that we have experienced, we believe that some customers have allocated some of 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. 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 that are actively developing alternative compound semiconductor materials.

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, 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 effective business practice insofar as trade secrets remain undisclosed and a proprietary product or process is not reverse engineered or independently developed.

To date, we have been issued 4four U.S. patents and have 4four U.S. patent applications pending, which relate to our VGF products and processes. We have 9fifteen patent applications pending (in PCT/national stage process) in Europe, Canada, China, Japan and South Korea which are based on our U.S. patents that relate to our VGF processes. We have 1one issued foreign patent.

Environmental Regulations

We are subject to federal, state and local environmental laws and regulations.regulations, including laws in China as well as the U.S. 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.

Employees

As of December 31, 2003,2004, we had 9721,010 employees, of whom 818854 were principally engaged in manufacturing, 141112 in sales and administration, and 1344 in research and development. Of these employees, 119

8

65 are located in the U.S., 852943 in China and 12 in Japan. As a result of shifting more of our substrate manufacturing to China, we implementedreduced our headcount reductions in our Fremont, California facilities, and expect further reductions asduring 2005. Some of our shift of manufacturing activities toemployees in China is completed. Our employees are not represented by a union, andbut we have never experienced a work stoppage. Although morale has been affected by our workforce reductions in California, we consider our relations with our employees to be good.


Item 2

Item 2..   Properties

Our principal properties as of March 15, 200410, 2005 are as follows:

Square

Location

Square
Feet

Principal Use

Ownership

Fremont, CA

80,000

Vacant

Owned

Fremont, CA

14,441

80,000

Vacant

ProductionOwned
Fremont, CA14,441Administration

Operating lease, expires May 2005

Fremont, CA

9,280

9,280

Warehouse

Warehouse

Operating lease, expires June 2005

Fremont, CA

24,100

24,100

Warehouse

Warehouse

Operating lease, expires July 2006

Fremont, CA

55,000

55,000

Production and Administration

Operating lease, expires March 2013

Monterey Park, CA

22,000

22,000

Vacant

Vacant

Owned; available foraccepted offer to purchase, expected to complete sale in 2nd quarter 2005

El Monte, CA

5,600

5,600

Vacant

Production

Operating lease, expires December 2006

Beijing, China

31,000

31,000

Production and Administration

Owned

Beijing, China

31,000

31,000

Production

Production

Owned

Beijing, China

32,000

32,000

Production

Production

Owned

Beijing, China

16,000

16,000

Housing

Housing

Owned

Beijing, China

34,000

34,000

Production

Production

Owned

Beijing, China

48,000

48,000

Production

Production

Owned

Beijing, China

22,000

22,000

Production and Administration

Owned

Beijing, China

53,000

53,000

Production

ProductionOwned; under construction

Owned

Xianshee, China

56,500

56,500

Production

Production

Owned by Beijing Ji Ya Semiconductor Materials, Co., Ltd.*

Xianshee, China

7,500

7,500

Administration

Administration

Owned by Beijing Ji Ya Semiconductor Materials, Co., Ltd.*

Xianshee, China

1,000

1,000

Administration

Administration

Owned by Beijing Ji Ya Semiconductor Materials, Co., Ltd.*

Nanjing, China

22,000

22,000

Production

Production

Owned by Nanjing Jin Mei Gallium Co., Ltd.*

Nanjing, China

5,700

5,700

R&D and Administration

Owned by Nanjing Jin Mei Gallium Co., Ltd.*

Nanjing, China

3,900

3,900

Production

Production

Owned by Nanjing Jin Mei Gallium Co., Ltd.*

Beijing, China

7,600

7,600

Production and Administration

Owned by Beijing Bo Yu Semiconductor Vessel Craftwork TechnologyTechnology*

*                    Joint ventures in which we hold an interest of between 25 percent and 88 percent.

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.

Item 3.Legal Proceedings

     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 expectintend to renew the operating leases of properties in Fremont and El Monte, California, that any of these matters, individually orexpire in the aggregate, will have2005 and 2006, respectively, as we are no longer using such facilities.

Item 3.   Legal Proceedings

On October 15, 2004, a material adverse effect on our business, financial condition, cash flows or results of operation.

9

     On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI)purported securities class action lawsuit was filed a complaint in the Tokyo District Court, Civil Division against us and our Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from AXT in the amount of $1.67 million plus interest and court costs and the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXT intends to defend itself vigorously in these lawsuits and continues to sell its products in Japan.

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for the Northern District of California against us alleging patent infringement.California. City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuit names AXT, Inc. and our chief executive officer, China operations, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004. The complaint soughtalleges that we announced financial results during this period that


were false and misleading. No specific amount of damages is claimed. On February 4, 2005, the Court consolidated the case with a related case making similar allegations, and injunctionappointed a lead plaintiff, who will file a consolidated complaint. We believe that there are meritorious defenses against infringement. this litigation and intends to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.

On July 23, 2003,December 2, 2004, we filedexecuted an agreement with Sumitomo Electric Industries, Ltd. (“SEI”), a counter complaintJapanese corporation, to settle litigation commenced by SEI against AXT in Japan alleging infringement of certain SEI patents, and an interference action between an AXT patent and an SEI reissue application brought in the United States CourtStates. We and SEI entered into a four-year cross-licensing agreement for Northern District of California, denying any patent infringement and alleging that Cree’s actions were intentionally designedall intellectual property used by either company related to interferecompound semiconductor substrates, which will expire on December 31, 2008, with our prospective business relationships. We reached an agreement with Cree resolving the disputes between us and signed a settlement agreement on March 5, 2004. The resolutionexception of the disputes did not havepatents that were the basis for the litigation in Japan and the interference in the U.S. where the license agreement shall last for the life of these patents. Under the terms of the settlement, we made a material adverse impactpayment to SEI in the amount of Japanese Yen one hundred and forty-seven million (¥147,000,000) on January 4, 2005, and we will make on-going royalty payments through 2012 on certain products sold by us in Japan. Subsequent to that payment, SEI dropped the Company’s consolidated financial position or resultslitigation in Japan and we abandoned the interference proceedings in the U.S.

Item 4.   Submission of operations.

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

None

12



PART II

Item 5.Market for Registrant’s Common Equity and Related Stockholder Matters

Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock has been trading publicly on the Nasdaq National Market, (NASDAQ) under the symbol “AXTI” since May 20, 1998, the date we consummated our initial public offering. The following table sets forth the range of high and low sales prices on NASDAQ of the common stock for the periods indicated, the range of quarterly highas reported by NASDAQ. Such quotations represent inter-dealer prices without retail markup, markdown or commission and low closing sales prices for our common stock on the Nasdaq National Market.

          
HighLow
Fiscal 2003        
 First Quarter ended March 31, 2003 $1.950  $0.670 
 Second Quarter ended June 30, 2003 $1.650  $0.680 
 Third Quarter ended September 30, 2003 $3.120  $1.200 
 Fourth Quarter ended December 31, 2003 $3.420  $1.890 
 
Fiscal 2002        
 First Quarter ended March 31, 2002 $16.890  $8.850 
 Second Quarter ended June 30, 2002 $11.600  $7.000 
 Third Quarter ended September 30, 2002 $8.390  $2.080 
 Fourth Quarter ended December 31, 2002 $2.820  $0.970 
may not necessarily represent actual transactions.

 

 

High

 

Low

 

2004

 

 

 

 

 

First Quarter

 

$

4.68

 

$

3.00

 

Second Quarter

 

$

3.57

 

$

1.73

 

Third Quarter

 

$

1.97

 

$

1.05

 

Fourth Quarter

 

$

2.04

 

$

1.37

 

2003

 

 

 

 

 

First Quarter

 

$

1.95

 

$

0.67

 

Second Quarter

 

$

1.65

 

$

0.68

 

Third Quarter

 

$

3.12

 

$

1.20

 

Fourth Quarter

 

$

3.42

 

$

1.89

 

As of December 31, 2003,2004, there were 121107 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.

We have never paid or declared any cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future. Dividends accrue on our outstanding Series A preferred stock at the rate of $0.20 per annum per share of Series A preferred stock.

Item 6.Selected Consolidated Financial Data

Issuer Purchases of Equity Securities

In August 2004, we announced the adoption of a stock repurchase program in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934 to provide for the repurchase of up to $2 million of our common stock. Repurchases may be made from time to time in the open market during the twelve-month period ending July 31, 2005, at prevailing market prices using our own cash resources. As of December 31, 2004, we had 23.1 million shares of common stock outstanding and none were repurchased in 2004 under this program. In January 2005, 10,000 shares were repurchased.


Item 6.   Selected Consolidated Financial Data

The following selected consolidated financial data are derived from and should be read in conjunction with 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 “Management’s Discussion and Analysis of Financial Condition

10

and Results of Operations” for further information relating to items reflecting our results of operations and financial condition.

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(in thousands, except per share data)

 

Income Statement Data:

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

35,454

 

$

34,713

 

$

44,865

 

$

108,800

 

$

113,374

 

Cost of revenue

 

35,705

 

32,478

 

53,758

 

67,494

 

61,361

 

Gross profit (loss)

 

(251

)

2,235

 

(8,893

)

41,306

 

52,013

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Selling, general, and administrative

 

11,561

 

10,475

 

13,860

 

17,208

 

13,619

 

Research and development

 

1,479

 

1,337

 

2,339

 

3,876

 

4,307

 

Impairment charges

 

210

 

—

 

14,632

 

—

 

—

 

Restructuring costs

 

1,308

 

—

 

—

 

—

 

—

 

Total operating expenses

 

14,558

 

11,812

 

30,831

 

21,084

 

17,926

 

Income (loss) from operations

 

(14,809

)

(9,577

)

(39,724

)

20,222

 

34,087

 

Interest expense

 

290

 

466

 

437

 

831

 

2,357

 

Other (income) and expense, net

 

(646

)

1,050

 

12,703

 

13,379

 

(28,463

)

Income (loss) from continuing operations before provision for income taxes

 

(14,453

)

(11,093

)

(52,864

)

6,012

 

60,193

 

Provision for income taxes

 

71

 

—

 

2,119

 

2,164

 

22,874

 

Income (loss) from continuing operations

 

(14,524

)

(11,093

)

(54,983

)

3,848

 

37,319

 

Discontinued operations:

 

 

 

 

 

 

 

 

 

 

 

Gain (loss) from discontinued operations

 

472

 

(6,163

)

(34,625

)

(13,818

)

(22,264

)

Gain (loss) on disposal

 

419

 

(9,475

)

—

 

—

 

(1,341

)

Benefit for income taxes

 

—

 

—

 

(8,427

)

(4,974

)

(7,896

)

Gain (loss) from discontinued operations

 

891

 

(15,638

)

(26,198

)

(8,844

)

(15,709

)

Net income (loss)

 

$

(13,633

)

$

(26,731

)

$

(81,181

)

$

(4,996

)

$

21,610

 

Basic income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

(0.64

)

$

(0.49

)

$

(2.46

)

$

0.17

 

$

1.90

 

Gain (loss) from discontinued operations

 

0.04

 

(0.69

)

(1.17

)

(0.40

)

(0.80

)

Net income (loss)

 

$

(0.60

)

$

(1.18

)

$

(3.63

)

$

(0.23

)

$

1.10

 

Diluted income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

(0.64

)

$

(0.49

)

$

(2.46

)

$

0.17

 

$

1.77

 

Gain (loss) from discontinued operations

 

0.04

 

(0.69

)

(1.17

)

(0.39

)

(0.75

)

Net income (loss)

 

$

(0.60

)

$

(1.18

)

$

(3.63

)

$

(0.23

)

$

1.03

 

Shares used in per share calculations:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

23,063

 

22,781

 

22,433

 

22,278

 

19,677

 

Diluted

 

23,063

 

22,781

 

22,433

 

22,879

 

21,059

 


                       
Years Ended December 31,
20032002200120001999
(In thousands, except per share data)
Income Statement Data:
                    
Revenue $34,713  $44,865  $108,800  $113,374  $56,732 
Cost of revenue  32,478   53,758   67,494   61,361   33,446 
   
   
   
   
   
 
Gross profit (loss)  2,235   (8,893)  41,306   52,013   23,286 
Operating expenses:                    
 Selling, general, and administrative  10,475   13,860   17,208   13,619   6,194 
 Research and development  1,337   2,339   3,876   4,307   2,007 
 Restructuring costs  —   14,632   —   —   — 
 Acquisition costs  —   —   —   —   2,810 
   
   
   
   
   
 
  Total operating expenses  11,812   30,831   21,084   17,926   11,011 
   
   
   
   
   
 
Income (loss) from operations  (9,577)  (39,724)  20,222   34,087   12,275 
Interest expense  466   437   831   2,357   1,431 
Other (income) and expense, net  1,050   12,703   13,379   (28,463)  (1,308)
   
   
   
   
   
 
Income (loss) from continuing operations before provision for income taxes  (11,093)  (52,864)  6,012   60,193   12,152 
Provision for income taxes  —   2,119   2,164   22,874   5,685 
   
   
   
   
   
 
Income (loss) from continuing operations  (11,093)  (54,983)  3,848   37,319   6,467 
Discontinued operations:                    
 Loss from discontinued operations  (6,163)  (34,625)  (13,818)  (22,264)  (7,092)
 Loss on disposal  (9,475)  —   —   (1,341)  — 
 Benefit for income taxes  —   (8,427)  (4,974)  (7,896)  (1,305)
   
   
   
   
   
 
Loss from discontinued operations  (15,638)  (26,198)  (8,844)  (15,709)  (5,787)
Extraordinary item, net of tax benefits  —   —   —   —   (508)
   
   
   
   
   
 
Net income (loss) $(26,731) $(81,181) $(4,996) $21,610  $172 
   
   
   
   
   
 
Basic income (loss) per share:                    
 Income (loss) from continuing operations $(0.49) $(2.46) $0.17  $1.90  $0.35 
 Loss from discontinued operations  (0.69)  (1.17)  (0.40)  (0.80)  (0.31)
 Extraordinary item  —   —   —   —   (0.03)
 Net income (loss)  (1.18)  (3.63)  (0.23)  1.10   0.01 
Diluted income (loss) per share:                    
 Income (loss) from continuing operations $(0.49) $(2.46) $0.17  $1.77  $0.33 
 Loss from discontinued operations  (0.69)  (1.17)  (0.39)  (0.75)  (0.29)
 Extraordinary item  —   —   —   —   (0.03)
 Net income (loss)  (1.18)  (3.63)  (0.23)  1.03   0.01 
Shares used in per share calculations:                    
 Basic  22,781   22,433   22,278   19,677   18,655 
 Diluted  22,781   22,433   22,879   21,059   19,771 

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(in thousands)

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

12,117

 

$

24,339

 

$

13,797

 

$

37,538

 

$

68,585

 

Short-term investments

 

20,062

 

14,669

 

8,205

 

25,673

 

30,852

 

Working capital

 

45,861

 

57,335

 

65,375

 

125,295

 

140,387

 

Restricted deposits

 

8,215

 

9,302

 

11,150

 

—

 

—

 

Long-term investments

 

—

 

—

 

3,657

 

6,552

 

—

 

Total assets

 

87,540

 

107,023

 

145,667

 

243,359

 

250,220

 

Long-term capital lease, net of current portion

 

—

 

—

 

4,847

 

10,002

 

7,278

 

Long-term debt, net of current portion

 

7,600

 

8,842

 

13,289

 

14,342

 

15,123

 

Stockholders’ equity

 

68,017

 

82,298

 

105,657

 

186,322

 

185,347

 

11

                     
December 31,
20032002200120001999
(In thousands)
Balance Sheet Data:
                    
Cash and cash equivalents $24,339  $13,797  $37,538  $68,585  $6,062 
Short-term investments  14,669   8,205   25,673   30,852   — 
Working capital  57,335   65,375   125,295   140,387   40,462 
Restricted deposits  9,302   11,150   —   —   — 
Long-term investments  —   3,657   6,552   —   — 
Total assets  107,023   145,667   243,359   250,220   115,762 
Long-term capital lease, net of current portion  —   4,847   10,002   7,278   6,853 
Long-term debt, net of current portion  8,842   13,289   14,342   15,123   15,254 
Stockholders’ equity  82,298   105,657   186,322   185,347   62,459 

All periods have been restated to reflect the accounting for discontinued operations. As a result, the discontinued opto-electronics and consumer products divisions have been eliminated from continuing operations in the income statements.statements of operations.

1215



Item 7.7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

     TheIn addition to historical information, the following discussion contains forward-looking statements that are subject to risks and analysisuncertainties. Actual results may differ substantially from those referred to herein due to a number of our financial conditionfactors, including but not limited to risks described in the section entitled Risks Related to Our Business and results of operationselsewhere in this Annual Report. This discussion should be read in conjunction with “Selected“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 “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 vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. Upon the discontinuance of our opto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating segment: our substrate division. We made our first substrate sales in 1990 and our substrate division currently sells gallium arsenide (GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, light emitting diodes (LEDs) and lasers. We also sell raw materials including gallium and germanium through our participation in majority- and minority-owned joint ventures. We have the capability to manufacture germanium substrates for use in satellite solar cells but withdrew from this business during 2000 so that we could more profitably use our then constrained capacity. We are now trying to re-qualify our germanium substrates with the few existing satellite solar cell system manufacturers.

     Our total revenue from continuing operations was $34.7 million for 2003, $44.9 million for 2002 and $108.8 million for 2001. In 2003 we incurred a loss from operations of $9.6 million compared to a loss of $39.7 million for 2002 and income of $20.2 million for 2001.

     On June 24, 2003, we announced the discontinuation of our opto-electronics division, which we established as part of our acquisition of Lyte Optronics, Inc. in May 1999. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our consolidated statements of operations for all periods presented (see Note 2 to our consolidated financial statements for details regarding the accounting for discontinued operations). The discontinued opto-electronics division manufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs) for the illumination markets, including full-color displays, wireless handset backlighting and traffic signals, and also manufactured vertical cavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communications and storage area networks.

     On September 27, 2003 we completed a sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics, Corp. and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese 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 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 expect to sell in 2004. This asset is classified as Held for Sale on our consolidated balance sheet at December 31, 2003.

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

     During the first half of 2002 our revenues grew due to improvements in the wireless market. In the second half of 2002 our revenue fell, however, because the substrate industry was still facing excess capacity that caused prices to decline, and because we experienced a loss of market share after two competitors developed technologies similar to ours. In addition, certain customers selected competitors’ products in order to diversify their supply sources and due to the belief that the competitors’ substrates offered better surface qualities. Full year 2002 revenue declined $63.9 million, or 58.8% compared 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 level of future industry demand or of our ability to regain lost market share, but they have impacted our ability to sell our products and operate profitably. If demand for our products remains depressed for an extended period, our business will be harmed as a result. Our business performance will be most influenced by market demand for compound semi-conductor substrates, our ability to offer products that equal or exceed the quality provided by competitors, product pricing, our ability to shift more of our manufacturing production to China, and our ability to create and defend our intellectual property while not infringing on the intellectual property of others.

Critical Accounting Policies and Estimates

We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such,Accordingly, we have had to make estimates, assumptions and judgments that affect the amounts reported on our consolidated 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 consolidated financial statements and requires us to make difficult, subjective or complex judgments that could have a material effectimpact on our consolidated 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 differentstatements. Different estimates that we could have used, or changes in the estimateestimates that are reasonably likely to occur, may have a material impact on our financial condition or results of operations. We also refer you to our “The Company and Summary of Significant Accounting Policies” discussed in the accompanying notes to our consolidated financial statements included elsewhere in this Form 10-K.

14Revenue Recognition

We believemanufacture and sell high-performance compound semiconductor substrates and sell certain raw materials including gallium, germanium dioxide, and pBN crucibles. After we ship our products, there are no remaining obligations or customer acceptance requirements that the followingwould preclude revenue recognition. Our products are typically sold pursuant to a purchase order placed by our critical accounting policies:

Revenue Recognition

customers, and our terms and conditions of sale do not require customer acceptance. We recognize revenue upon shipment and transfer of title of products to our customers, which is either upon shipment from our dock, receipt at the customer’s dock, or removal from consignment inventory at the customer’s location, provided that we have received a signed purchase order, the price is fixed or determinable, title hasand risk of ownership have transferred, collection of resulting receivables is probable, and product returns are reasonably estimable, thereestimable. We do not provide training, installation or commissioning services. Additionally, we do not provide discounts or other incentives to customers except for one customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discounts on future product purchases from us. We will recognize these discounts in future periods as a reduction in revenue as products 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. sold to this customer.

We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. ExceptIn the first quarter of 2004, we recorded a reserve for sales returns of $745,000 related to our failure to follow certain testing requirements and provision of testing data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific shipments. Approximately $285,000 of the $745,000 sales returns reserve had been utilized as of December 31, 2004. See further discussion 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“Results of Operations” below.


Allowance for warranty related exposure as such exposure has historically been immaterial.

Allowance for Doubtful Accounts

We periodically review the likelihood of collectingcollection on 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. We assess the probability of collection based on a number of factors, including the length of time a receivable balance has been outstanding, our past history with the customer and their credit worthiness.

In previous years, three of our customers had filed for bankruptcy protection. Upon notification of the bankruptcy, we immediately stopped shipping orders to these customers other than on payment in advance. At that time, the outstanding balances of these customers had been fully reserved. The related accounts receivable balances and reserve were subsequently written off in November 2004 when we finally determined that the balances were uncollectible. This determination was made as a result of our unsuccessful efforts to collect these accounts receivable, the significant length of time that the receivables balance was outstanding, and the unlikelihood that we would collect the balances from the bankrupt’s estate. As of December 31, 2004 and 2003, our accounts receivable balance was $4.0 million and $6.3 million, respectively, which was net of an allowance for doubtful accounts of $1.1 million and $4.3 million, respectively. During 2004, we wrote off $3.5 million of fully reserved accounts receivable and increased the allowance for doubtful accounts by $0.3 million.

Inventory
If actual uncollectible accounts differ substantially from our estimates, revisions to the estimated allowance for doubtful accounts would be required, which could have a material impact on our financial results for the period.

Warranty Reserve

We maintain a warranty reserve based upon our claims experience during the prior twelve months. Warranty costs are accrued at the time revenue is recognized. As of December 31, 2004, accrued product warranties totaled $135,000. If actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material impact on our financial condition and results of operations.

Inventory Valuation

Inventories are stated at the lower of cost or market. Cost is determined using the standardweighted average cost method. FinishedOur inventory consists of raw materials as well as finished goods and work-in-process inventoriesthat include material, labor and manufacturing overhead costs. Given the nature of our substrate products, and the materials used in the manufacturing process, the wafers and ingots comprising work-in-process may be held in inventory for up to two years and three years, respectively, as the risk of obsolescence for these materials is low. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and we provide a valuation allowance for certain inventories based upon the age and quality of the product. Competitive delivery times are frequently less thanproduct and the time requiredprojections for ussale of the completed products. During the third quarter of 2004, it became apparent that our revenues were likely to manufacture a product, requiring uscontinue to build some work-in-process inventoriesdecline in anticipationthe fourth and subsequent quarters due to the need to re-qualify our products with several customers. Furthermore, many new orders were for products with specifications that differed from the features of orders. If orders are not obtained for the product built, the products will ultimately be deemedheld in inventory. In accordance with our policy, we evaluated the levels of our inventory, and determined that in light of current market conditions, we had excess and obsolete inventory based upon its age and quality, and that the inventory exceeded the sales projections as revised. Accordingly, we will establishestablished a reserve for the excess. As of December 31, 2004 and 2003, we had an inventory reserve of $6.1 million and $7.2 million, respectively. The majority of this inventory has not been scrapped. If actual demand for our products were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory might be required, which could have a material impact on our business, financial condition and results of operations.


Impairment of Investments

We classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed in order to determine whether the decline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their value.operations. We also reviewmonitor our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determineinvestments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any itemsanticipated recovery in ending inventory exceeds the sales value less any related selling costs, a reserve is established for the difference.

Impairment of Long-Lived Assets
our carrying value.

Impairment of Long-Lived Assets

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

Investments

Employee Stock Options

We determinebelieve that employee stock options represent an appropriate and essential component of our overall compensation program. We grant options to substantially all management employees and believe that this broad-based program helps us to attract, motivate, and retain high quality employees, to the appropriate classificationultimate benefit of investments atour stockholders. We currently account for share-based payments to employees using the timeintrinsic value method under APB Opinion No. 25 and, as such, generally recognize no compensation cost for employee stock options. The adoption of purchase. Available-for-sale investments are carried at their fair valueStatement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment” (SFAS 123R) is expected to result in a material increase in expense during the second half of 2005 based on quoted market pricesunvested options outstanding as of December 31, 2004 and current compensation plans. While the balance sheet date. The amortized costeffect 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 determinedadoption depends on the specific identification method and are reflected in “other (income) and expense, net.” Net unrealized gains or losses are recorded directly in stockholders’ equity. Those unrealized losses that are deemed to be other than temporary are reflected in “interest and other income, net.” We also maintain minority investments in private companies which are accounted for under the cost basis. These investments are reviewed for other

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than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changeslevel of share-based payments granted in the future and unvested grants on the date we adopt SFAS 123(R), the effect of this accounting standard on our prior operating performanceresults would approximate the effect of SFAS 123 as described in the disclosure of pro forma net loss and changes in market conditions.
Income Taxes
net loss per share. See “Note 1—The Company and Summary of Significant Accounting Policies” of the notes to consolidated financial statements.

Income Taxes

We account for deferred income taxes in accordance with SFAS No. 109 (SFAS 109), “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the liability method, under which the expected future tax consequenceseffect of timingtemporary differences between the book and tax basisbases of recorded assets and liabilities are recognized asliabilities. SFAS 109


also requires that 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, thatbe reduced by a valuation allowance if it is more likely than not that a portion of the future income tax benefit represented by the net deferred tax asset will not be realized.

Voluntary Stock Option Exchange Program

     On May 27, 2003, we announced a voluntary stock option exchange programWe provide for our employees. Underincome taxes based upon the program, our option holders, excluding our executive officersgeographic composition of worldwide earnings and independent directors, hadtax regulations governing each region, particularly China. The calculation of tax liabilities involves significant judgment in estimating the opportunity to cancel outstanding options with an exercise price in excessimpact 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 tendereduncertainties in the Offer were tendered and cancelled. New options will vest at the same rateapplication of complex tax laws, particularly in foreign countries such 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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China.

Results of Operations

The following table sets forth certainOverview

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

Continuing Operations

Our continuing business, primarily sales of our substrate products, is dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both as a percentageresult of totaleconomic changes and overcapacity.

During the first half of 2002 our revenues grew due to improvements in the wireless market. In the second half of 2002 our revenue fell, however, because the substrate industry was still facing excess capacity that caused prices to decline, and because we experienced a loss of market share after two competitors developed technologies similar to ours. In addition, certain customers selected competitors’ products in order to diversify their supply sources and due to the belief that the competitors’ substrates offered better surface qualities. Full year 2002 revenue declined $63.9 million, or 58.8% compared with 2001. We recorded losses in each quarter of 2002 and incurred impairment charges against fixed assets and inventory due to the decline in demand and prices. In reaction to the economic downturn and competition, 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, California 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 time required to improve our substrate surface quality and regain some lost customers. Revenue for 2003 fell by $10.2 million, or 22.6% compared with 2002. We recorded net losses in each quarter of 2003. During 2003, we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

In 2004, our revenue increased $0.7 million as compared to 2003, primarily as a result of increased demand for HBLEDs.

In March 2004, we learned of certain failures to comply with requirements for product testing and the provision of testing data and information relating to requirements of certain customers. Specifically, we


determined that in some cases we had not provided accurate data to customers confirming that products shipped were compliant with all specifications provided by the customer, or had been manufactured at the location specified by the customer. As a result of our conclusions, we reorganized our production and quality control procedures, established quality control and assurance as a direct reporting group to the chief executive officer, and implemented measures, including additional employee training, statistical sampling of product shipments during the quarter, and review of our satisfaction of customer specifications each quarter, to ensure adherence to operational controls. We also implemented certain executive management changes.

As a result of the weaknesses identified, in the first quarter of 2004 we increased our sales return reserve by $745,000, based on our best estimate of future returns related to this matter. Approximately $285,000 of the $745,000 sales returns reserve had been utilized as of December 31, 2004. This reserve was based, in part, on discussion with affected customers. The amount of the reserve was determined in part based upon the amount of our historical product returns, payment history of prior period receivables, discussions with customers concerning the non-compliant product and testing data, and estimated levels of our product maintained by customers, and likelihood that products previously shipped would be returned to us.

During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China. See further discussion under “Impairment and Restructuring Charges” below.

Discontinued Opto-Electronics Business

In June 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of Lyte Optronics, Inc. in May 1999. 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. Accordingly, the results of operations of the opto-electronics division have been segregated from continuing operations and are reported separately as discontinued operations in our consolidated statements of operations for all periods indicated.

               
Years Ended December 31,
200320022001
Revenue  100.0%  100.0%  100.0%
Cost of revenue  93.6%  119.8%  62.0%
   
   
   
 
Gross profit (loss)  6.4%  (19.8)%  38.0%
Operating expenses:            
 Selling, general, and administrative  30.2%  30.9%  15.8%
 Research and development  3.9%  5.2%  3.6%
 Restructuring costs  0.0%  32.6%  0.0%
   
   
   
 
  Total operating expenses  34.1%  68.7%  19.4%
   
   
   
 
Income (loss) from operations  (27.7)%  (88.5)%  18.6%
Interest expense  1.3%  1.0%  0.8%
Other (income) and expense, net  3.0%  28.3%  12.3%
   
   
   
 
Income (loss) from continuing operations before provision for income taxes  (32.0)%  (117.8)%  5.5%
Provision for income taxes  0.0%  4.7%  2.0%
   
   
   
 
Income (loss) from continuing operations  (32.0)%  (122.5)%  3.5%
Discontinued operations:            
 Loss from discontinued operations  (17.8)%  (77.1)%  (12.7)%
 Loss on disposal  (27.3)%  0.0%  0.0%
 Benefit for income taxes  0.0%  18.8%  4.6%
   
   
   
 
Loss from discontinued operations  (45.1)%  (58.3)%  (8.1)%
   
   
   
 
Net Loss  (77.1)%  (180.8)%  (4.6)%
   
   
   
 
presented. See Note 2 to our consolidated financial statements for details regarding the accounting for discontinued operations.

Year EndedIn September 2003, we completed the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0 million was held in escrow to satisfy any claims that the purchaser might make for breaches of representations or warranties by us. Of this total escrow $750,000 could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division. We will only record amounts as and when they are received. To date, we have resolved all claims made against the first $750,000 held in escrow by the acquiring company, and expect to receive all but $31,000 of the first $750,000 held in escrow. As of December 31, 2003 Compared to Year Ended 2004, approximately $419,000 was released from escrow and accordingly we recorded a gain on discontinued operations in 2004. In February 2005, we received an additional $300,000 from escrow, leaving $250,000 in escrow, which will not be eligible for release until September 2005.

In addition, we retain a building located in Monterey Park, California that we have listed on the market for sale. This asset has been classified as held for sale on the consolidated balance sheets as of


December 31, 20022004 and 2003. We recorded in the fourth quarter 2004 a $0.25 million market value adjustment after we accepted an offer in January 2005 from a real estate developer to purchase the property for net proceeds of approximately $1.25 million, after deducting estimated commission and selling expenses. We expect the sale to be completed in the second quarter of 2005.

Impairment and Restructuring Charges

Inventory Impairment

Prior to 2001, our markets had steadily increased, causing us to build inventory to meet demand. In the second half of 2001, we experienced a 58.5% decrease in revenue as a result of a rapid decline in the mobile and fiber optic telecommunications markets. We experienced lower revenues and slower bookings than forecast, as well as postponements and cancellations of orders. The market decline continued into 2002, as significant excess capacity developed in the substrate industry, sales prices declined, and our revenues fell, resulting in a higher ratio of inventory levels to revenue. In addition, two competitors had developed and were successfully selling products with technologies similar to ours, capturing a significant portion of our market share. With this unexpected loss in market share, we determined that it would be harder to recover even once the market improved. As our revenue continued to decline, and the industry continued to experience excess capacity, it became apparent by the fourth quarter of 2002 that the amount of inventory we would be able to utilize was significantly less than previously projected and that the amount of inventory on hand exceeded the then current sales projections for those products. As a result, we wrote down $9.6 million of obsolete inventory in 2002, none of which has been subsequently sold. Of this amount, inventory valued at $1.2 million and $1.7 million were scrapped in the second and fourth quarter of 2003, respectively.

In September 2004, we wrote down an additional $2.1 million of obsolete inventory. The wafers and ingots comprising the written-down inventory had been manufactured within the prior two and three years, respectively. During the third quarter of 2004, it became apparent that our revenues were likely to continue to decline in the fourth and subsequent quarters due to the need to re-qualify our products with several customers. Furthermore, many new orders were for products with specifications that differed from the features of the products held in inventory. In accordance with our policy, we evaluated the levels of our inventory, and determined that in light of current market conditions, we had excess and obsolete inventory based upon its age and quality, and that the inventory exceeded the sales projections as revised. Accordingly, we established a reserve for the excess. The majority of this inventory has not been scrapped.

Reduction in Long-Lived Assets

Also as a result of this decline and the adverse impact on our revenues, during the second quarter of 2002 we revised our financial forecast and initiated an aggressive effort to reduce our substrate manufacturing costs. This included moving more of our substrate manufacturing to China beginning in the second quarter of 2002, and ultimately shutting down our Fremont, California facility. Given the lowered sales projections and the expectation to close down our Fremont manufacturing facility, we undertook a review of the long-lived assets of our substrate business in order to determine whether the expected undiscounted, future cash flows were sufficient to recover the carrying values of the related assets. This review undertaken in the second quarter of 2002 indicated that an impairment charge of $14.6 million was required to write down these long-lived assets to their estimated fair market value. In order to determine the fair value of these assets, we calculated the present value of expected cash flows of the substrate operations. The estimated cash flows were based on our updated revenue outlook, and accordingly we revised our operating budget and related cash flows discounted at the rate reflecting our average cost of capital.


Opto-Electronics Business

During the third quarter of 2002, we recorded an additional impairment charge of $24.5 million related to our opto-electronics division. The primary business of this division was the manufacture of light-emitting diodes (“LED’s”). Our business in this division was heavily dependent on one customer. In the third quarter of 2002, we experienced a significant quality problem which ultimately resulted in this customer canceling all current and future orders. Given the uncertainty of resolving the quality issue and the significance of this customer to the operations, we undertook an impairment review in the third quarter which indicated that the undiscounted cash flows were not sufficient to recover the carrying value of the related long-lived assets. Accordingly, an impairment charge was recorded to write down the assets to their estimated fair market value. The estimated fair market value was based on management’s estimate of the fair value, with management making this determination based in part on an independent valuation of the assets.

As a result of our decision to discontinue the opto-electronics business in 2003, the $24.5 million charge related to the opto-electronics business was reclassified into “loss from discontinued operations” in 2003.

Restructuring Charges

During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China. In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the United States. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $231,000 for a total of $1.3 million in 2004. These charges comprised costs related to the reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. In aggregate, we eliminated 50 positions, 47 of which were production workers. As of December 31, 2004, we saved approximately $560,000 in payroll and related expenses. On an annual basis, we anticipate payroll and related expense savings of $1.5 million. In 2005, we will continue to reduce costs by qualifying new lower cost suppliers, moving more of our administrative functions to China where our costs are lower, and streamlining our organization structure and costs in the United States and China to bring them in line with with our current business. Refer to Note 8 to our consolidated financial statements.

Other Impairment

Also in the third quarter of 2004, we recorded an impairment charge of $210,000 to write down the value of our investment in a private company. We made the decision to write down the investment as a result of the declining financial position of the investee, evidenced by an audit opinion with a going concern explanatory paragraph received by the investee. The $210,000 was the remaining balance of this investment.

Revenue

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

GaAs

 

$

27,272

 

$

28,354

 

$

32,892

 

 

$

(1,082

)

 

 

(3.8

)%

 

$

(4,538

)

 

(13.8

)%

 

InP

 

1,588

 

2,075

 

6,491

 

 

(487

)

 

 

(23.5

)

 

(4,416

)

 

(68.0

)

 

Raw Materials

 

6,499

 

4,118

 

4,485

 

 

2,381

 

 

 

57.8

 

 

(367

)

 

(8.2

)

 

Other

 

95

 

166

 

997

 

 

(71

)

 

 

(42.8

)

 

(831

)

 

(83.4

)

 

Total revenue

 

$

35,454

 

$

34,713

 

$

44,865

 

 

$

741

 

 

 

2.1

%

 

$

(10,152

)

 

(22.6

)%

 


Revenue from continuing operations.operations increased $741,000, or 2.1%, to $35.5 million in 2004 compared to $34.7 million in 2003. Total GaAs substrate revenue decreased $1.1 million, or 3.8%, to $27.3 million in 2004 compared to $28.4 million in 2003. Sales of 5 inch and 6 inch diameter GaAs substrates, which were used exclusively to manufacture electronic devices, decreased $1.9 million, or 36.1%, to $3.5 million in 2004 compared to $5.4 million in 2003. InP substrate revenue decreased $0.5 million, or 23.5%, to $1.6 million in 2004 compared to $2.1 million in 2003. InP substrates were used almost exclusively for telecommunications applications. The decrease in GaAs and InP substrate revenue was due to the pricing pressures causing prices to decline and overall lesser demand from our telecommunications and wireless application customers. Raw material sales increased $2.4 million, or 57.8%, to $6.5 million in 2004 compared to $4.1 million in 2003. The increase in raw material sales was due to customers’ higher demand, particularly for raw gallium and germanium dioxide.

Revenue from continuing operations decreased $10.2 million, or 22.6%, to $34.7 million in 2003 compared to $44.9 million in 2002. Total GaAs substrate revenue decreased $4.6$4.5 million, or 13.9%13.8%, to $28.3$28.4 million in 2003 compared to $32.9 million in 2002. Sales of 5 inch and 6 inch diameter GaAs substrates, which arewere used exclusively to manufacture electronic devices, decreased $3.4 million, or 38.9%,38.5% 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 arewere used almost exclusively for telecommunications applications. The decrease in GaAs and InP substrate revenue iswas 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.

Revenue by Geographic Region

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

North America*

 

$

7,514

 

$

12,009

 

$

26,208

 

 

$

(4,495

)

 

 

(37.4

)%

 

$

(14,199

)

 

(54.2

)%

 

% of total revenue

 

21

%

35

%

59

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Europe

 

6,840

 

5,638

 

5,508

 

 

1,202

 

 

 

21.3

 

 

130

 

 

2.4

 

 

% of total revenue

 

19

%

16

%

12

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Japan

 

5,156

 

4,167

 

3,000

 

 

989

 

 

 

23.7

 

 

1,167

 

 

38.9

 

 

% of total revenue

 

15

%

12

%

7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taiwan

 

8,397

 

7,055

 

4,246

 

 

1,342

 

 

 

19.0

 

 

2,809

 

 

66.2

 

 

% of total revenue

 

24

%

20

%

9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Asia Pacific (excluding Japan and Taiwan)

 

7,547

 

5,844

 

5,903

 

 

1,703

 

 

 

29.1

 

 

(59

)

 

(1.0

)

 

% of total revenue

 

21

%

17

%

13

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

$

35,454

 

$

34,713

 

$

44,865

 

 

$

741

 

 

 

2.1

%

 

$

(10,152

)

 

(22.6

)%

 

*                    Primarily the United States.

Sales to customers outside of North America represented approximately 79%, 65% and 41% of our revenue during 2004, 2003 and 2002, respectively. International revenue continued to increase during 2004 as compared to 2003 primarily due to sales growth of $1.2 million and $4.0 million in Europe and Asia Pacific including Japan and Taiwan, respectively. The increase was the result of our continued penetration into the Asian markets, particularly Taiwan and China.

International revenue increased to 65.9% of total revenue from continuing operations induring 2003 as compared to 43.9% in 2002. The increase was2002 primarily due to asales growth of $0.1 million, $1.2 million, and $2.8 million in Europe, Japan, and Taiwan, respectively. The increase was


driven by greater share of our GaAs substrates being used in opto-electronics applications and the majority of our customers forrequiring these applications beingwere in Asia.

Gross margin.Margin

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Gross profit (loss)

 

$

(251

)

$

2,235

 

$

(8,893

)

 

$

(2,486

)

 

 

(111

)%

 

 

$

11,128

 

 

 

125

%

 

Gross Margin %

 

(0.7

)%

6.4

%

(19.8

)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin decreased to negative 0.7% of revenue in 2004 compared to 6.4% of revenue in 2003. The decrease was primarily due to the following factors during 2004: (i) a $2.1 million charge for excess and obsolete inventory in the third quarter, (ii) an approximately $1.4 million settlement charge with Sumitomo Electric Industries, Ltd. in the third quarter, and (iii) the establishment of a sales return reserve of $745,000 in the first quarter related to our failure to follow certain testing requirements, which reduced revenues without affecting costs of revenues.

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.

17Selling, General and Administrative Expenses

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

SG&A expenses

 

$

11,561

 

$

10,475

 

$

13,860

 

 

$

1,086

 

 

 

10.4

%

 

 

$

(3,385

)

 

 

(24.4

)%

 

% of total revenue

 

32.6

%

30.2

%

30.9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative expenses.expenses increased $1.1 million, or 10.4%, to $11.6 million in 2004 compared to $10.5 million in 2003. As a percentage of total revenue, selling, general and administrative expenses were 32.6% in 2004 compared to 30.2% in 2003. The increase in selling, general and administrative expenses is primarily the result of increased legal and professional fees with respect to our product testing investigation, the Sumitomo litigation settlement, and implementation of Section 404 of the Sarbanes-Oxley Act of 2002.

Selling, general and administrative expenses decreased $3.4 million, or 24.4%, to $10.5 million in 2003 compared to $13.9 million in 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

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

R&D expenses

 

$

1,479

 

$

1,337

 

$

2,339

 

 

$

142

 

 

 

10.6

%

 

 

$

(1,002

)

 

 

(42.8

)%

 

% of total revenue

 

4.2

%

3.9

%

5.2

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

24



Research and development expenses.expenses increased $142,000, or 10.6%, to $1.5 million in 2004 compared to $1.3 million in 2003. As a percentage of total revenue, research and development expenses were 4.2% in 2004 compared to 3.9% in 2003. As planned, we maintained our investment in product development in 2004 in order to improve our substrate manufacturing technologies. We expect research and development expenses to increase by approximately 15% in 2005.

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.

Impairment and Restructuring Charges

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Impairment charges

 

$

210

 

$

—

 

$

14,632

 

 

$

210

 

 

 

NM

 

 

$

(14,632

)

 

NM

 

 

% of total revenue

 

0.6

%

—

 

32.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Restructuring costs

 

$

1,308

 

$

—

 

$

—

 

 

$

1,308

 

 

 

NM

 

 

$

—

 

 

NM

 

 

% of total revenue

 

3.7

%

—

 

—

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

NM: percentage not meaningful

In the third quarter of 2004, we recorded an impairment charge of $210,000 to write down the value of our investment in a private company. We made the decision to write down the investment as a result of the declining financial position of the investee, evidenced by an audit opinion with a going concern explanatory paragraph received by the investee. The $210,000 was the remaining balance of this investment.

Interest expense.Expense

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Interest expense

 

$

290

 

$

466

 

$

437

 

 

$

(176

)

 

 

(37.8

)%

 

 

$

29

 

 

 

6.6

%

 

% of total revenue

 

0.8

%

1.3

%

1.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense decreased $176,000, or 37.8%, to $290,000 in 2004 compared to $466,000 in 2003. The decrease in interest expense reflected the absence of equipment financing charges. By the end of 2003, we had repaid $10.1 million in equipment lease and loan debt.

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

Other Income and Expense, Net

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Other income (expense), net

 

$

646

 

$

(1,050

)

$

(12,703

)

 

$

1,696

 

 

 

161.5

%

 

 

$

11,653

 

 

 

91.7

%

 

% of total revenue

 

1.8

%

(3.0

)%

(28.3

)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income was $0.6 million in equipment lease and loan debt which will reduce future interest payments.

2004 compared to other expense of $1.1 million in 2003. Other income (expense) comprises foreign exchange gain (loss) and expense, net.minority interests from our China joint ventures. Other income in 2004 also included a gain of $237,000 as a result of a customer’s forfeiture of


deposits originally made in connection with the program we launched in late 2000 with selected customers to guarantee volume delivery of substrates. We terminated all remaining obligations under the program with this customer by mutual consent.

Other expense was $1.1 million in 2003 compared to $12.7 million in 2002. The amount in 2003 includes chargesincluded a charge of $2.1 million related to the write-down of our investments we hold in two privately held U.S. companies. The amount in 2002 includesincluded non-cash charges of $10.8 million related to the write-down to market value of our investment in Finisar CorporationCorporation’s common stock to its market value and $3.1 million related to the write-down of a building held for sale to its net realizable value.value as of December 31, 2002.

Provision for Income Taxes

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Provision for income taxes

 

$

71

 

$

—

 

$

2,119

 

 

$

71

 

 

 

NM

 

 

 

$

(2,119

)

 

 

NM

 

 

% of total revenue

 

0.2

%

—

 

4.7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

NM: percentage not meaningful

Provision for income taxes.taxes was $71,000 for 2004, all of which related to our foreign subsidiaries. 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$38.8 million in 2002. During 2003,2004.

Gain or Loss from Discontinued Operations

 

 

Years Ended December 31,

 

2003 to 2004

 

2002 to 2003

 

 

 

2004

 

2003

 

2002

 

Increase
(Decrease)

 

% Change

 

Increase
(Decrease)

 

% Change

 

 

 

($ in thousands)

 

Gain (loss) from discontinued operations

 

$

891

 

$

(15,638

)

$

(26,198

)

 

$

16,529

 

 

 

105.7

%

 

 

$

10,560

 

 

 

40.3

%

 

In 2004, we continued to recordrealized a full valuation allowance against our net deferred tax assets and$419,000 gain on discontinued opto-electronics operations as a result of the partial release of escrow funds. Also in 2004, we entered into an agreement with a real estate developer for the purchase of our effective tax rate decreaseddiscontinued opto-electronics’ property held for sale and realized a gain of $250,000 reflecting an adjustment to 0.0% for 2003.

Loss from discontinued operations.the realizable market value of the property. The remaining gain of $222,000 was a result of our reversal of accrued liabilities of general and administrative expenses no longer required. 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 was 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.

     International revenue decreased to 43.9% of total revenue in 2002 compared to 47.5% of total revenue in 2001.

Gross margin. Gross margin 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 initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We shifted much of our substrate manufacturing to China and reduced capacity in our Fremont, California facility.

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

18

revenue, selling, general and administrative expenses were 30.9% in 2002 compared to 15.8% in 2001. In order to align our cost structure with the rapid decline in revenues, we initiated and aggressively pursued cost reductions in this area, which led to the decrease in 2002.

Research and development expenses. Research and development expenses decreased $1.5 million or 39.7%, to $2.3 million in 2002 compared to $3.9 million in 2001. As a percentage of total revenue, research and development expenses were 5.2% in 2002 compared to 3.6% in 2001. Research and development efforts during 2002 were focused primarily on improving the yield and surface quality of our GaAs substrates.

Interest expense. Interest expense decreased $394,000, or 47.4%, to $437,000 in 2002 compared to $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. Our effective tax rate in 2001 was 36%.

Loss from discontinued operations. Loss from our discontinued opto-electronics division for the year ended December 31, 2002 was $26.2 million, netwhich included the operating loss and certain impairment charges for a total of $34.6 million, partially offset by a benefit for income taxes of $8.4 million. See further discussion under “Results of Operations—Overview” elsewhere in Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.

American Jobs Creation Act of 2004-Repatriation of Foreign Earnings

The American Jobs Creation Act of 2004 (the “Jobs Act”), enacted on October 22, 2004, allows us to repatriate earnings from our foreign subsidiaries at a reduced tax rate. Under the Jobs Act, we may elect, for one taxable year, an 85% dividends received deduction for eligible dividends from our foreign subsidiaries. The deduction would result in an approximate 5.25% federal tax rate on the repatriated earnings. To qualify for the deduction, the repatriated earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by our chief executive officer and approved by the


company’s board of directors. Certain other criteria in the Jobs Act must be satisfied as well. We may elect to apply this provision to qualifying earnings repatriations in either fiscal 2005 or fiscal 2006. We are in the process of evaluating whether we will repatriate foreign earnings under the repatriation provisions of the Jobs Act.

We are not yet in a position to determine the impact of a qualifying repatriation, should we choose to make one, on our income tax benefitexpense for either fiscal 2005 or fiscal 2006, the amount of $8.4 million.our indefinitely reinvested foreign earnings, or the amount of our deferred tax liability with respect to foreign earnings.

Liquidity and Capital Resources

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

 

 

($ in thousands)

 

Net cash provided by (used in):

 

 

 

 

 

 

 

Operating activities

 

$

(340

)

$

6,269

 

$

725

 

Investing activities

 

(7,846

)

13,723

 

(16,037

)

Financing activities

 

(4,216

)

(9,647

)

(8,116

)

Effect of exchange rate changes

 

180

 

197

 

(313

)

Net change in cash and cash equivalents

 

(12,222

)

10,542

 

(23,741

)

Cash and cash equivalents—beginning period

 

24,339

 

13,797

 

37,538

 

Cash and cash equivalents—end of period

 

12,117

 

24,339

 

13,797

 

Short-term investments—end of period

 

20,062

 

14,669

 

8,205

 

Total cash, cash equivalents and short-term investments

 

$

32,179

 

$

39,008

 

$

22,002

 

 

We consider cash and cash equivalents, and short-term investments as liquid and available for use. Short-term investments are comprised of government bonds and high-grade commercial debt instruments. Also included in short-term investments is our investment in common stock investmentof Finisar Corporation, a United States publicly-traded company. As of December 31, 2004, our principal sources of liquidity were $32.2 million in Finisar Corporation.cash and cash equivalents and short-term investments, excluding restricted deposits.

Cash and cash equivalents and short-term investments, and long-term investments, excluding $3.7$2.7 million and $1.1$3.7 million for our investment in Finisar common stock atas of December 31, 2004 and December 31, 2003, and 2002 respectively, increased $8.9decreased $5.8 million to $44.6$29.5 million atas of December 31, 20032004 compared to $35.7with $35.3 million at December 31, 2002.

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

     Net cash provided by operating activitiesas of $6.3 million for the year ended December 31, 2003 was comprised primarily of our net loss adjusted for non-cash items of $18.0 million, consisting primarily of the loss on disposal of our opto-electronics division of $9.5 million, depreciation of $5.8 million, and by a $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 income tax receivable, offset by decreases in accounts payable and accrued liabilities.

     Accounts receivable decreased $898,000, or 12.5%, to $6.3 million at December 31, 2003 compared to $7.2 million at December 31, 2002. The change reflects lower sales volume, collections of $32.5 million and a decrease in our allowance for doubtful accounts of $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 $13.5 million, or 35.9% to $24.1 million at December 31, 2003 compared to $37.6 million at December 31, 2002. The decrease in inventory included a $2 million write-down of inventory from our discontinued opto-electronics division, which is included in “loss on disposal” in our consolidated

19

statement of operations for the year ended December 31, 2003. The Companycombined decrease in cash and cash equivalents and short-term investments was primarily due to payments of long-term debt of $4.5 million, purchase of machinery and equipment of $0.9 million, and the continual funding of our operations.

The decrease in operating cash flow in 2004, as compared with 2003, was primarily the result of the absence during 2003 of certain non-cash charges of $9.5 million on the disposal of our discontinued opto-electronics business and $2.1 million on impairment of investments, a slower rate of decrease in inventories of $3.9 million, partially offset by an improvement to our net loss of $13.6 million.

Net accounts receivable decreased by $2.3 million, or 35.9%, to $4.0 million as of December 31, 2004 compared with $6.3 million as of December 31, 2003. The decrease reflects lower fourth quarter 2004 sales compared with the same period in 2003, better collections from customers and an establishment of a sales returns reserve of $745,000 recorded in the first quarter of 2004.

Net inventories decreased $7.6 million, or 31.6% to $16.5 million as of December 31, 2004 compared with $24.1 million as of December 31, 2003. We adopted a strategy of using inventory to conserve cash.cash beginning in 2001. During 2004, we had a $2.1 million inventory valuation charge due to excess and obsolete inventory. We do not expect to maintain the same rate of net inventory decrease in 2005 as we experienced in 2003.2004.


Net cash providedused by investing activities of $13.7$7.8 million for the year ended December 31, 2003 includes proceeds from the sale of property and equipment, and high grade investment securities totaling $27.7 million, offset by2004 included purchases of property and equipment of $2.2$2.1 million primarily used to transfer production capacity to China for the substrate division, and purchases of high grade investment securities with maturities of less than two years totaling $5.9$25.9 million. It also includes an increaseThis was partially offset by sales of high grade investment securities totaling $19.1 million and a decrease in our restricted cashdeposits of $5.8$1.1 million 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 2004.in 2005. 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.facilities. We expect to invest approximately $5.0 million in capital projects in 2004.2005. 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 $9.6$4.2 million for the year ended December 31, 2004 consisted of payments of $4.5 million related to long-term borrowings, partially offset by proceeds of $480,000$270,000 as a result of purchases of our common stock by employees under our employee stock compensation programs.

In December 2004, we reached a final settlement of our litigation with Sumitomo Electric Industries, Ltd. (SEI), which includes a global intellectual property cross-licensing agreement. We recorded a charge of approximately $1.4 million in the quarter ended September 30, 2004 in connection with this settlement. Under the terms of the settlement, we made a payment to SEI in the amount of Japanese Yen one hundred and forty-seven million (¥147,000,000) on January 4, 2005, and we will make on-going royalty payments through 2012 on certain products sold by AXT in Japan. Subsequent to that payment, SEI dropped the litigation in Japan and we abandoned the interference proceedings in the U.S.

We believe that we have adequate cash and investments to meet our needs over the next 12 months. If our sales decrease, however, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity, require us to use 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 us. 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.”

Off-Balance Sheet Arrangements

We have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not entered into any options on non-financial assets.

We have entered into contracts to supply several large customers with GaAs wafers. The contracts guaranteed delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of $130,000. The contract sales prices are subject to review quarterly and can be adjusted in the exerciseevent that raw material prices change. In the event of optionsnon-delivery of the determined wafer quantities in any monthly delivery period, we could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. We have not received any claims for non-performance penalties due to non-delivery. As of December 31, 2004, we have met all of its current delivery obligations under these contracts and expects to continue to meet delivery requirements during the remainder of the contract terms.

We indemnify certain customers for attorney fees and damages and costs awarded against these parties in certain circumstances if our products are found to infringe certain patents and they are sued by the patent holder and awarded damages. There are limits on and exceptions to our employees, offset bypotential liability for indemnification relating to intellectual patent infringement claims. We cannot estimate the amount of potential future payments, if any, that we might be required to make as a result of $10.1 millionthese agreements. To date, we have not paid any claim or been required to reduce long-term borrowingsdefend any action related to our indemnification obligations, and capital leases.accordingly, we have not accrued any amounts for such indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations.


Contractual Obligations

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 1.35% at2.49% as of December 31, 2003.2004. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. AtAs of December 31, 2003, $8.52004, $8.05 million was outstanding under these bonds.

     AtAs of December 31, 20032004, the credit facility maintained by us with a bank included a letter of credit supporting repayment of our industrial bonds with an outstanding amount of $8.5approximately $8.2 million. The Company hasWe have pledged and placed cash and certain investment securities with an affiliate of the bank as additional collateral for this facility. We have also pledged cashcertain investments for a credit facility for our workers compensation insurance. As a result, $9.3insurance policy for portions of 2003. Accordingly, $8.2 million of our cash and long-termshort-term investments are restricted.

     We currently hold a note payable secured by certain equipment in China totaling $3.3 million at December 31, 2003 (see Note 4 to our consolidated financial statements). The balance on this note will be due in December 2004.

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

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Outstanding contractual obligations as of December 31, 2003 are summarized below (in thousands):

             
Operating
DebtLeasesTotal
2004 $3,694  $1,231  $4,925 
2005  514   1,115   1,629 
2006  459   836   1,295 
2007  462   616   1,078 
2008  466   617   1,083 
Thereafter  6,941   3,236   10,177 
   
   
   
 
  $12,536  $7,651  $20,187 
   
   
   
 

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. On March 11, 2003, we completed the sale of our property located at 4281 Technology Drive, Fremont, California, for $6.3 million. Net cash proceeds from the sale were $5.2 million. The gain incurred by us on this transaction was less than $15,000. Under the terms of the sale agreement, we have agreed to lease back the property for a ten-year period. Accordingly, on March 11, 2003, we signed an operating lease for this property through March 2013. Total rent expenseexpenses under these operating leases waswere approximately $1.3 million, $1.2 million and $0.9 million for the yearyears ended December 31, 2004, 2003 $947,000and 2002, respectively. We have a purchase obligation with a third party vendor to purchase $1.3 million of equipment towards which we have paid a deposit of $300,000, leaving a net purchase obligation of $1.0 million.

The following table summarizes our contractual obligations as of December 31, 2004 (in thousands):

 

 

Payments Due by Period

 

Contractual Obligations

 

 

 

Total

 

Less than
1 year

 

1-3
years

 

4-5
years

 

More than
5 years

 

Long-term debt obligations

 

$

8,050

 

 

$

450

 

 

$

1,420

 

$

900

 

 

$

5,280

 

 

Operating lease obligations

 

6,837

 

 

1,319

 

 

2,299

 

1,486

 

 

1,733

 

 

Purchase obligations

 

1,017

 

 

1,017

 

 

—

 

—

 

 

—

 

 

Total

 

$

15,904

 

 

$

2,786

 

 

$

3,719

 

$

2,386

 

 

$

7,013

 

 

We have made strategic investments in 2002private companies located in China in order to gain access to raw materials at competitive costs that are critical to our substrate business. We are currently negotiating a new joint venture investment in China for a Germanium business opportunity, and $779,000upon the fulfillment of certain conditions, we may invest up to $1.0 million in 2001.the new joint venture in 2005.

Risks Related to Our Business

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

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

During the first quarter of 2004 we determined that we had not followed requirements for testing of products and provision of testing data and information relating to customer requirements. We notified affected customers concerning our findings, however, there can be no assurance that we will not incur customer claims or other liabilities or obligations in connection with this matter, nor, if we receive any such claims, that we will not have to restate results from prior periods. In addition, revenue in future periods


may be adversely impacted if customers decide not to order from us as a result of this disclosure. We experienced several cancellations of future orders by customers pending further information regarding enhancements to our product testing and quality control systems. In addition, some customers are requiring additional qualification of our China operations before placing future orders with us. We cannot be sure that we will not receive additional cancellations of orders by other customers, or fail to win expected future orders from customers, as a result of our disclosure of our investigation conclusions, or that our customers will qualify our China operations and place future orders with us.

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

The Chinese government faced a power crunch over the summer of 2004 and reported that power demand in 24 provinces outstripped supply in peak periods during the first four months of 2004. Instability in electrical supply caused sporadic outages among residential and commercial consumers. As a result, the Chinese government implemented tough measures in 2004 to ease the energy shortage which is expected to last at least through 2005. Provinces imposed power brownouts during 2004 to reduce electricity demand and some companies in Beijing were ordered to give their employees a week off to ease the pressure on power supply. The plants, most of which are state-owned, were closed and reopened on a staggered schedule to reduce power consumption during the capital’s hottest months during 2004. As a result we closed most of our operations for a week in late July 2004 in conformance with this policy. Some shortages have already been reported in 2005 and the power shortages may be more severe than during 2004. If we are required to make additional temporary closures of our Beijing and joint venture operations during 2005, we may be unable to manufacture our products, and would then be unable to meet customer orders except from inventory on hand. As a result, we could lose sales, adversely impacting our revenues, and our relationships with our customers could suffer, impacting our ability to generate future sales. In addition, if power is shut off at our Beijing operations at any time, either voluntarily or as a result of unplanned brownouts, during certain phases of our manufacturing process including our crystal growth phase, the work in process may be ruined and rendered unusable, causing us to incur expense that will not be covered by revenue, and negatively impacting our cost of goods sold and gross margins. We are attempting to partially mitigate the potential effects of power outages by building inventory during early 2005 in anticipation of power outages during the summer. This inventory build is prepared to accommodate forecast demand rather specific customer orders. If the inventory we build is not ordered by customers, we may have to scrap these products and incur a cost which will reduce our gross margins.

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

As we are now manufacturing only in China, if the shift of our substrate manufacturing operations to China is to be successful, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. We may lose sales of our products to competitors who are not manufacturing in China, or whose operations in China have already been qualified by customers. If customers do not fully qualify our China production, we may lose additional customers and fail to achieve revenue growth.

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 compound semiconductor 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.


Problems Incurred by Our Joint Ventures or Venture Partners Could Result in a Material Adverse Impact on Our Financial Condition or Results of Operations

We have invested in five joint venture operations in China that produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. We purchase the materials produced by these ventures for our use and sell other portions of their production to third parties. Our ownership interest in these entities ranges from 25 percent to 88 percent. We consolidate the three ventures in which we own a majority interest and employ equity accounting for the two joint ventures in which we have a 25 percent interest. Several of these ventures occupy facilities within larger facilities owned and/or operated by one of the other venture partners. Several of these venture partners are engaged in other manufacturing activities at or near the same facility. In some facilities, we share access to certain functions, including water, treatment of hazardous waste or air quality treatment. If any of our joint venture partners in any of these five ventures experience problems with their operations, disruptions of our joint venture operations could result, having a material adverse effect on the financial condition and results of operation of our joint ventures, and correspondingly on our financial condition or results of operations.

In addition, if any of our joint ventures or venture partners with whom our joint ventures share facilities are deemed to have violated applicable laws, rules or regulations governing the use, storage, discharge or disposal of hazardous chemicals during manufacturing, research and development, or sales demonstrations, the operations of our joint ventures could be adversely affected and we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our joint venture operations as a result of the actions of the joint ventures or other venture partners. Employees working at the operations of our joint ventures or the operations of any of the other venture partners could bring litigation against us as a result of actions taken at the joint venture or venture partner facilities, even though we are not directly controlling the operations, including actions for exposure to chemicals or other hazardous materials at the facilities of our joint ventures or the facilities of any venture partner that are shared by our joint ventures. If litigation is brought against us, litigation is inherently uncertain and while we would expect to defend ourselves vigorously, it is possible that our business, financial condition, results of operations or cash flows could be affected in any particular period by such litigation if brought against us, particularly if, as a non-Chinese company, litigation with us is deemed advantageous. Even if we are not deemed responsible for the actions of the joint ventures or venture partners, litigation could be costly, time consuming to defend and divert management attention; in addition, pursuit of us could occur if we are deemed to be the most financially viable of the partners.

Going forward, we believe that investing in additional joint ventures will be important to remaining competitive in our marketplace and ensuring a supply of critical raw materials. However, we may not be able to identify complementary joint venture opportunities or, even once opportunities are identified, we may not be able to reach agreement on the terms of the venture with the other venture partners. Additional joint ventures could cause us to incur contingent liabilities or other expenses, any of which could adversely affect our financial condition and operating results.

Since all of our joint venture activity is expected to occur in China, these activities could subject us to a number of risks associated with conducting operations internationally, including:

·       Difficulties in managing geographically disparate operations;

·       Difficulties in enforcing agreements through non-U.S. legal systems;

·       Unexpected changes in regulatory requirements that may limit our ability to export the venture products or sell into particular jurisdictions or impose multiple conflicting tax laws and regulations;

·       Political and economic instability, civil unrest or war;


·       Terrorist activities that impact international commerce;

·       Difficulties in protecting our intellectual property rights, particularly in countries where the laws and practices do not protect proprietary rights to as great an extent as do the laws and practices of the United States;

·       Changing laws and policies affecting economic liberalization, foreign investment, currency convertibility or exchange rates, taxation or employment; and

·       Nationalization of foreign owned assets, including intellectual property.

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

Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others. For example, we have previously been involved in two separate lawsuits alleging patent infringement.

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

On October 8, 2004, we announced that we had reached a tentative settlement of the litigation in Japan and interference actions in the United States with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a global intellectual property cross-licensing agreement. AXT and SEI finalized this agreement on December 2, 2004. Accordingly, we recorded a charge of approximately $1.4 million for the quarter ended September 2004 in connection with this settlement, and are expected to make royalty payments on future sales of certain products. The litigation was withdrawn in January, 2005 and we abandoned the interference proceeding.

32



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

We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations, including laws and regulations of China. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development, and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational 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 for $200,415, and during 2004 we were the target of press allegations and correspondence purportedly on behalf of current and/or former employees concerning our environmental compliance programs and exposure of our employees to hazardous materials, and there is a possibility that current and/or former employees may bring litigation against us. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. Existing or future changes in laws or regulations in the United States and China may require us to incur significant expenditures or liabilities, or may restrict our operations. In addition, our employees could be exposed to chemicals or other hazardous materials at our facilities and we may be subject to lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicals or hazardous materials at our facilities.

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

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

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

The industry has previouslyin the past experienced periods of oversupply that result in significantly reduced demand and prices for semiconductor devices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur, our operating results and financial condition are adversely affected, and create pressure on our revenue, gross margins and net income. Inventory buildups in telecommunications products and slower than expected sales of computer equipment resulted in overcapacity and led to reduced sales by our customers, and therefore reduced purchases of our products. During periods of weak demand such as those experienced over the past years, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition has resulted, causing pressure on our net sales, gross margin and net income. We experienced cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn were to continue, or occuroccurred again, in the future, further order cancellations,


reductions in order size or delays in orders willcould occur and would materially adversely affect our business and results of operations. Actions to reduce our costs, such as those we have recently taken, may be insufficient to align our structure with prevailing business conditions. We may be required to undertake additional cost-cutting measures, and may be unable to invest in marketing, research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investments could seriously harm our business.

During periods of increasing demand for semiconductor devices, we must have sufficient manufacturing capacity and inventory to meet customer demand, and must be able to attract, hire, train and retain qualified employees to meet demand. It appears that the semiconductor industry is in the early stages of an upturn and increasing demand.experienced increased demand during 2004. However, we cannot predict neither the sustainability nor rate of a recovery, if any, and the industry’s rate of growth in this recovery, if it occurs.any. If we are unable to effectively manage our resources and production

21

capacity during an industry upturn, there could be a material adverse effect on our business, financial condition and results of operations.
If the economy recovers and we are again in a period of high demand for our products, we may be unable to expand our manufacturing capacity quickly enough to meet increased demand, we may make decisions to expand capacity that are not profitable, and we may be unable to lower our costs or increase revenue.

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

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

• unforeseen environmental or engineering problems;
• unavailability or late delivery of production equipment;
• delays in completing new facilities;
• delays in bringing production equipment on-line;
• work stoppages or delays;
• inability to recruit and train qualified staff; and
• unanticipated cost increases and restrictions imposed by requirements of local, state or federal regulatory agencies in the United States and China.

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

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

     We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our net loss in 2002 was the largest in our history and our losses continued during 2003. We believe we will endure losses for at least part of 2004. We have and may continue to experience significant fluctuations in our revenue and earnings. Our quarterly and annual revenue and operating results have varied significantly in the past and may vary significantly in the future due to a number of factors, including:

• decline in general economic conditions or downturns in the industry in which we compete;
• fluctuations in demand for our products;
• expansion of our manufacturing capacity;
• expansion of our operations in China;

22

• limited availability and increased cost of raw materials;
• the volume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;
• fluctuation of our manufacturing yields;
• decreases in the prices of our competitors’ products;
• costs incurred in connection with any future acquisitions of businesses or technologies;
• increases in our expenses, including expenses for research and development; and
• our ability to develop, manufacture and deliver high quality products in a timely and cost-effective manner.

     Due to these factors, we believe that period-to-period comparisons of our operating results may not be meaningful indicators of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock could decline or fluctuate.

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

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

We must manage our inventory of component parts, work-in-process, and finished goods effectively to meet changing customer requirements, while keeping inventory costs down and improving gross margins. Some of our products and supplies have in the past and may in the future become obsolete while in inventory due to changing customer specifications, or become excess inventory due to decreased demand for our products and an inability to sell the inventory within a foreseeable period. Furthermore, if current costs of production increase or sales prices drop below the standard prices at which we value inventory, we may need to take a charge for a reduction in inventory values. We have in the past, including during 2004, had to take inventory valuation and impairment charges. If we are not successfully able to manage successfully our inventory in the future, we may again need to write off unsaleable,un-saleable, obsolete or excess inventory, which could adversely affect our results of operations. On October 1, 2003,

During early 2005 we implementedwill increase work-in-process inventory in order to avoid the effects of probable power shortages in China. We will prepare this inventory in accordance with our forecast of demand rather than against specific customer orders. If we do not forecast correctly, customers may not order the inventory we manufacture, and we will incur a new inventory control system thatcost with no offsetting revenue. Ultimately, we would have to incur a charge for the value of unused inventory.

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

The market for compound semiconductor substrates is characterized by pressures on average selling prices resulting from factors such as increased competition or overcapacity. We may experience unexpected difficulties.

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

price pressures on our products, and if average selling prices decline in the future, our revenues and gross margins could decline. We may not obtainbe unable to reduce the benefitscost of our products sufficiently to counter the effect of lower selling prices and allow us to keep pace with competitive pricing pressures and our margins could be adversely affected.

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

Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we expectfaced since late 2000 was more uncertain than in some prior periods, the downturn which began in 2001 lasted longer than expected and materially and adversely affected us and our operating results. 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 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.

Defects in our products could diminish demand for our products.

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

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

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

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

·       impurities in the materials used;

·       contamination of the manufacturing environment;

·       substrate breakage;

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

·       performance of personnel involved in the manufacturing process.

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

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

Our success depends on our ability to offer new products and product features that incorporate leading technology and respond to technological advances. In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industry standards. If our competitors introduce products employing new technologies or performance characteristics, our existing products could become obsolete and unmarketable. During the past two years, we have seen our competitors selling more substrates manufactured using a crystal growth technology similar to ours, which has eroded our technological differentiation. Other companies, including Triquent, are actively developing substrate materials that could


be used to manufacture devices that could provide the same high-performance, low-power capabilities as GaAs- and InP-based devices at competitive prices. If these substrate materials or VGF-derived products are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer.

The development of new products can be a highly complex process, and we may experience delays in developing and introducing new products. Any significant delays could cause us to fail to timely introduce and gain market acceptance of new products. Further, the costs involved in researching, developing and engineering new products could be greater than anticipated. If we fail to offer new products or product enhancements or fail to achieve higher quality products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements.

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

The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as greater strategic focus onFreiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as Triquent, that are actively developing alternative materials to GaAs and some semiconductor devices are being marketed using these materials. We believe that at least two of our core businesses. Wecompetitors are shipping high volumes of GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may be requireddevelop and begin using similar technology. If we are unable to return to the buyer some or all of the $1 million of the sale proceeds which will be held in escrow should the buyer successfully claim that we breached one of the representations or warranties made to it. Our building in Monterey Parkcompete effectively, our revenue may not be sold for the $1 million at which we are carrying it on our balance sheet. We may incur additional costs associated with the discontinued operations which could materially reduce our short term earnings.

Much of our cash resources are denominated in Chinese currencyincrease and are subject to exchange control restrictions.

     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 accessbe profitable. We face many competitors that have a number of significant advantages over us, 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 our products are.

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

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

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

·       the competition our customers face in their particular industries;

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

·       the financial and other resources of our customers; and


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

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

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

Many of our customers are facing business downturns that have reduced their cash heldbalances and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 120 days after delivery. Subsequent to our shipping a product, some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. During 2004, a customer of one agent filed for bankruptcy protection. We incurred a charge equal to the amount owed us and believe that there is a substantial likelihood that we will be able to recoup little, if any, of the this amount. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.

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

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

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

Through fiscal 2004, we have recorded investments in raw material suppliers in China, that provide us with opportunities to gain supply of key raw materials that are important to our substrate business. These affiliates each have a market beyond that provided by us. We do not have influence over all of these companies, each of which is located in China, and in some we have made only a strategic, minority investment. We may not be successful in achieving the financial, technological or commercial advantage upon which any given investment is premised, and we could end up losing all or part of our investment.

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

A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Our top five customers represented 30.1%, 28.9%, and 31.4% of product revenue for the years ended December 31, 2004, 2003, and 2002, respectively. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Our customers


are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders from some customers. In addition, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause revenue to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.

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

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

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

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

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

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


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

For example, we have recently been involved in litigation with Sumitomo Electric Industries, Ltd. (“SEI”) in Japan as well as interference actions in the United States. We and SEI approved a settlement of this litigation during the fourth quarter of 2004 and the litigation was withdrawn and we abandoned the interference proceeding. We incurred an initial charge of approximately $1.4 million and will have to pay ongoing royalties to SEI on certain of our products.

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

Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 79% and 66% of our total revenue for fiscal years ended December 31, 2004 and 2003, respectively. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue, particularly sales to customers in Asia.

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

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

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

·       unexpected changes in regulatory requirements;

·       longer periods to collect accounts receivable;

·       changes in export license requirements;

·       political and economic instability;

·       unexpected changes in diplomatic and trade relationships; and

·       foreign exchange rate fluctuations.

Our sales are denominated in U.S. dollars, except for sales to our Japanese and some Taiwanese customers, which are denominated in Japanese yen. Thus, increases in the value of the U.S. dollar could increase the price of our products in non-U.S. markets and make our products more expensive than competitors’ products in these markets. Also, denominating some sales in Japanese yen subjects us to fluctuations in the exchange rates between the U.S. dollar and the Japanese yen. The functional currencies


of our Japanese and Chinese subsidiaries are the local currencies. We incur transaction gains or losses resulting from consolidation of expenses incurred in local currencies for these subsidiaries, as well as in translation of the assets and liabilities of these assets at each balance sheet date. If we do not effectively manage the risks associated with international sales, our revenue, cash flows and financial condition could be adversely affected.

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

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

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

23To manage our business effectively, we may need to implement additional and improved management information systems, further develop our operating, administrative, financial and accounting systems and controls, add experienced senior level managers, and maintain close coordination among our executive, engineering, accounting, marketing, sales and operations organizations.

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

In order to comply with rules and regulations adopted pursuant to the Sarbanes-Oxley Act of 2002 by the SEC, as well as changes to listing standards adopted by NASDAQ, and accounting changes adopted affecting accounting for stock-based compensation we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year. Changes in the accounting rules, including legislative and other rules to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.

A reoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of a different contagious disease may adversely impact our manufacturing operations and some of our key suppliers and customers.If we fail to manage periodic contractions, we may utilize our cash balances and our existing cash and cash equivalent balances could decline.

We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. However, our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production, and other factors related to the uncertainties of the industry and global economies. If we fail to manage our contractions successfully we may draw down our


cash reserves, which would adversely affect our operating results and financial condition, reduce our value and may impinge our ability to raise debt and equity funding in the future, at a time when we may be required to raise additional cash. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital, or, if so required, that such capital will be available on terms acceptable to us, if at all. As part of our effort to reduce costs, we may lose key staff, production resources, and technology that we will need to grow when end markets recover. These events could reduce our ability to grow profitably as markets recover.

We anticipate that our existing cash resources will fund any anticipated operating losses, purchases of capital equipment and provide adequate working capital for the next twelve months. Our liquidity is affected by many factors including, among others, the extent to which we pursue additional capital expenditures, the level of our production efforts, and other factors related to the uncertainties of the industry and global economies. Accordingly, there can be no assurance that events in the future will not require us to seek additional capital sooner, or, if so required, that such capital will be available on terms acceptable to us if at all.

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

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

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

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

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


to close for an extended period, we may not be able to ship product to them, our revenue would decline and our financial performance would suffer.

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

Our operating results can vary significantly based upon the impactThe effect 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 expectedterrorist threats 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 dependsactions on the overall demandgeneral economy could decrease our revenues.

The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to our substrates,suppliers, customers and we are particularly dependant on the market conditions for the wireless, solid-state illumination, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

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

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

24

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

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

     To shift moreperform substantially all of our substrate manufacturing operations to China successfully, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. We may lose sales of our products to competitors who are not manufacturing in China, or whose operations in China, have already been qualified by customers. All of these events could reduce our revenue but increase our cost structure.

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

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

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

• greater experience in the business;
• more manufacturing experience;
• extensive intellectual property;
• broader name recognition; and
• significantly greater financial, technical and marketing resources.

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

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

Defects in our products could diminish demand for our products.

     Our products are complex and may contain defects. We have experienced quality control problems with some of our products over the past two years, which caused customers to return products to us, reduce orders for our products, or both. If we continue to experience quality control problems, or experience these or other problems in new products, customers may cancel or reduce orders or purchase products from our competitors

25

and sales of our products could decline. Defects in our products could cause us to incur higher manufacturing costs and suffer product returns and additional service expenses, all of which could adversely impact our operating results.

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

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

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

• impurities in the materials used;
• contamination of the manufacturing environment;
• substrate breakage;
• equipment failure, power outages or variations in the manufacturing process; and
• performance of personnel involved in the manufacturing process.

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

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

     Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 65.9% of our total revenue for the year ended December 31, 2003 and 43.9% for the year ended December 31, 2002. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue, particularly sales to customers in Asia.

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

Any future acquisitions may also affectdisrupt our business, financial condition and results of operations.

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

• changes in tariffs, import or export restrictions and other trade barriers;
• unexpected changes in regulatory requirements;

26

• longer periods to collect accounts receivable;
• changes in export license requirements;
• political and economic instability;
• unexpected changes in diplomatic and trade relationships; and
• foreign exchange rate fluctuations.

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

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

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

• the competition our customers face in their particular industries;
• the technical, manufacturing, sales and marketing and management capabilities of our customers;
• the financial and other resources of our customers; and
• the inability of our customers to sell their products if they infringe third party intellectual property rights.

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

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

Many of our customers are facing business downturns that have reduced their cash balances and their prospects. We frequently allow our customers to pay for products we ship to them within 30 to 90 days after delivery. Subsequent to our shipping a product, some customers have been unable to make payments as due, reducing our cash balances and causing us to incur charges to allow for a possibility that some accounts might not be paid. At least three customers that owed us a significant amount have filed for bankruptcy protection and we are unlikely to receive a substantial portion or any of the amounts owed to us as part of a bankruptcy settlement. Other customers may also be forced to file for bankruptcy. If our customers do not pay their accounts when due, we will be required to incur charges that would reduce our earnings.

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

     We depend on a limited number of suppliers for certain raw materials, components and equipment used in manufacturing our products, including key materials such as quartz tubing, polishing solutions, and paralytic boron nitride. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and no supplier guarantees supply of raw materials or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays

27

obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules and our revenue and operating results could suffer.

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

     We are subject to federal, state and local environmental and safety laws and regulations in all of our operating locations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development, and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. In March 2001, we settled a claim made by the California Occupational 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 for $200,415. Although we have put in place engineering, administrative and personnel protective equipment programs to address these issues, our ability to expand or continue to operate our present locations could be restricted or we could be required to acquire costly remediation equipment or incur other significant expenses. Existing or future changes in laws or regulations may require us to incur significant expenditures or liabilities, or may restrict our operations. In addition, our employees could be exposed to chemicals or other hazardous materials at our facilities and we may be subject to lawsuits seeking damages for wrongful death or personal injuries allegedly caused by exposure to chemicals or hazardous materials at our facilities.

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

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

A small number of substrate customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 28.9% of our total revenue for the year ended December 31, 2003 and 31.4% for the year ended December 31, 2002. One customer accounted for 6.8% of our revenue for the year ended December 31, 2003. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate customers. Our customers are not obligated to purchase a specified quantity of our products or to provide us with binding forecasts of product purchases. In addition, our customers may reduce, delay or cancel orders at any time without any significant penalty, and during the past year, we have experienced slower bookings, significant push outs and cancellation of orders. In addition, due to the difficult economic environment, several of our previously large customers have stopped operations entirely. If we lose a major customer or if a customer cancels, reduces or delays orders, our revenue would decline. In addition, customers that have accounted for significant revenue in the past may not continue to generate revenue for us in any future period. Any delay in scheduled shipments of our products could cause net sales to fall below our expectations and the expectations of market analysts or investors, causing our stock price to decline.

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

     Customers typically place orders with us for our substrate products three months to a year or more after our initial contact with them. The sale of our products may be subject to delays due to our customers’ lengthy internal budgeting, approval and evaluation processes. During this time, we may incur substantial expenses and expend sales, marketing and management efforts while the customers evaluate our products. These expenditures may not result in sales of our products. If we do not achieve anticipated sales in a period as

28

expected, we may experience an unplanned shortfall in our revenue. As a result, we may not be able to cover expenses, causing our operating results to vary. In addition, if a customer decides not to incorporate our products into its initial design, we may not have another opportunity to sell products to this customer for many months or even years. In the current competitive and economic climate, the average sales cycle for our products has lengthened even further and is expected to continue to make it difficult to accurately forecast our future sales. We anticipate that sales of any future substrate products will also have lengthy sales cycles and will, therefore, be subject to risks substantially similar to those inherent in the lengthy sales cycle of our current substrate products.
If we are unable to protect our intellectual property, we may lose valuable assets or incur costly litigation.

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

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

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

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

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

     Other companies may hold or obtain patents on inventions or may otherwise claim proprietary rights to technology necessary to our business. The markets in which we compete are comprised of competitors who in some cases hold substantial patent portfolios covering aspects of products that could be similar to ours. We could become subject to claims that we are infringing patent, trademark, copyright or other proprietary rights of others, and have recently been sued by a substrate competitor concerning alleged patent infringement. Litigation to determine the validity of alleged claims could be time-consuming and result in significant expense to us and divert the efforts of our technical and management personnel, whether or not the litigation is ultimately determined in our favor. If a lawsuit is decided against us, we could be subject to significant liabilities, requiring us to seek costly licenses or preventing us from manufacturing and selling our products. We may not be able to obtain required licensing agreements on terms acceptable to us or at all.

29

As our business matures, we may need to upgrade our systems, or incur additional costs related to regulatory compliance.

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

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

If necessary, we will spend substantial sums to support our future growth and shift to China and to comply with the reporting and attestation requirements of the Sarbanes-Oxley Act of 2002. We may incur additional unexpected costs. Our systems, procedures or controls may not be adequate to support our operations, and we may be unable to expand quickly enough to exploit potential market opportunities.

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

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

As a result of the difficult economic conditions, we have implemented restructuring and workforce reductions, which may adversely affect the morale and performance of our personnel and our ability to hire new personnel.

     In connection with our efforts to streamline operations, reduce costs and bring staffing and structure in line with demand for our products, we implemented a corporate restructuring beginning in 2001 and reduced our workforce, shifted production activities to China, reduced capital expenditures, and discontinued our opto-electronics business. In addition, our stock price is volatile, which can affect the value of stock options issued to our employees. Our restructuring may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce and loss of employee morale and decreased performance. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies that they perceive as having less volatile stock prices. Continuity of personnel can be very important factors in the sales and production of our products and completion of our research and development efforts.

30

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

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

• ·we may have difficulty assimilating the operations, products and personnel of the acquired businesses;
• our ongoing business may be disrupted;
• we may incur unanticipated costs;
• our management may be unable to manage the financial and strategic position of acquired or developed products, services and technologies;
• we may be unable to maintain uniform standards, controls, procedures, and policies; and
• our relationships with employees and customers may be impaired as a result of any integration.

·       our ongoing business may be disrupted;

·       we may incur unanticipated costs;

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

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

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

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

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

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

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

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

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to successfully manage our business or achieve our objectives.

42



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

We have not over the past year been able to sustain growth, and may not be able to return to historic growth levels in the current economic environment. Our success depends uponnet loss in 2002 was the largest in our history and our losses continued serviceduring 2003 and 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 Morris S. Young, Ph.D., our president, chairman of the board and chief executive officer, as well as other key management and technical personnel. We do not have long-term employment contracts with, or key person life insurance on, any of our key personnel.factors, including:

     We believe our future success will also depend in large part upon·       our ability to attractdevelop, manufacture and retain highly skilled managerial, engineering, salesdeliver high quality products in a timely and marketing, finance and manufacturing personnel. The competitioncost-effective manner;

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

·       fluctuations in demand for these employees is intense and we cannot assure you that we will be successful in attracting and retaining new personnel. The loss of the services of anyour products;

·       expansion of our key personnel,manufacturing capacity;

·       expansion of our operations in China;

·       limited availability and increased cost of raw materials;

·       the inability to attract or retain qualified personnelvolume and timing of orders from our customers, and cancellations, push outs and delays of customer orders;

·       fluctuation of our manufacturing yields;

·       decreases in the future or delays in hiring required personnel, particularly engineers, could make it difficult for us to manage our business and meet key objectives, including the timely introduction of new products.

31

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

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

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

·       increases in our partexpenses, including expenses for research and development.

Due to comply with governmental regulations could result in the lossthese factors, we believe that period-to-period comparisons of our ability to manufacture our products in China.

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

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

The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to our suppliers, customers and markets for our products and the U.S. economy are uncertain. There may be embargos of ports or products, or destruction of shipments or our facilities, or attacks that affect our personnel. There may be other potential adverse effects on our operating results duemay not be meaningful indicators of our future performance. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock could decline or fluctuate.

A substantial percentage of our operating expenses are fixed in the short term and we may be unable to adjust spending to compensate for an unexpected shortfall in revenues. As a significant event that we cannot foresee.

Our stock price has been and may continue to be volatile.
result, any delay in generating revenue could cause our operating results to be below the expectations of market analysts or investors, which could also cause our stock price to fall.

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

Our stock price has fluctuated significantly since we began trading on the NasdaqNASDAQ National Market. For the yeartwelve months ended December 31, 2003,2004, the high and low closing sales prices of our common stock were $3.42$4.68 and $0.67,$1.05, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

• ·actual or anticipated fluctuations in our quarterly or annual operating results;
• changes in expectations about our future financial performance or changes in financial estimates of securities analysts;
• announcements of technological innovations by us or our competitors;
• new product introduction by us or our competitors;
• large customer orders or order cancellations; and
• the operating and stock price performance of comparable companies.

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

·       announcements of technological innovations by us or our competitors;


·       new product introduction by us or our competitors;

·       large customer orders or order cancellations; and

·       the operating and stock price performance of comparable companies.

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

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

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

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for

32

other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock.

     Further, onOn April 24, 2001, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.

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

• ·the division of our board of directors into three separate classes, each with three year terms;
• the right of our board to elect a director to fill a space created by a board vacancy or the expansion of the board;
• the ability of our board to alter our bylaws;
• the ability of our board to authorize the issuance of up to 2,000,000 shares of blank check preferred stock; and
• the requirement that only our board or the holders of at least 10% of our outstanding shares may call a special meeting of our stockholders.

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

·       the ability of our board to alter our bylaws;

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

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

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

• 66 2/3% of the shares of voting stock not owned by these large stockholders approve the merger or combination, or
• the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock.

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

In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by Nasdaq, and proposed accounting changes by the Securities and Exchange Commission, we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result·       662¤3% of the high claims rates they incurred overshares of voting stock not owned by these large stockholders approve the past year, and our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, increased during 2003. Proposed changesmerger or combination, or

·       the board of directors approves the merger or combination or the transaction which resulted in the accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.

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

     The new requirements adopted by the Securities and Exchange Commission in response to the passage of the Sarbanes-Oxley Act of 2002 will require annual review and evaluationlarge stockholder owning 15% or more of our internal control systems,outstanding voting stock.


Item 7A.   Quantitative and attestation of these systems by our independent accountants. We are currently reviewing our internal control procedures and considering further documentation of such procedures that may be necessary. However, theQualitative Disclosures about Market Risk

33Foreign Currency Risk

guidelines for the evaluation and attestation of internal control systems have not yet been finalized. Furthermore, once the guidelines are finalized, the evaluation and attestation processes will be new and untested. Therefore, we can give no assurances that our systems will satisfy the new requirements of the Securities and Exchange Commission or that we will receive a favorable review and attestation by our independent auditors.
Item 7A.Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Risk

We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of December 31, 2003,2004, we had no outstanding commitments with respect to foreign exchange contracts.

Interest Rate Risk

Interest Rate Risk

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

                     
CurrentProforma 10%Proforma 10%
BalanceCurrentInterestInterest RateInterest Rate
December 31,InterestIncome/DeclineIncrease
Instrument2003Rate(Expense)Income/(Expense)Income/(Expense)
Cash and cash equivalents $24,339   1.80% $438  $394  $482 
Bonds (see Note 5)  8,450   1.35%  (114)  (103)  (125)
           
   
   
 
          $324  $291  $357 
           
   
   
 
Equity Risk

Instrument

 

 

 

Balance as of 
December 31,
2004

 

Current
Interest
Rate

 

Projected
Annual Interest
Income/
(Expense)

 

Proforma 10%
Interest Rate
Decline
Income/(Expense)

 

Proforma 10%
Interest Rate
Increase
Income/(Expense)

 

Cash and cash equivalents

 

 

$

12,117

 

 

 

0.50

%

 

 

$

61

 

 

 

$

55

 

 

 

$

67

 

 

Investment in debt instruments

 

 

25,322

 

 

 

1.40

 

 

 

523

 

 

 

470

 

 

 

575

 

 

Long-term debt

 

 

(8,050

)

 

 

2.49

 

 

 

(200

)

 

 

(180

)

 

 

(220

)

 

 

 

 

 

 

 

 

 

 

 

 

$

384

 

 

 

$

345

 

 

 

$

422

 

 

Equity Risk

We also maintain minority investments in private and publicly traded companies. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions. In 2004, we recorded $210,000 in charges in connection with an impairment write-down of our investments. In 2003, we recorded $2.0 million in charges to other expense to write downwrite-down our investment in two private USU.S. companies. As of December 31, 2003,2004, the minority investments we continue to hold totaled $4.3$0.4 million.


Item 8

Item 8..   Consolidated Financial Statements and Supplementary Data
Selected Quarterly Results of Operations

Selected Quarterly Results of Operations

The following table sets forth unaudited quarterly results in dollars and percentages for the eight quarters ended December 31, 2003.2004. We believe that all necessary adjustments, consisting only of normal recurring

34

adjustments, have been included in the amounts stated below to present fairly such quarterly information. The operating results for any quarter are not necessarily indicative of results for any subsequent period.
                                   
Quarters ended
Dec. 31,Sept. 30,June 30,Mar. 31,Dec. 31,Sept. 30,June 30,Mar. 31,
20032003200320032002200220022002
Revenue $9,129  $8,529  $8,519  $8,536  $8,503  $11,726  $12,897  $11,739 
Cost of revenue  8,342   8,029   7,844   8,263   18,253   12,885   11,087   11,533 
   
   
   
   
   
   
   
   
 
Gross profit (loss)  787   500   675   273   (9,750)  (1,159)  1,810   206 
Operating expenses:                                
 Selling, general and administrative  2,502   2,654   2,819   2,500   2,752   3,495   3,441   4,172 
 Research and development  289   301   368   379   597   486   513   743 
 Restructuring costs  —   —   —   —   —   542   14,090   — 
   
   
   
   
   
   
   
   
 
  Total operating expenses  2,791   2,955   3,187   2,879   3,349   4,523   18,044   4,915 
   
   
   
   
   
   
   
   
 
Loss from operations  (2,004)  (2,455)  (2,512)  (2,606)  (13,099)  (5,682)  (16,234)  (4,709)
Interest expense  96   145   108   117   75   105   122   135 
Other (income) and expense, net  15   (3)  1,269   (231)  4,520   (308)  9,208   (717)
   
   
   
   
   
   
   
   
 
Loss from continuing operations before provision for income taxes  (2,115)  (2,597)  (3,889)  (2,492)  (17,694)  (5,479)  (25,564)  (4,127)
Provision (benefit) for income taxes  —   —   —   —   (2,314)  10,673   (4,590)  (1,650)
   
   
   
   
   
   
   
   
 
Loss from continuing operations  (2,115)  (2,597)  (3,889)  (2,492)  (15,380)  (16,152)  (20,974)  (2,477)
Discontinued operations:                                
 Loss from discontinued operations  —   (1,591)  (2,747)  (1,825)  (2,476)  (19,533)  (10,813)  (1,803)
 Loss on disposal  —   1,625   (11,100)  —   —   —   —   — 
 Benefit for income taxes  —   —   —   —   (324)  (7,012)  (369)  (722)
   
   
   
   
   
   
   
   
 
Loss from discontinued operations  —   34   (13,847)  (1,825)  (2,152)  (12,521)  (10,444)  (1,081)
   
   
   
   
   
   
   
   
 
Net loss  (2,115)  (2,563)  (17,736)  (4,317)  (17,532)  (28,673)  (31,418)  (3,558)
   
   
   
   
   
   
   
   
 

 

 

Quarters Ended

 

 

 

Dec. 31,
2004

 

Sept. 30,
2004

 

June 30,
2004

 

Mar. 31,
2004

 

Dec. 31,
2003

 

Sept. 30,
2003

 

June 30,
2003

 

Mar. 31,
2003

 

Revenue

 

$

7,623

 

$

8,531

 

$

9,524

 

$

9,776

 

$

9,129

 

$

8,529

 

$

8,519

 

$

8,536

 

Cost of revenue

 

7,000

 

10,767

 

8,695

 

9,243

 

8,342

 

8,029

 

7,844

 

8,263

 

Gross profit (loss)

 

623

 

(2,236

)

829

 

533

 

787

 

500

 

675

 

273

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

3,120

 

2,468

 

3,203

 

2,770

 

2,502

 

2,654

 

2,819

 

2,500

 

Research and development

 

391

 

397

 

350

 

341

 

289

 

301

 

368

 

379

 

Impairment charges

 

—

 

210

 

—

 

—

 

—

 

—

 

—

 

—

 

Restructuring costs

 

73

 

158

 

1,077

 

—

 

—

 

—

 

—

 

—

 

Total operating expenses

 

3,584

 

3,233

 

4,630

 

3,111

 

2,791

 

2,955

 

3,187

 

2,879

 

Loss from operations

 

(2,961

)

(5,469

)

(3,801

)

(2,578

)

(2,004

)

(2,455

)

(2,512

)

(2,606

)

Interest expense

 

63

 

60

 

58

 

109

 

96

 

145

 

108

 

117

 

Other (income) and expense, net

 

(212

)

(380

)

113

 

(167

)

15

 

(3

)

1,269

 

(231

)

Loss from continuing operations before provision for income taxes

 

(2,812

)

(5,149

)

(3,972

)

(2,520

)

(2,115

)

(2,597

)

(3,889

)

(2,492

)

Provision (benefit) for income taxes

 

(106

)

40

 

97

 

40

 

—

 

—

 

—

 

—

 

Loss from continuing operations

 

(2,706

)

(5,189

)

(4,069

)

(2,560

)

(2,115

)

(2,597

)

(3,889

)

(2,492

)

Discontinued operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain (loss) from discontinued operations

 

250

 

—

 

222

 

—

 

—

 

(1,591

)

(2,747

)

(1,825

)

Gain (loss) on disposal

 

194

 

225

 

—

 

—

 

—

 

1,625

 

(11,100

)

—

 

Benefit for income taxes

 

—

 

—

 

—

 

—

 

—

 

—

 

—

 

—

 

Gain (loss) from discontinued operations

 

444

 

225

 

222

 

—

 

—

 

34

 

(13,847

)

(1,825

)

Net loss

 

$

(2,262

)

$

(4,964

)

$

(3,847

)

$

(2,560

)

$

(2,115

)

$

(2,563

)

$

(17,736

)

$

(4,317

)

35

                                   
Quarters ended
Dec. 31,Sept. 30,June 30,Mar. 31,Dec. 31,Sept. 30,June 30,Mar. 31,
20032003200320032002200220022002
Revenue  100.0%  100.0%  100.0%  100.0%  100.0%  100.0%  100.0%  100.0%
Cost of revenue  91.4%  94.1%  92.1%  96.8%  214.7%  109.9%  86.0%  98.2%
   
   
   
   
   
   
   
   
 
Gross profit (loss)  8.6%  5.9%  7.9%  3.2%  (114.7)%  (9.9)%  14.0%  1.8%
Operating expenses:                                
 Selling, general and administrative  27.4%  31.1%  33.1%  29.3%  32.4%  29.8%  26.7%  35.5%
 Research and development  3.2%  3.5%  4.3%  4.4%  7.0%  4.1%  4.0%  6.3%
 Restructuring costs  0.0%  0.0%  0.0%  0.0%  0.0%  4.6%  109.3%  0.0%
   
   
   
   
   
   
   
   
 
  Total operating expenses  30.6%  34.6%  37.4%  33.7%  39.4%  38.6%  139.9%  41.9%
   
   
   
   
   
   
   
   
 
Loss from operations  (22.0)%  (28.7)%  (29.5)%  (30.5)%  (154.1)%  (48.5)%  (125.9)%  (40.1)%
Interest expense  1.1%  1.7%  1.3%  1.4%  0.9%  0.9%  0.9%  1.2%
Other (income) and expense, net  0.2%  0.0%  14.9%  (2.7)%  53.2%  (2.6)%  71.4%  (6.1)%
   
   
   
   
   
   
   
   
 
Loss from continuing operations before provision for income taxes  (23.3)%  (30.4)%  (45.7)%  (29.2)%  (208.1)%  (46.7)%  (198.2)%  (35.2)%
Provision (benefit) for income taxes  0.0%  0.0%  0.0%  0.0%  (27.2)%  91.0%  (35.6)%  (14.1)%
   
   
   
   
   
   
   
   
 
Loss from continuing operations  (23.3)%  (30.4)%  (45.7)%  (29.2)%  (180.9)%  (137.7)%  (162.6)%  (21.1)%
Discontinued operations:                                
 Loss from discontinued operations  0.0%  (18.7)%  (32.2)%  (21.4)%  (29.1)%  (166.6)%  (83.8)%  (15.4)%
 Loss on disposal  0.0%  19.1%  (130.3)%  0.0%  0.0%  0.0%  0.0%  0.0%
 Benefit for income taxes  0.0%  0.0%  0.0%  0.0%  (3.8)%  (59.8)%  (2.9)%  (6.2)%
   
   
   
   
   
   
   
   
 
Loss from discontinued operations  0.0%  0.4%  (162.5)%  (21.4)%  (25.3)%  (106.8)%  (81.0)%  (9.2)%
   
   
   
   
   
   
   
   
 
Net loss  (23.3)%  (30.0)%  (208.2)%  (50.6)%  (206.2)%  (244.5)%  (243.6)%  (30.3)%
   
   
   
   
   
   
   
   
 

Other Consolidated Financial Statementsconsolidated financial statements and Supplementary Datasupplementary data required by this item are set forth at the pages indicated at Item 14(a)15(a).


Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

None.

Item 9A.9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

On June 23, 2004 we dismissed PricewaterhouseCoopers LLP (“PwC”) as our independent registered public accounting firm. The audit reports of PwC on our consolidated financial statements for each of past two years did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. The decision to change accountants was approved by our Audit Committee of the Board of Directors. In connection with its audits for the two recent fiscal years ending on December 31, 2003 and through June 18, 2004, there were no disagreements with PwC on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedures which disagreements, if not resolved to PwC’s satisfaction, would have caused PwC to make reference to such disagreement in their report on the financial statements for such years.

During the two fiscal years ending on December 31, 2003 and through June 18, 2004, there were no reportable events as defined in Item 304(a)(1)(v)(A), (B), (C) or (D) of Regulation S-K, except that, in its letter to the Audit Committee Members dated June 7, 2004, in connection with the review of the financial statements for the quarter ended March 31, 2004, PwC noted that as part of our implementation of our Code of Business Conduct and Ethics, we learned, and informed PwC, of certain failures to comply with requirements for product testing and the provision of testing data and information relating to requirements of certain customers. Our investigation into the product testing practices and procedures conducted, with the assistance of outside counsel, confirmed that certain customer requirements were not being complied with.

PwC indicated that it believed that the condition that enabled the deficiency to exist, including the lack of an effective monitoring and operational oversight function in this area, was a material weakness as defined in AU 325, Communication of Internal Control Related Matters Noted In An Audit (AU 325) of the AICPA Professional Standards. PwC recommended that we implement specific measures to ensure greater operational controls and compliance with customer requirements. Company management did not disagree with the suggestions made by PwC.

The Company engaged Burr, Pilger & Mayer LLP as its independent registered public accounting firm as of June 23, 2004. During the two fiscal years ending on December 31, 2003 and through the date of their engagement by us, we did not consult with Burr, Pilger & Mayer LLP regarding either (i) the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on our financial statements, and neither a written report was provided to us or oral advice was provided that Burr, Pilger & Mayer LLP concluded was an important factor considered by us in reaching a decision as to the accounting, auditing or financial reporting issue; or (ii) any matter that was either the subject of a disagreement, as that term is defined in Item 304(a)(1)(iv) of Regulation S-K and the related instructions to Item 304 of Regulation S-K, or a reportable event, as that term is defined in Item 304(a)(1)(v) of Regulation S-K.

Item 9A.   Controls and Procedures

     (a) Evaluation of disclosure controls and procedures.   Under the supervision and with the participation of our management, including our principal executive officerInterim Chief Executive Officer and principal financial officer, we conducted an evaluationChief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c)13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this report.amended. Based on theirupon that evaluation, our principal executive officerInterim Chief Executive Officer and principal financial officerour Chief Financial Officer concluded that the our disclosure controls and procedures were effective as of the end of the period covered by this report.

     (b) Changes in internal control over financial reporting.As required by Rule 13a-15(d), our management, including our principal executive officerInterim Chief Executive Officer and principal finance officer,Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the quarterperiod covered by this report that have materially affected, or are reasonably likely to materially affect, our


internal control over financial reporting. Based on that evaluation, there has been no such change during the quarterperiod covered by this report. It should be noted that any

Limitations of the effectiveness of internal control.A control system, of controls, howeverno matter how well designedconceived and operated, can provide only reasonable, and not absolute, assurance that the objectives of the internal control system will beare met. Because of the inherent limitations of any internal control system, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Notwithstanding these limitations, our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. Our Interim Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are, in fact, effective at the “reasonable assurance” level.

36Item 9B.   Other Information

None.

48



PART III

The SECUnited States Securities and Exchange Commission (“SEC”) allows us to include information required in this report by referring to other documents or reports we have already or will soon be filing. This is called “Incorporation by Reference.” We intend to file our definitive proxy statement pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report, and certain information therein is incorporated in this report by reference.

Item 10.Directors and Executive Officers of the Registrant.

Item 10.   Directors and Executive Officers of the Registrant.

The information required by this item pursuant to Item 401 of Regulation S-K concerning directors is incorporated herein by reference to the information set forth in our definitive proxy statement to be filed in connection with our annual meeting of stockholders to be held on May 18, 2004, under the section entitled “Proposal No. 1-Election1, Election of Directors.”Directors” in the Proxy Statement.

     Information concerning our executive officers is incorporated herein by reference to information set forth in our definitive proxy statement to be filed in connection with our annual meeting of stockholders to be held on May 18, 2004, under the section entitled “Executive Compensation and Other Matters.”

The information required by this item pursuant to Item with respect401 of Regulation S-K concerning executive officers is incorporated by reference to the section entitled “Proposal No.1 Election of Directors” and “Executive Compensation and Other Matters” in the Proxy Statement.

The information required by this item pursuant to Item 405 of Regulation S-K concerning compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated herein by reference to information set forth in the definitive Proxy statement to be filed in connection with our annual meetingsection entitled “Security Ownership of stockholders to be held on May 18, 2004, under the heading “SectionCertain Holders—Section 16(a) Beneficial Ownership Reporting Compliance.”Compliance” in the Proxy Statement.

     We have revised our Insider Trading Policy to allow our directors, officers and other employees covered under the policy to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange ActThe Board of 1934, written programs that permit automatic tradingDirectors of our stock or trading of our stock by an independent person (such as an investment bank) who is not aware of material inside information at the time of the trade. On February 28, 2003 Morris S. Young, our Chief Executive Officer, activated a trading plan under Rule 10b5-1. Some other of our directors or officers may establish such programs in future periods.

WeAXT, Inc. has adopted a code of Business Conductethics that applies to our principal executive officers, principal financial officer, and Ethicscorporate controller, as well as other employees. A copy of this code of ethics has been posted on our Internet website at www.axt.com. Any amendments to, or waivers from, a provision of our code of ethics that applies to our principal executive officer, principal financial officer, controller, or persons performing similar functions and other employees. A copythat relates to any element of this Codethe code of Business Conduct and Ethics is filed as an exhibit to this Form 10-K.ethics enumerated in paragraph (b) of Item 406 of Regulation S-K shall be disclosed by posting such information on our website.

Item 11.Executive Compensation.

Item 11.   Executive Compensation.

The information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed in connection with our annual meeting of stockholders to be held on May 18, 2004,June 28, 2005, under the section entitled “Executive Compensation and Other Matters.”

Item 12.Security Ownership of Certain Beneficial Owners and Management, and Equity Compensation Plan Information.

Item 12.   Security Ownership of Certain Beneficial Owners and Management, and Related Stockholder Matters.

The information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed in connection with our annual meeting of stockholders to be held on May 18, 2004,June 28, 2005, under the section entitled “Security Ownership of Certain Beneficial Owners and Management”Management and “EquityEquity Compensation Plan Information.”

Item 13.Certain Relationships and Related Transactions

Item 13.   Certain Relationships and Related Transactions

Since January 2002, there has not been, nor is there currently proposed, any transaction or series of similar transactions to which we were or are to be a party in which the amount involved exceeds $60,000, and in which any director, executive officer or holder of more than 5% of any class of our voting securities or members of that person’s immediate family had or will have a direct or indirect material interest other than the transactions described below.

We entered into an operating lease in July 2001 for warehouse space in Fremont, CA with 4160 Business Center, LLC, a real estate holding company, in which Davis Zhang, the president of our substrate division,China


Operations, is the sole shareholder. Lease payments to 4160 Business Center, LLC were approximately $484,000 for the year ended December 31, 2002 and $121,000 for the

37

three months ended March 31, 2003. In April of 2003, Mr. Zhang sold this warehouse to a party unrelated to the Company.us. We began leasing this warehouse from the new owner on the date of sale. Mr. Zhang will continue to hold a $3.7 million note on the property through April 2005.
Item 14.Principal Accountant Fees and Services

Item 14.   Principal Accountant Fees and Services

The information required by this Item is incorporated herein by reference to information set forth in our definitive Proxy statement to be filed in connection with our annual meeting of stockholders to be held on May 18, 2004,June 28, 2005, under the section entitled “Principal Accountant Fees and Services.Accounting Firm Fees.”

3850



PART IV

Item 15.Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(a) The following documents are filed as part of this report:
Item 15.   Exhibits and Financial Statement Schedules

(a)  The following documents are filed as part of this report:

(1)

Financial Statements:

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent AuditorsRegistered Public Accounting Firm, Burr, Pilger & Mayer LLP

40

52

Report of Independent Registered Public Accounting Firm, PricewaterhouseCoopers LLP

53

Consolidated Balance Sheets

41

54

Consolidated Statements of Operations

42

55

Consolidated Statements of Stockholders’ Equity

43

56

Consolidated Statements of Cash Flows

44

57

Notes to Consolidated Financial Statements

45-63

58

(2) (2)Financial Statement Schedules

All schedules have been omitted because the required information is not present or not present in amounts sufficient to require submission of the schedulesapplicable or because the information required is included in the Consolidated Financial Statementsconsolidated financial statements or Notesnotes thereto.

     (3)(b)         Exhibits

See Index to Exhibits on page 65 hereof.attached elsewhere to this Form 10-K. The exhibits listed in the accompanying Index to Exhibits are filed as part of, or incorporated by reference into, this report on Form 10-K.

     (b) Reports on Form 8-K51



     We filed or furnished the following quarterly reports on Form 8-K during the quarter ended December 31, 2003:

     (1) We furnished the report on Form 8-K on October 22, 2003 reporting our financial results for the quarter ended September 30, 2003.

39

REPORT OF INDEPENDENT AUDITORSREGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and Board of Directors and Stockholders of AXT, Inc.:

     In our opinion,We have audited the accompanying consolidated balance sheetssheet of AXT, Inc. and subsidiaries (the Company) as of December 31, 2004, and the related consolidated statements of operations, of stockholdersstockholders’ equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of AXT, Inc. and its subsidiaries atas of December 31, 2003 and 2002,2004, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

/s/ BURR, PILGER & MAYER LLP

Burr, Pilger & Mayer LLP

Palo Alto, California
February 4, 2005


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of AXT, Inc.:

In our opinion, the accompanying consolidated balance sheet as of December 31, 2003and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the threetwo years in the period ended December 31, 2003 present fairly, in all material respects, the financial position, results of operations and cash flows of AXT, Inc. and its subsidiaries at December 31, 2003 and for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; ourmanagement. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditingthe standards generally accepted inof the United States of America, whichPublic Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/S/s/ PRICEWATERHOUSECOOPERS LLP

PricewaterhouseCoopers LLP

San Jose, California


March 5, 2004

4053



AXT, INC.
CONSOLIDATED BALANCE SHEETS

 

 

December 31,

 

 

 

2004

 

2003

 

 

 

(In thousands, except
per share data)

 

ASSETS

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

12,117

 

$

24,339

 

Short-term investments

 

20,062

 

14,669

 

Accounts receivable, net of allowance of $1,087 and $4,304 as of December 31, 2004 and 2003, respectively

 

4,034

 

6,297

 

Inventories, net

 

16,462

 

24,083

 

Prepaid expenses and other current assets

 

2,523

 

1,575

 

Assets held for sale

 

1,250

 

1,000

 

Total current assets

 

56,448

 

71,963

 

Property, plant and equipment

 

19,045

 

21,795

 

Restricted deposits

 

8,215

 

9,302

 

Other assets

 

3,832

 

3,963

 

Total assets

 

$

87,540

 

$

107,023

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities

 

 

 

 

 

Accounts payable

 

$

1,895

 

$

2,638

 

Accrued liabilities

 

3,920

 

3,227

 

Accrued compensation and related charges

 

715

 

1,012

 

Accrued restructuring costs

 

552

 

—

 

Customer prepayments

 

130

 

994

 

Current portion of long-term debt

 

450

 

3,694

 

Income taxes payable

 

2,925

 

3,063

 

Total current liabilities

 

10,587

 

14,628

 

Long-term debt, net of current portion

 

7,600

 

8,842

 

Other long-term liabilities

 

1,336

 

1,255

 

Total liabilities

 

19,523

 

24,725

 

Commitments and contingencies (Note 18)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value; 2,000 shares authorized; 883 shares issued and outstanding as of December 31, 2004 and 2003, respectively

 

3,532

 

3,532

 

Common stock, $0.001 par value; 70,000 shares authorized; 23,119 and 22,957 shares issued and outstanding as of December 31, 2004 and 2003,
respectively

 

23

 

23

 

Additional paid-in-capital

 

155,431

 

155,155

 

Accumulated deficit

 

(92,561

)

(78,928

)

Other comprehensive income

 

1,592

 

2,516

 

Total stockholders’ equity

 

68,017

 

82,298

 

Total liabilities and stockholders’ equity

 

$

87,540

 

$

107,023

 

CONSOLIDATED BALANCE SHEETS

           
December 31,
20032002
(In thousands, except
per share data)
ASSETS
Current assets        
 Cash and cash equivalents $24,339  $13,797 
 Short-term investments  14,669   8,205 
 Accounts receivable, net  6,297   7,195 
 Inventories  24,083   37,598 
 Prepaid expenses and other current assets  1,575   4,002 
 Income tax receivable  —   8,783 
 Assets held for sale  1,000   5,957 
   
   
 
  Total current assets  71,963   85,537 
Property, plant and equipment  21,795   39,982 
Restricted deposits  9,302   11,150 
Long-term investments  —   3,657 
Other assets  3,963   5,341 
   
   
 
  Total assets $107,023  $145,667 
   
   
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities        
 Accounts payable $2,638  $4,228 
 Accrued liabilities  8,296   11,407 
 Current portion of long-term debt  3,694   965 
 Current portion of capital lease obligation  —   3,562 
   
   
 
  Total current liabilities  14,628   20,162 
Long-term debt, net of current portion  8,842   13,289 
Long-term capital lease, net of current portion  —   4,847 
Other long-term liabilities  1,255   1,712 
   
   
 
  Total liabilities  24,725   40,010 
   
   
 
Commitments and Contingencies (Note 14)         
Stockholders’ equity:        
 Preferred stock, $.001 par value; 2,000 shares authorized;
883 shares issued and outstanding		  3,532   3,532 
 Common stock, $.001 par value; 70,000 shares authorized;
22,957 and 22,495 shares issued and outstanding		  155,178   154,485 
 Accumulated deficit  (78,928)  (52,197)
 Other comprehensive income (loss)  2,516   (163)
   
   
 
  Total stockholders’ equity  82,298   105,657 
   
   
 
  Total liabilities and stockholders’ equity $107,023  $145,667 
   
   
 

The accompanying notes are an integral part of these consolidated financial statements.

4154



AXT, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS

               
Years Ended December 31,
200320022001
(In thousands, except per share data)
Revenue $34,713  $44,865  $108,800 
Cost of revenue  32,478   53,758   67,494 
   
   
   
 
Gross profit (loss)  2,235   (8,893)  41,306 
Operating expenses:            
 Selling, general and administrative  10,475   13,860   17,208 
 Research and development  1,337   2,339   3,876 
 Restructuring costs  —   14,632   — 
   
   
   
 
  Total operating expenses  11,812   30,831   21,084 
   
   
   
 
Income (loss) from operations  (9,577)  (39,724)  20,222 
Interest expense  466   437   831 
Other (income) and expense, net  1,050   12,703   13,379 
   
   
   
 
Income (loss) from continuing operations before benefit for income taxes  (11,093)  (52,864)  6,012 
Provision for income taxes  —   2,119   2,164 
   
   
   
 
Income (loss) from continuing operations  (11,093)  (54,983)  3,848 
Discontinued operations:            
 Loss from discontinued operations  (6,163)  (34,625)  (13,818)
 Loss on disposal  (9,475)  —   — 
 Benefit for income taxes  —   (8,427)  (4,974)
   
   
   
 
Loss from discontinued operations  (15,638)  (26,198)  (8,844)
   
   
   
 
Net loss $(26,731) $(81,181) $(4,996)
   
   
   
 
Basic income (loss) per share:            
 Income (loss) from continuing operations $(0.49) $(2.46) $0.17 
 Loss from discontinued operations  (0.69)  (1.17)  (0.40)
 Net loss  (1.18)  (3.63)  (0.23)
Diluted income (loss) per share:            
 Income (loss) from continuing operations $(0.49) $(2.46) $0.17 
 Loss from discontinued operations  (0.69)  (1.17)  (0.39)
 Net loss  (1.18)  (3.63)  (0.23)
Shares used in per share calculations:            
 Basic  22,781   22,433   22,278 
 Diluted  22,781   22,433   22,879 

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

 

 

(In thousands, except per share data)

 

Revenue

 

$

35,454

 

$

34,713

 

$

44,865

 

Cost of revenue

 

35,705

 

32,478

 

53,758

 

Gross profit (loss)

 

(251

)

2,235

 

(8,893

)

Operating expenses:

 

 

 

 

 

 

 

Selling, general and administrative

 

11,561

 

10,475

 

13,860

 

Research and development

 

1,479

 

1,337

 

2,339

 

Impairment charges

 

210

 

—

 

14,632

 

Restructuring costs

 

1,308

 

—

 

—

 

Total operating expenses

 

14,558

 

11,812

 

30,831

 

Loss from operations

 

(14,809

)

(9,577

)

(39,724

)

Interest expense

 

290

 

466

 

437

 

Other (income) and expense, net

 

(646

)

1,050

 

12,703

 

Loss from continuing operations before provision for income taxes

 

(14,453

)

(11,093

)

(52,864

)

Provision for income taxes

 

71

 

—

 

2,119

 

Loss from continuing operations

 

(14,524

)

(11,093

)

(54,983

)

Discontinued operations:

 

 

 

 

 

 

 

Gain (loss) from discontinued operations

 

472

 

(6,163

)

(34,625

)

Gain (loss) on disposal

 

419

 

(9,475

)

—

 

Benefit for income taxes

 

—

 

—

 

(8,427

)

Gain (loss) from discontinued operations

 

891

 

(15,638

)

(26,198

)

Net loss

 

$

(13,633

)

$

(26,731

)

$

(81,181

)

Basic and diluted income (loss) per share:

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.64

)

$

(0.49

)

$

(2.46

)

Gain (loss) from discontinued operations

 

0.04

 

(0.69

)

(1.17

)

Net loss

 

$

(0.60

)

$

(1.18

)

$

(3.63

)

Shares used in computing basic and diluted net loss per share

 

23,063

 

22,781

 

22,433

 

The accompanying notes are an integral part of these consolidated financial statements.

4255



AXT, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

                                      
Preferred StockCommon StockOther
DeferredRetainedComprehensiveComprehensive
SharesAmountSharesAmountCompensationEarningsIncome/(loss)TotalIncome/(loss)
(In thousands)
Balance at December 31, 2000  883  $3,532   21,952  $145,748  $(107) $33,980  $2,194  $185,347  $23,828 
                                   
 
Common stock options exercised          388   3,862               3,862     
Issuance of Employee Stock Purchase Plan stock          43   900               900     
Income tax benefit from stock option exercises              3,125               3,125     
Amortization of deferred compensation                  107           107     
Comprehensive loss                                    
 Net loss                      (4,996)      (4,996)  (4,996)
 Unrealized gain (loss) on marketable securities                          (2,052)  (2,052)  (2,052)
 Currency translation adjustment                          29   29   29 
   
   
   
   
   
   
   
   
   
 
Balance at December 31, 2001  883  $3,532   22,383  $153,635  $—  $28,984  $171  $186,322  $(7,019)
                                   
 
Common stock options exercised          88   684               684     
Issuance of Employee Stock Purchase Plan stock          24   166               166     
Comprehensive loss                                    
 Net loss                      (81,181)      (81,181)  (81,181)
 Unrealized gain (loss) on marketable securities                          (21)  (21)  (21)
 Currency translation adjustment                          (313)  (313)  (313)
   
   
   
   
   
   
   
   
   
 
Balance at December 31, 2002  883  $3,532   22,495  $154,485  $—  $(52,197) $(163) $105,657  $(81,515)
   
   
   
   
   
   
   
   
   
 
Common stock options exercised          33   73               73     
Issuance of Employee Stock Purchase Plan stock          404   592               592     
Issuance of common stock to board members          25   28               28     
Comprehensive loss                              —     
 Net loss                      (26,731)      (26,731)  (26,731)
 Unrealized gain (loss) on marketable securities                          2,482   2,482   2,482 
 Currency translation adjustment                          197   197   197 
   
   
   
   
   
   
   
   
   
 
Balance at December 31, 2003  883  $3,532   22,957  $155,178  $—  $(78,928) $2,516  $82,298  $(24,052)
   
   
   
   
   
   
   
   
   
 

 

 

 

 

 

 

 

 

 

 

 

 

Retained

 

 

 

 

 

 

 

 

 

 

 

Common Stock

 

Earnings

 

Other

 

 

 

 

 

 

 

Preferred Stock

 

 

 

 

 

Additional

 

(Accumulated

 

Comprehensive

 

 

 

Comprehensive

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

Paid In Capital

 

Deficit)

 

Income/(loss)

 

Total

 

Income/(loss)

 

 

 

(In thousands)

 

Balance as of December 31, 2001

 

 

883

 

 

 

$

3,532

 

 

22,383

 

 

$

22

 

 

 

$

153,613

 

 

 

$

28,984

 

 

 

$

171

 

 

$

186,322

 

 

 

 

 

Common stock options exercised

 

 

 

 

 

 

 

 

 

88

 

 

 

 

 

 

684

 

 

 

 

 

 

 

 

 

 

684

 

 

 

 

 

Issuance of Employee Stock Purchase Plan stock

 

 

 

 

 

 

 

 

 

24

 

 

 

 

 

 

166

 

 

 

 

 

 

 

 

 

 

166

 

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(81,181

)

 

 

 

 

 

(81,181

)

 

$

(81,181

)

 

Unrealized gain (loss) on marketable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(21

)

 

(21

)

 

(21

)

 

Currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(313

)

 

(313

)

 

(313

)

 

Balance as of December 31, 2002

 

 

883

 

 

 

3,532

 

 

22,495

 

 

22

 

 

 

154,463

 

 

 

(52,197

)

 

 

(163

)

 

105,657

 

 

(81,515

)

 

Common stock options exercised

 

 

 

 

 

 

 

 

 

33

 

 

 

 

 

 

73

 

 

 

 

 

 

 

 

 

 

73

 

 

 

 

 

Issuance of Employee Stock Purchase Plan stock

 

 

 

 

 

 

 

 

 

404

 

 

1

 

 

 

591

 

 

 

 

 

 

 

 

 

 

592

 

 

 

 

 

Issuance of common stock to board members

 

 

 

 

 

 

 

 

 

25

 

 

 

 

 

 

28

 

 

 

 

 

 

 

 

 

 

28

 

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(26,731

)

 

 

 

 

 

(26,731

)

 

(26,731

)

 

Unrealized gain (loss) on marketable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,482

 

 

2,482

 

 

2,482

 

 

Currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

197

 

 

197

 

 

197

 

 

Balance as of December 31, 2003

 

 

883

 

 

 

3,532

 

 

22,957

 

 

23

 

 

 

155,155

 

 

 

(78,928

)

 

 

2,516

 

 

82,298

 

 

(24,052

)

 

Common stock options exercised

 

 

 

 

 

 

 

 

 

56

 

 

 

 

 

 

153

 

 

 

 

 

 

 

 

 

 

153

 

 

 

 

 

Issuance of Employee Stock Purchase Plan stock

 

 

 

 

 

 

 

 

 

106

 

 

 

 

 

 

117

 

 

 

 

 

 

 

 

 

 

117

 

 

 

 

 

Compensation related to stock options

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6

 

 

 

 

 

 

 

 

 

 

6

 

 

 

 

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(13,633

)

 

 

 

 

 

(13,633

)

 

(13,633

)

 

Unrealized gain (loss) on marketable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1,104

)

 

(1,104

)

 

(1,104

)

 

Currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

180

 

 

180

 

 

180

 

 

Balance as of December 31, 2004

 

 

883

 

 

 

$

3,532

 

 

23,119

 

 

$

23

 

 

 

$

155,431

 

 

 

$

(92,561

)

 

 

$

1,592

 

 

$

68,017

 

 

$

(14,557

)

 

The accompanying notes are an integral part of these consolidated financial statements.

4356



AXT, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS

                 
Years Ended December 31,
200320022001
(In thousands)
Cash flows from operating activities:
            
 Net loss $(26,731) $(81,181) $(4,996)
  Adjustments to reconcile net loss to cash provided by operations:            
   Depreciation  5,782   9,493   8,538 
   Deferred income taxes  —   2,533   (5,041)
   Amortization  502   403   554 
   Stock compensation  28   —   107 
   Stock option tax benefits  —   —   3,125 
   Impairment of PP&E  —   39,086   — 
   Impairment of investments  2,128   10,577   15,636 
   Loss (gain) on disposal of property, plant and equipment  (11)  3,404   229 
   Loss on disposal of a discontinued business  9,475   —   — 
   Changes in assets and liabilities:            
    Accounts receivable, net  232   8,489   11,939 
    Inventories  11,541   17,989   (3,741)
    Prepaid expenses  2,217   (320)  1,240 
    Other assets  (137)  (362)  (454)
    Accounts payable  (1,590)  1,285   (7,013)
    Accrued liabilities  (5,493)  (5,019)  (2,967)
    Income tax receivable  8,783   (6,091)  — 
    Other long-term liabilities  (457)  439   (12)
   
   
   
 
    Net cash provided by operating activities  6,269   725   17,144 
   
   
   
 
Cash flows from investing activities:
            
 Purchases of property, plant and equipment  (2,175)  (14,238)  (25,834)
 Investment in marketable securities  (5,941)  (17,869)  (21,591)
 Investment in other assets  —   —   (1,307)
 Proceeds from sale of marketable securities  13,885   17,070   1,034 
 Proceeds from sale of property and equipment from discontinued opto-electronics business (Note 2)  8,600         
 Proceeds from sale of property located in Fremont, California (Note 3)  5,172   —   — 
 Increase in restricted cash  (5,818)  (1,000)  — 
   
   
   
 
    Net cash provided by (used in) investing activities  13,723   (16,037)  (47,698)
   
   
   
 
Cash flows from financing activities:
            
 Proceeds from (payments of):            
  Issuance of common stock  480   850   4,762 
  Capital lease payments  (8,409)  (5,965)  (4,274)
  Capital lease borrowings  —   —   3,143 
  Short-term bank borrowings  —   —   (1,353)
  Long-term debt borrowings  —   3,935   — 
  Long-term debt payments  (1,718)  (6,936)  (2,800)
   
   
   
 
    Net cash used in financing activities  (9,647)  (8,116)  (522)
   
   
   
 
Effect of exchange rate changes  197   (313)  29 
   
   
   
 
Net increase (decrease) in cash and cash equivalents  10,542   (23,741)  (31,047)
Cash and cash equivalents at the beginning of the period  13,797   37,538   68,585 
   
   
   
 
Cash and cash equivalents at the end of the period $24,339  $13,797  $37,538 
   
   
   
 
Non cash activity:            
 Purchases of property, plant and equipment through financing $—  $577  $2,170 
Supplemental Disclosures:
            
 Interest paid $790  $1,326  $2,081 

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

 

 

(In thousands)

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net loss

 

$

(13,633

)

$

(26,731

)

$

(81,181

)

Adjustments to reconcile net loss to cash (used in) provided by operations:

 

 

 

 

 

 

 

Depreciation

 

4,869

 

5,782

 

9,493

 

Deferred income taxes

 

—

 

—

 

2,533

 

Amortization of marketable securities premium/discount

 

307

 

502

 

403

 

Stock-based compensation

 

6

 

28

 

—

 

Non-cash restructuring charge

 

1,308

 

—

 

—

 

Impairment of property, plant and equipment

 

—

 

—

 

39,086

 

Impairment of investments

 

210

 

2,128

 

10,577

 

(Gain) loss on disposal of property, plant and equipment

 

10

 

(11

)

3,404

 

(Gain) loss on disposal on discontinued operations

 

(472

)

9,475

 

—

 

Changes in assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable, net

 

2,263

 

232

 

8,489

 

Inventories

 

7,621

 

11,541

 

17,989

 

Prepaid expenses

 

(948

)

2,217

 

(320

)

Other assets

 

(77

)

(137

)

(362

)

Accounts payable

 

(743

)

(1,590

)

1,285

 

Accrued liabilities

 

(1,001

)

(5,493

)

(5,019

)

Income taxes

 

(140

)

8,783

 

(6,091

)

Other long-term liabilities

 

80

 

(457

)

439

 

Net cash (used in) provided by operating activities

 

(340

)

6,269

 

725

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchases of property, plant and equipment

 

(2,139

)

(2,175

)

(14,238

)

Proceeds from disposal of property, plant and equipment

 

10

 

—

 

—

 

Purchases of marketable securities

 

(25,876

)

(5,941

)

(17,869

)

Proceeds from sale of marketable securities

 

19,072

 

13,885

 

17,070

 

Proceeds from sale of property and equipment from discontinued opto-electronics business

 

—

 

8,600

 

—

 

Proceeds from sale of property

 

—

 

5,172

 

—

 

Decrease (increase) in restricted deposits

 

1,087

 

(5,818

)

(1,000

)

Net cash (used in) provided by investing activities

 

(7,846

)

13,723

 

(16,037

)

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from issuance of common stock

 

270

 

480

 

850

 

Capital lease payments

 

—

 

(8,409

)

(5,965

)

Proceeds from long-term debt borrowings

 

—

 

—

 

3,935

 

Long-term debt payments

 

(4,486

)

(1,718

)

(6,936

)

Net cash used in financing activities

 

(4,216

)

(9,647

)

(8,116

)

Effect of exchange rate changes

 

180

 

197

 

(313

)

Net (decrease) increase in cash and cash equivalents

 

(12,222

)

10,542

 

(23,741

)

Cash and cash equivalents at the beginning of the period

 

24,339

 

13,797

 

37,538

 

Cash and cash equivalents at the end of the period

 

$

12,117

 

$

24,339

 

$

13,797

 

Non-cash activity:

 

 

 

 

 

 

 

Purchases of property, plant and equipment through financing

 

$

—

 

$

—

 

$

577

 

Supplemental Disclosures:

 

 

 

 

 

 

 

Interest paid

 

$

271

 

$

790

 

$

1,326

 

The accompanying notes are an integral part of these consolidated financial statements.

4457



AXT, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.The Company and Summary of Accounting Policies
The Company

Note 1. The Company and Summary of Significant Accounting Policies

The Company

AXT, Inc. (“AXT”, “we,” “us,” and “our” refer to AXT, Inc. and all of its subsidiaries) designs, develops, manufactures and distributes high-performance compound semiconductor substrates. AXT’sOur substrate products are used primarily in wireless communications, lighting display applications, and fiber optic communications. We believe our vertical gradient freeze, or VGF, technique for manufacturing semiconductor substrates provides significant benefits over other methods and enabled us to become a leading manufacturer of such substrates. We pioneered the commercial use of VGF technology to manufacture GaAs substrates and subsequently used VGF technology to manufacture substrates from InP, and Ge. We also manufacture and sell raw materials related to our substrate business through five joint ventures located in China. These joint ventures produce products including 99.99% pure gallium (4N Ga), high purity gallium, arsenic, and germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. AXT’s ownership interest in these entities ranges from 25 percent to 88 percent. We consolidate the three ventures in which we own a majority share and employ equity accounting for the two joint ventures in which we have a 25 percent interest. We purchase the materials produced by these ventures for our use and sell other portions of their production to third parties.

On June 24, 2003, the Company’sour Board of Directors approved management’s plan to exit the Company’sour unprofitable Opto-electronics business. Substantially all of the assets of this division were sold in September 2003. The decision to dispose of the business was due to continuing operating losses and negative cash flows from the division and significant uncertainty regarding future profitability.

The Company officially changed its name from American Xtal Technology, Inc. to AXT, Inc. on July 7, 2000.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted accounting principlesin the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates.

Principles of Consolidation

Principles of Consolidation

The consolidated financial statements include the accounts of the CompanyAXT and itsour majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in business entities in which AXT doeswe do not have control, but hashave the ability to exercise significant influence over operating and financial policies (generally 20-50% ownership), are accounted for by the equity method.

Foreign Currency Translation

Fair Value of Financial Instruments

The carrying amounts of certain of our financial instruments including cash and cash equivalents, accounts receivable, short-term investments, accounts payable and accrued liabilities approximate fair value due to their short maturities. The carrying amounts of short-term and long-term debt approximate fair value due to the market interest rates that these debts bear, and interest rates currently available to us.


Reclassifications

Certain reclassifications have been made to the prior years’ consolidated financial statements to conform to current year presentation. These reclassifications had no impact on previously reported total assets, stockholders’ equity or net loss.

Foreign Currency Translation

The functional currencies of the Company’sour Japanese and Chinese subsidiaries are the local currencies. Transaction gains and losses resulting from transactions denominated in currencies other than the U.S. dollar for the Company or in the functional currencies for theof our subsidiaries are included in other (income) expense, net for the periods presented.

The assets and liabilities of the subsidiaries are translated at the rates of exchange on the balance sheet date. Revenue and expense items are translated at the average rate of exchange for the period. Gains and losses from foreign currency translation are included in other comprehensive income in stockholders’ equity.

Revenue Recognition

     The Company recognizesRevenue Recognition

We recognize revenue upon the shipment of itsour products to the customer provided that the Company hascustomers when:

·       we have received a signed purchase order placed by our customers,

·the price is fixed or determinable,

·       title and risk of ownership has transferred to our customers upon shipment from our dock, receipt at customer’s dock, or removal from consignment inventory at customer’s location,

·       collection of resulting receivables is probable, and

·product returns are reasonably estimable, there are noestimable.

We do not provide training, installation or commissioning services. Our terms and conditions of sale do not require customer acceptance requirementsacceptance. We assess the probability of collection based on a number of factors including past history with the customer and there are no remaining significant obligations. The Company providescredit worthiness. We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. The Company doesAdditionally, we do not provide discounts or other incentives to customers except for warranty related exposureone customer with whom we agreed in the fourth quarter of 2004 to provide a certain amount of cumulative discounts on future product purchases from us. We will recognize these discounts in future periods as such exposurea reduction in revenue as products are sold to this customer.

Concentration of Credit Risk

Our business is very dependant on the semiconductor industry, which is highly cyclical and has historically been immaterial.

45

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Fair Value of Financial Instruments

The reported amountsexperienced downturns as a result of certaineconomic changes, overcapacity, and technological advancements. Significant technological changes in the industry or customer requirements, or the emergence of competitive products with new capabilities or technologies, could adversely affect operating results. In addition, a significant portion of our revenues and net income (loss) is derived from international sales. Fluctuations of the Company’s financial instruments including cashUnited States dollar against foreign currencies and cash equivalents, accounts receivable, short-term investments, accounts payablechanges in local regulatory or economic conditions, particularly in an emerging market such as China, could adversely affect operating results.

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, and accrued liabilities approximate fair value duepolishing solutions. We generally purchase these materials through standard purchase orders and not pursuant to their short maturities. The reported amounts of short-term and long-term debt approximate fair value due to the market interest rates that these debts bear, and interest rates currently available to the Company.supply contracts.


Concentration of Credit Risk

Financial instruments whichthat potentially subject the Companyus to concentration of credit risk consist primarily of cash and cash equivalents, short-term investments, and trade accounts receivable. The Company performsWe invest primarily in money market accounts, commercial paper instruments, and investment grade securities. We are exposed to credit risks in the event of default by the issuers to the extent of the amount recorded on the balance sheet.

We perform ongoing credit evaluations of itsour customers’ financial condition, and limitslimit the amount of credit extended when deemed necessary, but generally doesdo not require collateral. The Company invests primarilycredit risk in money marketour accounts receivable is substantially mitigated by our credit evaluation process, reasonably short collection terms and commercial paper instruments. Cash equivalents are maintained with high quality institutions and their composition and maturities are regularly monitored by management.

the geographical dispersion of sales transactions. No customer represented greater than 10% of product revenues for the years ended December 31, 2004, 2003 2002 and 2001. The company’s2002. Our top five customers represented 30.1%, 28.9% of product revenue for the year ended December 31, 2003,, and 31.4% of product revenue for the yearyears ended December 31, 2004, 2003, and 2002, and 31.1% of product revenue for the year ended December 31, 2001.respectively. We expect that sales to certain customers will continue to comprise a significant portion of our revenue in the future.

No customer Two customers each accounted for 10% or more of theour trade accounts receivable balance as of December 31, 20032004 at 10.1% and 2002.

Cash Equivalents
10.0%, and no customer accounted for 10% or more of our trade accounts receivable balance as of December 31, 2003.

The Company considers allCash Equivalents and Short-Term Investments

We classify our investments in debt and equity securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” We consider investments in highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

Investments

Management determines the appropriate classification of investments at the time of purchase. Available-for-sale Our short-term investments are carriedreported at their fair value based on quoted market prices as of the respective balance sheet date.dates with unrealized gains and losses included in accumulated other comprehensive income (loss) within stockholders’ equity on the consolidated balance sheet. The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in “otherother (income) and expense, net.”net in the consolidated statements of operations. Realized gains orand losses are determined on the specific identification method and are reflecteddeclines in “other (income) and expense, net.” Net unrealized gains or losses are recorded directly in stockholders’ equity. Those unrealized losses that are deemedvalue judged to be other than temporary on available-for-sale securities are reflectedalso included in “interest and other income, net.”(income) expense, net in the consolidated statements of operations. The Company also maintains minority investments in private companies which are accounted for undercost of securities sold is based upon the costs basis. These investmentsspecific identification method.

All available-for-sale securities with a quoted market value below cost (or adjusted cost) are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value includeorder to determine whether the related company would have insufficient cash flowdecline is other-than-temporary. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to operatehold the securities for a period of time sufficient to allow for any anticipated recovery in market value.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable are recorded at the next twelve months, significant changesinvoiced amount and are not interest bearing. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible trade receivables. We also review our trade receivables by aging category to identify specific customers with known disputes or collectibility issues. We exercise judgment when determining the adequacy of these reserves as we evaluate historical bad debt trends, general economic conditions in the operating performanceUnited States and internationally, and changes in marketcustomer financial conditions. Uncollectible receivables are recorded as bad debt expense when all efforts to collect have been exhausted and recoveries are recognized when they are received. During 2004, we wrote off $3.5 million of fully reserved accounts receivable and increased the allowance for doubtful accounts by $0.3 million.


Inventories

Inventories are stated at the lower of cost (approximated by standard cost) or market. Cost is determined using the weighted average cost method. FinishedOur inventory consists of raw materials as well as finished goods and work-in-process inventoriesthat include material, labor and manufacturing overhead costs.

46Property, Plant and Equipment

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Property, Plant and Equipment

Property, plant and equipment are stated at cost less accumulated depreciation computed using the straight-line method over the estimated economic lives of the assets, which vary from 3 to 27.5 years. Leasehold improvements are amortized over the shorter of the estimated useful life or the term of the lease. We generally depreciate computers and software over 3 years, automobiles over 5 years, office equipment, furniture and fixtures over 3 years, automobiles over 5 years, leasehold improvements over 10 years, and buildings over 27.5 years. DepreciationRepairs and maintenance costs are charged to expense was $5.8 million, $9.5 million, and $8.5 million for the years ended 2003, 2002, and 2001 respectively.

Impairment of Long-Lived Assets
as incurred.

Management evaluatesImpairment of Long-Lived Assets

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

Stock-Based Compensation

The Company accountsSegment Reporting

Our business is conducted in a single operating segment. Our interim chief executive officer reviews a single set of financial data that encompasses our entire operations for purpose of making operating decisions and assessing financial performance.

Investments

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. Determination of impairment is highly subjective and is based on a number of factors, including an assessment of the strength of investee’s management, the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, fundamental changes to the business prospects of the investee, share prices of subsequent offerings, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in our carrying value.

Stock-Based Compensation

We have employee stock option plans, which are described more fully in Note 11—Employee Benefit Plans. We account for stock-based employee compensation arrangements using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting“Accounting for Stock Issued to Employees”Employees,” and related interpretations thereof. Accordingly, compensation cost for stock options is measured as the excess, if any, of the market price of the Company’sAXT’s stock at the date of grant over the stock option exercise price. In addition,The following table illustrates the Company provides additional disclosureeffect on our net loss and net loss per share if we had applied the fair value recognition provisions as required under Statement of Financial Accounting StandardSFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS 148,“Accounting for Stock- BasedStock-Based Compensation, —” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure”Disclosure,” to options granted


under our stock option plans. For purposes of this pro forma disclosure, the value of the options is estimated using a Black-Scholes option pricing model and amortized to expense over the options’ vesting periods. Because the estimated value is determined as of the date of grant, the actual value ultimately realized by the employee may be significantly different.

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

 

 

(in thousands, except per share data)

 

Net loss to common stockholders:

 

 

 

 

 

 

 

As reported

 

$

(13,810

)

$

(26,908

)

$

(81,358

)

Add: Stock-based employee compensation expense included in net loss as reported

 

6

 

28

 

—

 

Less: Stock-based compensation expense using the fair value based method, net of related tax

 

(1,330

)

(7,323

)

(9,182

)

Pro forma net loss

 

$

(15,134

)

$

(34,203

)

$

(90,540

)

Basic and diluted net loss per share:

 

 

 

 

 

 

 

As reported

 

$

(0.60

)

$

(1.18

)

$

(3.63

)

Pro forma

 

$

(0.66

)

$

(1.50

)

$

(4.04

)

Shares used in computing basic and diluted net loss per share

 

23,063

 

22,781

 

22,433

 

The weighted average estimated value of employee stock options granted during 2004, 2003, and 2002 was $1.17, $1.70, and $2.39, respectively. The value of options granted was estimated at the date of grant using the following weighted average assumptions:

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Risk-free interest rate

 

3.6

%

2.9

%

3.0

%

Expected life (in years)

 

5.0

 

5.0

 

5.0

 

Dividend yield

 

—

 

—

 

—

 

Volatility

 

103.0

%

109.0

%

101.0

%

An analysis of historical information is used to determine the above assumptions, to the extent that historical information is relevant, based on the terms of the grants being issued in Note 13.

Research and Development
any given period. Assumptions related to the Employee Stock Purchase Plan are not presented as the related compensation expense amounts are insignificant.

SFAS No. 123 requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option pricing model was developed for use in estimating the fair value of short-lived exchange-traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of employee stock options.

Research and Development

Research and development costs are expensed as incurred.


Income Taxes

Advertising Costs

Advertising costs, included in selling and administrative, are expensed as incurred. Advertising costs for the years ended December 31, 2004, 2003, and 2002 were $51,000, $53,000 and $63,000, respectively.

The Company accountsShipping and Handling costs

We include fees billed to customers and costs incurred for shipping and handling as a component of cost of sales.

Income Taxes

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

Comprehensive Income

Comprehensive Income

We report comprehensive income is defined asor loss in accordance with the change in equityprovisions of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investment by owners and distribution to owners. The difference between netSFAS No. 130, “Reporting Comprehensive Income,” which establishes standards for reporting comprehensive income and its components in the financial statements. The components of other comprehensive income for the Company relates to foreign currency translation adjustments and(loss) consist of unrealized gains and losses on investment securities.marketable securities and foreign currency translation adjustments. Comprehensive income for(loss) and the years ended December 31, 2003, 2002 and 2001 is disclosedcomponents of accumulated other comprehensive income are presented in the “Consolidated Statementsaccompanying consolidated statements of Stockholders’ Equity.”

47

AXT, INC.stockholders’ equity.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Basic and Diluted Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the income (loss) available to holders of common stock for the period byusing the weighted average number of shares of common stockshares outstanding during the period. The calculation of dilutedperiods. Diluted net income (loss) per share excludes potentialis computed using the weighted average number of common stock ifshares outstanding and potentially dilutive common shares outstanding during the effect of such stock is antidilutive. Potentialperiods. Potentially dilutive common stock consistsshares consist of common shares issuable upon the exercise of stock options.

Reclassifications
Potentially dilutive common shares are excluded in net loss periods, as their effect would be anti-dilutive.

Recent Accounting Pronouncements

In June 2004, the Financial Accounting Standards Board (FASB) ratified Emerging Issues Task Force Issue No. 03-1 (EITF 03-1), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain reclassifications haveInvestments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. Adoption of the recognition and measurement guidance of EITF 03-1 has been madetemporarily deferred by the FASB, but the disclosure requirements of EITF 03-1 are effective for our 2004 annual consolidated financial statements. Accordingly, additional disclosures as required by EITF 03-1 are included in Note 3 to the prior years’ consolidated financial statements to conform to current period presentation.statements.

Recent Accounting Pronouncements

In November 2002,October 2004, the FASB issued Emerging Issues Task Force Issue No. 04-1 (EITF 04-1), “Accounting for Preexisting Relationships between the Parties to a Business Combination,” which provides new guidance for the accounting for preexisting relationships between the parties to a business combination. Additionally, EITF 04-1 includes additional disclosure requirements for business combinations between parties with a preexisting relationship. EITF 04-1 is effective for fiscal periods beginning after October 13,


2004. We do not expect the adoption of EITF 04-1 to have a material impact on our consolidated financial position, results of operations or cash flows.

In November 2004, the FASB Interpretationissued SFAS No. 45 ( FIN 45 ),151, “Guarantor’s AccountingInventory Costs, an amendment of ARB No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and Disclosure Requirements for Guarantees, Including Indirect Guaranteeswasted material (spoilage). Paragraph 5 of Indebtedness of Others.ARB 43, Chapter 4, previously stated that “…under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges....”FIN No. 45 This Statement requires that a liabilitythose items be recorded inrecognized as current period charges regardless of whether they meet the guarantor’s balance sheet upon issuancecriterion of a guarantee.“so abnormal.” In addition, FIN No. 45this Statement requires disclosures aboutthat allocation of fixed production overheads to the guarantees that an entity has issued, including a reconciliationcosts of changes inconversion be based on the entity’s product warranty liabilities.normal capacity of the production facilities. 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. 45this Statement are effective for financial statements of interim or annual periods endinginventory costs incurred during fiscal years beginning after DecemberJune 15, 2002. Our2005. The adoption of FIN No. 45 didthis Statement is not expected to have a material effect on our consolidated financial statements.position, results of operations or cash flows.

In January 2003,December 2004, the FASB issued SFAS No. 123 revised 2004 (SFAS 123R), “Share-Based Payment,” which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS 123R is effective for all interim periods beginning after June 15, 2005 and, thus, will be effective for us beginning with the third quarter of fiscal 2005. Early adoption is encouraged and retroactive application of the provisions of SFAS 123R to the beginning of the fiscal year that includes the effective date is permitted, but not required. We are currently evaluating the impact of SFAS 123R on our financial position and results of operations. See Stock-Based Compensation above for information related to the pro forma effects on our reported net loss and net loss per share when applying the fair value recognition provisions of the previous SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

In December 2004, the FASB Interpretationissued SFAS No. 46 ( FIN 46 ),153 (SFAS 153), “ConsolidationExchanges of Variable Interest Entities,Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated byexception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the primary beneficiaryfuture cash flows of the entity ifare expected to change significantly as a result of 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 46exchange. SFAS 153 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 December 15, 2003. Our adoption of FIN No. 46 did not have a material effect on our consolidated financial statements.

     In March 2003, the Emerging Issues Task Force, or EITF, reached a consensus on EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 requires revenue arrangements with multiple deliverables to be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. The arrangement’s consideration should be allocated among the separate units of accounting based on their relative fair values. Applicable revenue recognition criteria should be considered separately for each unit. The provisions of EITF Issue No. 00-21 are effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Our2005. We do not expect the adoption of EITF Issue No. 00-21 did notSFAS 153 to have a material effectimpact on our consolidated financial statements.

     In April 2003, the FASB issued SFAS No. 149, “Amendmentposition, results of Statement 133 on Derivative Instruments and Hedging Activities.” This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This Statement is effective for contracts entered intooperations or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Our adoption of SFAS No. 149 did not have a material effect on our consolidated financial statements.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for an issuer to classify

48

AXT, INC.cash flows.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)Note 2. Discontinued Operations and Related Assets Held for Sale

and measure certain financial instruments with characteristics of both liabilities and equity. This Statement requires an issuer to classify a financial instrument that meets certain characteristics as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31,In June 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Our adoption of SFAS No. 150 did not have a material effect on our consolidated financial statements.

Note 2.Discontinued Operations

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

     OnIn September 27, 2003, the Companywe completed athe sale of substantially all of the assets of itsour opto-electronics business to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. ProceedsA portion of the purchase price equal to $1.0 million will bewas held in escrow to satisfy any claims that the purchaser might make for up tobreaches of


representations or warranties by us. Of this total escrow, $750,000 could be released after the one year anniversary of the sale of the opto-electronics business and the remainder could be released after the second anniversary of the sale. Given the difficult negotiations we encountered with the acquiring company when negotiating the sale of the opto-electronics business, as well as the historical operating problems of the business, we determined there was significant uncertainty regarding the recoverability of the escrowed amounts. Accordingly, we did not recognize the cash held in escrow in recording the sale of the opto-electronics division. We will only record amounts as and when they are received. To date, we have resolved all claims made against the first $750,000 held in escrow by the acquiring company, and will record amounts as they are received from the escrow. As of December 31, 2004, approximately $419,000 was released from escrow and accordingly we recorded a gain on discontinued operations in 2004. In February 2005, we received an additional $300,000 from escrow which was the remaining portion of the first $750,000 held in escrow due to us, as we had resolved a claim of approximately $31,000 in favor of the buyer. The remaining $250,000 held in escrow will not be released until September 2005, if the buyer makes no claims against it by such date. In the second quarter of 2004, we recorded until all claims, if any, are settled. If unclaimed, up to $250,000a gain of the sale proceeds will be held in escrow for$222,000 as a second yearresult of our reversal of accrued liabilities of general and will not be recorded until all claims, if any, are settled. The Company retainsadministrative expenses no longer required.

In addition, we retain a building located in Monterey Park, CA,California that it expects to sell in 2004.we have listed on the market for sale. This asset ishas been classified as Held“Assets held for Salesale” on the consolidated balance sheet atsheets as of December 31, 2004 and 2003. In January 2005, we accepted an offer from a real estate developer to purchase the property for net proceeds of approximately $1.25 million, after deducting estimated commission and selling expenses. We expect the sale to complete by the second quarter of 2005.

     The Company recorded a loss on disposal of $9.5 million to write-down the book value of assets sold to their estimated fair market value.

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

               
Years Ended December 31,
200320022001
Revenue $7,245  $18,310  $10,730 
Cost of revenue  9,972   20,273   14,697 
   
   
   
 
Gross profit (loss)  (2,727)  (1,963)  (3,967)
Operating expenses:            
 Selling, general and administrative  2,297   4,788   4,279 
 Research and development  814   2,529   4,328 
 Impairment costs  —   24,454   — 
   
   
   
 
  Total operating expenses  3,111   31,771   8,607 
   
   
   
 
Loss from operations  (5,838)  (33,734)  (12,574)
Interest expense  325   891   1,244 
   
   
   
 
Loss before benefit for income taxes and loss on disposal  (6,163)  (34,625)  (13,818)
Income tax (benefit)  —   (8,427)  (4,974)
Loss on disposal  (9,475)  —   — 
   
   
   
 
Net loss $(15,638) $(26,198) $(8,844)
   
   
   
 
follows (in thousands):

49

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Revenue

 

$

—

 

$

7,245

 

$

18,310

 

Cost of revenue

 

—

 

9,972

 

20,273

 

Gross loss

 

—

 

(2,727

)

(1,963

)

Operating expenses:

 

 

 

 

 

 

 

Selling, general and administrative

 

(222

)

2,297

 

4,788

 

Research and development

 

—

 

814

 

2,529

 

Impairment charges

 

—

 

—

 

24,454

 

Total operating expenses

 

(222

)

3,111

 

31,771

 

Gain (loss) from operations

 

222

 

(5,838

)

(33,734

)

Other (income) expense, net

 

(250

)

—

 

—

 

Interest expense

 

—

 

325

 

891

 

Gain (loss) from discontinued operations before benefit for income taxes and gain (loss) on disposal

 

472

 

(6,163

)

(34,625

)

Income tax benefit

 

—

 

—

 

(8,427

)

Gain (loss) on disposal

 

419

 

(9,475

)

—

 

Net gain (loss) from discontinued operations

 

$

891

 

$

(15,638

)

$

(26,198

)

 


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

           
Years Ended
December 31,
20032002
Current assets:        
 Cash $539  $336 
 Accounts receivable, net  250   3,224 
 Inventories  —   3,439 
 Assets held for sale  1,000   — 
 Other current assets  —   2,482 
   
   
 
  Total current assets  1,789   9,481 
Propert, plant and equipment  —   14,854 
Other assets  200   200 
   
   
 
  Total assets $1,989  $24,535 
   
   
 
Current liabilities:        
 Accounts payable $43  $1,975 
 Accrued liabilites  1,232   2,806 
   
   
 
  Total liabilities  1,275   4,781 
Net assets  714   19,754 
   
   
 
Total liabilities and net assets $1,989  $24,535 
   
   
 
follows (in thousands):

 

 

As of December 31,

 

 

 

2004

 

2003

 

Current assets:

 

 

 

 

 

Cash

 

$

537

 

$

539

 

Accounts receivable, net

 

19

 

250

 

Assets held for sale

 

1,250

 

1,000

 

Total current assets

 

1,806

 

1,789

 

Other assets

 

200

 

200

 

Total assets

 

$

2,006

 

$

1,989

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

—

 

$

43

 

Accrued liabilities

 

359

 

1,232

 

Total liabilities

 

359

 

1,275

 

Net assets

 

1,647

 

714

 

Total liabilities and net assets

 

$

2,006

 

$

1,989

 

Assets held for sale consist of a building and are carried at management’s estimated fair value less costs to sell, totaling $1.25 million and $1.0 million atas of December 31, 2003.

Note 3.Assets Held for Sale

Assets held for sale at December 31,2004 and 2003, consist ofrespectively. We recorded in the fourth quarter 2004 a property located in Monterey Park, California, which is part of the Company’s discontinued opto-electronics division (see Note 2). Assets held for sale at December 31, 2002 consist of$0.25 million market value adjustment after we accepted an offer from a property located at 4281 Technology Drive, Fremont, California. In November of 2002, the Company entered into a contractreal estate developer to sell this property to a third party. On March 11, 2003, the Company completed the sale of its property located at 4281 Technology Drive, Fremont, California, for $6.3 million. Net cash proceeds from the sale were $5.2 million. The gain the Company incurred on this transaction was less than $15,000. Under the terms of the sale agreement, the Company has agreed to lease backpurchase the property for net proceeds of approximately $1.25 million, after deducting estimated commission and selling expenses in January 2005. We expect the sale to complete by the second quarter of 2005.

66



Note 3. Cash, Cash Equivalents and Short-Term Investments

Our cash, cash equivalents and short term investments are classified as follows (in thousands):

 

 

December 31, 2004

 

December 31, 2003

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gain

 

Gross
Unrealized
(Loss)

 

Fair
Value

 

Amortized
Cost

 

Gross
Unrealized
Gain

 

Gross
Unrealized
(Loss)

 

Fair
Value

 

Classified as:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

 

$ 8,638

 

 

 

$    —

 

 

 

$ —

 

 

$ 8,638

 

 

$ 6,843

 

 

 

$    —

 

 

 

$ —

 

 

$ 6,843

 

Cash equivalents:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Money market fund

 

 

1,681

 

 

 

—

 

 

 

—

 

 

1,681

 

 

2,961

 

 

 

—

 

 

 

—

 

 

2,961

 

US Treasury and agency securities

 

 

—

 

 

 

—

 

 

 

—

 

 

—

 

 

1,498

 

 

 

—

 

 

 

—

 

 

1,498

 

Commercial paper

 

 

398

 

 

 

—

 

 

 

—

 

 

398

 

 

8,387

 

 

 

—

 

 

 

—

 

 

8,387

 

Repurchase agreements

 

 

1,400

 

 

 

—

 

 

 

—

 

 

1,400

 

 

4,650

 

 

 

—

 

 

 

—

 

 

4,650

 

Total cash equivalents

 

 

3,479

 

 

 

—

 

 

 

—

 

 

3,479

 

 

17,496

 

 

 

—

 

 

 

—

 

 

17,496

 

Total cash and cash equivalents 

 

 

12,117

 

 

 

—

 

 

 

—

 

 

12,117

 

 

24,339

 

 

 

—

 

 

 

—

 

 

24,339

 

Short-term investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

US Treasury and agency securities

 

 

10,468

 

 

 

—

 

 

 

(16

)

 

10,452

 

 

14,567

 

 

 

18

 

 

 

—

 

 

14,585

 

Asset-backed securities

 

 

4,410

 

 

 

—

 

 

 

(25

)

 

4,385

 

 

2,506

 

 

 

7

 

 

 

—

 

 

2,513

 

Commercial paper

 

 

1,708

 

 

 

—

 

 

 

(1

)

 

1,707

 

 

1,300

 

 

 

—

 

 

 

—

 

 

1,300

 

Corporate bonds

 

 

8,737

 

 

 

—

 

 

 

(30

)

 

8,707

 

 

1,890

 

 

 

8

 

 

 

—

 

 

1,898

 

Corporate equity securities

 

 

1,465

 

 

 

1,561

 

 

 

—

 

 

3,026

 

 

1,115

 

 

 

2,560

 

 

 

—

 

 

3,675

 

Total short-term investments 

 

 

26,788

 

 

 

1,561

 

 

 

(72

)

 

28,277

 

 

21,378

 

 

 

2,593

 

 

 

—

 

 

23,971

 

Total cash, cash equivalents and short-term investments

 

 

$ 38,905

 

 

 

$ 1,561

 

 

 

$ (72

)

 

$ 40,394

 

 

$ 45,717

 

 

 

 

$2,593          

 

 

 

$ —

 

 

$ 48,310

 

Contractual maturities on short-term investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Due within 1 year

 

 

$ 21,879

 

 

 

 

 

 

 

 

 

 

$ 23,394

 

 

$ 18,190

 

 

 

 

 

 

 

 

 

 

$ 20,775

 

Due after 1 through 5 years

 

 

4,909

 

 

 

 

 

 

 

 

 

 

4,883

 

 

3,188

 

 

 

 

 

 

 

 

 

 

3,196

 

 

 

 

$ 26,788

 

 

 

 

 

 

 

 

 

 

$ 28,277

 

 

$ 21,378

 

 

 

 

 

 

 

 

 

 

$ 23,971

 

The short-term investments amounts include $8.2 million and $9.3 million recorded as restricted deposits on the consolidated balance sheets as of December 31, 2004 and 2003, respectively.

We manage our short-term investments as a ten-year period. Accordingly,single portfolio of highly marketable securities that is intended to be available to meet our current cash requirements. For the years ended December 31, 2004 and 2003, we had no gross realized gain or loss on March 11, 2003,sales of our available-for-sale securities.


The gross unrealized losses related to our portfolio of available-for-sale securities were primarily due to a decrease in the Company signedfair value of debt securities as a result of an operating lease for this property through March 2013. Annual rent under this operating lease is approximately $600,000.

Note 4.Inventories

     Inventoriesincrease in interest rates during 2004. We have determined that the gross unrealized losses on our available-for-sale securities as of December 31, 2004 are stated at the lower of cost or net realizable value. Cost is determined using the weighted average cost method. Finished goods and work-in-process inventories include material, labor and manufacturing overhead costs. The Company routinely evaluates the levels of its inventorytemporary in light of current market conditions in ordernature. We reviewed our investment portfolio to identify excess and obsolete inventoryevaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the magnitude of the decline in market value, the length of time the market value has been below cost (or adjusted cost), credit quality, and our ability and intent to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value. The following table provides a valuation allowance for certain inventories based upon the age and qualitybreakdown of the product.our available-for-sale securities with unrealized losses as of December 31, 2004 (in thousands):

 

 

In Loss Position
< 12 months

 

Total in Loss Position

 

 

 

Fair
Value

 

Gross
Unrealized
(Loss)

 

Fair
Value

 

Gross
Unrealized
(Loss)

 

Short-term investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

US Treasury and agency securities

 

$ 9,452

 

 

$ (16

)

 

$ 9,452

 

 

$ (16

)

 

Assets-backed securities

 

4,385

 

 

(25

)

 

4,385

 

 

(25

)

 

Commercial paper

 

1,312

 

 

(1

)

 

1,312

 

 

(1

)

 

Corporate bonds

 

8,706

 

 

(30

)

 

8,706

 

 

(30

)

 

Total in loss position

 

$ 23,855

 

 

$ (72

)

 

$ 23,855

 

 

$ (72

)

 

50

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)Note 4. Inventories, Net

The components of inventory are summarized below (in thousands):

          
Years Ended
December 31,
20032002
Inventories:        
 Raw materials $7,086  $12,559 
 Work in process  16,027   22,950 
 Finished goods  970   2,089 
   
   
 
  $24,083  $37,598 
   
   
 
Note 5.Debt
Credit Facility

 

 

As of December 31,

 

 

 

2004

 

2003

 

Inventories:

 

 

 

 

 

Raw materials

 

$ 4,416

 

$ 7,086

 

Work in process

 

10,474

 

16,027

 

Finished goods

 

1,572

 

970

 

 

 

$16,462

 

$ 24,083

 

     AtNote 5. Property, Plant and Equipment

The components of our property, plant and equipment are summarized below (in thousands):

 

 

As of December 31,

 

 

 

2004

 

2003

 

Property, plant and equipment:

 

 

 

 

 

Land

 

$   1,120

 

$ 1,120

 

Building

 

15,751

 

17,180

 

Machinery and equipment

 

16,176

 

8,275

 

Leasehold improvements

 

828

 

443

 

Construction in progress

 

634

 

1,150

 

 

 

34,509

 

28,168

 

Less: accumulated depreciation and amortization

 

(15,464

)

(6,373

)

 

 

$ 19,045

 

$ 21,795

 

Depreciation expenses were $4.9 million, $5.8 million, and $9.5 million for the years ended 2004, 2003, and 2002, respectively.


Note 6. Corporate Affiliates

We have made strategic investments in private companies located in China in order to gain access to raw materials at competitive cost that are critical to our substrate business. We are currently negotiating a new joint venture investment in China for a germanium business opportunity, and upon the fulfillment of certain conditions, we may invest up to $1.0 million in the new joint venture in 2005. Our corporate affiliates are summarized below (in thousands) :

 

 

Investment Balance

 

 

 

 

 

 

 

As of December 31,

 

Accounting

 

Ownership

 

Affiliate

 

 

 

2004

 

2003

 

Method

 

Percentage

 

Beijing Ji Ya Semiconductor Material Co., Ltd

 

$ 1,071

 

$ 1,071

 

Consolidated

 

 

51

%

 

Nanjing Jin Mei Gallium Co., Ltd

 

616

 

616

 

Consolidated

 

 

88

 

 

Beijing BoYu Manufacturing Co., Ltd

 

409

 

409

 

Consolidated

 

 

70

 

 

Xilingol Tongli Ge Co. Ltd

 

863

 

822

 

Equity

 

 

25

 

 

Emeishan Jia Mei High Pure Metals Co., Ltd

 

593

 

603

 

Equity

 

 

25

 

 

The investment balances for the two affiliates accounted for under the equity method are included in other assets in the consolidated balance sheets. We own 25% of the ownership interests in each of these affiliates. These two affiliates are not considered variable interest entities because:

·       both affiliates have sustainable businesses of their own;

·       our voting power is proportionate to our ownership interests; and

·       we only recognize our respective share of the losses and/or residual returns generated by the affiliates if they occur, or both.

We do not have controlling financial interests in either affiliate, do not maintain operational or management control, nor control of the board of directors, and are not required to provide additional investment or financial support to either affiliate.

Undistributed retained earnings relating to our corporate affiliates were $1.4 million and $769,000 as of December 31, 2004 and 2003, respectively. Net income (loss) recorded from our corporate affiliates were $668,000 and ($92,000) for the years ended December 31, 2004 and 2003, respectively.

Note 7. Investments

We invest in equity instruments of privately-held companies for business and strategic purposes. These investments are classified as other assets in the consolidated balance sheets and are accounted for under the cost method as we do not have the ability to exercise significant influence over their operations. We monitor our investments for impairment and record reductions in carrying value when events or changes in circumstances indicate that the carrying value may not be recoverable. In 2004, we recorded a $210,000 charge related to impairment in one of these U.S. private companies. In 2003, we recorded $2.0 million in charges to write-down its investment in two private U.S. companies. As of December 31, 2004, the investments we continue to hold totaled approximately $392,000.


Note 8. Restructuring Costs

As of December 31, 2004, our restructuring accrual is as follows (in thousands):

Description

 

 

 

Restructuring
Accrual as of
December 31,
2003

 

 Addition 

 

Payments

 

Restructuring
Accrual as of 
December 31,
2004

 

Future lease payments related to abandoned facilities

 

 

$ ––

 

 

 

$  845

 

 

 

$ (327

)

 

 

$ 518

 

 

Workforce reduction

 

 

—

 

 

 

463

 

 

 

(429

)

 

 

34

 

 

Total

 

 

$ ––

 

 

 

$ 1,308

 

 

 

$ (756

)

 

 

$ 552

 

 

During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China. In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the United States. In the third and fourth quarter of 2004, we incurred additional restructuring charges of $231,000 for a total of $1.3 million in 2004. These charges comprised costs related to the reduction in work force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. In aggregate, we eliminated 50 positions, 47 of which are production workers. The above accrued restructuring balance is included in accrued liabilities in the consolidated balance sheet. As of December 31, 2004, we saved approximately $560,000 in payroll and related expenses. On an annual basis, we anticipate payroll and related expense savings of $1.5 million. In 2005, we will continue to reduce costs by qualifying new lower cost suppliers, moving more of our administrative functions to China, and streamlining our organization structure and costs in the United States and China to bring them in line with market and product demand.

Note 9. Debt

Credit Facility

As of December 31, 2004, the credit facility maintained by the Companyus with a bank included a letter of credit supporting repayment of itsour industrial bonds with an outstanding amount of $8.5$8.2 million. The Company hasWe have pledged and placed cash and certain investment securities with the trust department of the bank as additional collateral for this facility. The Company has also pledged cash for a credit facility for workers compensation insurance. As a result, $9.3Accordingly, $8.2 million of cash and long-termshort-term investments are restricted.


51Long-Term Debt

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Long-Term Debt

The components of long-term debt are summarized below (in thousands):

         
Year Ended
December 31,
20032002
Various notes payable to banks, secured by certain equipment, bearing interest at fixed rates between 4.55% and 4.72% $—  $1,083 
Debenture loan to Bay Area Employment Development Company, guaranteed by the U.S. Small Business Administration, bearing interest at a fixed rate of 7.27%, maturing October 2016  788   823 
Taxable revenue bonds, secured by a letter of credit from a bank, bearing interest at the H15 30 day bond yield for commercial paper which was 1.35% on December 31, 2003, maturing December 2023  8,450   9,050 
Notes payable to a bank, secured by certain equipment in China, bearing interest at a fixed rate of 5.49%, maturing December 2004  3,298   3,298 
   
   
 
   12,536   14,254 
Less current portion  (3,694)  (965)
   
   
 
  $8,842  $13,289 
   
   
 
Maturities of long-term debt at December 31, 2003 were as follows:        
2004  3,694     
2005  514     
2006  459     
2007  462     
2008  466     
Thereafter  6,941     
   
     
  $12,536     
   
     
Note 6.Investments in Marketable Securities

 

 

As of December 31,

 

 

 

2004

 

2003

 

Debenture loan to Bay Area Employment Development Company, guaranteed by the U.S. Small Business Administration, bearing interest at a fixed rate of 7.27%, maturing October 2016

 

$     —

 

$    788

 

Taxable revenue bonds, secured by a letter of credit from a bank, bearing interest at the H15 30 day bond yield for commercial paper which was 2.49% on December 31, 2004, maturing December 2023

 

8,050

 

8,450

 

Notes payable to a bank, secured by certain equipment in China, bearing interest at a fixed rate of 5.49%, maturing December 2004

 

—

 

3,298

 

 

 

8,050

 

12,536

 

Less current portion

 

(450

)

(3,694

)

 

 

$7,600

 

$ 8,842

 

Maturities of long-term debt as of December 31, 2004 were as follows:

 

 

 

 

 

2005

 

$  450

 

 

 

2006

 

450

 

 

 

2007

 

450

 

 

 

2008

 

520

 

 

 

2009

 

450

 

 

 

Thereafter

 

5,730

 

 

 

 

 

$ 8,050

 

 

 

 The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115 or SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on

52

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)Note 10. Stockholders’ Equity

quotedIn August 2004, we announced the adoption of a stock repurchase program in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934 to provide for the repurchase of up to $2 million of our common stock. Repurchases may be made from time to time in the open market during the twelve-month period ending July 31, 2005, at prevailing market prices with net unrealized gains and losses included in comprehensive income, net of tax. The components of investments at December 31, 2003 are summarized below (in thousands):

             
Aggregate
UnrealizedFair
Available for SaleCostGain/(Loss)Value
Money market $17,495  $—  $17,495 
Corporate bonds  8,469   378   8,847 
Government agency bonds  4,155   (344)  3,811 
Corporate equity securities  1,115   2,560   3,675 
   
   
   
 
  $31,234  $2,594  $33,828 
   
   
   
 
Recorded as:            
Cash equivalents $9,857         
Short-term investments  14,669         
Restricted deposits  9,302         
   
         
  $33,828         
   
         
Note 7.Corporate Affiliates

The Company’s corporate affiliates are summarized below (in thousands):

                 
Investment Balance
at December 31,
AccountingOwnership
Affiliate20032002MethodPercentage
Xilingol Tongli Ge Co. Ltd. $822  $773   Equity   25%
Emeishan Jia Mei High Pure Metals Co., Ltd.  603   614   Equity   25%
Beijing Ji Ya Semiconductor Material Co., Ltd.  1,071   1,071   Consolidated   51%
Nanjing Jin Mei Gallium Co., Ltd.  616   616   Consolidated   88%
Beijing BoYu Manufacturing Co., Ltd  409   409   Consolidated   70%

     The investment balances for those affiliates accounted for under the equity method are included within “Other assets” in the consolidated balance sheets.

     Undistributed retained earnings relating to the Company’s corporate affiliates, was $769,000 at December 31, 2003 and $861,000 at December 31, 2002. Net income/(loss) recorded from the Company’s corporate affiliates was ($92,000) for the year ended December 31, 2003, $131,000 for 2002, and $701,000 for 2001.

The Company invested in these companies because each provides materials that are important to the Company’s substrate business, each can provide products at lower cost than other suppliers, and each has a market beyond that provided by the Company. At December 31, 2003, the Company had no obligations to make further investments in any of these companies, although it may choose to do so under certain conditions.

Note 8.Impairment of Investments

     The Company also maintains minority investments in private companies which are accounted for under the cost basis. These investments are reviewed for other than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficientusing our own cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions. In 2003, the Company recorded $2.0 million in charges to other expense to

53

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

write down its investment in two private US companies.resources. As of December 31, 2003, the minority investments the Company continues to hold totaled $602,000.

Note 9.Balance Sheet Detail

The components of selected balance sheet accounts are summarized below (in thousands):

         
Years Ended
December 31,
20032002
Accounts receivable:        
Accounts receivable, gross $10,601  $13,871 
Allowance for doubtful accounts  (4,304)  (6,676)
   
   
 
  $6,297  $7,195 
   
   
 
The reduction in allowance for doubtful accounts was due to the collection of previously written-down receivables.
Property, plant and equipment:        
Land $1,120  $1,722 
Building  17,180   15,849 
Machinery and equipment  8,275   13,142 
Leasehold improvements  443   2,600 
Construction in progress  1,150   7,260 
   
   
 
   28,168   40,573 
Less: accumulated depreciation and amortization  (6,373)  (591)
   
   
 
  $21,795  $39,982 
   
   
 
Accrued liabilities:        
Accrued compensation $1,012  $1,304 
Customer deposits  994   2,196 
Accrued restructuring costs  —   1,254 
Income tax payable  3,063   3,063 
Other  3,227   3,590 
   
   
 
  $8,296  $11,407 
   
   
 

54

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 10.Income Taxes

The components of the benefit for income taxes for income (loss) are summarized below (in thousands):

               
Years Ended December 31,
200320022001
Current:            
 Federal $—  $(8,841) $1,917 
 State  —   —   — 
 Foreign  —   —   314 
   
   
   
 
  Total current  —   (8,841)  2,231 
   
   
   
 
Deferred:            
 Federal  —   1,301   (3,481)
 State  —   1,232   (1,560)
   
   
   
 
  Total deferred  —   2,533   (5,041)
   
   
   
 
  Total net benefit for income taxes $—  $(6,308) $(2,810)
   
   
   
 

A reconciliation of the effective income tax rates and the U.S. statutory federal income tax rate is summarized below:

             
Years Ended December 31,
200320022001
Statutory federal income tax rate  (35.00)%  (35.0)%  (35.0)%
State income taxes, net of federal tax benefits  (1.71)%  (2.7)%  (5.0)%
Foreign sales corporation benefit  0.00%  0.0%  0.0%
Unbenefited losses and credits  35.83%  29.9%  0.0%
Change in valuation allowance  0.00%  2.8%  0.0%
Other  0.88%  (2.2)%  4.0%
   
   
   
 
Effective tax rate  0.00%  (7.2)%  (36.0)%
   
   
   
 

55

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Deferred tax assets and liabilities are summarized below (in thousands):

          
Years Ended
December 31,
20032002
Deferred tax assets:        
 Accruals and reserves not yet deductible $7,624  $15,337 
 Net operating loss  28,170   8,923 
 Depreciation  —   5,519 
 Credits  4,212   3,477 
   
   
 
  $40,006  $33,256 
Deferred tax liabilities:        
 Unrealized appreciation on Finisar marketable securities  —   — 
 State taxes  (526)  (980)
 Gain on receipt of Finisar marketable securities      — 
 Unrepatriated Foreign Earnings  (1,239)  (1,085)
 Depreciation  (3,634)  — 
   
   
 
  $(5,399) $(2,065)
   
   
 
 Net deferred tax assets $34,607  $31,191 
 Valuation allowance  (34,607)  (31,191)
 Net deferred tax assets  —   — 
   
   
 

     At December 31, 2003, the Company2004, we had federal and state net operating loss carryforwards of approximately $75.923.1 million and $31.4 million, respectively, which will expire beginning in 2020 and 2005, respectively. In addition, the Company had federal tax credit carryforwards of approximately $1.6 million, which will expire beginning in 2019. The Company also has state tax credit carryforwards of approximately $2.7 million which will expire beginning 2007.

     The deferred tax assets valuation allowance at December 31, 2003 is attributed to U.S. federal, and state deferred tax assets, which result primarily from future deductible accruals, reserves, net operating loss carryforwards, and tax credit carryforwards. The Company believes that, based on a number of factors, the available objective evidence creates sufficient uncertainty regarding the realizability of the deferred tax assets such that a full valuation allowance has been recorded. These factors include the Company’s history of losses, and the lack of carryback capacity to realize deferred tax assets.

     In accordance with Section 382 of the Internal Revenue Code, the amounts of and benefits from net operating loss and tax credit carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses or credits that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50% as defined, over a three year period.

56

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 11.Net loss per Share

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

               
Years Ended December 31,
200320022001
Numerator:            
 Income (loss) from continuing operations $(11,093) $(54,983) $3,848 
 Loss from discontinued operations  (15,638)  (26,198)  (8,844)
 Less: Preferred stock dividends  (177)  (177)  (177)
   
   
��  
 
 Net loss to common stockholders $(26,908) $(81,358) $(5,173)
   
   
   
 
Denominator:            
 Denominator for basic net loss per share — weighted average common shares  22,781   22,433   22,278 
 Effect of dilutive securities:            
  Common stock options  —   —   601 
   
   
   
 
Denominator for dilutive net loss per share  22,781   22,433   22,879 
   
   
   
 
Basic income (loss) per share:            
 Income (loss) from continuing operations $(0.49) $(2.46) $0.17 
 Loss from discontinued operations  (0.69)  (1.17)  (0.40)
 Net loss to common stockholders  (1.18)  (3.63)  (0.23)
Diluted income (loss) per share:            
 Income (loss) from continuing operations $(0.49) $(2.45) $0.17 
 Loss from discontinued operations  (0.69)  (1.17)  (0.39)
 Net loss to common stockholders  (1.18)  (3.63)  (0.23)
Options excluded from diluted net loss per share as the impact is antidilutive  2,326   2,867   2,107 
   
   
   
 
Note 12.Stockholders’ Equity

     In May 1998, the Company completed its initial public offering, or IPO, and issued 2,875,000 shares of its common stock at $10.00 per share, including the shares from the exercise of the underwriters’ over-allotment option. The Company received cash of approximately $25.8 million net of underwriting discounts, commissions and IPO expenses. Upon the closing of the IPO, all outstanding shares of the Company’s then convertible preferred stock were automatically converted into shares of common stock.

     On May 28, 1999, the Company completed its acquisition of Lyte Optronics, Inc. Under the terms of the acquisition, the Company issued approximately 2,023,000 shares of common stock outstanding and 883,000none were repurchased in 2004 under this program. In January 2005, 10,000 shares of non-voting and non-convertible preferred stock, in exchange for all of the issued and outstanding shares of the capital stock of Lyte. Dividends accrue on non-convertible preferred stock at the rate of $0.20 per annum per share and are payable when declared by the board of directors of the Company or in the case of a change in control. The preferred stock has a $4 per share liquidation preference over common stock.

     On July 25, 2000 the Company completed a private securities offering, raising approximately $8.5 million in exchange for 234,115 shares of common stock.

57

AXT, INC.
were repurchased.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)Note 11. Employee Benefit Plans

On September 19, 2000, the Company sold, pursuant to an underwritten public offering, 2,510,000 shares of its common stock at a price of $34.25 per share, including the shares from the exercise of the underwriters’ over-allotment option. The Company received cash of approximately $80.8 million net of underwriting discounts, commissions and expenses. Following the public offering, proceeds were used to repay its line of credit and for general corporate purposes.

Note 13.Employee Benefit Plans

Stock Option Plans

In March 1993, the Company’sour board of directors approved the 1993 Stock Option Plan (“1993 Plan”)(1993 Plan), which provided for granting of incentive and non-qualified stock options to our employees and directors of the Company.directors. Under the 1993 Plan, 880,000 shares of common stock were reservedauthorized for issuance as of December 31, 1998.issuance. Options granted under the 1993 Plan were generally for periods not to exceed ten years and were granted at the fair market value of the stock at the date of grant as determined by the board of directors. Options granted under the 1993 Plan generally vested 25.0%25% upon grant and 25.0%25% each year thereafter, with full vesting occurring on the third anniversary of the grant date. This plan terminated on March 12, 2003.

In July 1997, the Company’sour board of directors approved the 1997 Stock Option Plan (“1997 Plan”)(1997 Plan), which provides for granting of incentive and non-qualified stock options to our employees and directors of the Company.directors. Under the 1997 Plan, 5,901,5015,423,583 shares of common stock have been reservedauthorized for issuance as of December 31, 2003.issuance. Options granted under the 1997 Plan are generally for periods not to exceed ten years (five years if the option is granted to a 10.0%10% stockholder) and are granted at the fair market value of the stock at the date of grant as determined by the


board of directors. Options granted under the 1997 Plan generally vest 25.0%25% at the end of one year and 2.1% each month thereafter, with full vesting after four years.

The following summarizes the Company’s stock option activity under the 1993 Plan and the 1997 Plan, and related weighted average exercise price within each category for each of the years ended December 31, 2001, 2002, and 2003:

                  
AvailableNumber ofPrice per
For GrantSharesPrice per ShareShare
Balance at December 31, 2000  2,936,898   2,495,229      $20.46 
 Granted  (1,693,070)  1,693,070  $10.30 - 43.88   16.71 
 Exercised  —   (388,617)  5.00 - 39.00   9.94 
 Cancelled  485,272   (485,272)  5.00 - 44.25   22.14 
   
   
         
Balance at December 31, 2001  1,729,100   3,314,410      $19.63 
 Granted  (1,137,450)  1,137,450  $1.92 - 15.90   3.06 
 Exercised  —   (23,791)  5.00 - 9.125   6.94 
 Cancelled  863,204   (863,204)  5.00 - 42.50   20.10 
   
   
         
Balance at December 31, 2002  1,454,854   3,564,865      $14.15 
 Granted  (1,116,964)  1,116,964  $0.84 -  3.11   2.29 
 Exercised  —   (32,815)  2.19 -  2.19   2.19 
 Cancelled  2,060,178   (2,060,178)  1.38 - 43.88   15.64 
   
   
         
Balance at December 31, 2003  2,398,068   2,588,836      $10.79 
   
   
         

58

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Information about stock options outstanding at December 31,In May 2003, is summarized below:

                 
Options OutstandingOptions Exercisable
Weighted
AverageWeighted
RemainingAverage
Range ofNumberContractualNumberExercise
Exercise PricesOutstandingLifeOutstandingPrice
$ 0.84 - 1.34  8,500   9.12   677  $0.84 
  1.38 - 1.38  462,900   9.55   —   — 
  1.40 - 2.10  42,000   9.48   3,937   1.61 
  2.19 - 2.19  646,330   8.89   177,043   2.19 
  2.74 - 3.01  16,000   9.94   —   — 
  3.11 - 3.11  522,754   10.00   289,064   3.11 
  5.00 - 12.12  393,375   5.90   270,501   7.84 
 12.90 - 22.69  274,310   7.00   160,643   17.06 
 24.00 - 39.80  217,667   6.37   153,501   26.40 
$41.50 - 41.50  5,000   6.43   4,167   41.50 
   
   
   
   
 
   2,588,836   8.38   1,059,533  $9.80 
   
   
   
   
 
Stock-Based Compensation Under APB No. 25

     In connection with certain stock option grants the Company recorded deferred compensation costs totaling $203,000 for the year ended December 31, 1998. Compensation cost is the difference between the exercise price and the deemed fair value at the date of grant. Compensation cost is being amortized over the vesting period relating to these options, of which no amount was amortized for the years ended December 31, 2003 and 2002, and $107,000 was amortized for the year ended December 31, 2001.

Certain Pro Forma Disclosures

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

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

59

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

             
Years Ended December 31,
200320022001
Risk free interest rate  2.9%  3.0%  3.9%
Expected life (in years)  5.0   5.0   5.0 
Dividend yield  0.0%  0.0%  0.0%
Volatility  109.0%  101.0%  104.0%

     The weighted average grant-date fair value of options granted during the year ended December 31, 2003 was $1.19, $2.39 in 2002 and $12.97 in 2001.

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

               
Years Ended December 31,
200320022001
Net loss:            
 As reported $(26,731) $(81,181) $(4,996)
 Pro forma option expense  7,323   9,182   7,046 
 Pro forma net loss $(34,054) $(90,363) $(12,042)
Net loss per share:            
 As reported:            
  Basic $(1.18) $(3.63) $(0.23)
  Diluted  (1.18)  (3.63)  (0.23)
 Pro forma net loss:            
  Basic $(1.49) $(4.04) $(0.54)
  Diluted  (1.49)  (4.04)  (0.54)

     Because additional option grants are expected to be made each year, the above pro forma disclosures are not representative of pro forma effects on reported net income for future years.

Employee Stock Purchase Plan

     In February 1998, the Company’s board of directors approved the 1998 Employee Stock Purchase Plan (the “1998 Purchase Plan”). The Company’s stockholders approved the 1998 Purchase Plan in March 1998. At December 31, 2003 a total of 900,000 shares of the Company’s common stock were reserved for issuance under the 1998 Purchase Plan. A total of 683,000 shares were purchased as of December 31, 2003. The 1998 Purchase Plan permits eligible employees to acquire shares of the Company’s common stock through payroll deductions. The common stock purchase price is determined as 85.0% of the lower of the market price of the common stock at the purchase date or the date of offer to the employee.

Retirement Savings Plan

     The Company has a 401(k) Savings Plan (the “Savings Plan”) which qualifies as a thrift plan under Section 401(k) of the Internal Revenue Code. All full-time U.S. employees are eligible to participate in the Savings Plan after 90 days from the date of hire. Participants may contribute up to 10.0% of their earnings to the Savings Plan with a discretionary matching amount provided by the Company. The Company’s

60

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

contributions to the Savings Plan were $191,000 for the year ended December 31, 2003, $315,000 for 2002 and $456,000 for 2001.

Note 14.Voluntary Stock Option Exchange Program

On May 27, 2003, the Companywe announced a voluntary stock option exchange program for our employees. Under the program, 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 date of cancellation, which was June 30, 2003. 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 Offeroffer as of May 27, 2003, 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, the Company granted options to purchase an aggregate of 522,754 shares of our common stock in exchange for such tendered options. In 2004, several officers voluntarily cancelled 771,000 options granted to them previously.

The following summarizes our stock option activity under the 1993 Plan and the 1997 Plan, and related weighted average exercise price within each category for each of the years ended December 31, 2002, 2003, and 2004 (in thousands):

 

 

Available
For Grant

 

Number of
Options
Outstanding

 

Weighted
Average
Exercise
Price

 

Balance as of December 31, 2001

 

 

1,729

 

 

 

3,314

 

 

 

$ 19.63

 

 

Granted

 

 

(1,137

)

 

 

1,137

 

 

 

3.06

 

 

Exercised

 

 

—

 

 

 

(24

)

 

 

6.94

 

 

Cancelled

 

 

863

 

 

 

(863

)

 

 

20.10

 

 

Balance as of December 31, 2002

 

 

1,455

 

 

 

3,564

 

 

 

14.15

 

 

Granted

 

 

(1,117

)

 

 

1,117

 

 

 

2.29

 

 

Exercised

 

 

—

 

 

 

(33

)

 

 

2.19

 

 

Cancelled

 

 

2,060

 

 

 

(2,060

)

 

 

15.64

 

 

Balance as of December 31, 2003

 

 

2,398

 

 

 

2,588

 

 

 

10.79

 

 

Granted

 

 

(600

)

 

 

600

 

 

 

1.51

 

 

Exercised

 

 

—

 

 

 

(56

)

 

 

2.73

 

 

Cancelled

 

 

822

 

 

 

(822

)

 

 

15.47

 

 

Balance as of December 31, 2004

 

 

2,620

 

 

 

2,310

 

 

 

$ 2.70

 

 

Information about stock options outstanding as of December 31, 2004 is summarized below (in thousands):

 

 

Options Outstanding

 

Options Exercisable

 

Range of
Exercise Prices

 

 

 

Number
Outstanding

 

Weighted
Average
Remaining
Contractual
Life (Years)

 

Weighted
Average
Exercise
Price

 

Number
Exercisable

 

Weighted
Average
Exercise
Price

 

$1.18 - $  1.37

 

 

435

 

 

 

9.58

 

 

 

$ 1.24

 

 

 

1

 

 

 

$ 1.34

 

 

$1.38 - $  1.42

 

 

463

 

 

 

8.55

 

 

 

1.38

 

 

 

274

 

 

 

1.38

 

 

$1.43 - $  2.23

 

 

674

 

 

 

8.04

 

 

 

2.15

 

 

 

330

 

 

 

2.18

 

 

$2.24 - $  4.99

 

 

529

 

 

 

9.07

 

 

 

2.96

 

 

 

317

 

 

 

3.11

 

 

$5.00 - $41.50

 

 

209

 

 

 

3.91

 

 

 

9.78

 

 

 

192

 

 

 

8.86

 

 

 

 

 

2,310

 

 

 

8.29

 

 

 

$ 2.70

 

 

 

1,114

 

 

 

$ 3.40

 

 


As of December 31, 2004 options to purchase 1,059,533 shares of our common stock were exerciseable.

Employee Stock Purchase Plan

In February 1998, our board of directors approved the 1998 Employee Stock Purchase Plan (1998 Purchase Plan). Our stockholders approved the 1998 Purchase Plan in March 1998. As of December 31, 2004, a total of 900,000 shares of our common stock were reserved for issuance under the 1998 Purchase Plan. A total of approximately 789,000 shares were purchased as of December 31, 2004. The 1998 Purchase Plan permits eligible employees to acquire shares of our common stock through payroll deductions. The common stock purchase price was 85% of the lower of the market price of the common stock at the purchase date or the date of offer to the employee. A total of 106,459, 206,375 and 74,262 shares, respectively, of common stock have been issued under the 1998 Purchase Plan for the years ended December 31, 2004, 2003, and 2002, respectively.

Retirement Savings Plan

We have a 401(k) Savings Plan (Savings Plan) which qualifies as a thrift plan under Section 401(k) of the Internal Revenue Code. All full-time U.S. employees are eligible to participate in the Savings Plan after 90 days from the date of hire. In 2005 we changed this to make all full-time Participants may contribute up to 10% of their earnings to the Savings Plan with a discretionary matching amount provided AXT. Our contributions to the Savings Plan were $177,000, $191,000, and $315,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

Note 12. Guarantees

Indemnification Agreements

We enter into standard indemnification arrangements in the ordinary course of business. Pursuant to these arrangements, we indemnify, hold harmless, and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, generally their business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual anytime after the execution of the agreement. The maximum potential amount of future payments we could be required to make under these agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal.

We have entered into indemnification agreements with our directors and officers that may require us to indemnify our directors and officers against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from wilful misconduct of a culpable nature; to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified; and to obtain directors’ and officers’ insurance if available on reasonable terms, which we currently have in place.

Product Warranty

We warrant our products for a specific period of time, generally twelve months, against material defects. We provide for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represents the best estimate at the time of sale of the total costs that we expect to incur to repair or replace product parts, which fail while still under warranty. The amount of accrued estimated warranty costs are primarily based on historical experience as to product


failures as well as current information on repair costs. On a quarterly basis, we review the accrued balances and updates the historical warranty cost trends. The following table reflects the change in our warranty accrual during fiscal year 2004 (in thousands):

Amount

Note 15.

Warranty accrual, beginning of year

Segment and Foreign Operations Information

$ —

Charged to cost of sales

135

Actual warranty expenditures

—

Warranty accrual, end of year

$ 135

In March 2004, we determined that we had not followed certain requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. Since April 2004, we have continued to notify the affected customers concerning our findings. We recorded a reserve for sale returns of $745,000 and believed this was adequate to cover any product returns related to this matter. We are unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately $285,000 of the $745,000 sales returns reserve has been utilized as of December 31, 2004.

Note 13. Income Taxes

The Companycomponents of the provision (benefit) for income taxes are summarized below (in thousands):

 

 

Years Ended December 31,

 

 

 

    2004    

 

    2003    

 

2002

 

Current:

 

 

 

 

 

 

 

 

 

 

 

Federal

 

 

$ —

 

 

 

$ —

 

 

$ (8,841

)

Foreign

 

 

71

 

 

 

—

 

 

—

 

Total current

 

 

71

 

 

 

—

 

 

(8,841

)

Deferred:

 

 

 

 

 

 

 

 

 

 

 

Federal

 

 

—

 

 

 

—

 

 

1,301

 

State

 

 

—

 

 

 

—

 

 

1,232

 

Total deferred

 

 

—

 

 

 

—

 

 

2,533

 

Total net benefit for income taxes

 

 

$ 71

 

 

 

$ —

 

 

$ (6,308

)

A reconciliation of the effective income tax rates and the U.S. statutory federal income tax rate is summarized below:

 

 

Years Ended December 31,

 

 

 

   2004   

 

   2003   

 

   2002   

 

Statutory federal income tax rate

 

 

(35.0

)%

 

 

(35.0

)%

 

 

(35.0

)%

 

State income taxes, net of federal tax benefits

 

 

(1.7

)

 

 

(1.7

)

 

 

(2.7

)

 

Unbenefited losses and credits

 

 

0.0

 

 

 

0.0

 

 

 

2.8

 

 

Change in valuation allowance

 

 

30.1

 

 

 

35.8

 

 

 

29.9

 

 

Other

 

 

7.1

 

 

 

0.9

 

 

 

(2.2

)

 

Effective tax rate

 

 

0.5

%

 

 

0.0

%

 

 

(7.2

)%

 

74



Deferred tax assets and liabilities are summarized below (in thousands):

 

 

As of December 31,

 

 

 

2004

 

2003

 

Deferred tax assets:

 

 

 

 

 

Accruals and reserves not yet deductible

 

$

5,491

 

$

7,624

 

Net operating loss

 

32,605

 

28,170

 

Credits

 

4,329

 

4,212

 

 

 

42,425

 

40,006

 

Deferred tax liabilities:

 

 

 

 

 

State taxes

 

(151

)

(526

)

Unrepatriated foreign earnings

 

(1,239

)

(1,239

)

Depreciation

 

(2,270

)

(3,634

)

 

 

(3,660

)

(5,399

)

Net deferred tax assets

 

38,765

 

34,607

 

Valuation allowance

 

(38,765

)

(34,607

)

Net deferred tax assets

 

$

—

 

$

—

 

As of December 31, 2004, we had federal and state net operating loss carryforwards of approximately $89.5 million and $39.4 million, respectively, which will expire beginning in 2020 and 2007, respectively. In addition, we had federal tax credit carryforwards of approximately $1.6 million, which will expire beginning in 2020. We also had state tax credit carryforwards of approximately $2.7 million which will expire beginning 2008.

The deferred tax assets valuation allowance as of December 31, 2004 is attributed to U.S. federal, and state deferred tax assets, which result primarily from future deductible accruals, reserves, net operating loss carryforwards, and tax credit carryforwards. We believe that, based on a number of factors, the available objective evidence creates sufficient uncertainty regarding our ability to realize the deferred tax assets such that a full valuation allowance has been recorded. These factors include our history of losses, and the lack of carryback capacity to realize deferred tax assets.

In accordance with Section 382 of the Internal Revenue Code, the amounts of and benefits from net operating loss and tax credit carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses or credits that we may utilize in any one operatingyear include, but are not limited to, a cumulative ownership change of more than 50% as defined, over a three year period.


Note 14. Net loss per Share

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

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Numerator:

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(14,524

)

$

(11,093

)

$

(54,983

)

Gain (loss) from discontinued operations

 

891

 

(15,638

)

(26,198

)

Less: Preferred stock dividends

 

(177

)

(177

)

(177

)

Net loss to common stockholders

 

$

(13,810

)

$

(26,908

)

$

(81,358

)

Denominator:

 

 

 

 

 

 

 

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

 

23,063

 

22,781

 

22,433

 

Effect of dilutive securities:

 

 

 

 

 

 

 

Common stock options

 

—

 

—

 

—

 

Denominator for dilutive net loss per share

 

23,063

 

22,781

 

22,433

 

Basic and diluted income (loss) per share:

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.64

)

$

(0.49

)

$

(2.46

)

Gain (loss) from discontinued operations

 

0.04

 

(0.69

)

(1.17

)

Net loss to common stockholders

 

$

(0.60

)

$

(1.18

)

$

(3.63

)

Options excluded from diluted net loss per share
as the impact is anti-dilutive

 

2,310

 

2,588

 

3,564

 

Note 15. Segment Information and Foreign Operations

Segment Information

We operate in one segment comprising offor the design, development, manufacture and distribution of high-performance compound semiconductor substrates.

The Company sells its substrates and sale of materials. In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” our chief operating decision-maker has been identified as the Interim Chief Executive Officer, who reviews operating results to make decisions about allocating resources and assessing performance for the company. All material operating units qualify for aggregation under SFAS No. 131 due to their identical customer base and similarities in economic characteristics, nature of products and services, and procurement, manufacturing and distribution processes. Since we operate in one segment, all financial segment and product line information required by SFAS No. 131 can be found in the consolidated financial statements.


Geographical Information

The following table represents revenue amounts (in thousands) reported for products shipped to customers in the corresponding geographic region:

 

 

Years Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Product revenue:

 

 

 

 

 

 

 

North America*

 

$

7,514

 

$

12,009

 

$

26,208

 

Europe

 

6,840

 

5,638

 

5,508

 

Japan

 

5,156

 

4,167

 

3,000

 

Taiwan

 

8,397

 

7,055

 

4,246

 

Asia Pacific (excluding Japan and Taiwan)

 

7,547

 

5,844

 

5,903

 

 

 

$35,454

 

$

34,713

 

$

44,865

 

*                    Primarily the United States

Long-lived assets consist primarily of property, plant and equipment, and are attributed to the geographic location in other parts of the world. Also, the Company has operations in Japan and China. Revenueswhich they are located. Long-lived assets by geographic location based on the country of the customerregion were as follows (in thousands):

              
Years Ended December 31,
200320022001
Net revenues:            
 United States $11,823  $25,185  $57,137 
 Europe  5,638   5,508   21,341 
 Canada  186   1,023   6,643 
 Taiwan  7,055   4,246   10,441 
 Japan  4,167   3,000   8,355 
 Asia Pacific (excluding Japan and Taiwan)  5,844   5,903   4,883 
   
   
   
 
 Consolidated $34,713  $44,865  $108,800 
   
   
   
 

 

 

As of December 31,

 

 

 

2004

 

2003

 

Long-lived assets:

 

 

 

 

 

North America

 

$

7,163

 

$

7,583

 

Asia Pacific

 

11,882

 

14,212

 

 

 

$19,045

 

$

21,795

 

Property, plantSignificant Customers

No customer represented greater than 10% of product revenues for the years ended December 31, 2004, 2003 and equipment by geographic location is summarized below (in thousands):

          
Years Ended
December 31,
20032002
Property, plant and equipment, net:        
 United States $7,583  $21,133 
 China  14,212   18,849 
   
   
 
  $21,795  $39,982 
   
   
 

61

AXT, INC.
2002. Our top five customers represented 30.1%, 28.9%, and 31.4% of product revenue for the years ended December 31, 2004, 2003, and 2002, respectively.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)Note 16. Foreign Exchange Contracts and Transaction Gains/Losses

Note 16.Related Party Transactions

We use short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. We have purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of December 31, 2004, we had no outstanding commitments with respect to foreign exchange contracts.

We incurred foreign currency transaction exchange gains of $60,000, $110,000, and $19,000 for the years ended December 31, 2004, 2003, and 2002, respectively.

Note 17. Related Party Transactions

Since January 2002, there has not been, nor is there currently proposed, any transaction or series of similar transactions to which the CompanyAXT was or is to be a party in which the amount involved exceeds $60,000, and in which any director, executive officer or holder of more than 5% of any class of the Company’sour voting securities or members of that person’s immediate family had or will have a direct or indirect material interest other than the transactions described below.

The CompanyWe entered into an operating lease in July 2001 for warehouse space in Fremont, CA with 4160 Business Center, LLC, a real estate holding company, in which Davis Zhang, the president of our substrate division,China


Operations, is the sole shareholder. Lease payments to 4160 Business Center, LLC were approximately $484,000 for the year ended December 31, 2002 and $121,000 for the three months ended March 31, 2003. In April of 2003, Mr. Zhang sold this warehouse to a party unrelated to the Company. The Companyus. We began leasing this warehouse from the new owner on the date of sale. Mr. Zhang will continue to hold a $3.7 million note on the property through April 2005.

Note 17.Commitments and Contingencies

     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.Note 18. Commitments and Contingencies

     On April 15, 2003, Sumitomo Electric Industries, Ltd., (SEI) filed a complaint in the Tokyo District Court, Civil Division against us and our Japanese distributor alleging patent infringement of two patents held by SEI in Japan. The suit seeks penalties from AXT in the amount of $1.67 million plus interest and court costs and the cessation of AXT’s sales of gallium arsenide substrates in Japan. AXT intends to defend itself vigorously in these lawsuits and continues to sell its products in Japan.Legal Matters

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

On October 15, 2004, a purported securities class action lawsuit was filed in the United States Court for the Northern District of California. City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Company haslawsuit names AXT, Inc. and our chief executive officer, China operations, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004. The complaint alleges that we announced financial results during this period that were false and misleading. No specific amount of damages is claimed. On February 4, 2005, the Court consolidated the case with a related case making similar allegations, and appointed a lead plaintiff, who will file a consolidated complaint. We believe that there are meritorious defenses against this litigation and intends to vigorously defend it. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operations.

On December 2, 2004, we executed an agreement with Sumitomo Electric Industries, Ltd. (“SEI”), a Japanese corporation, to settle litigation commenced by SEI against AXT in Japan alleging infringement of certain SEI patents, and an interference action between an AXT patent and an SEI reissue application brought in the United States. We and SEI entered into a four-year cross-licensing agreement for all intellectual property used by either company related to compound semiconductor substrates, which will expire on December 31, 2008, with the exception of the patents that were the basis for the litigation in Japan and the interference in the U.S. where the license agreement shall last for the life of these patents. Under the terms of the settlement, we made a payment to SEI in the amount of Japanese Yen one hundred and forty-seven million (¥147,000,000) on January 4, 2005, and we will make on-going royalty payments through 2012 on certain products sold by us in Japan. Subsequent to that payment, SEI dropped the litigation in Japan and we abandoned the interference proceedings in the U.S.

Leases

We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Total rent expenses under these operating leases were $1.3 million, $1.2 million and $0.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. Total minimum lease payments under these leases as of December 31, 2004 are summarized below (in thousands):


 

 

Lease Payment

 

2005

 

 

$

1,319

 

 

2006

 

 

940

 

 

2007

 

 

645

 

 

2008

 

 

714

 

 

2009

 

 

733

 

 

Thereafter

 

 

2,486

 

 

 

 

 

$6,837

 

 

Contract Commitment

We have entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee theguaranteed delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of $2.0 million.$130,000. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Companywe could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. The Company hasWe have not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling $130,000 and $994,000 are included in accrued liabilities atin the accompanying condensed consolidated balance sheets as of December 31, 2003.2004 and 2003, respectively. During the third quarter of 2004, the Company refunded a portion of a prepayment on future purchases of goods and recorded a $237,000 gain for the amount of deposit forfeited by a private company, which investment was impaired by AXT. As of December 31, 2003, the Company has2004, we have met all of itsour current delivery obligations under these contracts and expectsexpect to do so forcontinue to meet delivery requirements during the remainder of the contract terms.

     The Company leases 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 year ended December 31, 2003, $947,000 in 2002 and $779,000 in 2001.

62

AXT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The Company has an outstanding purchase order for manufacturing equipment related to its discontinued opto-electronics division totaling $1.4 million at December 31, 2003. The Company isWe are currently negotiating a settlement withnew joint venture investment in China for a germanium business opportunity, and upon the supplierfulfillment of certain conditions, we may invest up to $1.0 million to the new joint venture in 2005.

Note 19. Unaudited Quarterly Consolidated Financial Data

 

 

Quarter

 

 

 

First

 

Second

 

Third

 

Fourth

 

 

 

(in thousands, except per share data)

 

2003:

 

 

 

 

 

 

 

 

 

Revenue

 

$

8,536

 

$

8,519

 

$

8,529

 

$

9,129

 

Gross profit

 

273

 

675

 

500

 

787

 

Net loss

 

(4,317

)

(17,736

)

(2,563

)

(2,115

)

Net loss per share, basic and diluted

 

$

(0.19

)

$

(0.78

)

$

(0.11

)

$

(0.09

)

2004:

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,776

 

$

9,524

 

$

8,531

 

$

7,623

 

Gross profit (loss)

 

533

 

829

 

(2,236

)

623

 

Net loss

 

(2,560

)

(3,847

)

(4,964

)

(2,262

)

Net loss per share, basic and diluted

 

$

(0.11

)

$

(0.17

)

$

(0.21

)

$

(0.10

)

Note 20. Subsequent Event

In January 2005, we accepted an offer from a real estate developer to purchase our Monterey Park facility for this un-needed equipment.

Total minimum lease payments undernet proceeds of approximately $1.25 million, after deducting estimated commission and selling expenses. This asset has been classified as held for sale on the above leasesconsolidated balance sheets as of December 31, 2003, are summarized below (in thousands):

     
Operating
Leases
2004 $1,231 
2005  1,115 
2006  836 
2007  616 
2008  617 
Thereafter  3,236 
   
 
  $7,651 
   
 
2004 and 2003. We expect the sale to be completed in the second quarter of 2005.

6379



SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.

AXT, INC.

AXT, INC.

By:

/s/ DONALD L. TATZIN

By: 

/s/ MORRIS S. YOUNG

Donald L. Tatzin

Morris S. Young,

Interim Chief Executive Officer and President

Date: March 29, 200418, 2005

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Morris S. Young and Donald L. Tatzin and Wilson W. Cheung, and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution, each with power to act alone, to sign and execute on behalf of the undersigned any and all amendments to this Report on Form 10-K, and to perform any acts necessary in order to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requested and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or their or his or her substitutes, shall do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature

Title

Date

/s/ DONALD L. TATZIN

Donald L. Tatzin

Interim Chief Executive Officer and Director

(Principal Executive Officer)

March 18, 2005

/s/ WILSON W. CHEUNG

Wilson W. Cheung


Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)

March 18, 2005

/s/ JESSE CHEN

Jesse Chen

Chairman of the Board of Directors

March 18, 2005

/s/ MORRIS S. YOUNG

Morris S. Young

President,

Chief Executive Officer, China Operations
and Chairman of the BoardDirector

March 29, 200418, 2005

/s/ DONALD L. TATZIN
Donald L. Tatzin		Senior Vice President, Chief Financial Officer, DirectorMarch 29, 2004

/s/ DAVID C. CHANG

David C. Chang

Director

March 29, 200415, 2005

/s/ JESSE CHEN
Jesse Chen		DirectorMarch 29, 2004

/s/ LEONARD LEBLANC

Leonard LeBlanc

Director

March 29, 200418, 2005

6480



AXT, Inc.

EXHIBITS


TO

FORM 10-K ANNUAL REPORT

For the Year Ended December 31, 20032004

     
Exhibit
NumberDescription
 3.1(3) Restated Certificate of Incorporation
 3.2(4) Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which is incorporated herein by reference to Exhibit 2.1 to the registrant’s form 8-K dated May 28, 1999).
 3.3(5) Second Amended and Restated By Laws
 4.2(5) Rights Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.
 10.1(1) Form of Indemnification Agreement for directors and officers.*
 10.2(1) 1993 Stock Option Plan and forms of agreements thereunder.*
 10.3(1) 1997 Stock Option Plan and forms of agreements thereunder.*
 10.4(1) 1997 Employee Stock Purchase Plan and forms of agreements thereunder.*
 10.5(1) 1998 Employee Stock Purchase Plan and forms of agreements thereunder.*
 10.7(2) Purchase and Sale Agreement by and between Limar Realty Corp. #23 and AXT, Inc. dated April 1998.
 10.10(3) Bond Purchase Contract between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.
 10.11(3) Remarketing Agreement between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.
 10.15(7) Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003.
 10.16(8) Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group, Ltd and AXT, Inc. and by and between Lumei Optoelectronics Corp., AXT, Inc., Lyte Optronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.

     
Exhibit
NumberDescription
 10.17 Code of Business Conduct and Ethics dated February 2, 2004.
 21.1(1) List of Subsidiaries.
 24.1 Power of Attorney (see signature page).
 31.1 Certification by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 31.2 Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 32.1 Certification by Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 32.2 Certification by Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Exhibit
Number

Description

(1) 

3.1(3)

Incorporated

Restated Certificate of Incorporation

3.2(4)

Certificate of Designation, Preferences and Rights of Series A Preferred Stock (which  is incorporated herein by reference to Exhibit 2.1 to the exhibit asregistrant’s form 8-K dated May 28, 1999).

3.3(5)

Second Amended and Restated By Laws

4.2(5)

Rights Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.

10.1(1)

Form of Indemnification Agreement for directors and officers.*

10.2(1)

1993 Stock Option Plan and forms of agreements thereunder.*

10.3(1)

1997 Stock Option Plan and forms of agreements thereunder.*

10.5(1)

1998 Employee Stock Purchase Plan and forms of agreements thereunder.*

10.7(2)

Purchase and Sale Agreement by and between Limar Realty Corp #23 and AXT, Inc. dated April 1998.

10.10(3)

Bond Purchase Contract between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.

10.11(3)

Remarketing Agreement between Dain Rauscher Incorporated and AXT, Inc. dated December 1, 1998.

10.15(7)

Reimbursement Agreement between Wells Fargo Bank National Association and AXT, Inc. dated April 7, 2003.

10.16(8)

Asset purchase agreements dated September 4, 2003 by and between Dalian Luming Science and Technology Group, Ltd and AXT, Inc. and by and between Lumei Optoelectronics Corp., AXT, Inc., Lyte Optronics, Inc., Beijing Tongmei Xtal Technology and Xiamen Advanced Semiconductor Co., Ltd.

21.1(1)

List of Subsidiaries.

23.1

Consent of Independent Registered Public Accounting Firm, Burr, Pilger, Mayer LLP.

23.2

Consent of Independent Registered Public Accounting Firm, PricewaterhouseCoopers LLP.

24.1

Power of Attorney (see signature page).

31.1

Certification by Interim Chief Executive Officer Pursuant to Section 302 of the same number as filed with the SEC in our Registration Statement on Form S-1 on March 17, 1998.Sarbanes-Oxley Act of 2002.

(2) 

31.2

Incorporated

Certification by referenceChief Financial Officer Pursuant to the exhibit asSection 302 of the same number as filed with the SEC in our Registration Statement on Amendment No. 2 to Form S-1 on May 11, 1998.Sarbanes-Oxley Act of 2002.

(3) 

32.1

Incorporated

Certification by referenceInterim Chief Executive Officer Pursuant to the exhibit asSection 906 of the same number as filed with the SEC in our Annual Report on Form 10-K for the year ended December 31, 1998Sarbanes-Oxley Act of 2002.

(4) 

32.2

Incorporated

Certification by referenceChief Financial Officer Pursuant to the exhibit asSection 906 of the same number as filed with the SEC in our Form 8-K on June 14, 1999Sarbanes-Oxley Act of 2002.

(5) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on May 30, 2001
(6) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10Q on November 12, 2002
(7) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10Q on May 9, 2003
(8) Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10Q on November 13, 2003
* Indicates a management contract

(1)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Registration Statement on Form S-1 on March 17, 1998.



(2)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Registration Statement on Amendment No. 2 to Form S-1 on May 11, 1998.

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

(4)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on June 14, 1999

(5)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 8-K on May 30, 2001

(6)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on November 12, 2002

(7)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on May 9, 2003

(8)          Incorporated by reference to the exhibit as of the same number as filed with the SEC in our Form 10-Q on November 13, 2003

   *           Indicates a management contract