AXT INC - Quarter Report: 2001 September (Form 10-Q)

AXT, Inc. Form 10-Q 9/30/01

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC. 20549

FORM 10-Q

(Mark One)


[X]	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2001

or

[ ]	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 0-24085

AXT, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		94-3031310
(State or other jurisdiction of Incorporation or organization)		(I.R.S. Employer Identification No.)

4281 Technology Drive, Fremont, California 94538
(Address of principal executive offices) (Zip code)
(510) 683-5900
(Registrant’s telephone number, including area code)

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

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


Class		Outstanding at September 30, 2001

Common Stock, $.001 par value		22,361,584

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED INCOME STATEMENTS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
PART II OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 6. Exhibits and reports on Form 8-K
SIGNATURES

AXT, INC.

TABLE OF CONTENTS


PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements.

		Condensed Consolidated Balance Sheets at September 30, 2001 and December 31, 2000

		Condensed Consolidated Income Statements for the three and nine months ended September 30, 2001 and 2000

		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and 2000

		Notes To Condensed Consolidated Financial Statements

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

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings

	Item 6.	Exhibits and Reports on Form 8-K

		Signatures

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(In thousands, except per share data)


				September 30,			December 31,
				2001			2000

				(Unaudited)
Assets:
	Current assets
		Cash and cash equivalents		$	38,823		$	68,585
		Short-term investments			8,785			30,852
		Accounts receivable			22,999			27,773
		Inventories			58,538			51,846
		Prepaid expenses and other current assets			5,045			3,603
		Deferred income taxes			6,020			—

			Total current assets		140,210			182,659
	Property, plant and equipment				83,640			63,401
	Investments				16,071			—
	Other assets				4,165			3,312
	Goodwill				1,195			848

			Total assets	$	245,281		$	250,220

Liabilities and Stockholders’ Equity:
	Current liabilities
		Short-term bank borrowing		$	386		$	1,353
		Accounts payable			8,424			10,009
		Accrued liabilities			19,896			16,651
		Deferred income taxes			—			3,847
		Current portion of long-term debt			2,487			4,355
		Current portion of capital lease obligation			4,290			6,057

			Total current liabilities		35,483			42,272
		Long-term debt, net of current portion			14,820			15,123
		Long-term capital lease, net of current portion			11,126			7,278
		Other long-term liabilities			1,356			200

			Total liabilities		62,785			64,873

	Stockholders’ equity:
		Preferred stock, $.001 par value per share; 2,000 shares authorized; 883 shares issued and outstanding			3,532			3,532
		Common stock, $.001 par value per share; 70,000 shares authorized; 22,362 and 21,952 shares issued and outstanding			150,360			145,748
		Deferred compensation			(24	)		(107	)
		Retained earnings			42,828			33,980
		Other comprehensive income (loss)			(14,200	)		2,194

			Total stockholders’ equity		182,496			185,347

		Total liabilities and stockholders’ equity		$	245,281		$	250,220

See accompanying notes to these unaudited condensed consolidated financial statements.

AXT, INC.

CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)
(In thousands, except per share data)


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2001			2000			2001			2000

Revenue			$	22,783		$	33,132		$	104,159		$	83,336
Cost of revenue				17,423			18,435			66,300			48,612

Gross profit				5,360			14,697			37,859			34,724
Operating expenses:
	Selling, general and administrative			5,826			5,134			17,105			12,627
	Research and development			1,701			3,267			6,834			6,976

		Total operating expenses		7,527			8,401			23,939			19,603

Income (loss) from operations				(2,167	)		6,296			13,920			15,121
Interest expense				493			762			1,637			2,680
Other (income) expense				(488	)		16			(1,542	)		(468	)

Income (loss) before provision for income taxes				(2,172	)		5,518			13,825			12,909
Provision for income taxes				(782	)		2,097			4,977			4,916

Income (loss) from continuing operations				(1,390	)		3,421			8,848			7,993
Loss from discontinued operations, net of tax benefits				—			(519	)		—			(766	)

Net Income (loss)			$	(1,390	)	$	2,902		$	8,848		$	7,227

Basic income (loss) per share:
	Income from continuing operations		$	(0.06	)	$	0.17		$	0.40		$	0.41
	Loss from discontinued operations			—			(0.03	)		—			(0.04	)
	Net income (loss)			(0.06	)		0.14			0.40			0.37
Diluted income (loss) per share:
	Income from continuing operations		$	(0.06	)	$	0.16		$	0.39		$	0.38
	Loss from discontinued operations			—			(0.03	)		—			(0.04	)
	Net income (loss)			(0.06	)		0.13			0.39			0.34
Shares used in per share calculations:
	Basic			22,333			19,832			22,246			19,595
	Diluted			22,333			21,226			22,931			21,062

See accompanying notes to these unaudited condensed consolidated financial statements.

AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)


					Nine Months Ended
					September 30,

					2001			2000

CASH FLOWS FROM OPERATING ACTIVITIES:
	Net income:				$	8,848		$	7,227
	Adjustments to reconcile net income to cash provided by operations:
		Depreciation				6,187			4,558
		Deferred income taxes				—			(1,375	)
		Amortization of goodwill				243			449
		Stock compensation				83			83
		Premium/discount amortization				23			—
		Changes in assets and liabilities:
			Accounts receivable			4,624			(6,551	)
			Inventories			(6,692	)		(11,241	)
			Prepaid expenses and other current assets			(228	)		(426	)
			Other assets			(120	)		(2,259	)
			Accounts payable			(1,532	)		1,933
			Accrued liabilities			3,256			7,965
			Other long-term liabilities			64			(260	)

				Net cash provided by operating activities		14,756			103

CASH FLOWS FROM INVESTING ACTIVITIES:
	Purchases of property, plant and equipment					(24,321	)		(16,807	)
	Purchases of investments					(22,748	)		—
	Sale of investments					1,034			—

				Net cash used in investing activities		(46,035	)		(16,807	)

CASH FLOWS FROM FINANCING ACTIVITIES:
		Proceeds from issuance of common stock				4,612			94,512
		Payments of capital leases				(3,231	)		(1,490	)
		Proceeds from capital leases				3,143
		Payments of short-term bank borrowings				(966	)		(11,298	)
		Payments of long-term debt				(2,171	)		(1,328	)

				Net cash provided by (used in) financing activities		1,387			80,396
Effect of exchange rate changes						130			18

Net decrease in cash and cash equivalents						(29,762	)		63,710
Cash and cash equivalents at the beginning of the period						68,585			6,062

Cash and cash equivalents at the end of the period					$	38,823		$	69,772

Non cash activity:
	Purchase of PP&E through capital leases				$	2,170		$	8,170

	Retirements of property, plant and equipment				$	(2,369	)	$	(1,558	)

See accompanying notes to these unaudited condensed consolidated financial statements.

AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

The accompanying condensed consolidated financial statements for the three and nine months ended September 30, 2001 and 2000 are unaudited. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT, Inc. (the “Company”) and its subsidiaries for all periods presented. Certain prior period reclassifications have been made to conform to the current period presentation.

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

The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2000 Annual Report on Form 10-K.

Note 2. Investments

The Company accounts for its cash equivalents and investments in marketable securities under Statement of Financial Accounting Standards No. 115 or SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” The Company classifies all investments as available for sale and carries them at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. The components of investments at September 30, 2001 are summarized below (in thousands):


			Aggregate		Unrealized
Available for sale	Cost		Fair value		Gain/(loss)

Money market	$	5,245	$	5,245	$	—
Corporate bonds		15,876		16,071		195
Government agency bonds		4,520		4,572		52
Corporate equity securities		27,328		4,213		(23,115	)

	$	52,969	$	30,101	$	(22,868	)

Recorded as:
Cash equivalents	$	5,245
Investments due within one year		8,785
Investments due in over one year		16,071

	$	30,101

Note 3. Joint Ventures

The Company’s Joint venture interests are summarized below (in thousands):


	Investment		Investment
	Balance		Balance
	September 30,		December 31,		Accounting	Ownership
Affiliate	2001		2000		Method	Percentage

Xilingol Tongli Ge Co. Ltd.	$	630	$	302	Equity		25	%
Emeishan Jia Mei High Pure Metals Co., Ltd.		629		—	Equity		25	%
Beijing Ji Ya Semiconductor Material Co., Ltd.		1,599		1,599	Consolidated		51	%
Nanjing Jin Mei Gallium Co., Ltd.		700		700	Consolidated		88	%

Note 4. Inventories

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


		September 30,		December 31,
		2001		2000

Inventories, net:
	Raw materials	$	22,958	$	20,623
	Work in process		25,544		26,795
	Finished goods		10,036		4,428

		$	58,538	$	51,846

Note 5. Net Income Per Share

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

A reconciliation of the numerators and denominators of the basic and diluted net earnings per share calculations is summarized below (in thousands except per share data):


			Three Months Ended					Nine Months Ended
			September 30,					September 30,

			2001			2000		2001			2000

Numerator:
	Net income (loss)		$	(1,390	)	$	2,902	$	8,848		$	7,227
	Less: Preferred stock dividends			(44	)		—		(133	)		—

	Income (loss) available to common stockholders		$	(1,434	)	$	2,902	$	8,715		$	7,227

Denominator:
	Denominator for basic earnings per share — weighted average common shares			22,333			19,832		22,246			19,595
	Effect of dilutive securities:
		Common stock options		—			1,394		685			1,467

Denominator for dilutive earnings per share				22,333			21,226		22,931			21,062

Basic earnings per share			$	(0.06	)	$	0.14	$	0.40		$	0.37
Diluted earnings per share			$	(0.06	)	$	0.13	$	0.39		$	0.34
Options excluded from diluted net income per share as the impact is antidilutive				2,670			97		1,136			90

Undeclared preferred stock dividends payable only upon voluntary liquidation by the company.

Note 6. Comprehensive Income

The components of comprehensive income are summarized below (in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,

	2001			2000			2001			2000

Net Income (loss)	$	(1,390	)	$	2,902		$	8,848		$	7,227
Foreign currency translation gain (loss)		263			(104	)		131			18
Unrealized gain (loss) on marketable securities		(9,918	)		—			(16,525	)		—

Comprehensive income (loss)	$	(11,045	)	$	2,798		$	(7,546	)	$	7,245

Note 7. Segment Information

Selected industry segment information is summarized below (in thousands):


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

		2001			2000			2001			2000

Substrates Division
	Net revenues from external customers	$	20,455		$	31,686		$	97,326		$	77,024
	Gross profit		6,470			14,614			41,207			35,763
	Operating income		1,093			8,717			24,111			23,136
	Identifiable assets		204,276			182,183			204,276			182,183
Opto-electronics Division
	Net revenues from external customers	$	2,328		$	1,446		$	6,833		$	6,312
	Gross profit (loss)		(1,110	)		83			(3,348	)		(1,039	)
	Operating income (loss)		(3,260	)		(2,421	)		(10,191	)		(8,015	)
	Identifiable assets		41,005			34,117			41,005			34,117
Discontinued Consumer Products Division
	Identifiable assets	$	—		$	4,994		$	—		$	4,994
Total
	Net revenues from external customers	$	22,783		$	33,132		$	104,159		$	83,336
	Gross profit		5,360			14,697			37,859			34,724
	Operating income (loss)		(2,167	)		6,296			13,920			15,121
	Identifiable assets		245,281			221,294			245,281			221,294

The Company changed the name of its Visible Emitter division to Opto-electronics division.

The Company sells its products in the United States and in other parts of the world. Also, the Company has operations in China and Japan. Revenues by geographic location based on product shipment destination are summarized below (in thousands):


		Three Months Ended				Nine Months Ended
		September 30,				September 30,

		2001		2000		2001		2000

Net revenues:
	United States	$	12,278	$	16,858	$	51,936	$	42,446
	Canada		1,673		3,709		6,212		4,839
	United Kingdom		1,963		—		11,830		—
	Other european countries		2,074		2,062		8,321		7,454
	Taiwan		2,601		190		12,326		1,244
	Other asian countries		2,194		10,313		13,534		27,353

	Consolidated	$	22,783	$	33,132	$	104,159	$	83,336

Note 8. Discontinued Operations

On December 14, 2000, the Company’s Board of Directors approved management’s plan to exit the Company’s unprofitable consumer products business. The Company expects to complete the plan by December 31, 2001.

Note 9. Restructuring costs

On December 14, 2000, the Company’s Board of Directors approved management’s plan to exit its unprofitable 650 nm laser diode product line within its Opto-electronics division. As a result, during the fourth quarter of 2000, the Company recorded a pre-tax restructuring charge of $8.2 million. The restructuring charge included $2.1 million for incremental costs and contractual obligations for such items as leasehold termination payments and other facility exit costs incurred as a direct result of this plan.

Certain information with respect to restructuring costs is summarized below (in thousands):


			Utilized				Balance
	Reserve		Cash		Non-cash		September 30, 2001

Inventory write-off	$	1,844	$	—	$	1,844	$	—
Property, plant and equipment write-off		3,436		—		3,436		—
Goodwill write-off		848		—		848		—
Other restructuring costs		2,124		74		121		1,929

	$	8,252	$	74	$	6,249	$	1,929

The fair value of assets determined to be impaired in accordance with the guidance for assets to be disposed of in SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,” were the result of management estimates. The above noted exit costs were determined in accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” The restructuring actions, as outlined by the plan, are intended to be executed to completion by December 31, 2001.

Note 10. Commitments

The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2001. The remaining value of these contracts was $56.6 million as of September 30, 2001. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties between 5% and 10% of the value of the delinquent monthly deliveries. Partial prepayments received for these supply contracts totaling $8.7 million are included in accrued liabilities at September 30, 2001.

Note 11. Recent Accounting Pronouncements

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 and No. 142, or SFAS 141, “Business Combinations”, and SFAS 142, “Goodwill and Other Intangible Assets.” Under SFAS 141, all business combinations must be accounted for using the purchase method of accounting; use of the pooling-of-interests (pooling) method is prohibited. The provisions of the statement will apply to all business combinations initiated after June 30, 2001. SFAS 142 will apply to all acquired intangible assets whether acquired singly, as a part of a group, or in a business combination. The statement will supersede APB Opinion No. 17, “Intangible Assets”, and will carry forward provisions in APB Opinion No. 17 relating to internally developed intangible assets. Adoption of SFAS 142 will result in ceasing amortization of goodwill. All of the statement should be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized in an entity’s statement of financial position at that date, regardless of when those assets were initially recognized. We believe adoption of the provisions of SFAS 141 and SFAS 142 will not have a material effect on the Company’s financial position or results of operations.

Note 12. Foreign Exchange Contracts and Transaction Losses

The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of September 30, 2001, the Company’s outstanding commitments with respect to the foreign exchange contracts, which were commitments to sell Japanese yen, had a total contract value of approximately $4.7 million.

The Company incurred foreign transaction exchange gains of $84,500 and $394,300 for the three and nine months ended September 30, 2001 respectively, and gains of $54,800 and $97,800 for the three and nine months ended September 30, 2000 respectively.

Note 13. Stockholder Rights Plan.

In April 2001, the Company adopted a Stockholder Rights Plan (the “Plan”) designed to enable all stockholders to realize the full value of their investment and to provide for fair and equal treatment for all stockholders in the event that an unsolicited attempt is made to acquire the Company. Under the Plan, stockholders received one Right to purchase one one-thousandth of a share of a new series of Preferred Stock for each outstanding share of Common Stock held of record at the close of business on May 30, 2001 at $131.00 per Right, when someone acquires 15 percent or more of the Company’s Common Stock or announces a tender offer which could result in such person owning 15 percent or more of the Common Stock. Each one one-thousandth of a share of the new Preferred Stock has terms designed to make it substantially the economic equivalent of one share of Common Stock. Prior to someone acquiring 15 percent, the Rights can be redeemed for $0.001 each by action of the Board of Directors. Under certain circumstances, if someone acquires 15 percent or more of the Common Stock, the Rights permit the stockholders other than the acquiror to purchase the Company’s Common Stock having a market value of twice the exercise price of the Rights, in lieu of the Preferred Stock. Alternatively, when the Rights become exercisable, the Board of Directors may authorize the issuance of one share of Common Stock in exchange for each Right that is then exercisable. In addition, in the event of certain business combinations, the Rights permit the purchase of the Common Stock of an acquiror at a 50 percent discount. Rights held by the acquiror will become null and void in both cases. The Rights expire on April 24, 2011.


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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. In this report, the words “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2000 and the condensed consolidated financial statements included elsewhere in this report.

Results of Operations

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


			Three Months Ended						Nine Months Ended
			September 30,						September 30,

			2001			2000			2001			2000

Revenues				100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenues				76.5			55.6			63.7			58.3

Gross profit				23.5			44.4			36.3			41.7
Operating expenses:
	Selling, general and administrative			25.6			15.5			16.4			15.2
	Research and development			7.5			9.9			6.6			8.4

		Total operating expenses		33.1			25.4			23.0			23.6

Income (loss) from operations				(9.6	)		19.0			13.4			18.1
Interest expense				2.2			2.3			1.6			3.2
Other (income)				(2.1	)		—			(1.5	)		(0.6	)

Income (loss) before provision for income taxes				(9.7	)		16.7			13.3			15.5
Provision for income taxes				(3.4	)		6.3			4.8			5.9

Income (loss) from continuing operations				(6.3	)		10.4			8.5			9.6
Loss from discontinued operations				—			(1.6	)		—			(0.9	)

Net Income (loss)				(6.3	)%		8.8	%		8.5	%		8.7	%

Three months ended September 30, 2001 compared with three months ended September 30, 2000

Revenue from continuing operations. Revenue decreased $10.3 million, or 31.2%, to $22.8 million for the three months ended September 30, 2001 compared with $33.1 million for the three months ended September 30, 2000. Revenue from our substrate division, which represents 89.8% of total revenue for the three months ended September 30, 2001 decreased $11.2 million, or 35.4%, to $20.5 million compared with $31.7 million for the three months ended September 30, 2000. Total GaAs substrate revenue decreased $16.3 million, or 59.3%, to $11.1 million for the three months ended September 30, 2001 compared with $27.4 million for the three months ended September 30, 2000. Sales of 5” and 6” GaAs substrates decreased $4.9 million, or 74.7%, to $1.6 million for the three months ended September 30, 2001 compared with $6.5 million for the three months ended September 30, 2000. InP substrate revenue increased $3.9 million, or 95.5%, to $7.9 million for the three months ended September 30, 2001 compared with $4.0 million for the three months ended September 30, 2000. The decrease in GaAs substrate revenue was a result of decreased sales volume to existing and new customers due in part to the current

economic slowdown in the fiber optic and wireless handset markets. Sales at our opto-electronics division increased $0.9 million, or 61.0% to $2.3 million due to an increase in sales of HBLEDs and VCSELs.

International revenue decreased $5.8 million, or 35.6%, to $10.5 million for the three months ended September 30, 2001 compared with $16.3 million for the three months ended September 30, 2000. The decrease is primarily due to the reduction of unit sales of GaAs substrates to all customers.

Gross margin. Gross margin decreased to 23.5% of total revenue for the three months ended September 30, 2001 compared with 44.4 % of total revenue for the three months ended September 30, 2000. Gross margin at the substrate division decreased to 31.6% of substrate revenue for the three months ended September 30, 2001 compared with 46.1% of substrate revenue for the period ended September 30, 2000. The decrease in gross margin at the substrate division was primarily the result of decreased unit sales. Gross margin at the opto-electronics division decreased to negative 47.7% of opto-electronics revenue for the three months ended September 30, 2001 compared with 5.7% of opto-electronics revenue for the three months ended September 30, 2000.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $692,000, or 13.5%, to $5.8 million for the three months ended September 30, 2001 compared with $5.1 million for the three months ended September 30, 2000. As a percentage of total revenue, selling, general and administrative expenses were 25.6% for the three months ended September 30, 2001 compared with 15.5% for the three months ended September 30, 2000.

Research and development expenses. Research and development expenses decreased $1.6 million, or 47.9%, to $1.7 million for the three months ended September 30, 2001 compared with $3.3 million for the three months ended September 30, 2000. As a percentage of total revenue, research and development expenses were 7.5% for the three months ended September 30, 2001 compared with 9.9% for the three months ended September 30, 2000. The decrease is primarily due to increased production of our new HBLED and VCSEL products.

Interest expense. Interest expense decreased $269,000, or 35.3%, to $493,000 for the three months ended September 30, 2001 compared with $762,000 for the three months ended September 30, 2000 due to the repayment of debt.

Other income and expense. Other income increased $504,000 to $488,000 for the three months ended September 30, 2001 compared with expense of $16,000 for the three months ended September 30, 2000. The increase was primarily due to interest earned on cash and investments.

Provision for income taxes. The effective tax rate decreased to 36.0% for the three months ended September 30, 2001 compared with 38.0% for the three months ended September 30, 2000. The decrease is primarily the result of shifting production to China.

Nine months ended September 30, 2001 compared with nine months ended September 30, 2000

Revenue from continuing operations. Revenue increased $20.8 million, or 25.0%, to $104.2 million for the nine months ended September 30, 2001 compared with $83.4 million for the nine months ended September 30, 2000. Revenue from our substrate division, which represents 93.4% of total revenue for the nine months ended September 30, 2001, increased $20.3 million, or 26.4%, to $97.3 million compared with $77.0 million for the nine months ended September 30, 2000. Total GaAs substrate revenue increased $1.2 million, or 1.8%, to $68.4 million for the nine months ended September 30, 2001 compared with $67.2 million for the nine months ended September 30, 2000. Sales of 5” and 6” GaAs substrates increased $7.5 million, or 67.0%, to $18.8 million for the nine months ended September 30, 2001 compared with $11.3 million for the nine months ended September 30, 2000. InP substrate revenue increased $16.6 million, or 196.1%, to $25.0 million for the nine months ended September 30, 2001 compared with $8.4 million for the nine months ended September 30, 2000. Sales at our opto-electronics division increased $521,000, or 8.3% to $6.8 million due to an increase in sales of HBLEDs and VCSELs.

International revenue increased $10.3 million, or 24.7%, to $52.2 million for the nine months ended September 30, 2001 compared with $41.9 million for the nine months ended September 30, 2000. The increase is primarily due to increased unit sales of GaAs and InP substrates in Q1 and Q2 of 2001.

Gross margin. Gross margin decreased to 36.3% of total revenue for the nine months ended September 30, 2001 compared with 41.7% of total revenue for the nine months ended September 30, 2000. Gross margin at the substrate division decreased to 42.3% of substrate revenue for the nine months ended September 30, 2001 compared with 46.4% of substrate revenue for the nine months ended September 30, 2000. The decrease in gross margin at the substrate division was primarily the result of decreased unit sales in Q3 2001. Gross margin at the opto-electronics division decreased to negative 49.0% of opto-electronics revenue for the nine months ended September 30, 2001 compared with negative 16.5% of opto-electronics revenue for the nine months ended September 30, 2000.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $4.5 million, or 35.5%, to $17.1 million for the nine months ended September 30, 2001 compared with $12.6 million for the nine months ended September 30, 2000. As a percentage of total revenue, selling, general and administrative expenses were 16.4% for the nine months ended September 30, 2001 compared with 15.2% for the nine months ended September 30, 2000. The increase is primarily due to increased unit sales of GaAs and InP substrates in Q1 and Q2 of 2001.

Research and development expenses. Research and development expenses decreased $142,000, or 2.0%, to $6.8 million for the nine months ended September 30, 2001 compared with $7.0 million for the nine months ended September 30, 2000. As a percentage of total revenue, research and development expenses were 6.6% for the nine months ended September 30, 2001 compared with 8.4% for the nine months ended September 30, 2000. The decrease is primarily due to increased production of our new HBLED and VCSEL products.

Interest expense. Interest expense decreased $1.1 million, or 38.9%, to $1.6 million for the nine months ended September 30, 2001 compared with $2.7 million for the nine months ended September 30, 2000 due to the repayment of debt.

Other income and expense. Other income increased $1.1 million to $1.6 million for the nine months ended September 30, 2001 compared with income of $468,000 for the nine months ended September 30, 2000. The increase was primarily due to interest earned on cash and investments.

Provision for income taxes. The effective tax rate decreased to 36.0% for the nine months ended September 30, 2001 compared with 38.0% for the nine months ended September 30, 2000. The decrease is primarily the result of shifting production to China.

Liquidity and Capital Resources

Cash and cash equivalents decreased $29.8 million to $38.8 million at September 30, 2001 compared with $68.6 million at December 31, 2000.

Net cash provided by operating activities of $14.8 million for the nine months ended September 30, 2001 was comprised primarily of net income adjusted for non-cash items of $6.5 million, and by a $628,000 increase in working capital and other activities. The net increase in working capital and other activities resulted primarily from increases in inventory and prepaid expenses, offset by an increase in accrued liabilities.

Accounts receivable decreased $4.7 million, or 17.0%, to $23.0 at September 30, 2001 compared to $27.7 million at December 31, 2000. Inventories increased $6.7 million, or 12.9%, to $58.5 million at September 30, 2001 compared to $51.8 million at December 31, 2001. The change in both these accounts is primarily due to decreased unit sales in Q3 2001.

Net cash used in investing activities of $46.0 million primarily reflects $21.7 million in investments and $24.3 million in purchases of property and equipment. These purchases of property and equipment were made to increase crystal growth and wafer processing capacity at the substrate division and to increase HBLED and VCSEL epitaxy growth and wafer processing capacity at the opto-electronics division.

We are currently constructing an additional 32,000 square foot building in Beijing, China to expand substrate wafer processing capacity. We are also constructing improvements to our existing production facilities in Fremont, California to increase crystal growth and wafer processing capacity, and to our production facilities in El Monte, California and Monterey Park, California to increase production capacity of our HBLED’s. We expect to invest approximately $6.0 million in additional facilities and equipment over the next 3 months.

Net cash provided by financing activities of $1.4 million consisted of proceeds of $4.6 million from the sale of common stock through employee stock compensation programs and $3.2 million from additional capital leases offset by payments to capital leases and long-term debt of $6.4 million.

We currently have a $20.0 million line of credit with a commercial bank bearing interest at 175 basis points above LIBOR. This line of credit is secured by all of our assets, other than equipment, and expires on May 31, 2002. At September 30, 2001, there was no balance outstanding under the line of credit.

We generally finance equipment purchases through secured equipment loans and capital leases over five-year terms at interest rates ranging from 6.0% to 9.0% per annum. Some of our manufacturing facilities have been 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 200 basis points below the prime rate. The bonds are traded in the public market. Repayment of principal and interest under the bonds on a quarterly basis is supported by a letter of credit from our bank. We have the option to redeem the bonds in whole or in part during their term. At September 30, 2001, $9.9 million was outstanding under these bonds.

We anticipate that the combination of existing cash on hand and the borrowings available under our current credit agreements will be sufficient to fund working capital and capital expenditure requirements for the next 12 months. However, our future capital requirements will be dependent on many factors including the rate of revenue growth, our profitability, the timing and extent of spending to support research and development programs, the expansion of our manufacturing facilities, the expansion of our selling and marketing and administrative activities and market acceptance of our products. We may need to obtain additional equity and debt financing in the future, which may not be available on acceptable terms or at all. If we are unable to obtain additional capital when needed, we may be required to reduce the scope of our planned expansion of our manufacturing capacity or of our product development and marketing efforts, which could adversely affect our business and operating results.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Since our Japanese and some Taiwanese invoices are denominated in Japanese yen, doing business in Japan and Taiwan subjects us to fluctuations in exchange rates between the U.S. dollar and the Japanese yen. We incurred a foreign transaction exchange gain of $84,500 for the three months ended September 30, 2001 and a gain of $54,800 for the three months ended September 30, 2000. We purchase foreign exchange contracts to economically hedge against certain trade accounts receivable in Japanese yen. The outstanding commitments with respect to such foreign exchange contracts had a total contract value of approximately $4.7 million as of September 30, 2001. Many of the contracts were entered into six months prior to the due date and the dates coincide with the receivable terms on customer invoices. By matching the receivable collection date and contract due date, we attempt to economically minimize the impact of foreign exchange fluctuations.

The fair market value of long-term fixed and variable interest rate debt is subject to interest rate risk. The effect of an immediate 10% change in interest rates would not have a material impact on our future operating results or cash flows.

Investments are valued at fair market value at September 30, 2001. There is no assurance that we will realize this value when we sell these investments in the future.

Risks Related to Our Business

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

We may not be able to sustain our historical growth rate, and we may experience significant fluctuations in our revenue and earnings in the future. 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:

	•		fluctuations in demand for our products;

	•		expansion of our manufacturing capacity;

	•		expansion of our operations in China;

	•		limited availability and increased cost of raw materials;

	•		the volume and timing of orders from our customers;

	•		fluctuation of our manufacturing yields;

	•		decreases in the prices of our competitors’ products;

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

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

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

Due to these factors, we believe that period-to-period comparisons of our operating results may not be a meaningful indicator of our future performance. It is possible that in some future quarter, our operating results may be below the expectations of securities analysts or investors. If this occurs, the price of our common stock would likely decline.

If we fail to expand our manufacturing capacity, we may not be able to meet demand for our products, lower our costs or increase revenue.

In order to increase production, we must build new facilities, expand our existing facilities and purchase additional manufacturing equipment. If we do not expand our manufacturing capacity, we will be unable to increase production, adversely impacting our ability to reduce unit costs, margins and improve our operating results.

We are currently constructing additional capacity and facilities in California and China. Our expansion 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;

	•		unanticipated cost increases; and

•

restrictions imposed by requirements of local, state or federal regulatory agencies.

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

We have limited experience with some of our new products, and we may not be able to achieve anticipated sales of these products.

To date, we have limited experience producing and selling our HBLED and VCSEL products, and we may be unable to successfully market and sell these products. To market and sell our HBLED and VCSEL products, we will have to develop additional distribution channels. In addition, we must apply our proprietary VGF technique to new substrate products and successfully introduce and market new opto-electronic semiconductor devices, including HBLED and VCSEL products.

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 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, our existing products could become obsolete and unmarketable. If we fail to offer new products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements. Other companies, including IBM, are actively developing substrate materials that could be used to manufacture devices that could provide the same high-performance, low-power capabilities as GaAs-based devices at competitive prices. If these substrate materials are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer.

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

Our operating results depend in large part on further customer acceptance of our existing substrate products and on our ability to develop new products based on our core VGF technology.

A majority of GaAs substrates are manufactured from crystals grown using the traditional Liquid Encapsulated Czochralski, or LEC, or Horizontal-Bridgeman, or HB, techniques. In order to expand sales of our products, we must continue to promote our VGF technique as a preferred process for producing substrates, and we must offer products with superior prices and performance on a timely basis and in sufficient volumes. If we fail to gain increased market acceptance of our VGF technique, we may not achieve anticipated revenue growth.

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, Litton Airtron and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as IBM, that are actively developing alternative materials to GaAs. We believe that at least one of our competitors has recently begun shipping 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 not continue to be profitable. We face many competitors that have a number of significant advantages over us, particularly in our compound semiconductor device products, including:

	•		greater experience in the business;

	•		more manufacturing experience;

	•		broader name recognition; and

	•		significantly greater financial, technical and marketing resources.

Our competitors could develop new or enhanced products that are more effective than the products that we have developed or may develop. For example, some competitors in the HBLED market offer devices that are brighter than our HBLEDs. Some of our competitors may also develop technologies that enable the production of commercial products with characteristics similar to or better than ours, but at a lower cost.

We expect the intensity of competition to increase in the future. Competitive pressures could reduce our market share, require us to reduce the prices of our products, affect our ability to recover costs or result in reduced gross margins.

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 and devices we can produce can fluctuate as a result of many factors, including:

	•		impurities in the materials used;

	•		contamination of the manufacturing environment;

	•		substrate breakage;

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

	•		performance of personnel involved in the manufacturing process.

Because many of our manufacturing costs are fixed, our revenue could decline if our yields decrease. 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 addition, many of our manufacturing processes are new and are still being refined, which can result in lower yields, particularly as we focus on producing higher diameter substrates and new opto-electronic semiconductor devices. For example, we recently began manufacturing six-inch GaAs wafers and have also made substantial investments in equipment and facilities to manufacture blue, green and cyan HBLEDs. If we are unable to produce adequate quantities of our high-brightness LEDs and VCSELs, we may not be able to meet customer demand and our revenue may decrease.

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 products offered by our customers decreases, our customers may reduce purchases of our products.

We purchase critical raw materials 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 gallium, arsenic and quartz. We generally purchase these materials through standard purchase orders and not pursuant to long-term supply contracts and none of our suppliers guarantees supply of raw materials to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials, 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 regulations, we may be subject to significant fines or cessation of our operations.

We are subject to federal, state and local environmental laws and regulations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. We are cooperating 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 on an amount of $200,415, and 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. In addition, existing or future changes in laws or regulations may require us to incur significant expenditures or liabilities, or may restrict our operations.

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 30.3% of our total revenue for the three months ended September 30, 2001 and 31.6% for the three months ended September 30, 2000. No one customer accounted for grater than 10% of total revenue for the three months ended September 30, 2001. Our substrate revenue accounted for 89.8% of our total revenue for the three months ended September 30, 2001 and 95.6% for the three months ended September 30, 2000. 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. 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.

Defects in our products could diminish demand for our products.

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

We are also developing new products and product enhancements, including substrates and compound semiconductor device products. If our new products 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.

Cyclicality in the semiconductor industry could cause our operating results to fluctuate significantly.

Our business depends in significant part upon manufacturers of semiconductor devices, as well as the current and anticipated market demand for such devices and the products using such devices. The semiconductor industry is highly cyclical. The industry has in the past, and will likely in the future, experience periods of oversupply that result in significantly reduced demand for semiconductor devices and components, including our products. When these periods occur, our operating results and financial condition are adversely affected.

Our substrate and opto-electronic semiconductor device products have a long sales cycle that makes it difficult to plan our expenses and forecast our results.

Customers typically place orders with us for our substrate and opto-electronic semiconductor device 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. We anticipate that sales of any future substrate and opto-electronic semiconductor device products under development 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 and opto-electronic semiconductor device products.

If we fail to manage our potential growth, our operations may be disrupted.

We have experienced a period of rapid growth and expansion that has strained our management and other resources, and we expect this rapid growth to continue. Our acquisition of Lyte Optronics, together with expansion of our manufacturing capacity, has placed and continues to place a significant strain on our operations and management resources. If we fail to manage our growth effectively, our operations may be disrupted. To manage our growth effectively, we must 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.

We will spend substantial sums to support our growth and 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. Our future operating results will also depend on expanding sales and marketing, research and development and administrative support. If we cannot attract qualified people or manage growth effectively, our business and operating results could be adversely affected.

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, such as our acquisition of Lyte Optronics in May 1999. 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 and 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, including the assumption of approximately $10.0 million of debt, much of which has been repaid or renegotiated, resulting in a decline of cash available. We incurred one-time charges and merger-related expenses of $2.8 million and an extraordinary item of $508,000 relating to the early extinguishment of debt in the quarter ended September 30, 1999 as a result of the acquisition.

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, 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. All of our crystal growth is currently performed at our Fremont, California facilities, which are located very near to 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.

Our success depends upon the continued service 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.

We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing, finance and manufacturing personnel. The competition for these employees is intense, especially in Silicon Valley, and we cannot assure you that we will be successful in attracting and retaining new personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel 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.

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 one of our competitors has 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, LED and VCSEL technologies upon which we rely, and thus may limit any exclusivity we enjoy by virtue of our patents.

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

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

We might face intellectual property infringement claims that 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. 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.

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 46.1% of our total revenue for the three months ended September 30, 2001 and 49.1% for the three months ended September 30, 2000. We expect that sales to customers outside the U.S. will continue to represent a significant portion of our revenue.

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

	•		changes in tariffs, import 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 and financial condition could be adversely affected.

If our expansion in China is more costly than we expect, our operating results will suffer.

As part of our planned expansion of our manufacturing capacity, we are building new facilities and expanding existing facilities in China. If we are unable to build and expand our Chinese facilities in a timely manner, we may not be able to increase production of our products and increase revenue as planned. If our expansion in China proves more costly than we anticipate or we incur greater ongoing costs than we expect, our operating results would be adversely affected. If we do not realize expected cost savings once our expansion is complete in China, our margins may be negatively impacted and our operating results may suffer.

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.

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

Our stock price has fluctuated significantly since we began trading on the Nasdaq National Market. For the three months ended September 30, 2001, the high and low closing sales prices of our common stock were $26.70 and $10.20. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

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

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

	•		announcements of technological innovations by us or our competitors;

	•		new product introduction by us or our competitors;

	•		large customer orders or order cancellations; and

	•		the operating and stock price performance of comparable companies.

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

We may need additional capital to fund expansion of our manufacturing capacity and our future operations, which may not be available.

We may need additional capital to fund expansion of our manufacturing and production capacity and our future operations or acquisitions. If we raise additional capital through the sale of equity or debt securities, the issuance of such securities could result in dilution to existing stockholders. These securities could have rights, preferences and privileges that are senior to those of holders of our common stock. For example, in December 1998 we issued debt securities for the purchase and improvement of our facilities in Fremont, California.

If we require additional capital in the future, it might not be available on acceptable terms, or at all. If we are unable to obtain additional capital when needed, we may be required to reduce the scope of our planned expansion of our manufacturing capacity or of our product development and marketing efforts, which could adversely affect our business and operating results.

Provisions in our charter, bylaws or Delaware law may delay or prevent a change in control of our company.

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. These provisions include:

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

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

	•		the ability of our board to alter our bylaws;

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

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

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

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

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

We and our suppliers rely on a continuous power supply to conduct operations, and California’s current energy crisis could disrupt our business and increase our expenses

California is in the midst of an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for California fall below 1.5%, California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout California.

Some of our suppliers are located in California. As a result of this crisis, these suppliers may be unable to manufacture sufficient quantities of product to meet our needs, or they may increase the fees they charge us for their services. We do not have long-term contracts with these suppliers. The inability of our suppliers to provide us with adequate supplies of products would cause a delay in our ability to fulfill our customers’ orders, which would hurt our business, and any increase in their fees could adversely affect our financial condition.

In addition, certain critical operations are located in California. We currently do not have sufficient backup power generation capacity to maintain full manufacturing capacity in the event of a blackout. If blackouts interrupt our power supply, we would be temporarily unable to continue operations at our facilities. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which may substantially harm our business and results of operation.

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

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the

holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock. Further, on 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.

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 are facing in 2001 is more uncertain than in recent periods and has the potential to materially and adversely affect us and our operating results. The revenue growth and profitability of our business depends on the overall demand for our substrates, light-emitting diodes and vertical cavity surface emitting lasers, and we are particularly dependant on the market conditions for the 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, LEDS and VCSELS caused by a weakening economy may result in decreased revenues and lower growth rates. 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.

PART II OTHER INFORMATION

Item 1. Legal Proceedings

On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against AXT in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The Complaint alleges violations of California Business and Professions Code section 17200 et seq., and Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. We believe that we have meritorious defenses against the alleged claims, and intend to defend ourselves vigorously. However, due to the nature of litigation and fact that the case is still in its early stages, we cannot determine the possible loss, if any, that may ultimately be incurred either in the context of a trial or as a result of a negotiated settlement. We may also incur substantial legal fees in this matter. However, we do not believe that this action is likely to have a material adverse effect on our business, financial condition or results of operation.

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 impact on our results of operations or financial condition.

Item 6. Exhibits and reports on Form 8-K

a. Exhibits

None

b. Reports on Form 8-K


	On May 30, 2001, we filed a report on form 8-K reporting the adoption of a “Shareholder Rights Agreement.”

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, thereunto duly authorized.


	AXT, INC.

		Chief Executive Officer
Dated: November 7, 2001	By:	/s/ Morris S. Young

		Morris S. Young


		Chief Financial Officer
Dated: November 7, 2001	By:	/s/ Donald L. Tatzin

		Donald L. Tatzin


		Corporate Controller
Dated: November 7, 2001	By:	/s/ John Drury

		John Drury

AXT INC - Quarter Report: 2001 September (Form 10-Q)

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