AXT INC - Quarter Report: 2002 March (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC. 20549

FORM 10-Q

(Mark One)

		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly
		period ended March 31, 2002

or

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

Commission File Number 0-24085

AXT, INC.

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

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

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

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AXT, INC.

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

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

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

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

See accompanying notes to these unaudited condensed consolidated financial statements.

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

         The accompanying condensed consolidated financial statements for the three months ended March 31, 2002 and 2001 are unaudited. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT, Inc. (“AXT” or the “Company”) and its subsidiaries for all periods presented. Certain prior period reclassifications have been made to conform to the current period presentation.

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

         The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2002.

Note 2. Gain on Demeter Warrants

         The Company received approximately 1.1 million shares of Finisar Corporation common stock as a result of the acquisition by Finisar Corporation of all of the outstanding capital stock of Demeter Technologies. AXT held a warrant in Demeter that it received in exchange for certain leases and transferred technology. On November 21, 2000, a gain of $27.3 million was recorded in other income as a result of the transaction. On December 10, 2001, the Company received approximately 86,000 additional shares of common stock of Finisar Corporation that had been held in escrow in accordance with the terms of the acquisition agreement between Demeter and Finisar. A gain of $1.1 million was recorded in other income as a result of receiving these additional shares. On December 31, 2001, the Company wrote its investment in Finisar Corporation down to current market value, in accordance with SFAS 115, resulting in a realized loss of $16.7 million recorded in other income. On February 4, 2002, the Company received approximately 24,000 additional shares of common stock of Finisar Corporation that had been held in escrow in accordance with the terms of the acquisition agreement between Demeter and Finisar. A gain of $251,000 was recorded in other income as a result of receiving these additional shares. The investment in the Finisar Corporation common stock is accounted for as available for sale and classified as a short-term investment.

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Note 3. Investments

         The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards 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. The components of investments at March 31, 2002 are summarized below (in thousands):

Note 4. Inventories

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

         During the three months ended March 31, 2002, the gross value of HBLED work in process and finished goods inventory was written down to current cost and the valuation allowance associated with this inventory was released. The decrease in gross inventory offset by the decrease in the valuation allowance had no effect on gross profit for the three months ended March 31, 2002.

Note 5. Net Income (loss) Per Share

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

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

Note 6. Comprehensive Income

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

Note 7. Segment Information

         The Company has three reportable segments: substrates, opto-electronics and discontinued consumer products. The segments in which the Company operates are subject to rapid technological change and significant competition. Also, the number of suppliers of certain materials used by the Company and the number of customers are limited.

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

         The Company sells its substrates in the United States and in other parts of the world. Also, the Company has operations in Japan and China. Revenues by geographic location based on the country of the customer were as follows (in thousands):

Note 8. Corporate Affiliates

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

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         Undistributed retained earnings relating to the Company’s corporate affiliates was $515,000 at March 31, 2002. Net loss recorded from the Company’s corporate affiliates was $164,000 for the three months ended March 31, 2002.

Note 9. Restructuring Costs

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

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

         The fair value of assets determined to be impaired in accordance with the guidance for assets to be disposed of in SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,” were the result of management estimates. The above noted exit costs were determined in accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” The restructuring actions, as outlined by the plan, are substantially complete. The remaining costs, which relate to clean up of a leased facility, are expected to be executed to completion in 2002.

Note 10. Commitments

         From time to time the Company is involved in litigation in the normal course of business. Management believes that the outcome of matters to date will not have a material adverse effect on the Company’s financial position or results of operations.

         On May 1, 2001, the Santa Clara Center for Occupational Safety and Health filed a complaint for injunctive relief and civil penalties against AXT in the Superior Court of California, County of Alameda, Hayward Division, Case No. H218237-5. The complaint alleges violations of California Business and Professions Code section 17200 et seq., and 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. The complaint seeks injunctive relief, an order requiring the Company to set up and pay for a medical surveillance program for individuals exposed to arsenic compounds, an order requiring the Company provide warnings, information and training to workers exposed to arsenic compounds, and for civil penalties and attorneys fees. Mediation has been scheduled for June 24, 2002, and a trial date of October 25, 2002 has been set. We believe that we have meritorious defenses against the alleged claims, and intend to defend ourselves vigorously. However, due to the nature of litigation and fact that the case is still in its early stages, we cannot determine the possible loss, if any, that may ultimately be incurred either in the context of a trial or as a result of a negotiated settlement. We may also incur substantial legal fees in this matter. However, we do not believe that this action is likely to have a material adverse effect on our business, financial condition or results of operation.

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         The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2002 with a current contract value of $15.7 million. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. Partial prepayments received for these supply contracts totaling $5.7 million are included in accrued liabilities at March 31, 2002. As of March 31, 2002 the Company has met all of its delivery obligations under these contracts and expects to do so for the remainder of the contract terms.

Note 11. Recent Accounting Pronouncements

         In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 and No. 142, or SFAS 141, “Business Combinations”, and SFAS 142, “Goodwill and Other Intangible Assets.” Under SFAS 141, all business combinations must be accounted for using the purchase method of accounting; use of the pooling-of-interests (pooling) method is prohibited. The provisions of the statement will apply to all business combinations initiated after June 30, 2001. SFAS 142 will apply to all acquired intangible assets whether acquired singly, as a part of a group, or in a business combination. The statement will supersede APB Opinion No. 17, “Intangible Assets”, and will carry forward provisions in APB Opinion No. 17 relating to internally developed intangible assets. Adoption of SFAS 142 will result in ceasing amortization of goodwill. All of the statement should be applied in fiscal years beginning after December 31, 2001 to all goodwill and other intangible assets recognized in an entity’s statement of financial position at that date, regardless of when those assets were initially recognized. We have tested all goodwill and intangible assets for impairment upon adoption of SFAS 142 and have determined that as of March 31, 2002, no impairment charge is necessary. As a result of adopting SFAS 142, $81,000 of goodwill amortization was not recorded for the three months ended March 31, 2002. Adoption of the provisions of SFAS 141 and SFAS 142 has not had a material effect on the Company’s financial position or results of operations.

         In October 2001, the FASB issued Statement of Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 supercedes SFAS 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” SFAS 144 applies to all long-lived assets (including discontinued operations) and consequently amends Accounting Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations Reporting the Effects of Disposal of a Segment of a Business. SFAS 144 develops one accounting model for long-lived assets that are to be disposed of by sale. SFAS 144 requires the long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, SFAS 144 expands the scope of discontinued operations to include all components of the entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS 144 is effective for the Company for all financial statements issued in fiscal 2002. We believe adoption of the provisions of SFAS 144 has not had a material effect on the Company’s financial position or results of operations.

Note 12. Foreign Exchange Contracts and Transaction Losses

         Since our Japanese and some Taiwanese invoices are denominated in Japanese yen, doing business in Japan subjects us to fluctuations in exchange rates between the U.S. dollar and the Japanese yen. We incurred a foreign transaction exchange gain of $40,000 for the three months ended March 31, 2002 and a loss of $223,000 for the three months ended March 31, 2001. We purchase foreign exchange contracts to hedge against certain trade accounts receivable in Japanese yen. Under these contracts, increases or decreases in currency commitments and balance sheet positions, as translated into U.S. dollars, are primarily offset by realized gains or losses on the hedging contracts. The outstanding commitments with respect to such foreign exchange contracts had a total contract value of approximately $4.7 million as of March 31, 2002. Many of the contracts were entered into six months prior to the due date and the dates coincide with the receivable terms on customer invoices. By matching the receivable collection date and contract due date, we attempt to economically minimize the impact of foreign exchange fluctuations.

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

         This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. In this report, the words “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 and the condensed consolidated financial statements included elsewhere in this report.

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.

Critical Accounting Policies and Estimates

         We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States. As such, we have made estimates and judgments that affect the preparation of these statements based upon historical experience and on other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. 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.

         We recognize revenue upon shipment of products to our customers provided that we have received a signed purchase order, the price is fixed, 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 significant 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 at the time revenue is recognized based on historical experience, current economic trends and changes in customer demand. 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 periodically review the collectability of our accounts receivable balances and provide an allowance for doubtful accounts receivable 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 March 31, 2002 our accounts receivable balance was $14.4 million net of an allowance for doubtful accounts of $7.6 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

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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 ending inventory plus any related selling costs exceeds the sales value, a reserve is established for the difference.

         Our industry requires substantial investments in property and equipment in order to meet demand and changes in technology. In addition, we occasionally make investments in companies, which are developing promising relevant technologies. We review the carrying value of our long-lived assets and investments in order to identify any impairment. Long-lived assets are written down when the carrying value of an asset exceeds their related undiscounted future cash flows. Key assumptions in estimating future cash flows include estimates of sales volumes, changes in selling prices, cost of materials, etc. It is possible that actual results will differ from these estimates and such differences may be material and require future adjustments to the carrying value of our long-lived assets. We have not recorded long-lived asset impairment charges during Q1 2002. We record investment impairment charges when we believe that an investment has experienced a decline in market value that is other than temporary.

Results of Operations

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

Three months ended March 31, 2002 compared to three months ended March 31, 2001

         Revenue. Revenue decreased $23.3 million, or 58.2%, to $16.8 million for the three months ended March 31, 2002 compared to $40.1 million for the three months ended March 31, 2001. Revenue from our substrate division, which represents 70.0% of total revenue for the three months ended March 31, 2002, decreased $27.0 million, or 69.8%, to $11.8 million compared to $38.8 million for the three months ended March 31, 2001. Total GaAs substrate revenue decreased $23.0 million, or 75.2%, to $7.6 million for the three months ended March 31, 2002 compared to $30.6 million for the three months ended March 31, 2001. Sales of 5” and 6” GaAs subtrates decreased $9.2 million, or 87.6%, to $1.3 million for the three months ended March 31, 2002 compared to $10.5 million for the three months ended March 31, 2001. InP substrate revenue decreased $4.5 million, or 60.0%, to $3.0 million for the three months ended March 31, 2002 compared to $7.5 million for the three months ended March 31,

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2001.     The decrease in GaAs and InP substrate sales was due to a decline in the wireless and fiber optic telecommunication markets.

         Revenue from our opto-electronics division, which represents 30% of total revenue for the three months ended March 31, 2002, increased $3.7 million, or 293.0% to $5.0 million compared to $1.3 million for the three months ended March 31, 2001. The increase was a result of higher sales volume of high brightness light emitting diode (“HBLED”) products. HBLED revenue increased $3.8 million, or 578.8%, to $4.4 million for the three months ended March 31, 2002 compared to $651,000 for the three months ended March 31, 2001. Vertical cavity surface emitting laser (“VCSEL”) revenue decreased $63,000, or 28.3%, to $160,000 for the three months ended March 31, 2002 compared to $223,000 for the three months ended March 31, 2001. LD revenue increased $50,000, or 12.2%, to $459,000 for the three months ended March 31, 2002 compared to $409,000 for the three months ended March 31, 2001.

         International revenue increased to 56.3% of total revenue for the three months ended March 31, 2002 compared to 48.1% of total revenue for the three months ended March 31, 2001. The increase was primarily due to increased sales of HBLED products to customers in Asia.

         Gross margin. Gross margin decreased to 1.75% of total revenue for the three months ended March 31, 2002 compared to 40.6% of total revenue for the three months ended March 31, 2001. Gross margin at the substrate division decreased to 1.75% of substrate revenue for the three months ended March 31, 2002 compared to 46.2% of substrate revenue for the three months ended March 31, 2001. The decrease was primarily due to lower unit sales and lower average sales prices of GaAs substrates spread over a relatively fixed manufacturing overhead base. As a result, we have initiated manufacturing costs reductions in order to align our costs with lower expected sales volumes and prices. We are currently shifting much of our substrate manufacturing to China, where costs are lower, and reducing capacity at our Fremont, California facility. Gross margin at the opto-electronics division increased to 1.73% of opto-electronics revenue for the three months ended March 31, 2002 compared to negative 128.0% of opto-electronics revenue for the three months ended March 31, 2001. The increase was primarily due to increased unit sales of our HBLED products.

         Selling, general and administrative expenses. Selling, general and administrative expenses decreased $665,000, or 11.3%, to $5.2 million for the three months ended March 31, 2002 compared to $5.9 million for the three months ended March 31, 2001. As a percentage of total revenue, selling, general and administrative expenses were 31.0% for the three months ended March 31, 2002 compared to 14.6% for the three months ended March 31, 2001. The increase in selling, general and administrative expenses as a percentage of total revenue was primarily due to revenue decreasing faster than the decrease in our fixed costs associated with selling, general and administrative expenses. As we adjust our fixed costs in line with our lower expected sales volumes, we expect this percentage to decrease.

         Research and development expenses. Research and development expenses decreased $1.3 million, or 49.9%, to $1.4 million for the three months ended March 31, 2002 compared to $2.7 million for the three months ended March 31, 2001. As a percentage of total revenue , research and development expenses were 8.1% for the three months ended March 31, 2002 compared to 6.7% for the three months ended March 31, 2001. The decrease in research and development expenses was primarily the result of our decision to reduce expenses in line with lower revenues. We feel that this decrease will not compromise our efforts to remain a leading supplier of GaAs and InP substrates in the future or to make further enhancements in our opto-electronic products.

         Interest expense. Interest expense decreased $244,000, or 38.8%, to $385,000 for the three months ended March 31, 2002 compared to $629,000 for the three months ended March 31, 2001 due to the repayment of debt and a reduction of rates on our variable interest rate debt.

         Other income and expense. Other income increased $8,000 to $717,000 for the three months ended March 31, 2002 compared to $709,000 for the three months ended March 31, 2001. The balance for the three months ended March 31, 2002 includes a non-cash gain of $251,000 from the receipt of additional shares of Finisar Corporation common stock that were held in escrow.

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         Provision for income taxes. The effective tax rate increased to 40.0% for the three months ended March 31, 2002 compared to 36.0% for the three months ended March 31, 2001. The 40.0% effective tax rate is due to the tax benefit of the Company’s projected losses increased by the benefit of tax credits.

Liquidity and Capital Resources

         Cash and cash equivalents increased $207,000 to $37.7 million at March 31, 2002 compared to $37.5 million at December 31, 2001.

         Net cash provided by operating activities of $2.5 million for the three months ended March 31, 2002 was comprised primarily of our net loss adjusted for non-cash items of $2.7 million, consisting primarily of depreciation expense, and by a $3.4 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in accounts receivable and inventory, and an increase in accounts payable, offset by a decrease in accrued liabilities.

         Accounts receivable decreased $1.3 million, or 8.1%, to $14.4 million at March 31, 2002 compared to $15.7 million at December 31, 2001. The change reflects lower sales volume, collections of $17.1 million and an increase in our allowance for doubtful accounts of $1.0 million. Inventories decreased $3.1million, or 5.6% to $52.5 million at March 31, 2002 compared to $55.6 million at December 31, 2001. The decrease in inventory is due to a reduction in manufacturing output during the current period as a result of reduced demand caused by the economic downturn affecting our industry.

         If our sales continue to decrease, our ability to generate cash from operations will be adversely affected which could adversely affect our future liquidity and cause us to seek additional capital, if available on acceptable terms.

         Net cash used in investing activities of $1.0 million for the three months ended March 31, 2002 includes purchases of property and equipment of $2.7 million primarily used to increase wafer processing capacity in China for the substrate division, and to increase HBLED and VCSEL epitaxy growth and wafer processing capacity at the opto-electronics division. It also includes $1.9 million in purchases of high grade investment securities with maturities of less than two years offset by $3.6 million in sales of these securities.

         We are currently investing in certain equipment to expand HBLED production. We are also constructing minor improvements to our existing production facilities in China and California. We expect to invest approximately $12.0 million in additional facilities and equipment over the next 9 months.

         Net cash used in financing activities of $1.4 million for the three months ended March 31, 2002 includes proceeds of $429,000 from the sale of common stock through our employee stock compensation programs, offset by payments of $624,000 for payments on long-term debt and $1.2 million for capital lease payments.

         We have a $5.0 million bank line of credit that expires on September 30, 2003. The line of credit is secured by our operating assets, excluding assets in China. Borrowings bear interest at 2.25% above LIBOR which was 4.93% at March 31, 2002. The interest rate for future borrowings compared to LIBOR is dependent on our financial performance. No amounts were outstanding under the line of credit at March 31, 2002.

         We generally finance equipment purchases through secured equipment loans and capital leases over four or five-year terms at interest rates ranging from 5.6% 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 2.0% below the prime rate. 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 March 31, 2002, $9.6 million was outstanding under these bonds.

         The credit facility that we have with our bank includes the line of credit, term loans in the amount of $5.0 million and the letter of credit supporting repayment of our bonds. The credit facility is subject to certain financial

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covenants regarding current financial ratios and cash flow requirements that have all been met as of March 31, 2002. If we fail to comply with these covenants in the future and are unable to obtain a waiver from our bank, the amounts due under this credit facility would become immediately due and payable. The total amount outstanding under the credit facility at March 31, 2002 was $14.6 million.

Risks Related to Our Business

The semiconductor industry is cyclical and is currently experiencing a severe and prolonged downturn which has adversely impacted our operating results.

         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. Inventory buildups in telecommunications products and slower than expected sales of computer equipment have resulted in overcapacity and led to reduced sales by our customers. 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.

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

         Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we have faced in the second half of 2001 and are continuing to face in 2002 is more uncertain than in prior periods 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, light-emitting diodes and laser diodes, and we are particularly dependant on the market conditions for the fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, LEDs and laser diodes caused by a weakening economy may result in decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

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

         We have not over the past year been able to sustain our historical growth rate, and may not be able to return to historic growth levels in the current economic environment. 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:

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         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 a year ago. As a result, our visibility regarding future financial performance is uncertain and we may 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.

If the economy recovers and we are again in a period of high demand for our products, if we fail to expand our manufacturing capacity, we may not be able to meet increased demand, lower our costs or increase revenue.

         Although we are currently in a period of overcapacity, if the economy recovers, demand may increase rapidly as it has in prior years. 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 our existing facilities, purchase additional manufacturing equipment, and add qualified staff. If we do not expand our manufacturing capacity, we will be unable to increase production, adversely impacting our ability to reduce unit costs, margins and improve our operating results.

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

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

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

         To achieve commercial success with our products, we will need to manage our inventory of component parts and finished goods effectively to meet changing customer requirements. 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, excess inventory or decreased demand for our products. 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.

Our HBLED and VCSEL products are in their early stages, and we may not be able to achieve anticipated sales of these products.

         We are continuing to ramp production and sale of our HBLED and VCSEL products, and 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. 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.

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

         Our success depends on our ability to offer new products that incorporate leading technology and respond to technological advances. In addition, our new products must meet customer needs and compete effectively on quality, price and performance. The life cycles of our products are difficult to predict because the markets for our products are characterized by rapid technological change, changing customer needs and evolving industry standards. If our competitors introduce products employing new technologies, our existing products could become obsolete and unmarketable. If we fail to offer new products, we may not generate sufficient revenue to offset our development costs and other expenses or meet our customers’ requirements. Other companies, including IBM 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. If these substrate materials are successfully developed and semiconductor device manufacturers adopt them, demand for our GaAs substrates could decline and our revenue could suffer.

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

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

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

         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. All of these events could reduce our revenue but increase our cost structure.

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

         The markets for our products are intensely competitive. We face competition for our substrate products from other manufacturers of substrates, such as Freiberger, Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor device manufacturers that produce substrates for their own use, and from companies, such as 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 one of our competitors is 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. 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.

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

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

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