AXT INC - Annual Report: 2002 (Form 10-K)

Table of Contents

Form 10-K

Commission file number 0-24085

AXT, Inc.

Registrant’s telephone number, including area code:

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

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

      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.     Yes þ          No o

      Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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 þ          No o

      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, 2002 as reported on the Nasdaq National Market, was approximately $128,411,024. 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, 22,495,094 shares, $.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 2003 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

TABLE OF CONTENTS

1

Table of Contents

PART I

      This report includes forward-looking statements that reflect our current views with respect to future events and our potential financial performance. These forward-looking statements are subject to certain risks and uncertainties, including those discussed in “Business”, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and elsewhere in this report, that could cause actual results to differ materially from historical results or those anticipated. In this report, the words “anticipates,” “believes,” “expects,” “intends,” “future” and similar expressions identify forward-looking statements. Forward-looking statements also include the assumptions that underlie such statements, Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.

Item 1.     Business — Overview

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

      We were incorporated in California in December 1986 and reincorporated in Delaware in May 1988. We changed our name from American Xtal Technology, Inc. to AXT, Inc. in July 2000. Our principal offices are located at 4281 Technology Drive, Fremont, California 94538, and our telephone number at this address is (510) 683-5900. Our web site is 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.

Industry Background

      Historically, most semiconductor devices were created on a single crystal base material, or substrate, of silicon. Today, however, many electronic and opto-electronics devices are being developed with requirements that exceed the capabilities of silicon. These devices address the continually increasing demand to send, receive and display information on high-speed wireless and wireline networks. This demand created a growing need for power-efficient high-performance systems that can operate at high frequencies and can be produced cost-effectively in large volumes. These systems enable the growth and development of a wide range of end-user applications. For example, Dataquest, Inc., expects worldwide cellular/PCS handset production to grow from approximately 405 million units in 2002 to approximately 580 million units by 2004.

      Other examples of applications for these systems include:

2

Table of Contents

      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:

      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 six-inch diameter substrates. The LEC and HB techniques each have difficulties producing high quality, low-cost compound semiconductor substrates for epitaxial processing and substrates produced using this technique have a high volume of defects as size increases beyond four-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.

      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 HBLEDs and VCSELs used in solid-state lighting and fiber optic communications.

      HBLEDs are solid-state compound semiconductor devices that emit light. The global demand for HBLEDs is experiencing rapid growth because HBLEDs have a long useful life, consume approximately 10% of the power consumed by incandescent or halogen lighting and improve display visibility. Applications where HBLEDs are increasingly used include wireless handset displays, automotive displays, full color video and sign displays, traffic lights and various consumer applications. According to Strategies Unlimited, an independent industry analyst, the market for HBLEDs is expected to grow from $1.8 billion in 2002 to approximately $3.9 billion by 2006.

The AXT Advantage

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

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

3

Table of Contents

      In addition, VGF technology gives us further benefits.

      Some customers specify VGF substrates. Our wafers are qualified with many of the key suppliers of GaAs and InP semiconductor devices. The qualification process, which is lengthy and must be repeated for each customer, can be a barrier to entry for a new material or supplier. Furthermore, certain of our customers now effectively specify that they will only accept VGF-grown or equivalent substrates for their manufacturing processes. As the businesses of these customers grow, we, and those competitors that developed a technology similar to VGF, are well positioned to capture their business.

      Our low-cost manufacturing is an advantage. In 1998, we began moving portions of our substrate manufacturing operations to China, to benefit from a combination of lower costs for facilities, labor and materials than we encounter in the United States. That move continued and at the end of 2002 most of our substrate manufacturing activities occur in China. We also made some strategic investments in raw materials producers, including one that produces gallium, that assure us of a secured and low cost source of these materials and enables us to market surplus production to others. By the end of 2003, we anticipate that almost all of our substrate production will be located in China. We believe this provides us with a cost advantage vis-à-vis our competitors.

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

4

Table of Contents

The AXT Strategy

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

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

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

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

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

Technology

      Our core technologies include our proprietary VGF technique used to produce high quality crystals that are processed into compound substrates, and our epitaxy technologies that enable us to manufacture blue, green and cyan HBLEDs, VCSELs and edge-emitting laser diodes.

5

Table of Contents

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

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

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

      The following table provides a comparison of these three techniques:

6

Table of Contents

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

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

Products

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

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

7

Table of Contents

      Opto-electronics. We sell blue, green and cyan HBLED products in wafer and chip form. We began selling blue HBLED products in the first quarter of 2000 and in 2001 began shipping green and cyan HBLEDs. We introduced our first VSCEL product in August 2000 and introduced a range of Fabry-Parot laser products beginning in 2001 and early 2002.

Customers

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

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

      Historically, we have sold a significant portion of our products in any particular period to a limited number of customers. Our five largest customers accounted for 35.6% of our total revenue from continuing operations in 2002, 28.3 % in 2001, and 26.1% in 2000. One customer accounted for 10.7% of our revenue in 2002 and no customer accounted for more than 10% percent of our total revenue in 2001 or 2000. We expect that sales to certain customers will continue to comprise a significant portion of our revenue in the future.

Manufacturing, Raw Materials and Supplies

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

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

8

Table of Contents

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

Sales and Marketing

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

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

      Opto-electronics. We sell our HBLED products through our direct sales force in the U.S. and Taiwan and through independent sales representatives to lamp package manufacturers in Asia. We intend to expand sales of these products in the U.S. and Europe primarily using our direct sales force. We sell our VCSEL and edge emitting laser diodes through our direct sales force and through independent sales representatives.

      International Sales. International sales are an important part of our business. In the year ended December 31, 2002, sales to customers outside of the United States accounted for 58.2% of our revenue, as compared with 50.4% in 2001 and with 48.2% in 2000. The primary markets for sales of our products outside of the United States include countries in Asia and Western Europe. Our ability to sustain and increase our international sales involves significant risks, including volatile political, social and economic instabilities abroad, possible fluctuations in currency exchange rates, and changes in tariffs, import restrictions or other trade barriers.

Research and Development

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

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

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

9

Table of Contents

      Research and development expenses were $4.9 million in 2002, compared with $8.2 million in 2001, and $8.8 million in 2000.

Competition

      The semiconductor industry is characterized by rapid technological change and price erosion, as well as intense foreign and domestic competition. We believe we currently have a leading position in the existing markets for compound semiconductor substrates primarily as a result of our expertise in VGF technology. However, we believe we face actual and potential competition from a number of established domestic and international companies.

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

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

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

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

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

Protection of our Intellectual Property

      Our success and the competitive position of our VGF technique depend on our ability to maintain trade secrets and other intellectual property protections. We rely on a combination of patents, copyrights, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. We believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership depends as much on the skills of our development personnel as upon the legal protections afforded our existing technologies. To protect our trade secrets, we take certain measures to ensure their secrecy, such as executing non-disclosure agreements with our employees, customers and suppliers. However, reliance on trade secrets is only an

10

Table of Contents

      To date, we have been issued one U.S. patents and have three U.S. patent applications pending, which relate to our VGF products and processes. We have three U.S. patents and eight U.S. patent applications pending which relate to our HBLED or laser diode technology, and have patent applications pending in Europe, Canada, China, Japan and Korea which are based on one of our U.S. patents that relates to our VGF and opto-electronic processes. We have no issued foreign patents.

Environmental Regulations

      We are subject to federal, state and local environmental laws and regulations. These laws, rules and regulations govern the use, storage, discharge and disposal of hazardous chemicals during manufacturing, research and development and sales demonstrations. If we fail to comply with applicable regulations, we could be subject to substantial liability for clean-up efforts, personal injury and fines or suspension or cessation of our operations. We cooperated with the California Occupational Safety and Health Administration, or Cal-OSHA, in an investigation primarily regarding impermissible levels of potentially hazardous materials in certain areas of our manufacturing facility in Fremont, California. In May 2000, Cal-OSHA levied a fine against us in the amount of $313,655 for alleged health and safety violations. In March 2001, we settled this claim in the amount of $200,415, and have put in place engineering, administrative and personnel protective equipment programs to address these issues. On May 1, 2001, the Santa Clara Center for Occupational Safety and Health (SCCOSH) filed a complaint for injunctive relief and civil penalties against us alleging violations of California Business Professions Code 17200 et seq., and Health and Safety Code section 25249 et seq. as a result of our use of arsenic and inorganic arsenic compounds in our workplace. We reached a settlement with SCCOSH during 2002. See “Legal Proceedings” below.

Employees

      As of December 31, 2002, we had 1,306 employees, of whom 1,075 were principally engaged in manufacturing, 197 in sales and administration, and 34 in research and development. Of these employees, 317 are located in the U.S., 988 in China and 1 in Japan. As a result of shifting more of our substrate manufacturing to China, we implemented headcount reductions in our Fremont, California facilities, and expect further reductions as our shift of our manufacturing activities to China is completed by the end of 2003. Our success is in part dependent on our ability to attract and retain highly skilled workers. Our employees are not represented by a union and we have never experienced a work stoppage. Although morale has been affected by our workforce reductions, we consider our relations with our employees to be good.

11

Table of Contents

Item 2.     Properties

      Our principal properties as of March 15, 2003 are as follows:

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

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 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.

12

Table of Contents

      On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against us in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The complaint alleged violations of California Business and Professions Code section 17200 et seq., and violations under Proposition 65 and California Health and Safety Code section 25249 et seq. as a result of AXT’s use of arsenic and inorganic arsenic compounds in its workplace. On June 24, 2002, we participated in a private mediation, and as a result, reached a settlement of all claims, pursuant to which we agreed to pay the Santa Clara Center for Occupational Safety and Health an amount equal to $175,000. The parties have executed a settlement agreement, and the court approved the settlement on December 31, 2002, and dismissal of the case is pending.

      None

PART II

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

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

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

13

Table of Contents

      The following selected consolidated financial data are derived from and should be read in conjunction with, and are referenced to, our consolidated financial statements and related notes and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

14

Table of Contents

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

      The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this Form 10-K. In addition to historical information, the discussion in this Form 10-K contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially from those projected. The statements contained in the Report on Form 10-K that are not purely historical are forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-K are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” 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 VGF technique for producing high-performance compound semiconductor substrates. We currently operate two divisions: our substrate division and our opto-electronics division. We made our first substrate sales in 1990 and our substrate division currently sells GaAs and InP substrates to manufacturers of semiconductor devices for use in applications such as fiber optic and wireless telecommunications, LEDs and lasers. We also sell germanium substrates for use in satellite solar cells. We acquired Lyte Optronics, Inc., on May 28, 1999, and currently operate part of Lyte’s historical business as our opto-electronics division. The opto-electronics division manufactures HBLEDs, VCSELs and laser diodes for the illumination markets, including full-color displays, automobile lighting and traffic signals, as well as fiber optic communications. We previously operated the consumer products division, discontinued in December 2000, which had focused on the design and manufacture of laser-pointing and alignment products for the consumer, commercial and industrial markets.

15

Table of Contents

      Our total revenue from continuing operations was $63.2 million for 2002, $119.5 million for 2001 and $121.5 million for 2000. In 2002 we incurred a loss from continuing operations of $81.2 million compared to a loss of $5.0 million for 2001 and income of $24.4 million for 2000.

      Several non-recurring events occurred that had a substantial impact on our performance and financial results for the years-ended December 31, 2002, 2001 and 2000. In 2002, we recorded excess inventory impairment charges of $9.7 million that are included in cost of revenue, equipment impairment charges of $38.0 million and goodwill impairment charges of $1.1 million that are included in operating expenses, a write-down in our investment in Finisar Corporation of $10.8 million and a loss on a building held for sale of $3.1 million that are included in other expense. In 2001, we realized a net $15.6 million non-cash loss as a result of writing down our investment in Finisar Corporation common stock. This loss is included in other expense. In 2000, we realized a $27.3 million non-cash gain as a result of acquiring Finisar Corporation common stock in connection with Finisar Corporation’s acquisition of Demeter Technologies, a company in which we held warrants to purchase preferred stock. This gain is included in other income. On December 14, 2000, the Board of Directors approved our plan to discontinue our unprofitable consumer products division. As a result of discontinuing the consumer products division, we incurred a pre-tax loss on disposal of $2.2 million. The results of operations of the consumer products division have been segregated from continuing operations and are reported separately as discontinued operations in the income statements. In 2000 we exited our unprofitable 650nm laser diode product line at the opto-electronics division. As a result of exiting this product line, we incurred a restructuring charge of $8.2 million, of which $1.8 million has been classified as cost of goods sold and $6.4 million has been classified as operating expense.

      Our business, particularly sales of our substrate products, are dependant on the semiconductor industry, which is highly cyclical and has historically experienced downturns both as a result of economic changes and of overcapacity. Following a strong period during the first half of 2001, we are now in the midst of a significant and prolonged downturn, and, together with other industry participants, have experienced lower revenues, slower bookings, push outs and cancellation of orders. We cannot predict the severity or duration of the downturn, but it has impacted our ability to sell our products and operate profitably. If demand for our products remains depressed for an extended period, our business will be harmed as a result.

      In the second half of 2001, we experienced a $43.2 million, or 53.1% decrease in revenue compared to the first half as a result of the rapid decline in the mobile and fiber optic telecommunications markets. As such, we recorded losses in the third and fourth quarters. In 2002, the downward revenue trend that began in the second half of 2001 continued and full year 2002 revenue declined $56.4 million, or 47.1% compared to 2001. We recorded losses in each quarter of 2002. In reaction to the economic downturn, we have initiated an aggressive effort to reduce substrate manufacturing costs. This includes moving 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. We are hopeful that the cost reduction efforts should allow us to operate profitably again by the end of 2003 and will position us well for future growth. During the second half of 2002, we experienced certain manufacturing and quality problems that had a negative impact in obtaining orders from several large customers for HBLEDs at the opto-electronics division, as well as on our substrates, which resulted in decreased orders at our substrate division. As a result, the divisions continued to experience losses in each quarter of 2002. We have initiated measures to improve our manufacturing and quality issues and have taken measures to reduce operating costs. As a result, we are hopeful that the opto-electronics division will also be profitable by the end of 2003.

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

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

16

Table of Contents

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

Critical Accounting Policies and Estimates

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

      We believe that the following are our critical accounting policies:

      We recognize revenue upon shipment of products to our customers provided that we have received a signed purchase order, the price is fixed or determinable, title has transferred, collection of resulting receivables is probable, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining obligations. We assess the probability of collection based on a number of factors including past history with the customer and credit worthiness. We provide for future returns based on historical experience, current economic trends and changes in customer demand at the time revenue is recognized. Except for sales in Japan and some sales in Taiwan, which in both cases are denominated in Japanese yen, we denominate and collect our international sales in U.S. dollars. We do not provide for warranty related exposure as such exposure has historically been immaterial.

      We periodically review the likelihood of collecting our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. At December 31, 2002 our accounts receivable balance was $7.2 million net of an allowance for doubtful accounts of $6.7 million.

      Inventories 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. We routinely evaluate the levels of our inventory in light of current market conditions in order to identify excess and obsolete inventory and we provide a valuation allowance for certain inventories based upon the age and quality of the product. The lives of our substrate products are relatively long and accordingly, obsolescence has historically not been a significant factor. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in

17

Table of Contents

      We review the carrying value of our long-lived assets and investments in order to identify any impairment. Long-lived assets are written down to their current fair market value when the carrying value of an asset exceeds their related undiscounted future cash flows. To determine the fair market value of our long-lived assets, we obtain appraisals from outside consultants. During 2002, we recorded long-lived asset and goodwill impairment charges of $42.2 million.

      The Company classifies its investments in marketable securities as available-for-sale securities as prescribed in Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. If a decline in fair value is judged to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis with the amount of the write down included in other (income) expense. We recorded an impairment charge of $10.8 million in 2002 and $15.6 million in 2001 to write-down our investment in Finisar Corporation common stock.

      The Company accounts 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.

18

Table of Contents

Results of Operations

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

      Revenue from continuing operations. Revenue decreased $56.4 million, or 47.1%, to $63.2 million in 2002 compared to $119.5 million in 2001. Revenue from our substrate division, which represents 71.0% of total revenue for the year ended 2002, decreased $63.9 million, or 58.8%, to $44.9 million 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 is due to decreased volume and sales prices as a result of the slowdown in our markets including telecommunications, high speed electronic devices, and short wavelength lasers.

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

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

19

Table of Contents

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

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

      Selling, general and administrative expenses. Selling, general and administrative expenses decreased $2.8 million, or 13.2%, to $18.6 million in 2002 compared to $21.5 million in 2001. As a percentage of total revenue, selling, general and administrative expenses were 29.5% in 2002 compared to 18.0% in 2001. In order to align our cost structure with the rapid decline in revenues, we have initiated and are aggressively pursuing cost reductions in this area, which led to the decrease in 2002.

      Research and development expenses. Research and development expenses decreased $3.3 million or 40.7%, to $4.9 million in 2002 compared to $8.2 million in 2001. As a percentage of total revenue, research and development expenses were 7.7% in 2002 compared to 6.9% in 2001. Although we reduced research and development expenses in 2002 as part of our effort to reduce costs, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels in future periods. Research and development efforts during 2002 were focused primarily on improving the yield and surface quality of our GaAs substrates, and improving the brightness, reliability, and yield of our HBLED products.

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

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

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

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

20

Table of Contents

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

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

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

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

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

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

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

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

Liquidity and Capital Resources

      We consider cash and cash equivalents, short-term investments and long-term investments as liquid and available for use. Short and long-term investments are comprised of government bonds and high-grade commercial debt instruments. Also included in short-term investments is our common stock investment in Finisar Corporation.

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

21

Table of Contents

      Cash and cash equivalents decreased $23.7 million to $13.8 million at December 31, 2002 compared to $37.5 million at December 31, 2001.

      Net cash provided by operating activities of $725,000 for the year ended December 31, 2002 was comprised primarily of our net loss adjusted for non-cash items of $65.5 million, consisting primarily of the equipment and goodwill impairment charges of $39.1 million, the write-down to market value of our investment in Finisar Corporation common stock of $10.6 million, and depreciation of $9.5 million and by a $16.4 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in inventory and accounts receivable, an increase in accounts payable, offset by increases in income tax receivables and a decrease in accrued liabilities.

      Accounts receivable decreased $8.5 million, or 54.1%, to $7.2 million at December 31, 2002 compared to $15.7 million at December 31, 2001. The change reflects lower sales volume, collections of $71.7 million and no change in our allowance for doubtful accounts of $6.7 million. Inventories decreased $18.0 million, or 32.4% to $37.6 million at December 31, 2002 compared to $55.6 million at December 31, 2001. The decrease in inventory included an increase in the valuation reserve of $11.8 million and a real decrease in on-hand components of $6.2 million. As a result of the continued decline in unit sales during 2002 and uncertainty regarding the future, we have initiated plans to aggressively reduce inventory levels during 2003.

      Net cash used in investing activities of $16.0 million for the year ended December 31, 2002 includes purchases of property and equipment of $14.2 million primarily used to transfer production capacity to China for the substrate division and to increase HBLED epitaxy growth and wafer processing capacity at the opto-electronics division. It also includes $799,000 in purchases of high grade investment securities with maturities of less than two years and a transfer of $1.0 million to restricted deposits to collateralize a letter of credit with a bank that supports our workers’ compensation insurance policy.

      We do not have any plans to initiate any major new capital spending projects through 2003. We are currently completing certain projects at our China facilities and are continuously constructing minor improvements to our existing production facilities in China and California. We expect to invest approximately $6.0 million in capital projects in 2003. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

      Net cash used in financing activities of $8.1 million consisted of proceeds of $850,000 from the exercise of options by our employees, additional long-term borrowings of $3.9 million, offset by payments of $6.9 million to reduce long-term borrowings and $6.0 million for capital lease payments.

      We generally finance equipment purchases through secured equipment loans and capital leases over four or five-year terms at interest rates ranging from 3.6% to 8.8% per annum. Our main Fremont, California manufacturing facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at a variable rate that was 1.6% at December 31, 2002. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. At December 31, 2002, $9.1 million was outstanding under these bonds.

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

22

Table of Contents

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

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

      Outstanding contractual obligations as of December 31, 2002 are summarized below (in thousands):

Recent Accounting Pronouncements

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

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

23

Table of Contents

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

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

Risks Related to Our Business

      Our 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. 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, 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 declining demand such as those experienced over the past year, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition may result, causing pressure on our net sales, gross margin and net income. We have over the past year experienced cancellations, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn continues, further order cancellations, reductions in order size or delays in orders will materially adversely affect our business and results of operations. Although we have taken actions to reduce our costs, if our actions are 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. In addition, we may continue to experience a decline in our cash and cash equivalents and therefore we may be required to seek additional sources of cash, which may not be available on acceptable terms or at all.

24

Table of Contents

      Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we faced in the second half of 2001 and continued to face in 2002 is more uncertain than in prior periods, has lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue growth and profitability of our business depends on the overall demand for our substrates, LED’s and laser diodes, and we are particularly dependant on the market conditions for the wireless, 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 laser diodes caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

      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 is the largest in our history. 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:

      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. Our operating results have over the past year at times been below the expectations of securities analysts or investors. If this occurs again in future periods, the price of our common stock would likely decline or fluctuate.

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

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

25

Table of Contents

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

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

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

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

      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.

26

Table of Contents

      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 product line, the planned expansion of our manufacturing capacity or of our product development and marketing efforts, which could adversely affect our business and operating results.

      We have experienced declining revenue for both our HBLED and laser diode products as a result of a loss of revenue from our leading LED customer and a decline in the market for our laser diode products, as well as due to quality control problems experienced on these products. We may be unable to successfully market and increase sales of these products. To market and increase sales of our HBLED and VCSEL products, we will have to continue to develop additional distribution channels and achieve certain product and reliability specifications. We may be unable to obtain significant increases in revenue and may seek potential investors for our opto-electronics business. We must also continue our research and development efforts to apply our proprietary VGF technique to new substrate products and successfully introduce and market new opto-electronic semiconductor devices, including enhancements to our HBLED and VCSEL products.

      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 and Motorola, 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. In addition, some of our competitors have developed VGF technology similar to ours. If these substrate materials or VGF derived products are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer. Similarly, other companies, including Kopin, are developing alternative production technologies for HBLEDs. If they are successful, demand for our HBLEDs could drop and our revenue could decline.

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

      Some of our competitors have developed a crystal growth technique similar to our VGF technology. As a result, some customers are now allocating their requirements for VGF grown substrates across more competitors and we believe that we may have lost revenue and market share as a result of these customer decisions, which we may be unable to recover. If we are unable to retain our market share, our revenue and performance will decline.

      To shift more of our substrate manufacturing operations to China successfully, we will need our customers to qualify products manufactured in China. If we are unable to achieve qualifications for these products, our China facility will be underutilized, our investments in China will not be recouped and we will be unable to lower our costs by moving to China. We may lose sales of our products to competitors who are not

27

Table of Contents

      The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as IBM and Motorola, 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 GaAs substrates manufactured using a technique similar to our VGF technique. Other competitors may develop and begin using similar technology. If we are unable to compete effectively, our revenue may not increase and we may be unable to be profitable. We face many competitors that have a number of significant advantages over us, particularly in our compound semiconductor device products, including:

      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 and have other desirable features. Some of our competitors may also develop technologies that enable the production of commercial products with characteristics similar to or better than ours, but at a lower cost.

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

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

      Because many of our manufacturing costs are fixed, our revenue could decline if our yields decrease but our costs would change little, if at all. We have experienced product shipment delays and difficulties in achieving acceptable yields on both new and older products, and delays and poor yields have adversely affected our operating results, as have quality control problems experienced on both our substrate and LED products. We may experience similar problems in the future and we cannot predict when they may occur or their

28

Table of Contents

      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:

      As inventory of telecommunication products and computer equipment remained high during the past year, resulting in overcapacity in the market, our customers have reduced sales of their products, causing them to reduce purchases of our products for both production and research and development purposes. As a result, our revenues have declined and may fail to recover until the overcapacity has been depleted and demand for our customers’ products once again increases and their expenditures for research and development increase.

      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, quartz, and parts for our MOCVD reactors. 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 or equipment to us. If we lose any of our key suppliers, our manufacturing efforts could be significantly hampered and we could be prevented from timely producing and delivering products to our customers. We have experienced delays obtaining critical raw materials and spare parts, including gallium, due to shortages of these materials. We may experience delays due to shortages of materials and may be unable to obtain an adequate supply of materials. These shortages and delays could result in higher materials costs and cause us to delay or reduce production of our products. If we have to delay or reduce production, we could fail to meet customer delivery schedules, and our revenue and operating results could suffer.

      We have periodically encountered a decline in quality of parts that are critical to the performance of our MOCVD reactors, which has led to lower yields of our HBLED products. If these quality problems continue, our ability to manufacture our HBLED products would be reduced, we could fail to meet customer delivery schedules, and our revenue and operating results could suffer.

      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

29

Table of Contents

      A small number of substrate and HBLED customers have historically accounted for a substantial portion of our total revenue. Five customers accounted for 35.6% of our total revenue for the year ended December 31, 2002 and 28.3% for the year ended December 31, 2001. One customer accounted for 10.7% of our revenue for the year ended December 31, 2002. Our substrate revenue accounted for 71% of our total revenue for the year ended December 31, 2002 and 91% for the year ended December 31, 2001. We expect that a significant portion of our future revenue will continue to be derived from a limited number of substrate and HBLED 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 products are complex and may contain defects. In the past we have experienced quality control problems with some of our products, which caused customers to return products to us or reduce orders for our products, such as our recent reduction in orders for our LED products by Agilent, and certain quality control problems experience in our substrate products. If we continue to experience quality control problems, or experience these problems in new 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.

      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

30

Table of Contents

      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 has placed and continues to place a significant strain on our operations and management resources, and we are in the process of upgrading 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. In addition, the Sarbanes-Oxley Act requires us to improve the quality of our systems and procedures.

      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. 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.

      We have experienced a period of rapid contraction in our business that caused us to reduce our costs in order to conserve our cash resources. However, in the three months ended September 30, 2002, we utilized $5.0 million in our operating activities and for the year ended December 31, 2002, our cash and cash equivalent balances, exclusive of restricted cash, declined by $33.5 million to $24.5 million.

      If we fail to manage our contractions successfully we may continue to 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. 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.

      In connection with our efforts to streamline operations, reduce costs and bring staffing and structure in line with current demand for our products, we implemented a corporate restructuring beginning in 2001 and reduced our workforce, shifted production activities to China and reduced capital expenditures. Our restructuring may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce and loss of employee morale and decreased performance. In addition, the recent trading levels of our stock have decreased the value of our stock options granted to employees under our stock option plan. 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.

31

Table of Contents

      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:

      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 have also incurred consistent operating losses for the business since 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.

      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 crystal growth 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.

      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 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.

32

Table of Contents

      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, LED and VCSEL technologies 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.

      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 are currently in discussions with one company 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.

      Our revenue growth depends in part on the expansion of our international sales and operations. International sales represented 58.2% of our total revenue for the year ended December 31, 2002 and 50.4% for the year ended December 31, 2001. 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.

33

Table of Contents

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

      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.

      As part of our planned reduction of our cost structure, 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 reduce the costs of our products 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.

      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.

      On September 11, 2001, the United States was subject to terrorist attacks at the World Trade Center buildings in New York and the Pentagon in Washington D.C., and continues to be on alert for further terrorist activity. In addition, the United States continues to consider hostile activity with Iraq. The potential near- and long-term impact of these attacks and other terrorist activities, as well as the threat of war may have in regards

34

Table of Contents

      Our stock price has fluctuated significantly since we began trading on the Nasdaq National Market. For the year ended December, 2002, the high and low closing sales prices of our common stock were $16.89 and $0.97, respectively. A number of factors could cause the price of our common stock to continue to fluctuate substantially, including:

      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.

      If we fail to meet the criteria for continued listing on The Nasdaq National Market, our common stock may be delisted from The Nasdaq National Market. For example, the sales price of our common stock on the Nasdaq National Market dropped below $1.00; if the price should be sustained at a level below one $1.00 for a period of 30 days, and we are thereafter unable to sustain the sales price above $1.00 for ten consecutive trading days in the subsequent 90 days, our stock could be delisted. If the stock is delisted, we may trade on the over-the-counter market, or even in the pink sheets, which would significantly decrease the liquidity of an investment in AXT common stock. In addition, the stock may be deemed to be penny stock. If our common stock is considered penny stock, it would be subject to rules that impose additional sales practices on broker-dealers who sell our securities. For example, broker-dealers would have to make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to sale. Also, a disclosure schedule must be prepared prior to any transaction involving a penny stock and disclosure is required about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Monthly statements are also required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock. Because of these additional obligations, some brokers may be unwilling to effect transactions in penny stocks. This could have an adverse effect on the liquidity of our common stock and the ability of investors to sell the common stock.

      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:

35

Table of Contents

      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:

      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.

      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 two 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 amount 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.

      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 are likely to increase premiums as a result of the high claims rates incurred over the past year, and so

36

Table of Contents

Liquidity