** **

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC. 20549**

 

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** **

**FORM10-Q**

 

| **(Mark  One)**                                        | ** ** | ** **                                                                                    |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                    |
| **x**                                                  | ** ** | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
| ** **                                             | ** ** | ** **                                                                                    |
| **for the  quarterly period ended September 30, 2007** |
| ** **                                             | ** ** | ** **                                                                                    |
| **or**                                                 |
| ** **                                             | ** ** | ** **                                                                                    |
| **o**                                                  | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |

 

**for the transition periodfrom          to**

 

**CommissionFile Number 000-24085**

 

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** **

**AXT,INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**4281Technology Drive, Fremont, California 94538**

(Addressof principal executive offices) (Zip code)

 

**(510)683-5900**

(Registrant’stelephone number, including area code)

 

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

 

Indicate by checkmark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Act. (Check one):

| Large accelerated  filer o |   | Accelerated filer o |   | Non-accelerated  filer x |
|---------------------------------|--------|--------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). YES o  NO  x

 

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

 

| **Class**                       | ** ** | **Outstanding at October 22, 2007** |
|---------------------------------|------------|---------------------------------------------------------|
| Common Stock, $0.001  par value |       | 30,287,889                                              |

 

 

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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, 2007 and December 31, 2006                             | 3  |
| Condensed Consolidated  Statements of Operations for the three and nine months ended September 30,  2007 and 2006 | 4  |
| Condensed Consolidated  Statements of Cash Flows for the nine months ended September 30, 2007 and  2006           | 5  |
| Notes To Condensed Consolidated Financial Statements                                                              | 6  |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations               | 16 |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                               | 29 |
| Item 4T. Controls and Procedures                                                                                  | 30 |
| PART  II. OTHER INFORMATION                                                                                       | 31 |
| Item  1. Legal Proceedings                                                                                        | 31 |
| Item  1A. Risk Factors                                                                                            | 31 |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                              | 31 |
| Item 3. Defaults Upon Senior Securities                                                                           | 32 |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                      | 32 |
| Item  5. Other Information                                                                                        | 32 |
| Item 6.  Exhibits                                                                                                 | 33 |
| Signatures                                                                                                        | 34 |

 

2

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**PART I. FINANCIAL INFORMATION**

**Item 1.Financial Statements**

AXT, INC.

CONDENSEDCONSOLIDATED BALANCE SHEETS

(Unaudited,in thousands, except per share data)
| ** **                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Assets:                                                                                                                                                                                       |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                               |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                    |       | $                      | 17,067     |                  | $          | 16,116 |   |
| Short-term  investments                                                                                                                                                                       |       | 18,174                 |       | 19,428                |       |
| Accounts  receivable, net of allowances of $560 and $140 as of September 30, 2007  and December 31, 2006, respectively                                                              |       | 11,948                 |       | 9,658                 |       |
| Inventories, net                                                                                                                                                                              |       | 25,124                 |       | 20,263                |       |
| Prepaid expenses  and other current assets                                                                                                                                                    |       | 3,590                  |       | 3,985                 |       |
| Assets held for  sale                                                                                                                                                                         |       | 5,140                  |       | 4,659                 |       |
| Total current  assets                                                                                                                                                                         |       | 81,043                 |       | 74,109                |       |
| Property, plant  and equipment, net                                                                                                                                                           |       | 15,072                 |       | 12,775                |       |
| Restricted  deposits                                                                                                                                                                          |       | 6,700                  |       | 7,150                 |       |
| Other assets                                                                                                                                                                                  |       | 5,036                  |       | 4,298                 |       |
| Total assets                                                                                                                                                                                  |       | $                      | 107,851    |                  | $          | 98,332 |   |
|                                                                                                                                                                                          |       |                   |       |                  |       |
| Liabilities and  stockholders’ equity:                                                                                                                                                   |       |                   |       |                  |       |
| Current  liabilities:                                                                                                                                                                         |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                              |       | $                      | 2,770      |                  | $          | 3,764 |   |
| Accrued  liabilities                                                                                                                                                                          |       | 3,877                  |       | 3,358                 |       |
| Current portion  of long-term debt                                                                                                                                                            |       | 450                    |       | 450                   |       |
| Income taxes  payable                                                                                                                                                                         |       | 446                    |       | 178                   |       |
| Total current  liabilities                                                                                                                                                                    |       | 7,543                  |       | 7,750                 |       |
| Long-term debt,  net of current portion                                                                                                                                                       |       | 6,295                  |       | 6,839                 |       |
| Other long-term  liabilities                                                                                                                                                                  |       | 3,129                  |       | 2,543                 |       |
| Total  liabilities                                                                                                                                                                            |       | 16,967                 |       | 17,132                |       |
| Commitments and  contingencies (Note 11)                                                                                                                                                 |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                                                                                   |       |                   |       |                  |       |
| Preferred stock,  $0.001 par value per share; 2,000 shares authorized; 883 shares issued and  outstanding as of September 30, 2007 and December 31, 2006.                                |       | 3,532                  |       | 3,532                 |       |
| Common stock, $0.001  par value per share; 70,000 shares authorized; 30,288 and 29,011 shares  issued and outstanding as of September 30, 2007 and December 31,  2006, respectively |       | 30                     |       | 29                    |       |
| Additional  paid-in capital                                                                                                                                                                   |       | 185,666                |       | 180,936               |       |
| Accumulated  deficit                                                                                                                                                                          |       | (100,417               | )          | (103,832              | )          |
| Accumulated  other comprehensive income                                                                                                                                                       |       | 2,073                  |       | 535                   |       |
| Total  stockholders’ equity                                                                                                                                                              |       | 90,884                 |       | 81,200                |       |
| Total  liabilities and stockholders’ equity                                                                                                                                              |       | $                      | 107,851    |                  | $          | 98,332 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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AXT, INC.

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited,in thousands, except per share data)
| ** **                                                   | ** ** | **Three Months Ended   September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                                   | ** ** | **2006**                                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                         |       |                                                       |       |                                                      |       |   |   |   |   |
| Revenue                                                      |       | $                                                          | 14,474     |                                                      | $          | 12,547 |   | $ | 40,639 |   | $ | 31,373 |   |
| Cost of revenue                                              |       | 9,944                                                      |       | 9,068                                                     |       | 25,672 |   | 23,625 |   |
| Gross profit                                                 |       | 4,530                                                      |       | 3,479                                                     |       | 14,967 |   | 7,748 |   |
| Operating  expenses:                                         |       |                                                       |       |                                                      |       |   |   |   |   |
| Selling, general  and administrative                         |       | 3,083                                                      |       | 2,641                                                     |       | 10,529 |   | 9,724 |   |
| Research and  development                                    |       | 382                                                        |       | 392                                                       |       | 1,190 |   | 1,497 |   |
| Impairment  (recovery of impairment) on assets held for sale |       | —                                                     |       | 1,417                                                     |       | (481 | ) | 1,417 |   |
| Restructuring  benefit                                       |       | —                                                     |       | —                                                    |       | — |   | (2 | ) |
| Total operating  expenses                                    |       | 3,465                                                      |       | 4,450                                                     |       | 11,238 |   | 12,636 |   |
| Income (loss)  from continuing operations                    |       | 1,065                                                      |       | (971                                                      | )          | 3,729 |   | (4,888 | ) |
| Interest income,  net                                        |       | 102                                                        |       | 103                                                       |       | 551 |   | 342 |   |
| Other income  (expense), net                                 |       | (156                                                       | )          | 641                                                       |       | (439 | ) | 1,693 |   |
| Income (loss)  before provision for income taxes             |       | 1,011                                                      |       | (227                                                      | )          | 3,841 |   | (2,853 | ) |
| Provision  (benefit) for income taxes                        |       | 153                                                        |       | (862                                                      | )          | 426 |   | (406 | ) |
| Income (loss)  from continuing operations                    |       | 858                                                        |       | 635                                                       |       | 3,415 |   | (2,447 | ) |
| Discontinued  operations:                                    |       |                                                       |       |                                                      |       |   |   |   |   |
| Gain from  discontinued operations, net of tax               |       | —                                                     |       | 4                                                         |       | — |   | 7 |   |
| Net income  (loss)                                           |       | $                                                          | 858        |                                                      | $          | 639 |   | $ | 3,415 |   | $ | (2,440 | ) |
| Basic income  (loss) per share:                              |       |                                                       |       |                                                      |       |   |   |   |   |
| Income (loss)  from continuing operations                    |       | $                                                          | 0.03       |                                                      | $          | 0.03 |   | $ | 0.11 |   | $ | (0.11 | ) |
| Gain from  discontinued operations, net of tax               |       | —                                                     |       | —                                                    |       | — |   | — |   |
| Net income (loss)                                            |       | $                                                          | 0.03       |                                                      | $          | 0.03 |   | $ | 0.11 |   | $ | (0.11 | ) |
|                                                         |       |                                                       |       |                                                      |       |   |   |   |   |
| Shares used in  computing basic income (loss) per share      |       | 30,150                                                     |       | 23,158                                                    |       | 29,940 |   | 23,066 |   |
| Diluted income  (loss) per share:                            |       |                                                       |       |                                                      |       |   |   |   |   |
| Income (loss)  from continuing operations                    |       | $                                                          | 0.03       |                                                      | $          | 0.02 |   | $ | 0.10 |   | $ | (0.11 | ) |
| Gain from  discontinued operations, net of tax               |       | —                                                     |       | —                                                    |       | — |   | — |   |
| Net income  (loss)                                           |       | $                                                          | 0.03       |                                                      | $          | 0.02 |   | $ | 0.10 |   | $ | (0.11 | ) |
|                                                         |       |                                                       |       |                                                      |       |   |   |   |   |
| Shares used in  computing diluted income (loss) per share    |       | 31,464                                                     |       | 24,378                                                    |       | 31,287 |   | 23,066 |   |
|                                                              |            |                                                            |            |                                                           |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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AXT, INC.

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited,in thousands)
| ** **                                                                  | ** ** | **Nine  Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                  | ** ** | **September 30,**      | ** ** |
| ** **                                                                  | ** ** | **2007**                    | ** ** | **2006** | ** ** |
| Cash flows from  operating activities:                                      |       |                        |       |   |   |
| Net income  (loss)                                                          |       | $                           | 3,415      |   | $ | (2,440 | ) |
| Adjustments to  reconcile net income (loss) to net cash used in operations: |       |                        |       |   |   |
| Depreciation                                                                |       | 1,064                       |       | 2,365 |   |
| Accretion of  marketable securities premium/discount                        |       | (51                         | )          | (55 | ) |
| Loss on disposal  of property, plant and equipment                          |       | —                      |       | 89 |   |
| Stock-based  compensation                                                   |       | 341                         |       | 649 |   |
| Realized loss  (gain) on sale of investments                                |       | 83                          |       | (2,032 | ) |
| Impairment  (recovery of impairment) on assets held for sale                |       | (481                        | )          | 1,417 |   |
| Changes in  assets and liabilities:                                         |       |                        |       |   |   |
| Accounts  receivable, net                                                   |       | (2,193                      | )          | (3,574 | ) |
| Inventories                                                                 |       | (4,712                      | )          | (1,203 | ) |
| Prepaid expenses                                                            |       | 512                         |       | (2,278 | ) |
| Other assets                                                                |       | (696                        | )          | 26 |   |
| Accounts payable                                                            |       | (1,050                      | )          | 1,008 |   |
| Accrued  liabilities                                                        |       | 475                         |       | (773 | ) |
| Income taxes  payable                                                       |       | 251                         |       | (1313 | ) |
| Other long-term  liabilities                                                |       | 467                         |       | 340 |   |
| Net cash used in  operating activities                                      |       | (2,575                      | )          | (7,774 | ) |
|                                                                        |       |                        |       |   |   |
| Cash flows from  investing activities:                                      |       |                        |       |   |   |
| Purchases of  property, plant and equipment                                 |       | (2,786                      | )          | (2,157 | ) |
| Proceeds from  disposal of property, plant and equipment                    |       | 6                           |       | 161 |   |
| Purchases of  marketable securities                                         |       | (22,704                     | )          | (7,924 | ) |
| Proceeds from  sale of marketable securities                                |       | 24,508                      |       | 10,174 |   |
| Decrease in  restricted deposits                                            |       | 450                         |       | 300 |   |
| Net cash (used  in)/ provided by investing activities                       |       | (526                        | )          | 554 |   |
|                                                                        |       |                        |       |   |   |
| Cash flows from  financing activities:                                      |       |                        |       |   |   |
| Proceeds from  issuance of common stock, net                                |       | 4,390                       |       | 528 |   |
| Long-term debt  payments                                                    |       | (546                        | )          | (467 | ) |
| Net cash  provided by financing activities                                  |       | 3,844                       |       | 61 |   |
| Effect of  exchange rate changes on cash and cash equivalents               |       | 208                         |       | 274 |   |
| Net increase  (decrease) in cash and cash equivalents                       |       | 951                         |       | (6,885 | ) |
| Cash and cash  equivalents at the beginning of the period                   |       | 16,116                      |       | 17,472 |   |
| Cash and cash  equivalents at the end of the period                         |       | $                           | 17,067     |   | $ | 10,587 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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AXT, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

**Note 1. Basis of Presentation**

 

The accompanying condensed consolidated financialstatements of AXT,Inc. (“AXT”, “Company”, “we,” “us,” and “our” refer to AXT, Inc. and allof its consolidated subsidiaries) are unaudited, and have been prepared inaccordance with accounting principles generally accepted in the United Statesof America forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, the year-end condensed consolidatedbalance sheet data was derived from audited consolidated financial statements,but does not include all disclosures required by accounting principles generallyaccepted in theUnited States of America. In the opinion of our management, the unauditedcondensed consolidated financial statements reflect all adjustments, consistingonly of normal recurring adjustments, considered necessary to present fairlythe financial position, results of operations and cash flows of AXT and oursubsidiaries for all periods presented.

 

Our management has made a number of estimates andassumptions relating to the reporting of assets and liabilities and thedisclosure of contingent assets and liabilities to prepare these condensedconsolidated financial statements in conformity with accounting principles generallyaccepted in the United States of America. Actual results could differ materially from thoseestimates.

 

The results of operations are not necessarilyindicative of the results to be expected in the future or for the full fiscalyear. It is recommended that these condensed consolidated financial statementsbe read in conjunction with our consolidated financial statements and the notesthereto included in our 2006 Annual Report on Form 10-K filed with theSecurities and Exchange Commission (“SEC”) on March 23, 2007 and our QuarterlyReports on Form 10-Q for the quarterly periods ended March 31, 2007 andJune 30, 2007 filed with the SEC on May 11, 2007 and August 13, 2007,respectively.

 

Certain reclassifications have been made to the priorperiod consolidated financial statements to conform to current periodpresentation.  These reclassificationshad no impact on previously reported total assets, stockholders’ equity or netincome (loss).

 

**Note 2. Discontinued Operations**

*** ***

Our condensedconsolidated financial statements have been presented to reflect theopto-electronics business as a discontinued operation for all periodspresented. Operating results of the discontinued operation are as follows (inthousands):

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                              |       | $                                                    | —     |                                                | $          | — |   | $ | — |   | $ | — |   |
| Cost of revenue                      |       | —                                               |       | —                                              |       | — |   | — |   |
| Gross profit                         |       | —                                               |       | —                                              |       | — |   | — |   |
| Operating  expenses:                 |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general  and administrative |       | —                                               |       | (4                                                  | )          | — |   | (7 | ) |
| Total operating  expenses            |       | —                                               |       | (4                                                  | )          | — |   | (7 | ) |
| Gain from  operations, net of tax    |       | —                                               |       | 4                                                   |       | — |   | 7 |   |
| Net income                           |       | $                                                    | —     |                                                | $          | 4 |   | $ | — |   | $ | 7 |   |

 

In the first quarter of 2007, we dissolved thecorporation that previously operated our discontinued operations andtransferred the cash balance to our continuing operations. Accordingly, we nolonger have discontinued operations. In the three and nine months endedSeptember 30, 2006, the $4,000 and $7,000, respectively, in income was interestearned on cash balances held in discontinued operations.

 

6

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The carrying value of the assets and liabilities ofthe discontinued opto-electronics business included in the condensedconsolidated balance sheets was as follows (in thousands):

 
| ** **                        | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Current assets:                   |       |                         |       |                        |       |
| Cash                              |       | $                            | —     |                        | $          | 395 |   |
| Total current  assets             |       | —                       |       | 395                         |       |
| Total assets                      |       | $                            | —     |                        | $          | 395 |   |
|                              |       |                         |       |                        |       |
| Net assets                        |       | —                       |       | 395                         |       |
| Total  liabilities and net assets |       | $                            | —     |                        | $          | 395 |   |

 

**Note****3****. Accounting for Stock-Based Compensation**

 

Effective January 1, 2006, we adopted theprovisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123 (revised 2004), “*Share-Based Payment*,” (“SFAS 123(R)”). SFAS123(R) establishes accounting for stock-based awards exchanged foremployee services. Accordingly, stock-based compensation cost is measured atgrant date, based on the fair value of the award, and is recognized as expenseover the employee requisite service period. All of our stock compensation isaccounted for as an equity instrument. We previously applied AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations and provided the required pro formadisclosures of SFAS No. 123, “*Accounting for Stock-BasedCompensation*”.

 

We elected the modified prospective transition method for adopting SFAS123(R). Under this method, the provisions of SFAS 123(R) apply to all awardsgranted or modified after the date of adoption. The unrecognized expense ofawards not yet vested at the date of adoption will be recognized in net income(loss) in the periods after the date of adoption using the same Black-Scholesvaluation method and assumptions determined under the original provisions ofSFAS No. 123, “ *Accounting for Stock-BasedCompensation,”*as disclosed in our previous quarterly and annualreports.

 

***Impact of the Adoption of SFAS123(R)***

 

Under the modified prospective application transitionmethod as provided by SFAS 123(R), we recorded $130,000and $206,000 of stock compensation expense in our unaudited condensedconsolidated statements of operations for the three months endedSeptember 30, 2007, and 2006, respectively, and $341,000 and $649,000 ofstock compensation expense in our unaudited condensed consolidated statementsof operations for the nine months ended September 30, 2007, and 2006,respectively. We elected not to capitalize anystock-based compensation to inventory as of January 1, 2006 when theprovisions of SFAS 123(R) were initially adopted. Weutilized the Black-Scholes valuation model for estimating the fair value of thestock compensation granted both before and after the adoption of SFAS 123(R). The following table summarizes thecompensation expense related to our stock-based compensation plan (inthousands, except per share data):

 

| ** **                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stock-based  compensation in the form of employee stock options, included in: |       |                                                 |       |                                                |       |   |   |   |   |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of revenue                                                                    |       | $                                                    | 12         |                                                | $          | 20 |   | $ | 38 |   | $ | 80 |   |
| Selling, general  and administrative                                               |       | 96                                                   |       | 148                                                 |       | 245 |   | 412 |   |
| Research and  development                                                          |       | 22                                                   |       | 38                                                  |       | 58 |   | 156 |   |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Total  stock-based compensation                                                    |       | 130                                                  |       | 206                                                 |       | 341 |   | 649 |   |
| Tax effect on  stock-based compensation                                            |       | —                                               |       | —                                              |       | — |   | — |   |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Net effect on  net income (loss)                                                   |       | $                                                    | 130        |                                                | $          | 206 |   | $ | 341 |   | $ | 649 |   |
|                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Effect on basic  net income (loss) per share                                       |       | $                                                    | 0.00       |                                                | $          | (0.01 | ) | $ | 0.01 |   | $ | (0.03 | ) |
| Effect on  diluted net income (loss) per share                                     |       | $                                                    | 0.00       |                                                | $          | (0.01 | ) | $ | 0.01 |   | $ | (0.03 | ) |
|                                                                                    |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

7

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***Stock options***

 

As of September 30, 2007, the total compensation costs related to unvestedstock-based awards granted to employees under our stock option plan but not yetrecognized was approximately $811,000, net of estimated forfeitures of $60,000,and will be adjusted for subsequent changes in estimated forfeitures. This costwill be amortized on a straight-line basis over a weighted-average period ofapproximately 2.1 years. We elected not to capitalize any stock-based compensation to inventory asof September 30, 2007 and 2006, due to the immateriality of the amount.

 

The amortization of stock compensation under SFAS 123(R) for the periodafter our January 1, 2006 adoption is based on the single-option approach.

 

We estimate the fair value of stock options using aBlack-Scholes valuation model, consistent with the provisions of SFAS 123(R),Securities and Exchange Commission Staff Accounting Bulletin No. 107 and ourprior period pro forma disclosures of net income (loss), including stock-basedcompensation (determined under a fair value method as prescribed by SFASNo. 123). The fair value of our stock options granted to employees for the three and nine monthsended September 30, 2007, and 2006, was estimated using the followingweighted-average assumptions:

 

| ** **                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected term (in years)    |       | 4.0                                                  |       | 5.0                                                 |       | 4.0 |   | 5.0 |   |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Volatility                  |       | 64.08                                                | %          | 82.26                                               | %          | 64.08 | % | 84.86 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Expected dividend           |       | 0.00                                                 | %          | 0.00                                                | %          | 0.00 | % | 0.00 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Risk-free interest rate     |       | 4.62                                                 | %          | 4.59                                                | %          | 4.62 | % | 4.80 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Estimated forfeitures       |       | 5.99                                                 | %          | 1.49                                                | %          | 5.99 | % | 12.33 | % |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average fair value |       | $                                                    | 4.92       |                                                | $          | 2.17 |   | $ | 4.92 |   | $ | 1.82 |   |
|                             |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

The following tablesummarizes the stock option transactions during the nine months ended September30, 2007 (in thousands, except per share data):

 
| ** **                                                         | ** ** | **Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Weighted-  average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** **                              | ** ** | **(in years****)**                              | ** ** | ** **                      | ** ** |
| Options  outstanding as of December 31, 2006                       |       | 2,728      |       | $                                       | 2.51       |                                                 |       |                            |       |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Granted                                                            |       | 31         |       | 4.92                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercised                                                          |       | (391       | )          | 1.98                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Canceled                                                           |       | (127       | )          | 4.59                                    |       |                                                 |       |                            |       |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options  outstanding as of September 30, 2007                 |       | 2,241      |       | $                                       | 2.52       |                                                 | 6.64       |                            | $          | 9,092 |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options vested  and expected to vest as of September 30, 2007 |       | 2,177      |       | $                                       | 2.53       |                                                 | 6.60       |                            | $          | 8,838 |   |
|                                                               |       |       |       |                                    |       |                                                 |       |                            |       |
| Options  exercisable as of September 30, 2007                 |       | 1,594      |       | $                                       | 2.58       |                                                 | 6.05       |                            | $          | 6,622 |   |

 

8

----

 

The optionsoutstanding and exercisable as of September 30, 2007 were in the followingexercise price ranges:

 
| **Options Outstanding as of September 30, 2007** | ** ** | **Options Exercisable  as of September 30, 2007** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| **Range of Exercise Price**                                     | ** ** | **Shares**                                                                 | ** ** | **Weighted-average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contractual Life** | ** ** | **Shares** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $1.17 - $ 1.38                                                            |       | 1,287,010                                                                  |       | $ | 1.28 |   | 6.97 |   | 875,972 |   | $ | 1.29 |   |
| $1.39 - $ 1.44                                                            |       | 11,500                                                                     |       | $ | 1.41 |   | 7.64 |   | 6,605 |   | $ | 1.41 |   |
| $1.45 - $ 2.24                                                            |       | 473,530                                                                    |       | $ | 2.17 |   | 5.66 |   | 440,176 |   | $ | 2.18 |   |
| $2.25 - $ 5.00                                                            |       | 371,468                                                                    |       | $ | 4.00 |   | 7.81 |   | 174,031 |   | $ | 3.16 |   |
| $5.01 - $41.50                                                                 |       | 97,500                                                                     |       | $ | 15.03 |   | 2.46 |   | 97,500 |   | $ | 15.03 |   |
|                                                                           |       | 2,241,008                                                                  |       | $ | 2.52 |   | 6.64 |   | 1,594,284 |   | $ | 2.58 |   |
|                                                                                |            |                                                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The total intrinsic valueof options exercised for the three and nine months ended September 30,2007 was $929,000 and $1,089,000, respectively. Cash received from optionexercises for the three and nine months ended September 30, 2007 was$548,000 and $776,000, respectively. The total intrinsic value of optionsexercised for the three and nine months ended September 30, 2006 was $203,000and $395,000, respectively. Cash received from option exercises for the threeand nine months ended September 30, 2006 was $229,000 and $527,000,respectively.

 

***Restricted stock awards***

 

A summary of activity related to restricted stock awards for the threemonths ended September 30, 2007 is presented below:

 
| ** **                                                                  | ** ** | **Shares** | ** ** | **Weighted-Average  Grant Date Fair Value** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
| Non-vested  restricted stock shares outstanding at beginning of the quarter |       | 10,608     |       | $                                                          | 3.77       |   |
| Restricted stock  shares granted                                            |       | 12,872     |       | $                                                          | 4.66       |   |
| Restricted stock  shares vested                                             |       | —     |       | $                                                          | —     |   |
| Non-vested  restricted stock shares outstanding as of September 30, 2007    |       | 23,480     |       | $                                                          | 4.26       |   |

 

A summary of activity related to restricted stock awards for the ninemonths ended September 30, 2007 is presented below:

 
| ** **                                                               | ** ** | **Shares** | ** ** | **Weighted-Average  Grant Date Fair Value** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
| Non-vested  restricted stock shares outstanding at beginning of the year |       | —     |       | $                                                          | —     |   |
| Restricted stock  shares granted                                         |       | 23,480     |       | $                                                          | 4.26       |   |
| Restricted stock  shares vested                                          |       | —     |       | $                                                          | —     |   |
| Non-vested  restricted stock shares outstanding as of September 30, 2007 |       | 23,480     |       | $                                                          | 4.26       |   |

 

As of September 30, 2007,we had $92,000 of unrecognized compensation expense, net of forfeitures,related to restricted stock awards, which will be recognized over the weightedaverage period of 2.76 years. During the three and nine months endedSeptember 30, 2007, no shares of restricted stock were vested.

 

9

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**Note 4. Cash, Cash Equivalents and Investments**

*** ***

Our cash, cashequivalents and investments are classified as follows (in thousands):

 
| ** **                                    | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | ** **                       | ** ** | **Gross**                       | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Amortized**                    | ** ** | **Unrealized**                  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                    | ** ** | **Cost**                         | ** ** | **Gain**                        | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gain** | ** ** | **(Loss)** | ** ** | **Value** | ** ** |
| **Classified  as:**                           | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash                                          |       | $                                | 6,800      |                            | $          | — |   | $ | — |   | $ | 6,800 |   | $ | 6,892 |   | $ | — |   | $ | — |   | $ | 6,892 |   |
| Cash  equivalents:                            |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market  fund                            |       | 8,075                            |       | —                          |       | — |   | 8,075 |   | 7,045 |   | — |   | — |   | 7,045 |   |
| U.S. Treasury  and agency securities          |       | 2,192                            |       | —                          |       | — |   | 2,192 |   | 2,179 |   | — |   | — |   | 2,179 |   |
|                                          |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cash  equivalents                       |       | 10,267                           |       | —                          |       | — |   | 10,267 |   | 9,224 |   | — |   | — |   | 9,224 |   |
| Total cash and  cash equivalents              |       | 17,067                           |       | —                          |       | — |   | 17,067 |   | 16,116 |   | — |   | — |   | 16,116 |   |
|                                          |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                  |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  and agency securities          |       | 1,400                            |       | —                          |       | — |   | 1,400 |   | 12,277 |   | — |   | (39 | ) | 12,238 |   |
| Asset-backed  securities                      |       | 3,985                            |       | —                          |       | (10 | ) | 3,975 |   | 809 |   | — |   | (1 | ) | 808 |   |
| Commercial paper                              |       | 3,300                            |       | —                          |       | (115 | ) | 3,185 |   | 500 |   | — |   | — |   | 500 |   |
| Corporate bonds                               |       | 15,650                           |       | 665                             |       | (1 | ) | 16,314 |   | 13,035 |   | — |   | (3 | ) | 13,032 |   |
| Total  investments                            |       | 24,335                           |       | 665                             |       | (126 | ) | 24,874 |   | 26,621 |   | — |   | (43 | ) | 26,578 |   |
| Total cash, cash  equivalents and investments |       | $                                | 41,402     |                            | $          | 665 |   | $ | (126 | ) | $ | 41,941 |   | $ | 42,737 |   | $ | — |   | $ | (43 | ) | $ | 42,694 |   |
| **Contractual  maturities  on investments:**  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Mature within 1  year                         |       | $                                | 2,048      |                            |       |   |   |   | $ | 2,048 |   | $ | 13,767 |   |   |   |   |   | $ | 13,727 |   |
| Mature after 1  through 5 years               |       | 18,302                           |       |                            |       |   |   | 18,851 |   | 12,854 |   |   |   |   |   | 12,851 |   |
| Mature after 5  years                         |       | 3,985                            |       |                            |       |   |   | 3,975 |   | — |   |   |   |   |   | — |   |
|                                          |       | $                                | 24,335     |                            |       |   |   |   | $ | 24,874 |   | $ | 26,621 |   |   |   |   |   | $ | 26,578 |   |
|                                               |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The investmentsinclude $6.7 million and $7.2 million recorded as restricted deposits on thecondensed consolidated balance sheets as of September 30, 2007 and December 31,2006, respectively, as a result of the outstanding principal amount on ourindustrial revenue bonds.

 

We manage ourinvestments as a single portfolio of highly marketable securities that isintended to be available to meet our current cash requirements. For the threeand nine months ended September 30, 2007, we had $54,000 and $83,000 ingross realized losses on sales of our available-for-sale securities. For thethree and nine months ended September 30, 2006, we had $0.7 million and $2.0million, respectively, in gross realized gains on sales of ouravailable-for-sale securities.

 

The grossunrealized losses related to our portfolio of available-for-sale securitieswere primarily due to a decrease in the fair value of debt securities as aresult of an increase in interest rates during 2006 and the first nine monthsof 2007. We have determined that the gross unrealized losses on ouravailable-for-sale securities as of September 30, 2007 are temporary in nature.We reviewed our investment portfolio to identify and evaluate investments thathave indications of possible impairment. Factors considered in determiningwhether a loss is temporary include the magnitude of the decline in marketvalue, the length of time the market value has been below cost (or adjustedcost), credit quality, and our ability and intent to hold the securities for aperiod of time sufficient to allow for any anticipated recovery in marketvalue.

 

10

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The following table provides a breakdown of our available-for-salesecurities with unrealized losses as of September 30, 2007 (in thousands):

 

| ** **                           | ** ** | **In Loss Position** | ** ** | **In Loss Position** | ** ** | **Total In**      | ** ** |
|--------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **< 12 months**   | ** ** | **> 12 months**   | ** ** | **Loss Position** | ** ** |
| ** **                           | ** ** | ** **                     | ** ** | **Gross**                      | ** ** | ** **             | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                           | ** ** | **Fair**                       | ** ** | **Unrealized**                 | ** ** | **Fair**               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                           | ** ** | **Value**                      | ** ** | **(Loss)**                     | ** ** | **Value**              | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **(Loss)** | ** ** |
| Investments:                         |       |                           |       |                           |       |                   |       |   |   |   |   |   |   |
| U.S. Treasury  and agency securities |       | $                              | —     |                           | $          | —                 |       | $ | 3,975 |   | $ | (10 | ) | $ | 3,975 |   | $ | (10 | ) |
| Asset-backed  securities             |       | —                         |       | —                         |       | 3,185                  |       | (115 | ) | 3,185 |   | (115 | ) |
| Corporate bonds                      |       | 298                            |       | (1                             | )          | —                 |       | — |   | 298 |   | (1 | ) |
| Total in loss  position              |       | $                              | 298        |                           | $          | (1                     | )          | $ | 7,160 |   | $ | (125 | ) | $ | 7,458 |   | $ | (126 | ) |

 

**Note 5. Inventories, Net**

 

Inventories are stated at the lower of cost ormarket.  The components of inventoriesare summarized below (in thousands):

 

| ** **         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------|------------|------------------------|------------|-----------------------|------------|
| ** **         | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Inventories,  net: |       |                   |       |                  |       |
| Raw materials      |       | $                      | 11,426     |                  | $          | 8,419 |   |
| Work in process    |       | 11,614                 |       | 11,222                |       |
| Finished goods     |       | 2,084                  |       | 622                   |       |
|               |       | $                      | 25,124     |                  | $          | 20,263 |   |

 

***Note 6.***Recoveryof Impairment on Assets Held for Sale

*** ***

Duringthe three months ended June 30, 2007, we benefited from a recovery ofimpairment on assets held for sale in connection with our adjustment of thefair value of our U.S. property located in Fremont, California, which has beendecontaminated and is being prepared for sale. Accordingly, we recorded a $481,000 market value adjustment after weentered into an agreement with an independent third party purchaser to purchasethe property for estimated net proceeds of $5.1 million, after deductingestimated commission and selling expenses. Subsequent to the three and nine months ended  September 30, 2007, we received a notice fromthis third party purchaser terminating the agreement to purchase theproperty.  On October 22, 2007, weentered into a new agreement with a different independent third party purchaserto purchase the property for $5.65 million, subject to certain contingencies.  See Note 14 below.  This property has been classified as “assetsheld for sale” in the amount of $5.1 million on the condensed consolidatedbalance sheet as of September 30, 2007.

 

**Note 7.Net Income (Loss) Per Share**

 

Basic net income (loss) per common share is calculated bydividing net income (loss) available to common stockholders by the weightedaverage number of common shares outstanding during the period. Diluted netincome (loss) per common and common equivalent shares include the dilutiveeffect of common stock equivalents outstanding during the period calculatedusing the treasury stock method. Common stock equivalents consist of the sharesissueable upon the exercise of stock options.

 

11

----

 

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

 

| ** **                                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                          | ** ** | **September 30,**           | ** ** | **September 30,**     | ** ** |
| ** **                                                                          | ** ** | **2007**                         | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator:                                                                          |       |                             |       |                       |       |   |   |   |   |
| Net income  (loss)                                                                  |       | $                                | 858        |                       | $          | 639 |   | $ | 3,415 |   | $ | (2,440 | ) |
| Less: Preferred  stock dividends                                                    |       | (44                              | )          | (44                        | )          | (132 | ) | (132 | ) |
|                                                                                |       |                             |       |                       |       |   |   |   |   |
| Net income  (loss) available to common stockholders                                 |       | $                                | 814        |                       | $          | 595 |   | $ | 3,283 |   | $ | (2,572 | ) |
| Denominator:                                                                        |       |                             |       |                       |       |   |   |   |   |
| Denominator for  basic net income (loss) per share - weighted average common shares |       | 30,150                           |       | 23,158                     |       | 29,940 |   | 23,066 |   |
| Effect of  dilutive securities:                                                     |       |                             |       |                       |       |   |   |   |   |
| Common stock  options                                                               |       | 1,314                            |       | 1,220                      |       | 1,347 |   | — |   |
| Denominator for  dilutive net income (loss) per common share                        |       | 31,464                           |       | 24,378                     |       | 31,287 |   | 23,066 |   |
| Basic net income  (loss) per share                                                  |       | $                                | 0.03       |                       | $          | 0.03 |   | $ | 0.11 |   | $ | (0.11 | ) |
| Diluted net  income (loss) per share                                                |       | $                                | 0.03       |                       | $          | 0.02 |   | $ | 0.10 |   | $ | (0.11 | ) |
| Options excluded  from diluted net loss per share as the impact is anti-dilutive    |       | 98                               |       | 120                        |       | 822 |   | 2,589 |   |
|                                                                                     |            |                                  |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Note 8. Comprehensive Income (Loss)**

 

The components of comprehensive income (loss) are asfollows (in thousands):

 

| ** **                                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                         | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                               |       |                             |       |                            |       |   |   |   |   |
| Net income  (loss)                                                                 |       | $                                | 858        |                            | $          | 639 |   | $ | 3,415 |   | $ | (2,440 | ) |
| Foreign currency  translation gain                                                 |       | 357                              |       | 196                             |       | 956 |   | 274 |   |
| Unrealized gain  on available-for-sale investments                                 |       | 110                              |       | 151                             |       | 582 |   | 1,997 |   |
| Less:  reclassification adjustment for realized gain included in net income (loss) |       | —                           |       | (650                            | )          | — |   | (2,032 | ) |
| Comprehensive  income (loss)                                                       |       | $                                | 1,325      |                            | $          | 336 |   | $ | 4,953 |   | $ | (2,201 | ) |

 

**Note 9. Segment Information andForeign Operations**

 

***Segment Information***

*** ***

We operate in one segment for the design, development,manufacture and distribution of high-performance compound semiconductorsubstrates and sale of materials. In accordance with SFAS No. 131, *“Disclosures About Segments of an Enterprise andRelated Information”* (“SFAS No. 131”), our chief operatingdecision-maker has been identified as the Chief Executive Officer, who reviewsoperating results to make decisions about allocating our resources andassessing our performance. All material operating units qualify for aggregationunder SFAS No. 131 due to their identical customer base andsimilarities in economic characteristics, nature of products and services, andprocurement, manufacturing and distribution processes. Since we operate in onesegment, all financial segment and product line information required by SFAS No. 131can be found in the condensed consolidated financial statements.

 

12

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***GeographicalInformation***

*** ***

The following table represents revenue amounts (inthousands) reported for products shipped during the respective periods tocustomers in the corresponding geographic region:

 

| ** **     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **     | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net revenues:  |       |                             |       |                            |       |   |   |   |   |
| North America* |       | $                                | 2,820      |                            | $          | 3,033 |   | $ | 8,918 |   | $ | 7,704 |   |
| Europe         |       | 2,521                            |       | 2,012                           |       | 7,163 |   | 5,684 |   |
| Japan          |       | 3,301                            |       | 842                             |       | 8,699 |   | 2,638 |   |
| Taiwan         |       | 2,444                            |       | 2,869                           |       | 6,512 |   | 5,782 |   |
| Asia Pacific   |       | 3,388                            |       | 3,791                           |       | 9,347 |   | 9,565 |   |
| Consolidated   |       | $                                | 14,474     |                            | $          | 12,547 |   | $ | 40,639 |   | $ | 31,373 |   |

 

----

*   Primarilythe United States

 

Long-lived assets consist primarily of property, plantand equipment, and are attributed to the geographic location in which they arelocated. Long-lived assets by geographic region were as follows (in thousands):

 

| ** **          | ** ** | **As of**         | ** ** |
|---------------------|------------|------------------------|------------|
| ** **          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **2007**               | ** ** | **2006** | ** ** |
| Long-lived  assets: |       |                   |       |   |   |
| North America       |       | $                      | 139        |   | $ | 426 |   |
| China               |       | 14,933                 |       | 12,349 |   |
|                |       | $                      | 15,072     |   | $ | 12,775 |   |
|                     |            |                        |            |  |  |  |  |  |

 

***SignificantCustomers***

*** ***

No customer representedmore than 10% of revenue for the three months ended September 30, 2007. Onecustomer represented 18.4% of revenue for the three months ended September 30,2006. No customer represented more than 10% of revenue for the nine monthsended September 30, 2007. One customer represented 15.0% of revenue for thenine months ended September 30, 2006. Our top five customers represented 30.9%and 44.1% of revenue for the three months ended September 30, 2007, and2006, respectively. Our top five customers represented 31.8% and 40.3% ofrevenue for the nine months ended September 30, 2007, and 2006,respectively.

 

**Note 10. Investments inPrivately-held Companies**

 

We have made strategic investments in privatecompanies located in China in order to gain access at a competitive cost to rawmaterials that are critical to our substrate business. Our investments in theseprivately-held companies are summarized below (in thousands):

 
| ** **                                     | ** ** | **Investment Balance as of** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| **Company**                                    | ** ** | **September 30,  2007**                | ** ** | **December 31,  2006** | ** ** | **Accounting  Method** | ** ** | **Ownership  Percentage** | ** ** |
| Beijing Ji Ya  Semiconductor Material Co., Ltd |       | $                                           | 996        |                        | $          | 996                    |       | Consolidated |   | 46 | % |
| Nanjing Jin Mei  Gallium Co., Ltd              |       | 592                                         |       | 592                         |       | Consolidated           |       | 83 |   |
| Beijing BoYu  Manufacturing Co., Ltd           |       | 410                                         |       | 410                         |       | Consolidated           |       | 70 |   |
| Xilingol Tongli  Ge Co. Ltd                    |       | 1,998                                       |       | 1,304                       |       | Equity                 |       | 25 |   |
| Emeishan Jia Mei  High Pure Metals Co., Ltd    |       | 721                                         |       | 670                         |       | Equity                 |       | 25 |   |
|                                                |            |                                             |            |                             |            |                        |            |  |  |  |  |

 

The investment balances for the two companiesaccounted for under the equity method are included in “other assets” in thecondensed consolidated balance sheets. We own 25% of the ownership interests ineach of these companies. These two companies are not considered variableinterest entities because:

 

•                       both companies have sustainablebusinesses of their own;

 

•                       our voting power isproportionate to our ownership interests;

 

13

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•                       we only recognize our respectiveshare of the losses and/or residual returns generated by the companies if theyoccur; and

 

•                       we do not have a controllingfinancial interest in, do not maintain operational or management control of, donot control the board of directors of, and are not required to provideadditional investment or financial support to, either company.

 

Undistributed retained earnings relating to ourinvestments were $6.7 million and $4.4 million as of September 30, 2007and December 31, 2006, respectively. Net income recorded from our investmentswas $729,000 and $609,000 for the three months ended September 30, 2007and 2006, respectively. Net income recorded from our investments was $2.3million and $1.3 million for the nine months ended September 30, 2007 and2006, respectively.

 

The minority interest for those investments that areconsolidated is included in “Other long-term liabilities” in the condensedconsolidated balance sheets and in “Other income (expense), net” on thecondensed consolidated statements of operations.

 

**Note 11. Commitments andContingencies**

 

***IndemnificationAgreements***

 

Included in our standard terms and conditions of salethat we enter into in the ordinary course of business with our customers arestandard indemnification arrangements. Pursuant to these arrangements, weindemnify, hold harmless, and agree to reimburse the indemnified parties forlosses suffered or incurred by the indemnified party in connection with anyclaim by a third party that our products violate or infringe any U.S. patent,or any copyright or other intellectual property right. The term of theseindemnification provisions is generally perpetual from the date of theexecution of the agreement. The maximum potential amount of future payments wecould be required to make under these agreements is unlimited. We have neverincurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value ofthese agreements is minimal.

 

We have entered into indemnification agreements withour directors, officers and key employees that may require us to indemnify ourdirectors, officers and key employees against liabilities that may arise byreason of their status or service as directors or officers or key employees,other than liabilities arising from willful misconduct of a culpable nature; toadvance their expenses incurred as a result of any proceeding against them asto which they could be indemnified; and to obtain directors’ and officers’insurance if available on reasonable terms, which we currently have in place.

 

***Product Warranty***

*** ***

We warrant our productsfor a specific period of time, generally twelve months, against materialdefects. We provide for the estimated future costs of warranty obligations incost of sales when the related revenue is recognized. The accrued warrantycosts represent the best estimate at the time of sale of the total costs thatwe expect to incur to repair or replace product parts that fail while stillunder warranty. The amount of accrued estimated warranty costs are primarilybased on historical experience as to product failures as well as currentinformation on repair costs. On a quarterly basis, we review the accruedbalances and update these based on the historical warranty cost trends. Thefollowing table reflects the change in our warranty accrual, which is includedin “accrued liabilities” on the condensed consolidated balance sheets, duringthe three months and nine months ended September 30, 2007 and 2006 (inthousands):

 
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                        | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                          |       |                                            |       |                                                |       |   |   |   |   |
| Beginning  accrued warranty and related costs |       | $                                               | 949        |                                                | $          | 204 |   | $ | 459 |   | $ | 120 |   |
| Charged  (credited) to cost of revenue        |       | (116                                            | )          | 553                                                 |       | 580 |   | 699 |   |
| Actual warranty  expenditures                 |       | (14                                             | )          | (186                                                | )          | (220 | ) | (248 | ) |
| Ending accrued  warranty and related costs    |       | $                                               | 819        |                                                | $          | 571 |   | $ | 819 |   | $ | 571 |   |

 

14

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***PurchaseCommitment***

 

On February 27, 2007, we entered into anagreement with Recapture Metals Limited of Ontario, Canada (“Recapture”),pursuant to which Recapture will supply our subsidiary in the People’s Repiblicof China with one thousand kilograms per month of 99.99999% pure gallium,during the eighteen month period beginning July 1, 2007. Under the termsof the agreement, we are required to purchase a minimum of eighteen thousandkilograms of gallium, unless the agreement is terminated prior to theexpiration of the eighteen month period on December 31, 2008. As ofSeptember 30, 2007, our total remaining commitment under this agreement isapproximately $6.1 million.

 

**Note 12. Foreign Exchange TransactionGains/Losses**

 

We incurred foreign currency transaction exchangegains of $162,000 and losses of $59,000 for the three months ended September30, 2007, and 2006, respectively. We incurred foreign currency transactionexchange losses of $128,000 and $48,000 for the nine months ended September 30,2007, and 2006, respectively. These amounts are included in other income(expense), net on the condensed consolidated statements of operations.

 

**Note 13.Income Taxes**

 

In July 2006, the Financial Accounting Standards Board(“FASB”) issued Interpretation No. (“FIN”) 48, “**Accounting for Uncertainty in Income Taxes”**.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with SFAS 109. Thisinterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onderecognition of tax benefits, classification on the balance sheet, interestand penalties, accounting in interim periods, disclosure, and transition. Weadopted FIN 48 effective January 1, 2007. We recognize interest andpenalties related to uncertain tax positions in income tax expense. As ofSeptember 30, 2007, we do not have any gross unrecognized tax benefits, nor anyaccrued interest and penalties related to uncertain tax positions. As a resultof the implementation of FIN 48, we identified $16.4 million inunrecognized tax benefits. This amount decreased the tax loss carryforwards inthe U.S. which are fully offset by a valuation allowance. We file income taxreturns in the U.S. federal, various states and foreign jurisdictions. We havesubstantially concluded all U.S. federal and state income tax matters throughDecember 31, 2006.

 

**Note 14.Subsequent Events**

 

On October 4, 2007, we received a notice from Mr. andMrs. Allen and Janette Blazick (collectively, the “Original Buyers”)terminating the Purchase and Sale Agreement (the “Old Agreement”) dated June15, 2007, under section 2.2.1 of the Old Agreement.  Pursuant to the Old Agreement, AXT had agreedto sell its property and building at 4311 Solar Way in Fremont, California tothe Original Buyers, in return of a cash payment of $5.35 million, subject tocertain contingencies.

 

On October 19, 2007, our board of directors appointedour chief executive officer, Dr. Philip C.S. Yin, as chairman of the board,succeeding Jesse Chen.  Mr. Chen has beennamed as lead independent director of the company.  Both appointments are effective October 19,2007.

 

On October 22, 2007, we entered into a Purchase andSale Agreement (the “New Agreement”) with SBC&D Co., Inc., a Californiacorporation, dba South Bay Development (the “Buyer”) under which it agreed tosell its property and building at 4311 Solar Way in Fremont, California inreturn for a cash payment of $5.65 million, subject to certaincontingencies.  In connection with theexecution of the New Agreement, the Buyer deposited $250,000 with an escrowagrent, which shall be fully refundable to Buyer prior to the expiration of the30-day Due Diligence Period, then, after the expiration of the Due DiligencePeriod, the deposit shall be deemed non-refundable to Buyer for any reasonother than as a result of a breach or default by Seller or the occurrence ofcertain casualty or condemnation events prior to the close of escrow.  The closing of the sale of the property is tooccur within fifteen days of the lapse of the Due Diligence Period.

 

15

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

 

This quarterlyreport on Form 10-Q, including the following sections, contains forward-lookingstatements within the meaning of Section 21E of the Securities ExchangeAct of 1934, particularly statementsrelating to our expectations regarding results of operations, customer demand,improvements in our product quality, our ability to expand our markets andincrease sales, customer qualifications of our products, gross margins,favorable pricing, reliable supply and enhanced sourcing lead-times of rawmaterials, and our reserve balances.  These forward-looking statements are basedupon management’s current views with respect to future events and financialperformance, and are subject to certain risks and uncertainties that couldcause actual results to differ materially from historical results or thoseanticipated in such forward-looking statements. Such risks and uncertaintiesinclude those set forth under Item 1A “Risk Factors” below,  which identifyimportant factors that could cause actual results to differ materially fromthose predicted in any such forward-looking statements. We caution investorsthat actual results may differ materially from those projected in theforward-looking statements as a result of certain risk factors identified inthis Form 10-Q and other filings we have made with the Securities and ExchangeCommission. Forward-looking statements may be identified by the use ofterms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” andsimilar expressions. Statements concerning our future or expected financialresults and condition, business strategy and plans or objectives for futureoperations are forward-looking statements.

 

These forward-looking statements are not guarantees offuture performance. Readers are cautioned not to place undue reliance on theseforward-looking statements, which speak only as of the date hereof. Thisdiscussion should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations included in ourAnnual Report on Form 10-K for the year ended December 31, 2006 and thecondensed consolidated financial statements included elsewhere in this report.

 

**Overview**

 

We are a leading worldwide developer and producer ofhigh-performance compound and single element semiconductor substratescomprising gallium arsenide (GaAs), indium phosphide (InP) and germanium (Ge).We currently sell the following substrate products:

 

| **Product**            | ** ** | ** **                |
|------------------------|------------|---------------------------|
| **Substrates**         | ** ** | **Diameter**              | ** ** | **Applications** |
| GaAs (semi-insulating) |       | 2”, 4”, 6” |   | •  Power  amplifiers and integrated circuits for wireless handsets |
|                   |       |                      |   | •  Direct  broadcast television |
|                   |       |                      |   | •  High-performance  transistors |
|                   |       |                      |   | •  Satellite  communications |
| GaAs (semi-conducting) |       | 2”, 4”          |   | •  LEDs |
|                   |       |                      |   | •  Lasers |
|                   |       |                      |   | •  Optical  couplers |
| InP                    |       | 2”, 4”, 6” |   | •  Broadband  and Fiber optic communications |
| Ge                     |       | 2”, 4”          |   | •  Satellite  solar cells |

 

We manufacture compound semiconductor substrates usingour proprietary vertical gradient freeze, or VGF, technology.  Our in-house VGF technology enables us to addcapacity quickly and cost efficiently. We manufacture all of our products in China, which generally has lowercosts for facilities, labor and materials.

 

We also have three majority-owned and twominority-owned joint ventures in China which provide us favorable pricing, reliable supply and enhanced sourcinglead-times for key raw materials which are central to our finalmanufactured products.  Thesejoint ventures produce products including 99.99% pure gallium (4N Ga), highpurity gallium, arsenic, germanium, germanium dioxide, paralytic boron nitride(pBN) crucibles and boron oxide. AXT’s ownership interest in these entitiesranges from 25% to 83%. We consolidate the three ventures in which we own amajority or controlling financial interest and employ equity accounting for thetwo joint ventures in which we have a 25% interest. We purchase portions of thematerials produced by these ventures for our own use and the joint venturessell the remainder of their production to third parties.

 

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Revenue increased $9.3 million, or 29.5%, to $40.6million for the nine months ended September 30, 2007 from $31.4 million for thesame period of 2006 primarily from an increase in raw material sales and highercustomer demands for smaller diameter wafers, offset by inventory adjustmentsof select handset manufacturers and foundaries. As of September 30, 2007, wehad available cash, cash equivalents and short-term investments of $35.2million, excluding restricted deposits.

 

***Recovery ofImpairment on Assets Held for Sale***

*** ***

Duringthe three months ended June 30, 2007, we benefited from a recovery ofimpairment on assets held for sale in connection with our adjustment of thefair value of our U.S. property located in Fremont, California, which has beendecontaminated and is being prepared for sale, to market value. Accordingly, werecorded a $481,000 market value adjustment after we entered into an agreementwith an independent third party purchaser to purchase the property forestimated net proceeds of $5.1 million, after deducting estimated commissionand selling expenses. Subsequent to the three and nine months ended  September 30, 2007, we received a notice fromthis third party purchaser terminating the agreement to purchase theproperty.  On October 22, 2007, weentered into a new agreement with a different independent third party purchaserto purchase the property for $5.65 million, subject to certain contingencies.See Note 14 to our condensed consolidated financial statements.  This property has been classified as “assetsheld for sale” in the amount of $5.1 million on the condensed consolidatedbalance sheet as of September 30, 2007.

 

**CriticalAccounting Policies and Estimates**

 

We have prepared our condensed consolidated financialstatements in accordance with accounting principles generally accepted in theUnited States of America. As such, we have had to make estimates, assumptionsand judgments that affect the amounts reported on our financial statements.These estimates, assumptions and judgments about future events and theireffects on our results cannot be determined with certainty, and are made basedupon our historical experience and on other assumptions that are believed to bereasonable under the circumstances. These estimates may change as newevents occur or additional information is obtained, and wemay periodically be faced with uncertainties, the outcomes of which are notwithin our control and may not be known for a prolonged period of time.The discussion and analysis of our results of operations and financialcondition are based upon these condensed consolidated financial statements.

 

A critical accounting policy is one that is bothmaterial to the presentation of our financial statements and requires us tomake difficult, subjective or complex judgments that could have a materialeffect on our financial condition and results of operations. Theymay require us to make assumptions about matters that are highly uncertainat 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 amaterial impact on our financial condition or results of operations. We haveidentified the policies below as critical to our business operations andunderstanding of our financial condition and results of operations.

 

***Revenue Recognition***

 

We manufacture and sell high-performance compound andsingle element semiconductor substrates and sell certain raw materialsincluding gallium, germanium dioxide and pBN crucibles. After we ship ourproducts, there are no remaining obligations or customer acceptancerequirements that would preclude recognition of the revenue earned on the sale.Our products are typically sold pursuant to a purchase order placed by ourcustomers, and our terms and conditions of sale do not require customeracceptance. We recognize revenue upon shipment and transfer of title ofproducts to our customers, which is ordinarily upon shipment from our dock,receipt at the customer’s dock, or removal from consignment inventory at thecustomer’s location, provided that we have received a signed purchase order,the price is fixed or determinable, title and risk of ownership havetransferred, collection of resulting receivables is probable, and productreturns are reasonably estimable. We do not provide training, installation orcommissioning services.

 

We provide for future returns based on historicalexperience, current economic trends and changes in customer demand at the timerevenue is recognized.

 

In June 2006, the FASB ratified the consensusreached by the Emerging Issues Task Force (“EITF”) regarding EITF IssueNo. 06-03, “*How Taxes Collected fromCustomers and Remitted to Government Authorities Should be Presented in theIncome Statement (That Is, Gross versus Net Presentation)”*. We havehistorically presented, and will continue to present sales tax, value addedtax, and other similar taxes on a net basis, excluding them from revenue.

 

17

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***Allowance for Doubtful Accounts***

 

We periodically review the likelihood of collection onour accounts receivable balances and provide an allowance for doubtful accountsreceivable primarily based upon the age of these accounts. We typically providea 100% allowance for receivables from U.S. customers in excess of 90 days andfor receivables from customers located outside the U.S. in excess of 120 days.We assess the probability of collection based on a number of factors, includingthe length of time a receivable balance has been outstanding, our past historywith the customer and their creditworthiness.

 

As of September 30, 2007 and December 31,2006, our accounts receivable, net, balance was $11.9 million and $9.7 million,respectively, which was net of an allowance for doubtful accounts of $0.6million and $0.1 million, respectively. The increase in gross accountsreceivable balance was primarily due to increased sales, while the increase inallowance for doubtful accounts was mainly for our slow-paying customers inAsia. If actual uncollectible accounts differ substantially from our estimates,revisions to the estimated allowance for doubtful accounts would be required,which could have a material impact on our financial results for the period.

 

***Warranty Reserve***

 

We maintain a warranty reserve based upon our claimsexperience during the prior twelve months. Warranty costs are accrued at thetime revenue is recognized. As of September 30, 2007 and December 31,2006, accrued product warranties totaled $819,000 and $459,000, respectively.The increase in accrued warranties is primarily attributable to increasedclaims on quality experienced by some customers as well as an increase inrevenues. If actual warranty costs differ substantially from our estimates,revisions to the estimated warranty liability would be required, which couldhave a material impact on our financial condition and results of operations.

 

***Inventory Valuation***

 

Inventories are stated at the lower of cost or market.Cost is determined using the weighted average cost method. Our inventoryconsists of raw materials as well as finished goods and work-in-process thatinclude material, labor and manufacturing overhead costs. Given the nature ofour substrate products, and the materials used in the manufacturing process,the wafers and ingots comprising work-in-process may be held in inventoryfor up to two years and three years, respectively, as the risk of obsolescencefor these materials is low. We routinely evaluate the levels of our inventoryin light of current market conditions in order to identify excess and obsoleteinventory, and we provide a valuation allowance for certain inventories basedupon the age and quality of the product and the projections for sale of thecompleted products. As of September 30, 2007 and December 31, 2006,we had an inventory reserve of $13.2 million and $15.4 million for excess andobsolete inventory, respectively. The majority of this inventory has not beenscrapped, and accordingly, may be sold in future periods. If actual demand forour products were to be substantially lower than estimated, additionalinventory adjustments for excess or obsolete inventory might be required, whichcould have a material impact on our business, financial condition and resultsof operations.

 

***Impairment of Investments***

 

We classify our investments in debt and equitysecurities as available-for-sale securities as prescribed by Statement ofFinancial Accounting Standards (“SFAS”) No. 115, *“Accounting for Certain Investments in Debt andEquity Securities”.*All available-for-sale securities with a quotedmarket value below cost (or adjusted cost) are reviewed in order to determinewhether the decline is other-than-temporary. Factors considered in determiningwhether a loss is temporary include the magnitude of the decline in marketvalue, the length of time the market value has been below cost (or adjustedcost), credit quality, and our ability and intent to hold the securities for aperiod of time sufficient to allow for any anticipated recovery in marketvalue.

 

We invest in equity instruments of privately-heldcompanies for business and strategic purposes. These investments are classifiedas other assets and, other than companies that we consolidate, are accountedfor under the cost method as we do not have the ability to exercise significantinfluence over their operations. We monitor our investments for impairment andwould record reductions in carrying value when events or changes incircumstances indicate that the carrying value may not be recoverable.Determination of impairment is highly subjective and is based on a number offactors, including an assessment of the strength of the investee’s management,the length of time and extent to which the fair value has been less than ourcost basis, the financial condition and near-term prospects of the investee,fundamental changes to the business prospects of the investee, share prices ofsubsequent offerings, and our intent and ability to hold the investment for aperiod of time sufficient to allow for any anticipated recovery in our carryingvalue.

 

18

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***Impairment of Long-Lived Assets***

 

We evaluate the recoverability of property, equipmentand intangible assets in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets.”* When events and circumstances indicate thatlong-lived assets may be impaired, we compare the carrying value of thelong-lived assets to the projection of future undiscounted cash flowsattributable to these assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against incomeequal to the excess of the carrying value over the assets’ fair value. Fairvalues are determined based on quoted market values, discounted cash flows orinternal and external appraisals, as applicable. Assets held for sale arecarried at the lower of carrying value or estimated net realizable value.

 

***Employee Stock Options***

 

We grant options to purchase our common stock tosubstantially all management employees and believe that this program helps usto attract, motivate and retain high quality employees, to the ultimate benefitof our stockholders. Effective January 1, 2006, we adopted the fair valuerecognition provisions of SFASNo. 123 (revised 2004), “*Share-BasedPayment*” (“SFAS123(R)”), using the modified prospective application transition method. Underthis transition method, stock-based compensation cost was recognized in thecondensed consolidated financial statements for all share-based payments afterJanuary 1, 2006. Compensation cost recognized includes the estimatedexpense for the portion of the vesting period after January 1, 2006 forshare-based payments granted prior to, but not vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, “*Accounting for Stock-BasedCompensation.”* Results for prior periods have not been restated, asprovided for under the modified prospective application transition method.

 

***Income Taxes***

 

We account for income taxes in accordance withSFAS No. 109, *“Accounting forIncome Taxes”*(“SFAS 109”)*,*which requires that deferred tax assets and liabilities be recognized usingenacted tax rates for the effect of temporary differences between the book andtax bases of recorded assets and liabilities. SFAS 109 also requires thatdeferred tax assets be reduced by a valuation allowance if it is more likelythan not that a portion of the deferred tax asset will not be realized.

 

We provide for income taxes based upon the geographiccomposition of worldwide earnings and tax regulations governing each country,including particularly the People’s Republic of China. The calculation of taxliabilities involves significant judgment in estimating the impact ofuncertainties in the application of complex tax laws, particularly in foreigncountries such as the People’s Republic of China.

 

In July 2006, the Financial Accounting Standards Board(“FASB”) issued FASB Interpretation No. 48, “**Accounting for Uncertainty in IncomeTaxes, an interpretation of FASB Statement No. 109” (“FIN 48”)**.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with SFAS 109. Thisinterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onderecognition of tax benefits, classification on the balance sheet, interestand penalties, accounting in interim periods, disclosure, and transition. Weadopted FIN 48 effective January 1, 2007. We recognize interest andpenalties related to uncertain tax positions in income tax expense. As ofSeptember 30, 2007, we do not have any gross unrecognized tax benefits, nor anyaccrued interest and penalties related to uncertain tax positions. As a resultof the implementation of FIN 48, we identified $16.4 million inunrecognized tax benefits. This amount decreased the tax loss carryforwards inthe U.S. which are fully offset by a valuation allowance. We file income taxreturns in the U.S. federal, various states and foreign jurisdictions. We havesubstantially concluded all U.S. federal and state income tax matters throughDecember 31, 2006.

 

As of the date of the filing of this quarterly report,there have been no material changes to our critical accounting policies andprocedures during the three months and nine months ended September 30, 2007compared to that disclosed in our Annual Report on Form 10K for the fiscalyear ended December 31, 2006 filed with the SEC on March 23, 2007 and ourQuarterly Reports on Form 10-Q for the quarterly periods ended March 31,2007 and June 30, 2007 filed with the SEC on May 11, 2007 and August 13,2007, respectively.

 

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**Results of Operations**

 

**Revenue**

** **

| ** **    | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **    | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                                | 9,909      |         | $          | 10,561         |       | $ | (652 | ) | (6.2 | )% |
| InP           |       | 408                              |       | 340          |       | 68             |       | 20.0 | % |
| Ge            |       | 536                              |       | 387          |       | 149            |       | 38.5 | % |
| Raw materials |       | 3,621                            |       | 1,251        |       | 2,370          |       | 189.4 | % |
| Other         |       | —                           |       | 8            |       | (8             | )          | NM |   |
| Total revenue |       | $                                | 14,474     |         | $          | 12,547         |       | $ | 1,927 |   | 15.4 | % |
|               |            |                                  |            |              |            |                |            |  |  |  |  |  |  |

----

NM = % not meaningful

 

Revenue increased $1.9 million, or 15.4%, to $14.5million for the three months ended September 30, 2007 from $12.5 millionfor the three months ended September 30, 2006. Total GaAs substraterevenue decreased $0.7 million, or 6.2%, to $9.9 million for the three monthsended September 30, 2007 from $10.6 million for the three months endedSeptember 30, 2006.

 

Sales of 5 inch and 6 inch diameter GaAs substrateswere $3.1 million for the three months ended September 30, 2007 comparedto $5.3 million for the three months ended September 30, 2006. Thedecrease was due mainly to held shipments by a major customer who was transitioningto a new device in the third quarter of 2007 and encountered an issue with oursubstrates due to a change in their specifications, and held orders by anothermajor customer that had an inventory adjustment causing 6 inch orders to belower than normal. We expect both customers to resume orders beginning thefourth quarter of 2007.

 

Sales of 2 inch, 3 inch and 4 inch diameter GaAssubstrates were $6.8 million for the three months ended September 30, 2007compared to $5.3 million for the three months ended September 30, 2006.The increase in revenue from smaller diameter substrates was due to thecontinued market growth of LED laser diodes and commercial epitaxy.

 

InP revenue increased $68,000, or 20.0%, to $408,000for the three months ended September 30, 2007 from $340,000 for the threemonths ended September 30, 2006. InP substrate revenue increased due tosome continued demand of specialized automotive applications, and overalloptical communications applications. However, we do not expect significant nearterm changes in the market for InP.

 

Ge substrate revenue increased $149,000, or 38.5%, to$536,000 for the three months ended September 30, 2007 from $387,000 for thethree months ended September 30, 2006. The increase in Ge substraterevenue was due to a customer in Germany who has now qualified our product, asdemand for photovoltaic and opto-electronic applications increases.

 

Raw materials revenue increased $2.4 million, or189.4%, to $3.6 million for the three months ended September 30, 2007 from$1.3 million for the three months ended September 30, 2006. The increase in rawmaterials revenue was primarily due to sales of gallium to a customer in NorthAmerica as the demand for gallium increases, as well as an increase in rawmaterials pricing. We expect this demand for gallium to continue at this pace.

 

| ** **    | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **    | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                               | 27,997     |         | $          | 25,441         |       | $ | 2,556 |   | 10.0 | % |
| InP           |       | 1,586                           |       | 1,249        |       | 337            |       | 27.0 | % |
| Ge            |       | 1,479                           |       | 592          |       | 887            |       | 149.8 | % |
| Raw materials |       | 9,532                           |       | 4,083        |       | 5,449          |       | 133.5 | % |
| Other         |       | 45                              |       | 8            |       | 37             |       | 462.5 | % |
| Total revenue |       | $                               | 40,639     |         | $          | 31,373         |       | $ | 9,266 |   | 29.5 | % |
|               |            |                                 |            |              |            |                |            |  |  |  |  |  |  |

 

20

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Revenue increased $9.3 million, or 29.5%, to $40.6million for the nine months ended September 30, 2007 from $31.4 millionfor the nine months ended September 30, 2006. Total GaAs substrate revenueincreased $2.6 million, or 10.0%, to $28.0 million for the nine months endedSeptember 30, 2007 from $25.4 million for the nine months endedSeptember 30, 2006.

 

Sales of 5 inch and 6inch diameter GaAs substrates were $11.1 million for the nine months endedSeptember 30, 2007 compared to $11.4 million for the nine months endedSeptember 30, 2006. The decrease was mainly due to the impact in the threemonths ended March 31, 2007 when we experienced a decrease in 6 inch diameterwafer sales from the prior quarter primarily due to less than expected ordersfrom a few handset market customers, as well as less than expected sales tocertain customers that did not materialize due to the delay in BIFETqualifications of those customers. In addition, in the three months endedSeptember 30, 2007, a major customer who was transitioning to a new devicedelayed shipments of our products pending this transition, and encountered anissue with our substrates due to a change in their specifications. We alsoexperienced a delay in shipments by another major customer that had aninventory adjustment causing 6 inch orders to be lower than normal. We expectto resume orders beginning the fourth quarter of 2007.

 

Sales of 2 inch, 3 inch and 4 inch diameter GaAssubstrates were $16.9 million for the nine months ended September 30, 2007compared to $13.9 million for the nine months ended September 30, 2006.The increase in revenue from smaller diameter substrates was due to thecontinued market growth generally of LED laser diodes and commercial epitaxy.

 

InP revenue increased $337,000, or 27.0%, to $1.6million for the nine months ended September 30, 2007 from $1.2 million for thenine months ended September 30, 2006. The increase in InP revenue wasprimarily due to a one-time sale of $251,000 indium scrap metal, while InPsubstrate revenue increased slightly from customers in the optical networkingindustry.  However, we do not expectsignificant near term changes in the market for InP, and we do not expect tosustain this increased level of InP revenue.

 

Ge substrate revenue increased $887,000, or 149.8%, to$1.5 million for the nine months ended September 30, 2007 from $592,000 for thenine months ended September 30, 2006. The increase in Ge substrate revenuewas due to a customer in Germany who has now qualified our product, as demandfor photovoltaic and opto-electronic applications continues to increase.

 

Raw materials revenue increased $5.4 million, or133.5%, to $9.5 million for the nine months ended September 30, 2007 from$4.1 million for the nine months ended September 30, 2006. The increase in rawmaterials revenue was primarily due to sales of gallium to new customers inJapan and Europe, and increased demand by a customer in North America as thedemand for gallium increases, as well as an increase in raw materials pricing.We expect this demand for gallium to continue at this pace.

 

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***Revenue byGeographic Region***

*** ***

| ** **                                 | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                 | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                            |       | $                                | 2,820      |         | $          | 3,033          |       | $ | (213 | ) | (7.0 | )% |
| *% of  total revenue*                      |       | 19.5                             | %          | 24.2         | %          |           |       |   |   |
| Europe                                     |       | 2,521                            |       | 2,012        |       | 509            |       | 25.3 | % |
| *% of  total revenue*                      |       | 17.4                             | %          | 16.0         | %          |           |       |   |   |
| Japan                                      |       | 3,301                            |       | 842          |       | 2,459          |       | 292.0 | % |
| *% of  total revenue*                      |       | 22.8                             | %          | 6.7          | %          |           |       |   |   |
| Taiwan                                     |       | 2,444                            |       | 2,869        |       | (425           | )          | (14.8 | )% |
| *% of  total revenue*                      |       | 16.9                             | %          | 22.9         | %          |           |       |   |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 3,388                            |       | 3,791        |       | (403           | )          | (10.6 | )% |
| *% of  total revenue*                      |       | 23.4                             | %          | 30.2         | %          |           |       |   |   |
| Total revenue                              |       | $                                | 14,474     |         | $          | 12,547         |       | $ | 1,927 |   | 15.4 | % |

----

*                                        Primarilythe United States

 

North America revenue decreased by $0.2 million, or7.0%, to $2.8 million for the three months ended September 30, 2007 from$3.0 million for the three months ended September 30, 2006. In the threemonths ended September 30, 2006 one new customer bought $0.3 million 4”semi-insulating wafers for the first time, and has never purchased from ussince. That decline in substrate wafer sales was partially offset by anincrease in raw material sales.

 

Europe revenue increased by $0.5 million, or 25.3%, to$2.5 million for the three months ended September 30, 2007 from $2.0million for the three months ended September 30, 2006. This increase cameprimarily from increased substrate sales to customers in Germany partiallyoffset by decreased sales to customers in France.

 

Japan revenue increased by $2.5 million, or 292.0%, to$3.3 million for the three months ended September 30, 2007 from $0.8million for the three months ended September 30, 2006. The increase came fromthree new customers for raw materials sales amounting to $1.9 million, whilesubstrate sales to existing customers increased by $0.6 million.

 

Taiwan revenue decreased by $0.4 million, or 14.8%, to$2.4 million for the three months ended September 30, 2007 from $2.9million for the three months ended September 30, 2006. The decrease wasdue mainly to a major customer who was transitioning to a new device delayedshipments of our products pending this transition, and encountered an issuewith our substrates due to a change in their specifications. We expect thiscustomer to resume orders beginning the fourth quarter of 2007.

 

Asia Pacific (excluding Japan and Taiwan) revenuedecreased by $0.4 million, or 10.6%, to $3.4 million for the three months endedSeptember 30, 2007 from $3.8 million for the three months endedSeptember 30, 2006. The decrease was due mainly to reduced sales to ourcustomers in Malaysia and Singapore from a fall in demand.

 

22

----

 

| ** **                                 | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                 | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                 | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                            |       | $                               | 8,918      |         | $          | 7,704          |       | $ | 1,214 |   | 15.8 | % |
| *% of  total revenue*                      |       | 21.9                            | %          | 24.6         | %          |           |       |   |   |
| Europe                                     |       | 7,163                           |       | 5,684        |       | 1,479          |       | 26.0 | % |
| *% of  total revenue*                      |       | 17.6                            | %          | 18.1         | %          |           |       |   |   |
| Japan                                      |       | 8,699                           |       | 2,638        |       | 6,061          |       | 229.8 | % |
| *% of  total revenue*                      |       | 21.4                            | %          | 8.4          | %          |           |       |   |   |
| Taiwan                                     |       | 6,512                           |       | 5,782        |       | 730            |       | 12.6 | % |
| *% of  total revenue*                      |       | 16.0                            | %          | 18.4         | %          |           |       |   |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 9,347                           |       | 9,565        |       | (218           | )          | (2.3 | )% |
| *% of  total revenue*                      |       | 23.0                            | %          | 30.5         | %          |           |       |   |   |
| Total revenue                              |       | $                               | 40,639     |         | $          | 31,373         |       | $ | 9,266 |   | 29.5 | % |
|                                            |            |                                 |            |              |            |                |            |  |  |  |  |  |  |

----

*                                        Primarilythe United States

 

North America revenue increased by $1.2 million, or15.8%, to $8.9 million for the nine months ended September 30, 2007 from $7.7million for the nine months ended September 30, 2006. The increase was dueto approximately $0.7 million more raw material sales, a one-time sale of $0.3million indium scrap metal, and $0.2 million of increased substrate sales.

 

Europe revenue increased by $1.5 million, or 26.0%, to$7.2 million for the nine months ended September 30, 2007 from $5.7million for the nine months ended Septembere 30, 2006. This increase cameprimarily from increased substrate sales to customers in Germany and Russia,partially offset by decreased substrate sales to customers in France, andincreased raw materials sales to customers in the Netherlands.

 

Japan revenue increased by $6.1 million, or 229.8%, to$8.7 million for the nine months ended September 30, 2007 from $2.6million for the nine months ended September 30, 2006. The increase camefrom five new customers for raw materials amounting to $4.8 million, whilesubstrate sales to existing customers increased by $1.3 million due to higherdemand.

 

Taiwan revenue increased by $0.7 million, or 12.6%, to$6.5 million for the nine months ended September 30, 2007 from $5.8million for the nine months ended September 30, 2006. We had $2.2 millionincreased sales in small diameter wafers as demand grew, partially offset by$1.4 million decrease in sales of large diameter wafers from a major customerwho was transitioning to a new device delayed shipments of our products pendingthis transition, and encountered an issue with our substrates due to a changein their specifications. We expect this customer to resume orders beginning thefourth quarter of 2007.

 

Asia Pacific (excluding Japan and Taiwan) revenuedecreased by $0.2 million, or 2.3%, to $9.3 million for the nine months endedSeptember 30, 2007 from $9.6 million for the nine months endedSeptember 30, 2006. We had a decrease in raw material sales of $1.0million as demand dropped slightly in P.R. China, offset by an increase of $0.8million in small diameter substrate sales to customers in P.R. China.

 

***Gross Margin***

 

| ** **        | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **        | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                                | 4,530      |         | $          | 3,479          |       | $ | 1,051 |   | 30.2 | % |
| *Gross  Margin %* |       | 31.3                             | %          | 27.7         | %          |           |       |   |   |
|                   |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

*Grossmargin.* Gross margin increased to 31.3% of total revenue forthe three months ended September 30, 2007 from 27.7% of total revenue forthe three months ended September 30, 2006. Gross margin for the threemonths ended September 30, 2007 was positively impacted by sales ofapproximately $0.6 million of gallium arsenide (“GaAs”) wafers that werepreviously fully reserved. Product mix also contributed to higher gross marginsas we sold a greater amount of  raw

 

23

----

 

materials which contributed higher gross margins. Inaddition, we had manufacturing equipment that has become fully depreciatedsince the third quarter of 2006, and the absence of depreciation expense forthis equipment, partially offset by depreciation on property, plant andequipment additions, contributed approximately 1.8 percentage points to grossmargin for the three months ended September 30, 2007. Finally, higher substrategross margins were also achieved through better slicing techniques, longerlength ingot growth, shorter runtimes, and higher production volumes, partiallyoffset by higher prices of raw materials for gallium and arsenic. Gross marginfor the three months ended September 30, 2006 was positively impacted bysales of approximately $0.8 million of GaAs wafers which were previously fullyreserved.

 

| ** **        | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **        | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                               | 14,967     |         | $          | 7,748          |       | $ | 7,219 |   | 93.2 | % |
| *Gross  Margin %* |       | 36.8                            | %          | 24.7         | %          |           |       |   |   |
|                   |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

*Grossmargin.*Grossmargin increased to 36.8% of total revenue for the nine months endedSeptember 30, 2007 from 24.7% of total revenue for the nine months endedSeptember 30, 2006. Gross margin for the nine months endedSeptember 30, 2007 was positively impacted by sales of approximately $1.7million of GaAs wafers that were previously fully reserved. Product mix alsocontributed to higher gross margins as we sold InP scrap metal, as well as rawmaterials, both of which contributed higher gross margins. In addition, we hadmanufacturing equipment that has become fully depreciated since the thirdquarter of 2006, and the absence of depreciation expense for this equipment,partially offset by depreciation on property, plant and equipment additions,contributed approximately 2.5 percentage points to gross margin for the ninemonths ended September 30, 2007. Finally, higher substrate gross margins were alsoachieved through better slicing techniques, longer length ingot growth, shorterruntimes, and higher production volumes, partially offset by higher prices ofraw materials for gallium and arsenic. Gross margin for the nine months endedSeptember 30, 2006 was positively impacted by sales of approximately $2.2million of GaAs wafers, which were previously fully reserved, and byapproximately $53,000 as a result of a reversal of a sales return reserveestablished in 2004 as we favorably resolved an outstanding matter with acustomer.

 

***Selling, General andAdministrative Expenses***

*** ***

| ** **                                    | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                    | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general  and administrative expenses |       | $                                | 3,083      |         | $          | 2,641          |       | $ | 442 |   | 16.7 | % |
| *% of  total revenue*                         |       | 21.3                             | %          | 21.0         | %          |           |       |   |   |
|                                               |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

Selling, general and administrative expenses increased$0.4 million to $3.1 million for the three months ended September 30, 2007from $2.6 million for the three months ended September 30, 2006. Theincrease was primarily $0.2 million in general increases in employee salariesand related costs in 2007 over 2006, as well as $0.2 million higher bad debtexpenses mainly for our slow-paying customers in Asia, $0.3 million in higherlegal fees mainly because 2006 included a $0.3 million refund from insurance,partially offset by $0.3 million lower decontamination fees on our property inFremont, California.

 

| ** **                                    | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                    | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general  and administrative expenses |       | $                               | 10,529     |         | $          | 9,724          |       | $ | 805 |   | 8.3 | % |
| *% of  total revenue*                         |       | 25.9                            | %          | 31.0         | %          |           |       |   |   |
|                                               |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

Selling, general and administrative expenses increased$0.8 million to $10.5 million for the nine months ended September 30, 2007from $9.7 million for the nine months ended September 30, 2006. Theincrease was primarily due to $0.2 million higher bad debt expenses mainly forour slow-paying customers in Asia, a $0.4 million bad debt recovery taken in2006 which was provided for an Asian customer in late 2005, and $0.2 million inhigher salaries and related costs in 2007 over 2006.

 

24

----

 

***Research and Development***

*** ***

| ** **                | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and  development |       | $                                | 382        |         | $          | 392            |       | $ | (10 | ) | (2.6 | )% |
| *% of  total revenue*     |       | 2.6                              | %          | 3.1          | %          |           |       |   |   |
|                           |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

Research and development expenses decreased $10,000,or 2.6% to $382,000 for the three months ended September 30, 2007 from $392,000for the three months ended September 30, 2006, mainly from $70,000 savings insalary and related costs as a result of the retirement of Dr. Morris Young, ourformer Chief Technology Officer effective December 31, 2006, partially offsetby $60,000 in increased new products testing expenses.

 

| ** **                | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and  development |       | $                               | 1,190      |         | $          | 1,497          |       | $ | (307 | ) | (20.5 | )% |
| *% of  total revenue*     |       | 2.9                             | %          | 4.8          | %          |           |       |   |   |
|                           |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

Research and development expenses decreased $0.3million, or 20.5% to $1.2 million for the nine months ended September 30, 2007from $1.5 million for the nine months ended September 30, 2006, mainly from$0.4 million savings in salary and related costs as a result of the retirementof Dr. Morris Young, our former Chief Technology Officer effective December 31,2006 and the reduction in engineering headcount including severance pay,partially offset by increased new products testing expenses of $0.1 million.

 

***Impairment (recovery ofimpairment) on assets held for sale***

 

| ** **                          | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                          | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                          | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                          | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Impairment on  assets held for sale |       | $                                | —     |         | $          | 1,417          |       | $ | (1,417 | ) | NA |   |
| *% of  total revenue*               |       | NA                               |       | 11.3         | %          |           |       |   |   |
|                                     |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

Duringthe three months ended September 30, 2006, we incurred an impairmentcharge of $1.4 million to write down our U.S. property located in Fremont,California, which had been decontaminated and was being prepared for sale. Thatproperty had been classified as “Assets held for sale” in the amount of $4.7million on the condensed consolidated balance sheet as of December 31, 2006.

 

| ** **                                                   | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                                   | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                                   | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                                   | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Impairment  (Recovery of impairment) on assets held for sale |       | $                               | (481       | )            | $          | 1,417          |       | $ | (1,898 | ) | (133.9 | )% |
| *% of  total revenue*                                        |       | (1.2                            | )%         | 4.5          | %          |           |       |   |   |
|                                                              |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

Duringthe nine months ended September 30, 2007, we benefited from a recovery ofimpairment on assets held for sale in connection with our adjustment of thefair value of our U.S. property located in Fremont, California, which had beendecontaminated and is being prepared for sale. Accordingly, we recorded a$481,000 market value adjustment after we entered into an agreement with anindependent third party purchaser in June 2007 to purchase the property forestimated net proceeds of $5.1 million, after deducting estimated commissionand selling expenses. Subsequent to the three and nine months ended  September 30, 2007, we received a notice fromthis third party purchaser terminating the agreement to purchase theproperty.  On October 22, 2007, weentered into a new agreement with a different independent third party purchaserto purchase the property for $5.65 million, subject to certain contingencies.

 

Duringthe nine months ended September 30, 2006, we incurred an impairment chargeof $1.4 million to write down our U.S. property located in Fremont, California,which had been decontaminated and was being prepared for sale. That propertyhad been classified as “Assets held for sale” in the amount of $4.7 million onthe condensed consolidated balance sheet as of December 31, 2006.

 

25

----

 

***Interest Income, net***

*** ***

| ** **            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income,  net |       | $                                | 102        |         | $          | 103            |       | $ | (1 | ) | (1.0 | )% |
| *% of  total revenue* |       | 0.7                              | %          | 0.8          | %          |           |       |   |   |
|                       |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

Interest income, net wascomparable at $0.1 million for the three months ended September 30, 2007 and2006.

 

| ** **            | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income,  net |       | $                               | 551        |         | $          | 342            |       | $ | 209 |   | 61.1 | % |
| *% of  total revenue* |       | 1.4                             | %          | 1.1          | %          |           |       |   |   |
|                       |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

Interest income, netincreased $0.2 million to $0.6 million for the nine months ended September 30,2007 from $0.3 million for the nine months ended September 30, 2006 as a resultof higher balances of our investments which came from the net proceeds of ourpublic offering of common stock, completed in December 2006 and January2007.

 

***Other Income and Expense, net***

*** ***

| ** **                   | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                   | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                   | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                   | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income  (expense), net |       | $                                | (156       | )            | $          | 641            |       | $ | (797 | ) | (124.3 | )% |
| *% of  total revenue*        |       | (1.1                             | )%         | 5.1          | %          |           |       |   |   |
|                              |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

Other expense was $0.2million for the three months ended September 30, 2007 due to the minorityinterests in our joint ventures. Other income was $0.6 million for the threemonths ended September 30, 2006 due to a realized gain of $0.7 million on thesale of shares of common stock of Finisar Corporation which we no longer hold,partially offset by minority interests in our joint ventures.

 

| ** **                  | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                  | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                  | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                  | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income  (expense) net |       | $                               | (439       | )            | $          | 1,693          |       | $ | (2,132 | ) | (125.9 | )% |
| *% of  total revenue*       |       | (1.1                            | )%         | 5.4          | %          |           |       |   |   |
|                             |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

Other expense was $0.4million for the nine months ended September 30, 2007 due to the minorityinterests in our joint ventures. Other income was $1.7 million for the ninemonths ended September 30, 2006 due to a realized gain of $2.2 million on thesale of shares of common stock of Finisar Corporation which we no longer hold,partially offset by minority interests in our joint ventures.

 

***Provision for Income Taxes***

*** ***

| ** **                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                            | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                            | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision  (benefit) for income taxes |       | $                                | 153        |         | $          | (862           | )          | $ | (1,015 | ) | (117.7 | )% |
| *% of  total revenue*                 |       | 1.1                              | %          | (6.9         | )%         |           |       |   |   |
|                                       |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

We provided for incometaxes of $0.2 million for our China operations for the three months endedSeptember 30, 2007. For the three months ended September 30, 2006, we reversedapproximately $1.0 million of income tax payable accrued for potentialexposures relating to 1999 and 2000 net operating loss carryback as a benefitfrom income taxes in 2006, offset by a provision for income taxes of $0.1million, which was related to our China operations.

 

26

----

 

| ** **                            | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|---------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                            | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                            | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision  (benefit) for income taxes |       | $                               | 426        |         | $          | (406           | )          | $ | (832 | ) | (204.9 | )% |
| *% of  total revenue*                 |       | 1.0                             | %          | (1.3         | )%         |           |       |   |   |
|                                       |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

We provided for incometaxes of $0.4 million for our China operations for the nine months endedSeptember 30, 2007.  For the nine monthsended September 30, 2006, we reversed approximately $1.0 million of income taxpayable accrued for potential exposures relating to 1999 and 2000 net operatingloss carryback as a benefit from income taxes in 2006, partially offset by aprovision for income taxes of $0.5 million, which was related to our Chinaoperations.

 

***Gain from Discontinued Operations***

*** ***

| ** **                         | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                         | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                         | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                         | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from  discontinued operations |       | $                                | —     |         | $          | 4              |       | $ | (4 | ) | (100.0 | )% |
| *% of  total revenue*              |       | NA                               |       | 0.0          | %          |           |       |   |   |
|                                    |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

In January, 2007, wedissolved the corporation that operated our discontinued operations thatrelated to our opto-electronics business and transferred the cash balance to ourcontinuing operations. Accordingly, we no longer have discontinued operations.For the three months ended September 30, 2006, the $4,000 in income was frominterest income earned on cash balances held in the discontinued operations.

 

| ** **                         | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **     | ** ** |
|------------------------------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **                         | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                         | ** ** | **2007**                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                         | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from  discontinued operations |       | $                               | —     |         | $          | 7              |       | $ | (7 | ) | (100.0 | )% |
| *% of  total revenue*              |       | NA                              |       | 0.0          | %          |           |       |   |   |
|                                    |            |                                 |            |              |            |                |            |  |  |  |  |  |

 

In January 2007, wedissolved the corporation that operated our discontinued operations thatrelated to our opto-electronics business and transferred the cash balance toour continuing operations. Accordingly, we no longer have discontinuedoperations. For the nine months ended September 30, 2006, the $7,000 in incomewas from interest income earned on cash balances held in the discontinuedoperations.

 

**Liquidityand Capital Resources**

 

As of September 30,2007, our principal sources of liquidity were $35.2 million in cash and cashequivalents and short-term investments, excluding restricted deposits. Weconsider cash and cash equivalents and short-term investments as liquid andavailable for use. Short-term investments are comprised of government bonds andhigh-grade commercial debt instruments.

 

Cash and cash equivalents and short-term investmentsdecreased $0.3 million to $35.2 million as of September 30, 2007 compared with $35.5 million asof December 31, 2006. Included in this decrease are the purchase of machinery and equipment of $2.8 million,payments of long-term debt of $0.5 million, and the continual funding ofour operations, partially offsetby the net proceeds of $3.7 million received from the publicoffering of 862,500 shares of our common stock inJanuary 2007, and a China tax refund of $0.9 million from our PRCsubsidiary.

 

Net cash used inoperating activities of $2.6 million for the nine months ended September 30,2007 was primarily comprised of our net income of $3.4 million, adjusted fornon-cash items of depreciation of $1.1 million, stock based compensation of$0.3 million, partially offset by a recovery of impairment on assets held forsale of $0.5 million, and offset by a net increase of $6.9 million in assetsand liabilities. The net increase in assets and liabilities resulted from a$4.7 million increase in inventories, a $2.2 million increase in accountsreceivable, net, a $1.1 million decrease in accounts payable, and a $0.7million increase in other assets and partially offset by a $0.5 milliondecrease in prepaid expenses, an increase of $0.5 million in accruedliabilities, and a $0.3 million decrease in income taxes payable.

 

27

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Inventories increased by$4.9 million, or 24.0%, to $25.1 million as of September 30, 2007 compared with$20.3 million as of December 31, 2006, as we increased inventory in rawmaterials, work-in-process, and finished goods to increase production in anticipationof increased forecast sales and increased costs of raw materials. The value offinished goods held as consignment inventory increased by $0.6 million as weincreased our number of consignees from four to six.

 

Accounts receivable, netincreased by $2.3 million, or 23.7%, to $11.9 million as of September 30, 2007compared to $9.7 million as of December 31, 2006. Gross accounts receivableincreased by $2.7 million from $9.8 million to $12.5 million as revenueincreased. The allowance for doubtful accounts increased by $0.5 million from$0.1 million to $0.6 million mainly for slow-paying customers in Asia. Wecontinue to pursue collections on slow-paying customers. Our days salesoutstanding is 76 days as of September 30, 2007 compared to 68 days as of December31, 2006.

 

Net cash used ininvesting activities of $0.5 million for the nine months ended September 30,2007 was primarily for the purchase of investments totaling $22.7 million, thepurchase of property, plant and equipment of $2.8 million, partially offset bythe proceeds from sale of investments of $24.5 million and the decrease ofrestricted cash of $0.5 million.

 

We expect to investapproximately $2.1 million in capital projects for the remainder of 2007. Webelieve that our existing and planned facilities and equipment are sufficientto fulfill current and expected future orders.

 

Net cash provided byfinancing activities of $3.8 million for the nine months ended September 30,2007 consisted of $3.7 million net proceeds from the issuance of 862,500 sharesof common stock as a result of our January 2007 closing of our publicoffer of our common stock and $0.7 million from employee stock optionsexercised, partially offset by payments of $0.5 million related tolong-term borrowings.

 

Our main Fremont,California facility is financed by long-term borrowings, which were refinancedby taxable variable rate revenue bonds in 1998. These bonds mature in 2023 andbear interest at a variable rate that was 5.23% as of September 30, 2007. Thebonds are traded in the public market. Repayment of principal and interestunder the bonds is supported by a letter of credit from our bank and is paid ona quarterly basis. We have the option to redeem the bonds in whole or in partduring their term. As of September 30, 2007, $6.7 million was outstanding underthese bonds.

 

As of September 30, 2007, the credit facility maintained by uswith a bank included a letter of credit supporting repayment of our revenuebonds with an outstanding amount of $6.7 million. We have pledged and placed alike amount of investment securities with an affiliate of the bank asadditional collateral for this facility.

 

On October 22, 2007, we entered into a new sales agreementwith an independent third party to sell our main Fremont, California facility.We estimate our net proceeds will be approximately $5.4 million after deductingsales commission and other selling expenses. We expect to close escrow in thefourth quarter of 2007.  Please refer toNote 14 to the condensed consolidated financial statements for further details.

 

We believe that we haveadequate cash and investments to meet our needs over the next 12 months. Cashfrom operations could be affected by various risks and uncertainties,including, but not limited to those set forth below under Item 1A “RisksFactors.”

 

Outstanding contractualobligations as of September 30, 2007 are summarized as follows (in thousands):

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More than  5 years** | ** ** |
| Debt                             |       | $                                         | 6,745      |   | $ | 450 |   | $ | 945 |   | $ | 750 |   | $ | 4,600 |   |
| Operating leases                 |       | 4,057                                     |       | 659 |   | 1,476 |   | 1,564 |   | 357 |   |
| Purchase  obligation             |       | 6,105                                     |       | 4,860 |   | 1,245 |   | — |   | — |   |
| Total                            |       | $                                         | 16,907     |   | $ | 5,969 |   | $ | 3,666 |   | $ | 2,314 |   | $ | 4,957 |   |

 

We lease certain officespace, manufacturing facilities and property under long-term operating leasesexpiring at various dates through March 2013. Total rent payments under theseoperating leases were approximately $0.5 million and $0.8 million for the ninemonth periods ended September 30, 2007 and 2006, respectively.

 

28

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On February 27,2007, we entered into an agreement with Recapture Metals Limited of Ontario,Canada (“Recapture”), pursuant to which Recapture will supply our subsidiary inthe People’s Republic of China with one thousand kilograms per month of99.99999% pure gallium, during the eighteen month period beginning July 1,2007 for a total value of $7.3 million. Under the terms of the agreement, weare required to purchase a minimum of eighteen thousand kilograms of gallium,unless the agreement is terminated prior to the expiration of the eighteenmonth period on December 31, 2008. As of September 30, 2007, our total remaining commitment under thisagreement is approximately $6.1 million.

 

**ITEM 3*.*QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**ForeignCurrency Exchange Rate Exposure**

 

We operate in the United States, manufacturein the People’s Republic of China (“PRC”), and the substantial majority of oursales to date have been made in U.S. dollars. Certain expenses from our PRCoperations are incurred in the PRC’s Renminbi. As a result, currencyfluctuations between the U.S. dollar and the Renminbi could cause foreigncurrency transaction gains or losses that we would recognize in the periodincurred. However, a10% fluctuation in the dollar at September 30, 2007 would have an immaterialimpact on our net dollar position in outstanding trade payables andreceivables.

 

SinceJuly 2005, when the PRC uncoupled the Renminbi from the U.S. dollarand began to permit it to float in a narrow band against a basket of foreigncurrencies, the Renminbi has progressively appreciated atan accelerating rate against the U.S. dollar.  However, the governmentof the PRC has yet to allow the Renminbi to ”float,” or to be freelytraded against foreign currencies.  Accordingly, it is uncertain whether,and to what extent, further adjustments will follow.  Regardless ofwhether the PRC government allows the Renminbi-U.S. dollar exchangerate to float in the future, the Renminbi could likely continue toappreciate further relative to the U.S. dollar.

 

We expect our international revenues andexpenses to continue to be denominated largely in U.S. dollars. We also believethat our PRC operations will likely expand in the future as our businesscontinues to grow. As a result, we anticipate that we may experience increasedexposure to the risks of fluctuating currencies and may choose to engage incurrency hedging activities to reduce these risks. However, we cannot becertain that any such hedging activities will be effective, or available to usat commercially reasonable rates.

 

**Interest Rate Risk**

 

Cash and cash equivalentsearning interest and certain variable rate debt instruments are subject tointerest rate fluctuations. The following table sets forth the probable impactof a 10% change in interest rates (in thousands):

 
| **Instrument**                             | ** ** | **Balance as of  September 30,  2007** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash                                       |       | $                                                     | 6,800      |                        | 0.50       | %                                                     | $          | 34                                                                   |       | $                                                                     | 31         |   | $ | 37 |   |
| Cash equivalents                           |       | 10,267                                                |       | 5.29                        |       | 543                                                   |       | 489                                                                  |       | 597                                                                   |       |
| Investment in  debt and equity instruments |       | 24,874                                                |       | 4.99                        |       | 1,241                                                 |       | 1,117                                                                |       | 1,365                                                                 |       |
| Taxable variable  rate revenue bonds       |       | (6,700                                                | )          | 5.23                        |       | (350                                                  | )          | (315                                                                 | )          | (385                                                                  | )          |
|                                       |       |                                                  |       |                        |       |                                                  |       |                                                                 |       |                                                                  |       |
|                                       |       |                                                  |       |                        |       | $                                                     | 1,468      |                                                                 | $          | 1,322                                                                 |       | $ | 1,614 |   |
|                                            |            |                                                       |            |                             |            |                                                       |            |                                                                      |            |                                                                       |            |  |  |  |  |

 

29

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**Equity Risk**

 

We maintain minority investmentsin two privately-held U.S. companies. We maintain a minorityinvestment in Global Communication Semiconductors, Inc. (GCS) as a result ofits acquisition of Alpha Photonics, Inc. We also maintain a minority investment in Intelligent Epitaxy Technology,Inc. (IntelliEPI) as a result of certain in-kind contracts whereby we deliveredGaAs and InP wafers to IntelliEPI and IntelliEPI agreed to issue shares of itsSeries B Preferred Stock in return in year 2000. These investments are reviewed for other thantemporary declines in value on a quarterly basis. These investments areclassified as other assets in the consolidated balance sheets and are accountedfor under the cost method as we do not have the ability to exercise significantinfluence over their operations. We monitor our investments for impairment andrecord reductions in carrying value when events or changes in circumstancesindicate that the carrying value may not be recoverable. Reasons for other thantemporary declines in value include whether the related company would haveinsufficient cash flow to operate for the next twelve months, significantchanges in the operating performance and changes in market conditions. Theminority investments totaled $0.4 million as of December 31, 2006 and September30, 2007.

 

**ITEM 4T*.*CONTROLS AND PROCEDURES**

 

(a) Under the supervision and with the participationof our management, our Chief Executive Officer and Chief Financial Officer haveevaluated the effectiveness of our disclosure controls and procedures, as suchterm is defined under Rule 13a-15(e) promulgated under the Securities ExchangeAct of 1934, as amended. Based upon that evaluation, our Chief ExecutiveOfficer and our Chief Financial Officer concluded that the our disclosurecontrols and procedures were effective as of the end of the period covered bythis quarterly report.

 

(b) No change in our internal control over financialreporting was made during the quarter ended September 30, 2007, that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

30

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**PART II.OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

From time to time wemay be involved in judicial or administrative proceedings concerningmatters arising in the ordinary course of business. We do not expect that anyof these matters, individually or in the aggregate, will have a materialadverse effect on our business, financial condition, cash flows or results ofoperation.

 

On October 15, 2004, apurported securities class action lawsuit was filed in the United States Courtfor the Northern District of California, City of Harper Woods EmployeesRetirement System v. AXT, Inc. et al., No. C 04 4362 MJJ. The Courtconsolidated the case with a subsequent related case and appointed a leadplaintiff. On April 5, 2005, the lead plaintiff filed a consolidated complaint,captioned as Morgan v. AXT, Inc. et al., No. C 04 4362 MJJ. The lawsuitcomplaint names AXT, Inc. and our chief technology officer as defendants, andis brought on behalf of a class of all purchasers of our securities fromFebruary 6, 2001 through April 27, 2004. The complaint alleges that weannounced financial results during this period that were false and misleading.No specific amount of damages is claimed. On September 23, 2005, the Courtgranted our motion to dismiss the complaint, with leave to amend. The leadplaintiff filed an amended complaint, which we had moved to dismiss. On April24, 2007, we reached a settlement of this litigation for which we areresponsible only for the amount remaining in our insurance retention. We paidthe remaining amount of the retention (approximately $350,000) as of September30, 2007.

 

On June 1, 2005, alawsuit was filed in the Superior Court of California, County of Alameda, Zhaoet al. v. American Xtal Technology, et al., No. R 605215713. The lawsuitcomplaint names as defendants AXT, Inc., our chief technology officer and oneof our suppliers. The lawsuit was brought on behalf of two former employees andtheir minor child. The complaint alleged personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure of the child while in utero to high levels of gallium arsenideand methanol used in the production of gallium arsenide wafers. On April 23,2007, we reached a settlement of this litigation, all of which is covered byour insurance carriers.

 

**Item 1A. Risk Factors**

 

There are no material changes from the risk factorsset forth under Part I, Item 1A. “Risk Factors” in our Annual Report onForm 10-K for the fiscal year ended December 31, 2006, provided,however, that the two litigation matters described under the risks disclosedunder the captions “***Ifwe fail to comply with environmental and safety regulations, we may besubject to significant fines or forced to cease our operations; in addition, wecould be subject to suits for personal injuries caused by hazardous materials”***and***“Existing or future litigationcould result in significant judgments against us, or cause us to incur costlysettlements.”***  These two settled matters comprise (i) thecomplaint filed against us and a current and former officer, allegingpersonal injury, general negligence, intentional tort, wage loss and otherdamages as a result of exposure of plaintiffs, who are former employees of AXT,including a minor child in utero, to high levels of gallium arsenide in galliumarsenide wafers, and methanol, and (ii) the ongoing securities litigation matter.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

***Use of Proceeds***

*** ***

On December 19, 2006 and January 9, 2007, we sold5,750,000 shares and 862,500 shares, respectively, of our common stock in afirmly underwritten public offering pursuant to a registration statement onForm S-3 (SEC file number 333-135474), which was declared effective by the SECon August 3, 2006, and a registration statement on Form S-3MEF (SEC file number333-139365), which was effective upon filing with the SEC on December 15,2006.  Needham & Company, LLC actedas the sole underwriter.  The price pershare to the public was $4.50.  Wereceived net proceeds of $24.1 million and $3.7 million, for an aggregate netproceeds of $27.8 million.  The netproceeds have been and will continue to be used for corporate and joint venturecapacity expansion, research and development and working capital requirements,as well as potential acquisitions of complementary products, technologies orbusinesses.

 

31

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**Item3. Defaults upon Senior Securities**

 

None

 

**Item 4. Submission of Matters to aVote of Security Holders**

 

None

 

**Item 5. Other Information**

 

None

 

32

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**Item 6. Exhibits**

 

**a. Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                 |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                            |
| 3.1(1)              |       | Restated Certificate of Incorporation                                                                                                                                                           |
|                |       |                                                                                                                                                                                            |
| 3.2(2)              |       | Certificate of Designation, Preferences and Rights  of Series A Preferred Stock (which is incorporated here in reference to  Exhibit 2.1 to the registrant’s Form 8-K dated May 28, 1999). |
|                |       |                                                                                                                                                                                            |
| 3.3(3)              |       | Second Amended and Restated By Laws                                                                                                                                                             |
|                |       |                                                                                                                                                                                            |
| 4.2(3)              |       | Rights Agreement dated April 24, 2001 by and between  AXT, Inc. and ComputerShare Trust Company, Inc.                                                                                           |
|                |       |                                                                                                                                                                                            |
| 10.24(4)            |       | Purchase and Sale Agreement dated October 22, 2007  by and between AXT, Inc. and SBC&D Co., Inc., a California Corporation,  dba South Bay Development.                                     |
|                |       |                                                                                                                                                                                            |
| 31.1                |       | Certification by Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                            |
|                |       |                                                                                                                                                                                            |
| 31.2                |       | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                            |
|                |       |                                                                                                                                                                                            |
| 32.1                |       | Certification by Chief Executive Officer Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                            |
|                |       |                                                                                                                                                                                            |
| 32.2                |       | Certification by Chief Financial Officer Pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                            |

 

----

(1)          Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourAnnual Report on Form 10-K for the year ended December 31, 1998.

(2)          Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on June 14, 1999.

(3)          Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on May 30, 2001.

(4)          Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on October 25, 2007.

 

33

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this Report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                    | AXT, INC. |
|-------------------------|-----------|
|                    |      |   |
| Dated: November 7, 2007 | By:       | /s/ Philip C. S. Yin |
|                    |      | Philip C. S. Yin |
|                    |      | Chairman of the Board and |
|                    |      | Chief Executive Officer |
|                    |      | (Principal Executive Officer) |
|                    |      |   |
|                    |      | /s/ Wilson W. Cheung |
|                    |      | Wilson W. Cheung |
|                    |      | Chief Financial Officer |
|                    |      | (Principal Financial and Accounting Officer) |

 

34

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**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                  |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                             |
| 3.1(1)              |       | Restated Certificate of  Incorporation                                                                                                                                                           |
|                |       |                                                                                                                                                                                             |
| 3.2(2)              |       | Certificate of  Designation, Preferences and Rights of Series A Preferred Stock (which is  incorporated here in reference to Exhibit 2.1 to the registrant’s Form 8-K  dated May 28, 1999). |
|                |       |                                                                                                                                                                                             |
| 3.3(3)              |       | Second Amended and  Restated By Laws                                                                                                                                                             |
|                |       |                                                                                                                                                                                             |
| 4.2(3)              |       | Rights Agreement dated  April 24, 2001 by and between AXT, Inc. and ComputerShare Trust Company, Inc.                                                                                            |
|                |       |                                                                                                                                                                                             |
| 10.24(4)            |       | Purchase and Sale  Agreement dated October 22, 2007 by and between AXT, Inc. and SBC&D Co.,  Inc., a California Corporation, dba South Bay Development.                                      |
|                |       |                                                                                                                                                                                             |
| 31.1                |       | Certification by Chief  Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                             |
|                |       |                                                                                                                                                                                             |
| 31.2                |       | Certification by Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                             |
|                |       |                                                                                                                                                                                             |
| 32.1                |       | Certification by Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                             |
|                |       |                                                                                                                                                                                             |
| 32.2                |       | Certification by Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                             |

 

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(1)                      Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourAnnual Report on Form 10-K for the year ended December 31, 1998.

(2)                      Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on June 14, 1999.

(3)                      Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on May 30, 2001.

(4)                      Incorporatedby reference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on October 25, 2007.

 

35

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