AXT INC - Annual Report: 2003 (Form 10-K)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

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 o          No þ

      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, 2003 as reported on the Nasdaq National Market, was approximately $20,120,644. Shares of common stock held by each officer, director and by each person who owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes.

      As of January 31, 2003, 22,960,606 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 2004 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.

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PART I

      Some of the information set forth in this annual report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, including statements as to industry trends, our future expectations and other matters that do not relate strictly to historical facts, are based on certain assumptions made by management. These statements are often identified by the use of words such as “may,” “will,” “expect,” “plans,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue” and similar expressions or variations, and are based on the beliefs and assumptions of our management based on information then currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include, among others, the risks discussed below under “Risks Related to Our Business.” These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, may be significant, presently or in the future, and may affect us to a greater extent than indicated. Such forward-looking statements speak only as of the date on which such statements are made; except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

      We design, develop, manufacture and distribute high-performance compound semiconductor substrates comprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge). Our substrate products are used primarily in wireless communications, lighting display applications, and fiber optic communications. We believe our proprietary vertical gradient freeze, or VGF, technique for manufacturing compound semiconductor substrates provides significant benefits over other methods and has enabled us to become a leading manufacturer of compound semiconductor substrates. We pioneered the commercial use of VGF technology to manufacture GaAs substrates and subsequently used VGF technology to manufacture substrates from InP, and Ge. Some of our competitors followed our lead by developing their own versions of VGF technology. Customers for our substrates include United Epitaxy Company, Motorola, Agilent Technologies, Samsung, EMCORE, Kopin, IQE, and Sumika. Over the past four years, we have implemented an initiative, which is now largely complete, to reduce the cost of manufacturing our substrates by moving most of our operations to China and by investing in sources of low cost raw materials.

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

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

Industry Background

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

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      Other examples of applications for these systems include:

      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 larger diameter substrates, including six-inch diameters for electronic device applications and three- and four-inch for opto-electronic device applications. The LEC and HB techniques each have difficulties producing high quality, low-cost compound semiconductor substrates for epitaxial processing. Substrates produced using the LEC technique have a high volume of defects as size increases beyond four-inches in diameter. The HB technique has been unable to reliably produce substrates more than three-inches in diameter.

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

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

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The AXT Advantage

      We are a leading developer and supplier of high-performance compound semiconductor substrates. There are three 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 became a leading worldwide supplier of GaAs substrates. Our VGF process produces substrates with high mechanical strength and physical and chemical uniformity, as well as low crystal defect densities. The following changes in our customers’ technologies are increasing the share of substrates sold with these features:

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

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

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Technology

      Our core technologies include our proprietary VGF technique used to produce high quality crystals that are processed into compound substrates, and our gallium extraction technology which allows us to extract raw gallium from aluminum ore.

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

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

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

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

Products

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

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

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      Materials. We sell 99.99% pure gallium. We began selling Ga in 2001, primarily through our majority owned subsidiary, Beijing Ji Ya Semiconductor Material Company, Ltd. We sell primarily to re-processors who improve the purity of the gallium. In 2003 sales of gallium were approximately $3.3 million.

Customers

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

      Historically, we have sold a significant portion of our products in any particular period to a limited number of customers. No customer represented greater than 10% of product revenues for the years ended December 31, 2003, 2002 and 2001. The company’s top five customers represented 28.9% of product revenue for the year ended December 31, 2003, 31.4% of product revenue for the year ended December 31, 2002, and 31.1% of product revenue for the year ended December 31, 2001. 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 results are partially due to our manufacturing efficiency and high product yields and we continually emphasize quality and process control throughout our manufacturing operations. We perform our substrate manufacturing operations at our facilities in Beijing, China and Fremont, California. As part of our plan to reduce substrate manufacturing costs, we shifted the vast majority of our manufacturing processes to our facilities in China, where costs are generally lower, by the end of 2003. We currently perform research and development and limited manufacturing in our Fremont, California facilities. We believe that our capital investment and subsequent operating costs are lower for our manufacturing facilities in China relative to the U.S. Many of our manufacturing operations are fully automated and computer monitored or controlled, enhancing reliability and yield. We use proprietary equipment in our substrate manufacturing operations to protect our intellectual property and control the timing and pace of capacity additions. All of our manufacturing facilities are ISO 9001 or 9002 certified.

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

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Sales and Marketing

      We advertise in trade publications, distribute promotional materials, conduct marketing and sales programs, and participate in industry trade shows and conferences in order to raise market awareness of our products. We sell our substrate products through our direct sales force in the U.S. and Japan and through independent sales representatives in France, 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. At December 31, 2003, the unearned pre-payments we retained under this program equaled $1.0 million. We do not expect to continue this program after the pre-payments currently in hand are utilized by customers.

      International Sales. International sales are an important part of our business. In the year ended December 31, 2003, sales to customers outside of the United States accounted for 65.9% of our revenue, as compared with 43.9% in 2002 and with 47.5% in 2001. The primary markets for sales of our products outside of the United States include countries in Asia and Western Europe. Our ability to sustain and increase our international sales involves significant risks, including volatile political, social and economic instabilities abroad, possible fluctuations in currency exchange rates, and changes in tariffs, import restrictions or other trade barriers.

Research and Development

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

      Our current substrate research and development activities focus on continued development and enhancement of GaAs, InP and Ge substrates, including improved yield, enhanced surface characteristics and uniformity, greater substrate strength and increased crystal length. During 2003 we experienced surface quality problems with our GaAs substrates for some customers.

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

Competition

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

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

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      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, including Hitachi, and from companies such as IBM that are actively developing alternative compound semiconductor materials.

Protection of our Intellectual Property

      Our success and the competitive position of our VGF technique depend on our ability to maintain trade secrets and other intellectual property protections. We rely on a combination of patents, trademark and trade secret laws, non-disclosure agreements and other intellectual property protection methods to protect our proprietary technology. We believe that, due to the rapid pace of technological innovation in the markets for our products, our ability to establish and maintain a position of technology leadership depends as much on the skills of our development personnel as upon the legal protections afforded our existing technologies. To protect our trade secrets, we take certain measures to ensure their secrecy, such as executing non-disclosure agreements with our employees, customers and suppliers. However, reliance on trade secrets is only an effective business practice insofar as trade secrets remain undisclosed and a proprietary product or process is not reverse engineered or independently developed.

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

Environmental Regulations

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

Employees

      As of December 31, 2003, we had 972 employees, of whom 818 were principally engaged in manufacturing, 141 in sales and administration, and 13 in research and development. Of these employees, 119

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      Our principal properties as of March 15, 2004 are as follows:

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

      From time to time we are involved in judicial or administrative proceedings concerning matters arising in the ordinary course of our business. We do not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on our business, financial condition, cash flows or results of operation.

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

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

      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, 2003, there were 121 holders of record of our common stock. Because many shares of AXT’s common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders.

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

      The following selected consolidated financial data are derived from and should be read in conjunction with our consolidated financial statements and related notes set forth in Item 8 below, and in our previously filed reports on Form 10-K. See also Item 7 “Management’s Discussion and Analysis of Financial Condition

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

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      Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

      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 “continues” or the negative of these terms or other comparable terminology. Factors that might cause or contribute to such differences include, but are not limited to, those set forth under “Risks Related to Our Business” and elsewhere in this Form 10-K.

Overview

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

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

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

      On September 27, 2003 we completed a sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics, Corp. and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6 million. Sale proceeds of $1.0 million will be held in escrow for up to one year and will not be recorded until all claims, if any, are settled. If unclaimed, up to $250,000 of the sale proceeds will be held in escrow for a second year and will not be recorded until all claims, if any, are settled. We retain a building located in Monterey Park, CA, that we expect to sell in 2004. This asset is classified as Held for Sale on our consolidated balance sheet at December 31, 2003.

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

      During the first half of 2002 our revenues grew due to improvements in the wireless market. In the second half of 2002 our revenue fell, however, because the substrate industry was still facing excess capacity that caused prices to decline, and because we experienced a loss of market share after two competitors developed technologies similar to ours. In addition, certain customers selected competitors’ products in order to diversify their supply sources and due to the belief that the competitors’ substrates offered better surface qualities. Full year 2002 revenue declined $63.9 million, or 58.8% compared to 2001. We recorded losses in each quarter of 2002 and incurred impairment charges against fixed assets and inventory due to the decline in demand and prices. In reaction to the economic downturn, we initiated an aggressive effort to reduce substrate manufacturing costs. This included moving much of our substrate manufacturing operations to China, reducing capacity in our Fremont, CA facility and developing and investing in key low-cost raw material sources.

      In 2003, we believe that the wireless communications and HBLED markets grew, but our revenue did not increase until the fourth quarter of 2003 due to continued reductions in prices and the time required to improve our substrate surface quality and regain some lost customers. Revenue for 2003 fell by $10.2 million, or 22.6% compared with 2002. We recorded losses in each quarter of 2003. During the year we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

      We cannot predict the level of future industry demand or of our ability to regain lost market share, but they have impacted our ability to sell our products and operate profitably. If demand for our products remains depressed for an extended period, our business will be harmed as a result. Our business performance will be most influenced by market demand for compound semi-conductor substrates, our ability to offer products that equal or exceed the quality provided by competitors, product pricing, our ability to shift more of our manufacturing production to China, and our ability to create and defend our intellectual property while not infringing on the intellectual property of others.

Critical Accounting Policies and Estimates

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

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      We believe that the following are our critical accounting policies:

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

      We periodically review the likelihood of collecting our accounts receivable balances and provide an allowance for doubtful accounts receivable primarily based upon the age of these accounts. We provide a 100% allowance for U.S. receivables in excess of 90 days and for foreign receivables in excess of 120 days. At December 31, 2003 our accounts receivable balance was $6.3 million net of an allowance for doubtful accounts of $4.3 million.

      Inventories are stated at the lower of cost or market. Cost is determined using the standard 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. Competitive delivery times are frequently less than the time required for us to manufacture a product, requiring us to build some work-in-process inventories in anticipation of orders. If orders are not obtained for the product built, the products will ultimately be deemed obsolete and we will establish a reserve for their value. We also review our inventory to ensure costs can be realized upon ultimate sale to our customers. If we determine that the value of any items in ending inventory exceeds the sales value less any related selling costs, a reserve is established for the difference.

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

      We determine the appropriate classification of investments at the time of purchase. Available-for-sale investments are carried at their fair value based on quoted market prices as of the balance sheet date. The amortized cost of securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in “other (income) and expense, net.” Realized gains or losses are determined on the specific identification method and are reflected in “other (income) and expense, net.” Net unrealized gains or losses are recorded directly in stockholders’ equity. Those unrealized losses that are deemed to be other than temporary are reflected in “interest and other income, net.” We also maintain minority investments in private companies which are accounted for under the cost basis. These investments are reviewed for other

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

Voluntary Stock Option Exchange Program

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

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Results of Operations

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

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

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

      International revenue increased to 65.9% of total revenue from continuing operations in 2003 compared to 43.9% in 2002. The increase was primarily due to a greater share of our GaAs substrates being used in opto-electronics applications and the majority of our customers for these applications being in Asia.

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

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

      Research and development expenses. Research and development expenses decreased $1.0 million or 42.8%, to $1.3 million in 2003 compared to $2.3 million in 2002. As a percentage of total revenue, research and development expenses were 3.9% in 2003 compared to 5.2% in 2002. Although we reduced research and development expenses in 2003 as part of our effort to reduce costs, we believe that continued investment in product development is critical to attaining our strategic objectives of maintaining and increasing our technology leadership, and as a result, we expect research and development expenses to remain at current levels in future periods. Research and development efforts during 2003 were focused primarily on improving the yield and surface quality of our GaAs substrates.

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

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

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

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

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

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

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

      Gross margin. Gross margin decreased to negative 19.8% of revenue in 2002 compared to positive 38.0% in 2001. The decrease was primarily due to lower unit sales and average sales prices of GaAs and InP substrates spread over a relatively fixed manufacturing overhead base and a $9.7 million charge to write-down excess inventory. As a result, we initiated manufacturing cost reductions in order to align our costs with lower expected sales volumes and prices. We shifted much of our substrate manufacturing to China and reduced capacity in our Fremont, California facility.

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

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

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

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

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

      Loss from discontinued operations. Loss from our discontinued opto-electronics division for the year ended December 31, 2002 was $26.2 million net of income tax benefit of $8.4 million.

Liquidity and Capital Resources

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

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

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

      Net cash provided by operating activities of $6.3 million for the year ended December 31, 2003 was comprised primarily of our net loss adjusted for non-cash items of $18.0 million, consisting primarily of the loss on disposal of our opto-electronics division of $9.5 million, depreciation of $5.8 million, and by a $15.0 million net change in assets and liabilities. The net change in assets and liabilities resulted primarily from a decrease in inventory, prepaid expenses and income tax receivable, offset by decreases in accounts payable and accrued liabilities.

      Accounts receivable decreased $898,000, or 12.5%, to $6.3 million at December 31, 2003 compared to $7.2 million at December 31, 2002. The change reflects lower sales volume, collections of $32.5 million and a decrease in our allowance for doubtful accounts of $2.4 million due to the collection of previously written-down receivables. It also included a $666,000 write-down of accounts receivable from our discontinued opto-electronics division, which is included in “loss on disposal” in our consolidated statement of operations for the year ended December 31, 2003.

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

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      Net cash provided by investing activities of $13.7 million for the year ended December 31, 2003 includes proceeds from the sale of property and equipment, and high grade investment securities totaling $27.7 million, offset by purchases of property and equipment of $2.2 million primarily used to transfer production capacity to China for the substrate division, and purchases of high grade investment securities with maturities of less than two years totaling $5.9 million. It also includes an increase in restricted cash of $5.8 million to collateralize a letter of credit with a bank that supports our long-term debt and workers’ compensation insurance policy.

      We do not have any plans to initiate any major new capital spending projects through 2004. 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 $5.0 million in capital projects in 2004. We believe that our existing and planned facilities and equipment are sufficient to fulfill current and expected future orders.

      Net cash used in financing activities of $9.6 million consisted of proceeds of $480,000 from the exercise of options by our employees, offset by payments of $10.1 million to reduce long-term borrowings and capital leases.

      Our main Fremont, California manufacturing facility is financed by long-term borrowings, which were refinanced by taxable variable rate revenue bonds in 1998. These bonds mature in 2023 and bear interest at a variable rate that was 1.35% at December 31, 2003. The bonds are traded in the public market. Repayment of principal and interest under the bonds is supported by a letter of credit from our bank and is paid on a quarterly basis. We have the option to redeem the bonds in whole or in part during their term. At December 31, 2003, $8.5 million was outstanding under these bonds.

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

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

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

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

      We lease certain office space, manufacturing facilities and property under long-term operating leases expiring at various dates through March 2013. Total rent expense under these operating leases was approximately $1.2 million for the year ended December 31, 2003, $947,000 in 2002 and $779,000 in 2001.

Risks Related to Our Business

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

      The industry has previously experienced periods of oversupply that result in significantly reduced demand for semiconductor devices and components, including our products, both as a result of general economic changes and overcapacity. When these periods occur, our operating results and financial condition are adversely affected, and create pressure on our revenue, gross margins and net income. Inventory buildups in telecommunications products and slower than expected sales of computer equipment resulted in overcapacity and led to reduced sales by our customers, and therefore reduced purchases of our products. During periods of weak demand such as those experienced over the past years, customers typically reduce purchases, delay delivery of products and/or cancel orders of component parts such as our products. Increased price competition has resulted, causing pressure on our net sales, gross margin and net income. We experienced cancellations, price reductions, delays and push outs of orders, which have resulted in reduced revenues. If the economic downturn were to continue, or occur again in the future, further order cancellations, reductions in order size or delays in orders will materially adversely affect our business and results of operations. Actions to reduce our costs, such as those we have recently taken, may be insufficient to align our structure with prevailing business conditions. We may be required to undertake additional cost-cutting measures, and may be unable to invest in marketing, research and development and engineering at the levels we believe are necessary to maintain our competitive position. Our failure to make these investments could seriously harm our business.

      During periods of increasing demand for semiconductor devices, we must have sufficient manufacturing capacity and inventory to meet customer demand, and must be able to attract, hire, train and retain qualified employees to meet demand. It appears that the semiconductor industry is in the early stages of an upturn and increasing demand. However, we cannot predict the sustainability of a recovery, if any, and the industry’s rate of growth in this recovery, if it occurs. If we are unable to effectively manage our resources and production

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

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

      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 may not be able to timely meet customer requirements, and we could lose future sales. We are also completing selective investments in equipment and facilities as part of our previously planned capacity expansion. To offset the additional fixed operating expenses, we must increase our revenue by increasing production and improving yields. If demand for our products does not grow, if prices decline significantly, or if our yields do not improve as anticipated, we may be unable to offset these costs against increased revenue, which would adversely impact our operating results.

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

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

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

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

      We may not obtain the benefits we expect as a result of discontinuation of our opto-electronics business, such as greater strategic focus on our core businesses. We may be required to return to the buyer some or all of the $1 million of the sale proceeds which will be held in escrow should the buyer successfully claim that we breached one of the representations or warranties made to it. Our building in Monterey Park may not be sold for the $1 million at which we are carrying it on our balance sheet. We may incur additional costs associated with the discontinued operations which could materially reduce our short term earnings.

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

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

      Our operating results can vary significantly based upon the impact of changes in global economic conditions on our customers. More specifically, the macro-economic environment that we faced in 2003 was more uncertain than in some prior periods, lasted longer than expected and has materially and adversely affected us and our operating results and may continue to do so. The revenue growth and profitability of our business depends on the overall demand for our substrates, and we are particularly dependant on the market conditions for the wireless, solid-state illumination, fiber optics and telecommunications industries. Because our sales are primarily to major corporate customers whose businesses fluctuate with general economic and business conditions, a softening of demand for products that use our substrates, caused by a weakening economy may result in further or prolonged decreased revenues. Customers may find themselves facing excess inventory from earlier purchases, and may defer or reconsider purchasing products due to the downturn in their business and in the general economy.

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

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

      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 manufacturing in China, or whose operations in China have already been qualified by customers. All of these events could reduce our revenue but increase our cost structure.

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

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

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

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

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

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

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

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

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

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

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

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      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.

      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:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

      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.

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      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.

      The United States continues to be on alert for terrorist activity. The potential near- and long-term impact terrorist activities may have in regards to our suppliers, customers and markets for our products and the U.S. economy are uncertain. There may be embargos of ports or products, or destruction of shipments or our facilities, or attacks that affect our personnel. There may be other potential adverse effects on our operating results due to a significant event that we cannot foresee.

      Our stock price has fluctuated significantly since we began trading on the Nasdaq National Market. For the year ended December 31, 2003, the high and low closing sales prices of our common stock were $3.42 and $0.67, 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.

      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

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      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.

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

      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:

      In order to comply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposed changes to listing standards by Nasdaq, and proposed accounting changes by the Securities and Exchange Commission, we may be required to increase our internal controls, hire additional personnel and additional outside legal, accounting and advisory services, all of which will cause our general and administrative costs to increase. Insurers may increase premiums as a result of the high claims rates they incurred over the past year, and our premiums for our various insurance policies, including our directors’ and officers’ insurance policies, increased during 2003. Proposed changes in the accounting rules, including legislative and other proposals to account for employee stock options as a compensation expense among others, could materially increase the expense that we report under generally accepted accounting principles and adversely affect our operating results.

      The new requirements adopted by the Securities and Exchange Commission in response to the passage of the Sarbanes-Oxley Act of 2002 will require annual review and evaluation of our internal control systems, and attestation of these systems by our independent accountants. We are currently reviewing our internal control procedures and considering further documentation of such procedures that may be necessary. However, the

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

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