AXT INC - Quarter Report: 2004 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC. 20549

 

 

FORM 10-Q

 

(Mark One)

 

 

Commission File Number 000-24085

 

 

AXT, INC.

(Exact name of registrant as specified in its charter)

 

 

4281 Technology Drive, Fremont, California 94538

(Address of principal executive offices) (Zip code)

 

(510) 683-5900

(Registrant’s telephone number, including area code)

 

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý

 

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

 

 

 

AXT, INC.
FORM 10-Q
TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION	3
Item 1. Financial Statements (unaudited)	3
Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003	3
Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2004 and 2003	4
Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2004 and 2003	5
Notes To Condensed Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3. Quantitative and Qualitative Disclosures About Market Risk	33
Item 4. Controls and Procedures	34
PART II. OTHER INFORMATION	35
Item 1. Legal Proceedings	35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 3. Defaults Upon Senior Securities	35
Item 4. Submission of Matters to a Vote of Security Holders	35
Item 5. Other Information	35
Item 6. Exhibits	36
Signatures	37

 

2

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

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

 

		September 30, 2004			December 31, 2003
Assets:
Current assets
Cash and cash equivalents		$	16,220		$	24,339
Short-term investments		16,670			14,669
Accounts receivable, net of allowance of $4,758 and $4,304 as of September 30, 2004 and December 31, 2003, respectively		5,237			6,297
Inventories		18,005			24,083
Prepaid expenses and other current assets		2,107			1,301
Assets held for sale		1,000			1,000
Total current assets		59,239			71,689
Property, plant and equipment		20,512			21,795
Other assets		3,089			4,237
Restricted deposits		8,365			9,302
Total Assets		$	91,205		$	107,023
Liabilities:
Current liabilities
Current portion of long-term debt		$	2,108		$	3,694
Accounts payable		2,160			2,638
Accrued liabilities		8,587			8,296
Accrued restructuring		642			—
Total current liabilities		13,497			14,628
Long-term debt, net of current portion		7,600			8,842
Other long-term liabilities		1,313			1,255
Total liabilities		22,410			24,725
Stockholders’ equity:
Preferred stock, $0.001 par value per share; 2,000 shares authorized; 882 shares issued and outstanding		3,532			3,532
Common stock, $0.001 par value per share; 70,000 shares authorized; 23,119 and 22,957 shares issued and outstanding, respectively		155,448			155,178
Accumulated deficit		(90,299		)	(78,928		)
Accumulated other comprehensive income		114			2,516
Total stockholders’ equity		68,795			82,298
Total Liabilities and Stockholders’ Equity		$	91,205		$	107,023

 

See accompanying notes to condensed consolidated financial statements.

 

3

 

AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenue		$	8,531		$	8,529		$	27,831		$	25,583
Cost of revenue		10,767			8,029			28,705			24,135
Gross profit (loss)		(2,236		)	500			(874		)	1,448
Operating expenses:
Selling, general and administrative		2,468			2,654			8,441			7,973
Research and development		397			301			1,088			1,048
Asset impairment charge		210			—			210			—
Restructuring charge		158			—			1,235			—
Total operating expenses		3,233			2,955			10,974			9,021
Loss from operations		(5,469		)	(2,455		)	(11,848		)	(7,573		)
Interest expense		60			145			227			368
Other expense (income), net		(380		)	(3		)	(434		)	1,035
Loss before provision for income taxes		(5,149		)	(2,597		)	(11,641		)	(8,976		)
Provision for incomes taxes		40			—			177			—
Loss from continuing operations		(5,189		)	(2,597		)	(11,818		)	(8,976		)
Discontinued operations:
Gain (loss) from discontinued operations		—			(1,591		)	222			(6,165		)
Gain (loss) from disposal		225			1,625			225			(9,475		)
Net loss		$	(4,964	)	$	(2,563	)	$	(11,371	)	$	(24,616	)
Basic and diluted loss per share:
Loss from continuing operations		$	(0.22	)	$	(0.11	)	$	(0.51	)	$	(0.39	)
Gain (loss) from discontinued operations		0.01			—			0.02			(0.69		)
Net loss		$	(0.21	)	$	(0.11	)	$	(0.49	)	$	(1.08	)
Basic and diluted shares used in per share calculations		23,094			22,857			23,044			22,727

 

See accompanying notes to condensed consolidated financial statements.

 

4

 

AXT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

 

		Nine Months Ended September 30,
		2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(11,371	)	$	(24,616	)
Adjustments to reconcile net loss to net cash provided by (used in) operations:
Depreciation		3,647			4,583
Amortization of marketable securities premium/discount		207			279
Non-cash restructuring charge		1,235			—
Loss on disposal		—			9,475
Asset impairment charge		210			1,320
Gain on disposal of property, plant and equipment		—			(11		)
Stock based compensation		—			28
Changes in assets and liabilities:
Accounts receivable, net		1,060			1,576
Inventories		6,078			9,529
Prepaid expenses		(1,000		)	1,988
Other assets		30			(139		)
Accounts payable		(478		)	(2,329		)
Accrued liabilities		(505		)	(4,306		)
Income taxes		203			8,711
Other long-term liabilities		58			(129		)
Net cash provided by (used in) operating activities		(626		)	5,959
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(1,262		)	(1,911		)
Proceeds from sale of property, plant and equipment		—			14,772
Purchases of marketable securities		(24,371		)	(3,305		)
Proceeds from sale of marketable securities		13,222			5,700
Decrease (increase) in restricted cash		7,639			(4,012		)
Net cash provided by (used in) investing activities		(4,772		)	11,244
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from (payments of):
Issuance of common stock		270			424
Capital leases payments		—			(8,409		)
Long-term debt payments		(2,828		)	(1,615		)
Net cash used in financing activities		(2,558		)	(9,600		)
Effect of exchange rate changes		(163		)	86
Net (decrease) increase in cash and cash equivalents		(8,119		)	7,689
Cash and cash equivalents at the beginning of the period		24,339			13,797
Cash and cash equivalents at the end of the period		$	16,220		$	21,486

 

See accompanying notes to condensed consolidated financial statements.

 

5

 

AXT, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

Note 1. Basis of Presentation

 

The accompanying interim condensed consolidated financial statements of AXT, Inc. (“AXT” or the “Company”) are unaudited, and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary to present fairly the financial position, results of operations and cash flows of AXT and its subsidiaries for all periods presented.

 

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

 

The results of operations are not necessarily indicative of the results to be expected in the future or for the full fiscal year. It is recommended that these condensed consolidated financial statements be read in conjunction with the Company’s consolidated financial statements and the notes thereto included in its 2003 Annual Report on Form 10-K and its Quarterly Reports on Form 10-Q filed with the Securities and Exchange Commission on March 29, 2004, May 24, 2004 and August 5, 2004, respectively.

 

Revenues from continuing operations increased modestly for the nine months ended September 30, 2004 compared to the same period of fiscal 2003. In response to continued net losses, the Company has taken measures including the shifting of production to China, which was completed in September 2004, to reduce costs and increase cash flows. As of September 30, 2004, the Company had available cash, cash equivalents and liquid short-term investments of $32.9 million, excluding restricted deposits. The Company believes that its existing cash and liquid investments, cash generated from operations, coupled with additional efforts to reduce expenditures in support of the continuing substrate business will be sufficient to meet working capital expenditure requirements for the next twelve months. However, existing cash and liquid investments could decline during the remainder of 2004 due to a weakening of the economy, a loss in revenue, an unanticipated increase in expenses, or changes in our planned cash outlay.

 

If the Company’s sales decrease, the ability to generate cash from operations will be adversely affected which could adversely affect its future liquidity, requiring it to use cash at a more rapid rate than expected and to seek additional capital. There can be no assurance that such additional capital will be available or, if available, that it will be at terms acceptable to the Company.

 

Certain reclassifications have been made to the prior years consolidated financial statements to conform to current period presentation.

 

Note 2. Discontinued Operations

 

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

 

On September 27, 2003 the Company completed a sale of substantially all of the assets of its opto-electronics business to Lumei Optoelectronics, Corp. (“Lumei”) and Dalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi equivalent of $9.6 million. Proceeds of $1.0 million were held in escrow for up to one year.  In September 2004, $225,000 of the escrow funds were released to AXT; Lumei made claims against the escrow in the approximate amount of $0.5 million which the Company has contested and intends to vigorously pursue legal action against the claims.  The remaining $250,000 in escrow will be held for a second year in accordance with the terms of the agreement and will not be recorded as a gain from discontinued operations, if at all, until all claims, if any, are settled.  The Company retains a building located in Monterey Park, CA, that it has on the market to sell. This asset has been classified as held for sale on the condensed consolidated balance sheets as of September 30, 2004 and December 31, 2003.

 

6

 

The Company recorded gains before income taxes and loss on disposals on discontinued operations of $0.2 and $0.4 million during the three and nine month periods ended September 30, 2004, respectively.  The Company recorded a gain on disposal of $1.6 million and a loss on disposal of $9.5 million during the three and nine month periods ended September 30, 2003, respectively.

 

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

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenue		$	—		$	227		$	—		$	7,246
Cost of revenue		—			854			—			9,973
Gross loss		—			(627		)	—			(2,727		)
Operating expenses:
Selling, general and administrative		—			761			(222		)	2,297
Research and development		—			107			—			814
Impairment costs		—			—			—			—
Total operating expenses		—			868			(222		)	3,111
Gain (loss) from operations		—			(1,495		)	222			(5,838		)
Interest expense		—			96			—			327
Gain (loss) before benefit for income taxes and loss on disposal		—			(1,591		)	222			(6,165		)
Income tax		—			—			—			—
Gain (loss) on disposal		225			1,625			225			(9,475		)
Net income (loss)		$	225		$	34		$	447		$	(15,640	)

 

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

 

		September 30, 2004			December 31, 2003
Current assets:
Cash		$	536		$	539
Accounts receivable, net		19			250
Assets held for sale		1,000			1,000
Total current assets		1,555			1,789
Other assets		200			200
Total assets		$	1,755		$	1,989
Current liabilities:
Accounts payable		$	—		$	43
Accrued liabilities		430			1,232
Total liabilities		430			1,275
Net assets		1,325			714
Total liabilities and net assets		$	1,755		$	1,989

 

Assets held for sale consist of a building and are carried at management’s estimated fair value less costs to sell.

 

7

 

Note 3. Accounting for Stock Options

 

The Company records compensation expense for employee stock options based upon their intrinsic value on the date of grant pursuant to Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees” and has adopted the disclosure-only alternative of Statement of Financial Accounting Standards No. 123 (SFAS 123) “Accounting for Stock-Based Compensation”. Because the Company establishes the exercise price based on the fair market value of the Company’s stock at the date of grant, the options have no intrinsic value upon grant, and therefore no expense is recorded. Each quarter, the Company reports the potential dilutive impact of stock options in its diluted earnings per share using the treasury-stock method. Out-of-the-money stock options (i.e., options where the average sales price of our common stock as reported on the Nasdaq National Market during the period is below the exercise price of the option) are not included in diluted earnings per share.

 

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

 

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

 

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model as prescribed by SFAS 123 using the following assumptions:

 

 

The weighted average fair value as of the date of grant of options granted during the nine months ended September 30, 2004 and 2003 were $1.20 and $1.15, respectively.

 

8

 

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

 

 

Because additional option grants are expected to be made each quarter, the above pro forma disclosures are not representative of pro forma effects on reported net income (loss) for future quarters.

 

Note 4. Investments

 

The Company classifies its investment securities as available-for-sale securities as prescribed by Statement of Financial Accounting Standards No. 115 (SFAS 115) “Accounting for Certain Investments in Debt and Equity Securities.” All investments are carried at fair market value, which is determined based on quoted market prices, with net unrealized gains and losses included in comprehensive income, net of tax. A decline in the market value of the security below cost that is deemed other than temporary is charged to earnings, resulting in the establishment of a new cost basis for the security. The components of investments as of September 30, 2004 are as follows (in thousands):

 

 

Note 5. Assets Held for Sale

 

Assets held for sale at September 30, 2004 consist of a building located in Monterey Park, California, which is part of the Company’s discontinued opto-electronics division (see Note 2). This building is carried at management’s estimated fair value less costs to sell, totaling $1.0 million as of both September 30, 2004 and December 31, 2003.

 

9

 

Note 6. Inventories

 

The components of inventory are as follows (in thousands):

 

 

Note 7. Restructuring Charge

 

The Company’s restructuring accrual is as follows (in thousands):

 

For the three month period ended September 30, 2004		Restructuring Accrual as of June 30, 2004			Additions/ Reversals			Payments			Restructuring Accrual as of September 30, 2004
Future lease payments related to abandoned facilities		$	690		$	82		$	(164	)	$	608
Workforce reduction		350			76			(392		)	34
Total		$	1,040		$	158		$	(556	)	$	642

 

For the nine month period ended September 30, 2004		Restructuring Accrual as of December 31, 2003			Additions/ Reversals			Payments			Restructuring Accrual as of September 30, 2004
Future lease payments related to abandoned facilities		$	—		$	772		$	(164	)	$	608
Workforce reduction		—			463			(429		)	34
Total		$	—		$	1,235		$	(593	)	$	642

 

During the three and nine month periods ended September 30, 2004, the Company recorded restructuring charges of $158,000 and $1.2 million, respectively, related to the reduction in work force effected in June 2004, and to lease costs associated with facilities located in California that are no longer required to support production.

 

The remaining restructuring accrual for future lease payments related to abandoned facilities of $0.6 million and workforce reduction of $34,000, is expected to be paid out through 2006 and 2004, respectively, and is included on the accompanying condensed consolidated balance sheet as accrued restructuring.

 

10

 

Note 8. Net Loss Per Share

 

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

 

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

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Numerator:
Net loss		$	(4,964	)	$	(2,563	)	$	(11,371	)	$	(24,616	)
Less: Preferred stock dividends		(44		)	(44		)	(132		)	(133		)
Net loss available to common stockholders		$	(5,008	)	$	(2,607	)	$	(11,503	)	$	(24,749	)
Denominator:
Denominator for basic net loss per share - weighted average common shares		23,094			22,857			23,044			22,727
Effect of dilutive securities:
Common stock options		—			—			—			—
Denominator for dilutive net loss per common share		23,094			22,857			23,044			22,727
Basic and diluted net loss per share		$	(0.22	)	$	(0.11	)	$	(0.50	)	$	(1.09	)
Options excluded from diluted net loss per share as the impact is anti-dilutive		2,365			2,361			2,365			2,411

 

Note 9. Comprehensive Loss

 

The components of comprehensive loss are as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net loss		$	(4,964	)	$	(2,563	)	$	(11,371	)	$	(24,616	)
Foreign currency translation (loss) gain		(107		)	131			(164		)	86
Unrealized (loss) gain on available for sale investments		(786		)	871			(2,238		)	1,548
Comprehensive loss		$	(5,857	)	$	(1,561	)	$	(13,773	)	$	(22,982	)

 

Note 10. Segment Information

 

The Company has one operating segment comprising the design, development, manufacture and distribution of high-performance compound semiconductor substrates. The Company’s operating segment reports to the Interim Chief Executive Officer.

 

The Company sells its substrates products in the United States and in other parts of the world, and maintains operations in the United States, Japan and China. Revenues by geographic location based on the country where the customer is located are as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net revenues:
United States		$	1,849		$	3,030		$	6,048		$	8,947
Europe		1,731			1,621			5,433			4,661
Canada		24			40			113			147
Japan		1,274			1,080			3,533			2,866
Taiwan		1,940			1,405			7,623			4,549
Asia Pacific and other		1,713			1,353			5,081			4,413
Consolidated		$	8,531		$	8,529		$	27,831		$	25,583

 

11

 

Note 11. Corporate Affiliates

 

The Company’s investments in its corporate affiliates are as follows (in thousands):

 

Affiliate		Investment Balance September 30, 2004			Investment Balance December 31, 2003			Accounting Method		Ownership Percentage
Xilingol Tongli Ge Co. Ltd.		$	845		$	822		Equity		25	%
Emeishan Jia Mei High Pure Metals Co., Ltd.		598			603			Equity		25	%
Beijing Ji Ya Semiconductor Material Co., Ltd.		1,071			1,071			Consolidate		51	%
Nanjing Jin Mei Gallium Co., Ltd.		616			616			Consolidate		88	%
Beijing Bo Yu Manufacturing Co., Ltd.		409			409			Consolidate		70	%

 

The investment balances for those affiliates accounted for under the equity method are included within “Other assets” in the condensed consolidated balance sheets. The minority interest for those affiliates that are consolidated is included within “Other long-term liabilities” in the condensed consolidated balance sheets and within “Other expense (income)” on the condensed consolidated statements of operations.

 

Undistributed retained earnings relating to the Company’s corporate affiliates was $1.4 million as of September 30, 2004 and $739,000 as of September 30, 2003.  The Company’s corporate affiliates recorded an aggregate net loss of $4,000 for the three month period ended September 30, 2004 and an aggregate net income of $607,000 for the nine month period ended September 30, 2004.  Net losses recorded from the Company’s corporate affiliates were $54,000 and $121,000 for the three and nine month periods ended September 30, 2003, respectively.

 

The Company invested in these companies because each provides materials that are important to the Company’s substrate business, each can provide products or materials at lower cost than other suppliers, and each has a market beyond that provided by the Company. The Company is currently negotiating a new joint venture investment in China for a Germanium business opportunity, and upon the fulfillment of certain conditions, the Company may invest up to US$1.0 million to the new joint venture by December 2004.

 

Note 12. Commitments and Contingencies

 

From time to time the Company is involved in judicial or administrative proceedings concerning matters arising in the ordinary course of our business. The Company does 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.

 

On June 11, 2003, Cree, Inc. filed a complaint in the United States Court for Northern District of California against the Company alleging patent infringement. The complaint sought damages and injunction against infringement. On July 23, 2003, the Company 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 the Company’s prospective business relationships. The Company reached an agreement with Cree resolving the disputes 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. All parties signed a final release regarding all disputes on April 15, 2004.

 

On October 8, 2004, the Company announced that it had reached a tentative settlement of the litigation in Japan and interference actions in the United States with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a global intellectual property cross-licensing agreement. AXT expects to finalize this agreement in the fourth quarter of 2004, subject to Board of Directors approval from AXT and SEI.  Accordingly, the Company recorded a charge of approximately $1.4 million for the quarter ended September 2004 in connection with this settlement, and is expected to make royalty payments on future sales of certain products.

 

On October 15, 2004, a purported securities class action lawsuit was filed in the United States District Court for the Northern District of California.  See note 15 for further details.

 

12

 

The Company has entered into contracts to supply several large customers with GaAs wafers. The contracts guarantee the delivery of a certain number of wafers between January 1, 2001 and December 31, 2004 with a current contract value of $560,000. The contract sales prices are subject to review quarterly and can be adjusted in the event that raw material prices change. In the event of non-delivery of the determined wafer quantities in any monthly delivery period, the Company could be subject to non-performance penalties of between 5% and 10% of the value of the delinquent monthly deliveries. The Company has not received any claims for non-performance penalties due to non-delivery. Partial prepayments received for these supply contracts totaling $130,000 and $994,000 are included in accrued liabilities in the accompanying condensed consolidated balance sheets as of September 30, 2004 and December 31, 2003, respectively. During the third quarter of 2004, the Company refunded a portion of a prepayment on future purchases of goods and recorded a $237,000 gain for the amount of deposit forfeited by a private company, which investment was impaired by AXT.  As of September 30, 2004, the Company has met all of its current delivery obligations under these contracts and expects to continue to meet delivery requirements during the remainder of the contract terms.

 

The Company indemnifies certain customers for attorney fees and damages and costs awarded against these parties in certain circumstances if its products are found to infringe certain patents and they are sued by the patent holder and awarded damages. There are limits on and exceptions to its potential liability for indemnification relating to intellectual patent infringement claims. The Company cannot estimate the amount of potential future payments, if any, that it might be required to make as a result of these agreements. To date, the Company has not paid any claim or been required to defend any action related to its indemnification obligations, and accordingly, the Company has not accrued any amounts for such indemnification obligations. However, we may record charges in the future as a result of these indemnification obligations.

 

The Company’s financial statements include accruals for potential product liability and warranty claims based on the Company’s claims experience. Such costs are accrued at the time revenue is recognized. As of September 30, 2004 and December 31, 2003, accrued product warranties totaled $135,000 and $0, respectively, and are included in “accrued liabilities” in the accompanying condensed consolidated balance sheets. If there is a material increase in customer claims compared with our historical experience, or if costs of servicing claims are greater than expected, the Company may record a charge against cost of sales.

 

The following table reconciles changes in the Company’s accrued product warranties which is included in accrued liabilities for the three and nine month periods ended September 30, 2004 and 2003, respectively (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Beginning accrued warranty and related costs		$	135		$	—		$	—		$	—
Charged to cost of revenue		—			—			135			—
Actual warranty expenditures		—			—			—			—
Ending accrued warranty and related costs		$	135		$	—		$	135		$	—

 

In April 2004, the Company determined that it had not followed requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. Since April 2004, the Company has continued to notify the affected customers concerning its findings. The Company has established a reserve based on its best estimate of future returns related to this matter. Although actual returns may differ, the Company does not believe future claims in the aggregate will be material.  The Company has recorded a reserve for sale returns of $745,000 and believes this is adequate to cover any product returns related to this matter, however, the Company is unable to assess the impact that this matter might have, if any, on its future revenues or gross margins. Approximately $155,000 of the $745,000 sales returns reserve has been utilized as of September 30, 2004.  Refer to “Item 4 Controls and Procedures” for further information.

 

The Company is currently negotiating a new joint venture investment in China for a Germanium business opportunity, and upon the fulfillment of certain conditions, the Company may invest up to US$1.0 million to the new joint venture by December 2004.

 

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Note 13. Foreign Exchange Contracts and Transaction Gains/Losses

 

The Company uses short-term forward exchange contracts for hedging purposes to reduce the effects of adverse foreign exchange rate movements. The Company has purchased foreign exchange contracts to hedge against certain trade accounts receivable denominated in Japanese yen. The change in the fair value of the forward contracts is recognized as part of the related foreign currency transactions as they occur. As of September 30, 2004, the Company had no outstanding commitments with respect to foreign exchange contracts.

 

The Company incurred foreign currency transaction exchange losses of $(23,000) and $(34,000) for the three and nine month periods ended September 30, 2004, respectively, and a foreign currency transaction exchange loss of ($7,000) for the three month period ended September 30, 2003 and a gain of $53,000 for the nine month period ended September 30, 2003.

 

Note 14. Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, which addresses consolidation by business enterprises of variable interest entities, or VIEs, either that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46, or FIN 46(R), resulting in an effective date of no later than the first interim or annual period ending after March 15, 2004. The Company’s adoption of FIN 46(R) did not have an impact on our results of operations or financial position.

 

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06, (EITF 03-06), Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share. EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 was effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have a material effect on the Company’s results of operations or financial position.

 

Note 15. Subsequent Event

 

On October 15, 2004, a purported securities class action lawsuit was filed in the United States District Court for the Northern District of California: City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.  The lawsuit names the Company and its CEO, China Operations, as defendants, and is brought on behalf of a class of all purchasers of the Company’s securities from February 6, 2001 through April 27, 2004.  The complaint alleges that the Company’s announced financial results during this period were false and misleading.  No specific amount of damages is claimed.  The Company believes that there are meritorious defenses against this lawsuit and intends to vigorously defend it.  However, due to the inherent uncertainties of litigation, the Company cannot accurately predict the ultimate outcome of the litigation.  Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operation.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based upon management’s current views with respect to future events and financial performance, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated. Such risks and uncertainties include those set forth under “Risks Related to our Business” below. Forward-looking statements may be identified by the use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” and similar expressions, and include statements concerning future sales returns and claims arising from our recent investigation into product testing and reporting practices; the adequacy of our reserves; future industry demand; our ability to regain lost market share; our ability to offer products that equal or exceed the quality provided by competitors; product pricing; cost savings as a result of our move to China; and intellectual property litigation. Statements concerning our financial position, business strategy and plans or objectives for future operations are forward-looking statements.

 

These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and the condensed consolidated financial statements included elsewhere in this report.

 

Overview

 

We were founded in 1986 to commercialize and enhance our proprietary vertical gradient freeze (VGF) technique for producing high-performance compound semiconductor substrates. As a result of the discontinuance of our opto-electronics division, and the sale of substantially all of the assets of this business in 2003, we now have one operating 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 $8.5 million for the third quarter of 2004, $9.5 million for the second quarter of 2004 and $9.8 million for the first quarter of 2004. In the third quarter of 2004 we incurred a loss from continuing operations of $5.2 million compared with a loss of $4.1 million for the second quarter of 2004 and a loss of $2.6 million for the first quarter of 2004.  For the third quarter of 2004, our revenue from continuing operations remained flat at $8.5 million compared to the third quarter of 2003. Our gross margin decreased from the third quarter of 2003 to negative 26.2 percent primarily due to an approximately $1.4 million charge in connection with the settlement of our litigation in Japan and interference actions in the United States with Sumitomo Electrical Industries, Ltd. and a $2.1 million inventory charge due to excess and obsolete inventory.

 

On June 24, 2003, we announced the discontinuation of our opto-electronics division, which we had established as part of our acquisition of Lyte Optronics, Inc. in May 1999. 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 of the notes to our condensed 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 the sale of substantially all of the assets of our opto-electronics business to Lumei Optoelectronics Corp. (“Lumei”) and Dalian Luming Science and Technology Group, Co., Ltd. for the China Renminbi (RMB) equivalent of $9.6 million. During the first quarter of 2004, $7.8 million was converted to US dollars. The remaining funds were converted to US dollars in early April 2004.  Proceeds of $1.0 million were held in escrow for up to one year.  In September 2004, $225,000 of the escrow funds were released to AXT; Lumei made claims against the escrow in the

 

15

 

approximate amount of $0.5 million which we have contested and we intend to vigorously pursue legal action against the claims.  The remaining $250,000 in escrow will be held for a second year in accordance with the terms of the agreement and will not be recorded as a gain from discontinued operations until all claims, if any, are settled.  We retain a building located in Monterey Park, CA, that we have on the market to sell. This asset has been classified as held for sale on the condensed consolidated balance sheets as of September 30, 2004 and December 31, 2003.

 

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 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 with 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, postponements 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 with 2001. We recorded losses in each quarter of 2002 and incurred impairment charges against fixed assets and inventory due to the decline in demand and prices. In reaction to the economic downturn, 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 net losses in each quarter of 2003. During 2003 we continued to shift more of our manufacturing operations to China and reduced our costs incurred in the United States.

 

During the first nine months of 2004, our revenue increased compared with the first nine months of 2003, primarily as a result of increased demand for HBLEDs. We have recorded net losses in all three quarters of 2004. During the second quarter of 2004, we announced plans to cease all production activities in the United States and to manufacture our products only in China.

 

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 realize cost-savings as a result of our shift of production to China, and our ability to create and defend our intellectual property while not infringing on the intellectual property of others.

 

In April 2004, we determined that we had not followed requirements for testing of products and provision of testing data and information relating to customer requirements for certain shipments made over the past several years. We have notified the affected customers concerning our findings. We have established a reserve based on our best estimate of future returns related to this matter. Although actual returns may differ, we do not believe future claims in the aggregate will be material. We have recorded a reserve for sales returns of $745,000 and believe this is adequate to cover any product returns related to this matter, however, we are unable to assess the impact that this matter might have, if any, on our future revenues or gross margins. Approximately $155,000 of the $745,000 sales returns reserve has been utilized as of September 30, 2004.  See “Item 4. Controls and Procedures” for further information.

 

In June 2004, we incurred a restructuring charge of $1.1 million as a result of our decision to close down our remaining manufacturing facilities in the United States. In September 2004, we incurred an additional restructuring charge of $158,000.  These charges comprised of costs related to the reduction in force effected in June 2004, and lease costs associated with the facilities located in California that are no longer required to support production. See Note 7 of the notes to our condensed consolidated financial statements for further details.

 

In August 2004, we announced the adoption of a stock repurchase program in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934 to provide for the repurchase of up to $2 million of our common stock.  Repurchases may be made from time to time in the open market during the twelve-month period ending July 31, 2005, at prevailing market prices, although to date no repurchases have been made. As of September 30, 2004, we had 23.1 million shares of common stock outstanding.  Repurchases, if any, will be made under the program using our own cash resources.

 

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In October 2004, we announced that we had reached a tentative settlement of the litigation in Japan and interference actions in the United States with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a global intellectual property cross-licensing agreement. AXT expects to finalize this agreement in the fourth quarter of 2004, subject to Board of Directors approval from AXT and SEI.  Accordingly, we recorded a charge of approximately $1.4 million for the quarter ended September 2004 in connection with this settlement, and are expected to make royalty payments to SEI on future sales of certain products.

 

Also in October 2004, a purported securities class action lawsuit was filed in the United States District Court for the Northern District of California: City of Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.  The lawsuit names the Company and its CEO, China Operations, as defendants, and is brought on behalf of a class of all purchasers of our securities from February 6, 2001 through April 27, 2004.  The complaint alleges that our announced financial results during this period were false and misleading.  No specific amount of damages is claimed.  We believe that there are meritorious defenses against this lawsuit and intends to vigorously defend it.  However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation.  Any unfavorable outcome of the litigation could have an adverse impact on our business, financial condition and results of operation.

 

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.

 

We believe that the following are our critical accounting policies:

 

Revenue Recognition

 

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 establish a reserve when there is uncertainty regarding customer acceptance. 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. During the first quarter of 2004, we increased our reserve for sales returns by $745,000 related to our failure to follow certain testing requirements and provision of testing data and information to certain customers. This reserve was based on discussions with some of the affected customers and review of specific shipments made during the quarter. 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.

 

Allowance for Doubtful Accounts

 

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. As of September 30, 2004, our accounts receivable balance was $5.2 million, which is net of an allowance for doubtful accounts of $4.8 million.

 

Warranty Reserve

 

We maintain a warranty reserve based upon our claims experience during the prior twelve months. Such costs are accrued at the time revenue is recognized. As of September 30, 2004, accrued product warranties totaled $135,000.

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the standard cost method. Finished goods

 

17

 

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 products 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.

 

Impairment of Long-Lived Assets

 

We evaluate the recoverability of property, equipment, and intangible assets in accordance with Statement of Financial Accounting Standards No. 144, or SFAS No. 144, “Accounting 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.

 

Investments

 

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 than temporary declines in value on a quarterly basis. Reasons for other than temporary declines in value include whether the related company would have insufficient cash flow to operate for the next twelve months, significant changes in the operating performance and changes in market conditions.

 

Income Taxes

 

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

 

Results of Operations

 

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

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2004		2003		2004		2003
Revenues		100.0	%	100.0	%	100.0	%	100.0	%
Cost of revenues		126.2		94.1		103.1		94.3
Gross profit (loss)		(26.2	)%	5.9	%	(3.1	)%	5.7	%
Operating expenses:
Selling, general and administrative		28.9		31.1		30.3		31.2
Research and development		4.7		3.5		3.9		4.1
Asset impairment charge		2.5		—		0.8		—
Restructuring charge		1.9		—		4.4		—
Total operating expenses		37.9		34.6		39.4		35.3
Loss from operations		(64.1	)	(28.7	)	(42.6	)	(29.6	)
Interest expense (income)		(0.7	)	1.7		(0.8	)	1.4
Other expense (income), net		4.5		—		1.6		4.0
Loss before provision for income taxes		(60.4	)	(30.4	)	(41.8	)	(35.0	)
Provision for incomes taxes		(0.5	)	—		(0.6	)	—
Loss from continuing operations		(60.8	)	(30.4	)	(42.5	)	(35.0	)
Discontinued operations:
Gain (loss) from discontinued operations, net of tax		—		(18.7	)	0.8		(24.1	)
Gain (loss) from disposal		2.6		19.0		0.8		(37.1	)
Net loss		(58.2	)%	(30.1	)%	(40.9	)%	(96.2	)%

 

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Three months ended September 30, 2004 compared with three months ended September 30, 2003

 

Revenue from continuing operations. Revenue from continuing operations remained flat at $8.5 million for the three months ended September 30, 2004 compared with $8.5 million for the three months ended September 30, 2003.

 

Total GaAs substrate revenue increased $156,000 or 2.3%, to $7.0 million for the three months ended September 30, 2004 compared with $6.9 million for the three months ended September 30, 2003. Sales of 5 inch and 6 inch diameter GaAs substrates were $193,000 for the three months ended September 30, 2004 compared with $1.7 million for the three months ended September 30, 2003. InP substrate revenue decreased $282,000, or 57%, to $214,000 for the three months ended September 30, 2004 compared with $496,000 for the three months ended September 30, 2003. The increase in GaAs substrate revenue during the past year is due to market growth in the HBLED market and to our ability to gain share among some Asian customers. The decrease in revenue from 5 inch and 6 inch diameter substrates is related to a loss in market share for these products, particularly among customers in the United States.  These substrates are primarily used to manufacture devices for wireless handsets.  The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our China-made products.

 

International revenue increased to 78.0% of total revenue from continuing operations for the three months ended September 30, 2004 compared with 64.5% of total revenue from continuing operations for the three months ended September 30, 2003. 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 decreased to (26.2)% of total revenue for the three months ended September 30, 2004 compared with 5.9% of total revenue for the three months ended September 30, 2003. The decrease was primarily due to an approximately $1.4 million charge in connection with the settlement of our litigation in Japan and interference actions in the United States with Sumitomo Electrical Industries, Ltd. and a $2.1 million inventory valuation charge due to excess and obsolete inventory.

 

Selling, general and administrative expenses. Selling, general and administrative expenses decreased to $2.5 million for the three months ended September 30, 2004 compared with $2.7 million for the three months ended September 30, 2003. The decrease is due to continuing reduction of legal and other professional expenses. As a percentage of revenue, selling, general and administrative expenses were 28.9% for the three months ended September 30, 2004 compared with 31.1% for the three months ended September 30, 2003.

 

Research and development expenses. Research and development expenses increased $96,000, or 31.9%, to $397,000 for the three months ended September 30, 2004 compared with $301,000 for the three months ended September 30, 2003. As a percentage of total revenue, research and development expenses were 4.7% for the three months ended September 30, 2004 compared with 3.5% for the three months ended September 30, 2003.  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 the levels of recent quarters or increase in future periods. Research and development efforts during 2004 were focused primarily on improving the yield and surface quality of our GaAs substrates.

 

Interest expense. Interest expense decreased $85,000, or 58.6%, to $60,000 for the three months ended September 30, 2004 compared with $145,000 for the three months ended September 30, 2003. Interest expense decreased due to lower debt levels as we continued to pay down our debt.  Interest costs on our taxable variable rate revenue bonds have increased by approximately 60 basis points during the past six months.

 

Other income and expense, net. Other income increased $377,000 to $380,000 for the three months ended September 30, 2004 compared with other income of $3,000 for the three months ended September 30, 2003. The increase was mainly due to a one-time gain of $237,000 for a deposit on future purchases of goods forfeited by a private company. In addition, our investment in this company was written off during the quarter for which we recorded a $210,000 asset impairment charge.

 

Provision for income taxes. Due to our continuing operating losses in the United States and uncertainty regarding future profitability, in 2003 we recorded a full valuation allowance for our United States losses against our net deferred tax assets of $34.6 million. We incurred a tax liability of $40,000 for our overseas businesses for the three months ended September 30, 2004.

 

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Nine months ended September 30, 2004 compared with nine months ended September 30, 2003

 

Revenue from continuing operations. Revenue from continuing operations increased $2.2 million, or 8.8%, to $27.8 million for the nine months ended September 30, 2004 compared with $25.6 million for the nine months ended September 30, 2003.

 

Total GaAs substrate revenue increased $1.7 million, or 8.1%, to $22.6 million for the nine months ended September 30, 2004 compared with $20.9 million for the nine months ended September 30, 2003. Sales of 5 inch and 6 inch diameter GaAs substrates were $3.3 million for the nine months ended September 30, 2004 compared with $3.8 million for the nine months ended September 30, 2003. InP substrate revenue decreased $300,000, or 19.2%, to $1.3 million for the nine months ended September 30, 2004 compared with $1.6 million for the nine months ended September 30, 2003. The increase in GaAs substrate revenue during the past year is due to market expansion in the HBLED and wireless handset markets and to our ability to gain additional market share among Asian customers. The decrease in InP substrate revenue was due to a decline in orders from customers who are qualifying our China operations.

 

International revenue increased to 78.0% of total revenue from continuing operations for the nine months ended September 30, 2004 compared with 65.0% of total revenue from continuing operations for the nine months ended September 30, 2003. 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 decreased to (3.1)% of total revenue for the nine months ended September 30, 2004 compared with 5.7% of total revenue for the nine months ended September 30, 2003. The decrease was primarily due to a valuation charge of $2.1 million as a result of the write down of excess and obsolete inventory during the quarter and a charge of approximately $1.4 million in connection with the settlement of the litigation in Japan and interference actions in the United States with Sumitomo Electric Industries, Ltd. taken in the third quarter of 2004.

 

Selling, general and administrative expenses. Selling, general and administrative expenses increased to $8.4 million for the nine months ended September 30, 2004 compared with $8.0 million for the nine months ended September 30, 2003. The increase is due to an additional expense of $350,000 for legal fees related to the investigation by our Audit Committee into product testing and compliance practices in the second quarter of 2004. As a percentage of revenue, selling, general and administrative expenses were 30.3% for the nine months ended September 30, 2004 compared with 31.2% for the nine months ended September 30, 2003.

 

Research and development expenses. Research and development expenses increased $40,000, or 3.8%, to $1.1 million for the nine months ended September 30, 2004 compared with $1.0 million for the nine months ended September 30, 2003. As a percentage of total revenue, research and development expenses were 3.9% for the nine months ended September 30, 2004 compared with 4.1% for the nine months ended September 30, 2003.  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 or increase in future periods. Research and development efforts during 2004 were focused primarily on improving the yield and surface quality of our GaAs substrates.

 

Interest expense. Interest expense decreased $141,000, or 38.3%, to $227,000 for the nine months ended September 30, 2004 compared with $368,000 for the nine months ended September 30, 2003. Interest expense includes a prepayment penalty incurred by voluntarily repaying off a loan before it was due with an outstanding principal balance of $781,000, which we acquired in 1996.  Interest expense decreased due to lower debt levels as we continue to pay down our debt.  Interest costs on our taxable variable rate revenue bonds have increased by approximately 60 basis points during the past six months.

 

Other income and expense, net. Other income increased $1.5 million to $434,000 for the nine months ended September 30, 2004 compared with other expense of $1.0 million for the nine months ended September 30, 2003. The increase was mainly due to a one-time gain of $237,000 recorded in 2004 for a deposit on future purchases of goods forfeited by a private company while in 2003, we recorded an impairment charge of $1.3 million related to a non-consolidated subsidiary. In addition, our investment in this company was written off during the quarter for which we recorded a $210,000 asset impairment charge.

 

Provision for income taxes. Due to our continuing operating losses in the United States and uncertainty regarding future profitability, in 2003 we recorded a full valuation allowance for our United States losses against our net deferred tax assets of $34.6 million. We incurred a tax liability of $177,000 for our overseas businesses for the nine months ended September 30, 2004.

 

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