**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC. 20549**

 

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**FORM10-Q**

 

**(MarkOne)**

 
| **ý**                                                                                                                                                    | ** ** | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **for the quarterly period ended June 30,  2005**                                                                                                             |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **or**                                                                                                                                                        |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **o**                                                                                                                                                         | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **for the transition period  from          to          ** |

 

**Commission File Number 000-24085**

 

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**AXT,INC.**

(Exact name of registrant as specified in itscharter)

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

 

**4281 Technology Drive, Fremont, California94538**

(Address of principal executive offices) (Zipcode)

 

**(510) 683-5900**

(Registrant’s telephone number, includingarea code)

 

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Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. YES  ý  NO  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). YES  o NO  ý

 

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

 
| **Class**                      | ** ** | **Outstanding at July 29, 2005** |
|--------------------------------|------------|----------------------------------|
| Common Stock, $0.001 par value |       | 23,007,043                       |

 

 

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AXT, INC.FORM 10-QTABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION                                                                                      |   |
|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.  Financial Statements (unaudited)                                                                          |   |
| Condensed  Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004                                   |   |
| Condensed  Consolidated Statements of Operations for the three and six month periods  ended June 30, 2005 and 2004 |   |
| Condensed  Consolidated Statements of Cash Flows for the six month periods ended June  30, 2005 and 2004           |   |
| Notes To  Condensed Consolidated Financial Statements                                                              |   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations               |   |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                                |   |
| Item  4. Controls and Procedures                                                                                   |   |
| PART  II. OTHER INFORMATION                                                                                        |   |
| Item  1. Legal Proceedings                                                                                         |   |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                               |   |
| Item  3. Defaults Upon Senior Securities                                                                           |   |
| Item  4. Submission of Matters to a Vote of Security Holders                                                       |   |
| Item  5. Other Information                                                                                         |   |
| Item  6. Exhibits                                                                                                  |   |
| Signatures                                                                                                         |   |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

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

 
| ** **                                                                                                                                                                  | ** ** | **June 30,  2005** | ** ** | **December 31,   2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------------|------------|
| Assets:                                                                                                                                                                     |       |               |       |                    |       |
| Current assets                                                                                                                                                              |       |               |       |                    |       |
| Cash and cash equivalents                                                                                                                                                   |       | $                  | 15,112     |                    | $          | 12,117 |   |
| Short-term investments                                                                                                                                                      |       | 9,881              |       | 20,062                  |       |
| Accounts receivable, net of allowance of  $526 and $1,087 as of June 30, 2005 and December 31, 2004, respectively                                                           |       | 4,955              |       | 4,034                   |       |
| Inventories, net                                                                                                                                                            |       | 15,336             |       | 16,462                  |       |
| Prepaid expenses and other current assets                                                                                                                                   |       | 2,438              |       | 2,523                   |       |
| Assets held for sale                                                                                                                                                        |       | —             |       | 1,250                   |       |
| Total current assets                                                                                                                                                        |       | 47,722             |       | 56,448                  |       |
| Property, plant and equipment, net                                                                                                                                          |       | 17,556             |       | 19,045                  |       |
| Restricted deposits                                                                                                                                                         |       | 8,215              |       | 8,215                   |       |
| Other assets                                                                                                                                                                |       | 3,789              |       | 3,832                   |       |
| Total assets                                                                                                                                                                |       | $                  | 77,282     |                    | $          | 87,540 |   |
|                                                                                                                                                                        |       |               |       |                    |       |
| Liabilities and stockholders’ equity:                                                                                                                                  |       |               |       |                    |       |
| Current liabilities                                                                                                                                                         |       |               |       |                    |       |
| Accounts payable                                                                                                                                                            |       | $                  | 1,816      |                    | $          | 1,895 |   |
| Accrued liabilities                                                                                                                                                         |       | 3,994              |       | 4,765                   |       |
| Accrued restructuring                                                                                                                                                       |       | 504                |       | 552                     |       |
| Current portion of long-term debt                                                                                                                                           |       | 450                |       | 450                     |       |
| Income taxes payable                                                                                                                                                        |       | 3,015              |       | 2,925                   |       |
| Total current liabilities                                                                                                                                                   |       | 9,779              |       | 10,587                  |       |
| Long-term debt, net of current portion                                                                                                                                      |       | 7,300              |       | 7,600                   |       |
| Other long-term liabilities                                                                                                                                                 |       | 1,362              |       | 1,336                   |       |
| Total liabilities                                                                                                                                                           |       | 18,441             |       | 19,523                  |       |
| Commitments and contingencies (Note 11)                                                                                                                                |       |               |       |                    |       |
| Stockholders’ equity:                                                                                                                                                  |       |               |       |                    |       |
| Preferred stock, $0.001 par value per share; 2,000  shares authorized; 883 shares issued and outstanding                                                                    |       | 3,532              |       | 3,532                   |       |
| Common stock, $0.001 par value per share; 70,000  shares authorized; 23,017 and 23,119 shares issued and outstanding, at June  30, 2005 and December 31, 2004, respectively |       | 23                 |       | 23                      |       |
| Additional paid-in-capital                                                                                                                                                  |       | 155,296            |       | 155,431                 |       |
| Accumulated deficit                                                                                                                                                         |       | (99,963            | )          | (92,561                 | )          |
| Accumulated other comprehensive income                                                                                                                                      |       | (47                | )          | 1,592                   |       |
| Total stockholders’ equity                                                                                                                                             |       | 58,841             |       | 68,017                  |       |
| Total liabilities and stockholders’ equity                                                                                                                             |       | $                  | 77,282     |                    | $          | 87,540 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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

 
| ** **                                                     | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                     | ** ** | **2005**                          | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                              |       |                            |       |   |   |   |   |
| Revenue                                                        |       | $                                 | 6,032      |                            | $          | 9,524 |   | $ | 12,666 |   | $ | 19,300 |   |
| Cost of revenue                                                |       | 5,905                             |       | 8,695                           |       | 12,260 |   | 17,938 |   |
| Gross profit                                                   |       | 127                               |       | 829                             |       | 406 |   | 1,362 |   |
| Operating expenses:                                            |       |                              |       |                            |       |   |   |   |   |
| Selling, general and administrative                            |       | 2,716                             |       | 3,203                           |       | 6,968 |   | 5,973 |   |
| Research and development                                       |       | 423                               |       | 350                             |       | 785 |   | 691 |   |
| Restructuring charges                                          |       | 237                               |       | 1,077                           |       | 362 |   | 1,077 |   |
| Total operating expenses                                       |       | 3,376                             |       | 4,630                           |       | 8,115 |   | 7,741 |   |
| Loss from operations                                           |       | (3,249                            | )          | (3,801                          | )          | (7,709 | ) | (6,379 | ) |
| Interest income, net                                           |       | 131                               |       | 54                              |       | 250 |   | 78 |   |
| Other expense, net                                             |       | (196                              | )          | (225                            | )          | (301 | ) | (191 | ) |
| Loss before provision for income taxes                         |       | (3,314                            | )          | (3,972                          | )          | (7,760 | ) | (6,492 | ) |
| Provision for incomes taxes                                    |       | 18                                |       | 97                              |       | 53 |   | 137 |   |
| Loss from continuing operations                                |       | (3,332                            | )          | (4,069                          | )          | (7,813 | ) | (6,629 | ) |
| Discontinued operations:                                       |       |                              |       |                            |       |   |   |   |   |
| Gain from discontinued operations, net of  tax                 |       | 53                                |       | 222                             |       | 411 |   | 222 |   |
| Net loss                                                       |       | $                                 | (3,279     | )                               | $          | (3,847 | ) | $ | (7,402 | ) | $ | (6,407 | ) |
|                                                           |       |                              |       |                            |       |   |   |   |   |
| Basic and diluted loss per share:                              |       |                              |       |                            |       |   |   |   |   |
| Loss from continuing operations                                |       | $                                 | (0.14      | )                               | $          | (0.18 | ) | $ | (0.34 | ) | $ | (0.29 | ) |
| Gain from discontinued operations                              |       | —                            |       | 0.01                            |       | 0.02 |   | 0.01 |   |
| Net loss                                                       |       | $                                 | (0.14      | )                               | $          | (0.17 | ) | $ | (0.32 | ) | $ | (0.28 | ) |
|                                                           |       |                              |       |                            |       |   |   |   |   |
| Shares used in computing basic and diluted  net loss per share |       | 23,079                            |       | 23,045                          |       | 23,113 |   | 23,020 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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

 
| ** **                                                        | ** ** | **Six Months Ended   June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                        | ** ** | **2005**                        | ** ** | **2004** | ** ** |
|                                                              |       |                            |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                             |       |                            |       |   |   |
| Net loss                                                          |       | $                               | (7,402     | ) | $ | (6,407 | ) |
| Adjustments to reconcile net loss to net cash used in operations: |       |                            |       |   |   |
| Depreciation                                                      |       | 2,068                           |       | 2,437 |   |
| Amortization of marketable securities  premium/discount           |       | 152                             |       | 123 |   |
| Non-cash restructuring charge                                     |       | 362                             |       | 1,077 |   |
| Loss on disposal of property, plant and  equipment                |       | 217                             |       | — |   |
| Stock based compensation                                          |       | (2                              | )          | — |   |
| Gain on disposal of discontinued operations                       |       | (53                             | )          | (222 | ) |
| Changes in assets and liabilities:                                |       |                            |       |   |   |
| Accounts receivable, net                                          |       | (921                            | )          | 1,907 |   |
| Inventories, net                                                  |       | 1,126                           |       | 2,261 |   |
| Prepaid expenses                                                  |       | 85                              |       | (1,271 | ) |
| Other assets                                                      |       | 43                              |       | 38 |   |
| Accounts payable                                                  |       | (79                             | )          | 153 |   |
| Accrued liabilities                                               |       | (1,181                          | )          | (309 | ) |
| Income taxes                                                      |       | 90                              |       | — |   |
| Other long-term liabilities                                       |       | 26                              |       | 27 |   |
| Net cash used in operating activities                             |       | (5,469                          | )          | (186 | ) |
|                                                              |       |                            |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                             |       |                            |       |   |   |
| Purchases of property, plant and equipment                        |       | (827                            | )          | (702 | ) |
| Proceeds from sales of property, plant and  equipment             |       | 31                              |       | — |   |
| Purchases  of marketable securities                               |       | (5,380                          | )          | (20,650 | ) |
| Proceeds from sale of marketable securities                       |       | 13,988                          |       | 10,422 |   |
| Proceeds from sale of assets held for sale,  net                  |       | 1,303                           |       | — |   |
| Decrease in restricted cash                                       |       | —                          |       | 4,150 |   |
| Net cash provided by (used in) investing  activities              |       | 9,115                           |       | (6,780 | ) |
|                                                              |       |                            |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                             |       |                            |       |   |   |
| Proceeds from (payments of):                                      |       |                            |       |   |   |
| Issuance of common stock                                          |       | 60                              |       | 193 |   |
| Repurchase of common stock                                        |       | (193                            | )          | — |   |
| Long-term debt payments                                           |       | (300                            | )          | (2,728 | ) |
| Net cash used in financing activities                             |       | (433                            | )          | (2,535 | ) |
| Effect of exchange rate changes                                   |       | (218                            | )          | (55 | ) |
| Net increase (decrease) in cash and cash  equivalents             |       | 2,995                           |       | (9,556 | ) |
| Cash and cash equivalents at the beginning  of the period         |       | 12,117                          |       | 24,339 |   |
| Cash and cash equivalents at the end of the  period               |       | $                               | 15,112     |   | $ | 14,783 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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

 

**Note1. Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements of AXT, Inc. (“AXT”,“Company”, we,” “us,” and “our” refer to AXT, Inc. and all of itsconsolidated subsidiaries) are unaudited,and have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, certain information and footnote disclosure normally includedin financial statements prepared in accordance with accounting principles generally accepted in the UnitedStates of America have been condensed or omitted. In the opinion of management,the unaudited condensed consolidated financial statements reflect alladjustments, consisting only of normal recurring adjustments, considerednecessary to present fairly the financial position, results of operations andcash flows of AXT and its subsidiaries for all periods presented.

 

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

 

The results ofoperations are not necessarily indicative of the results to be expected in thefuture or for the full fiscal year. It is recommended that these condensedconsolidated financial statements be read in conjunction with our consolidatedfinancial statements and the notes thereto included in our 2004 Annual Reporton Form 10-K and our Quarterly Report on Form 10-Q filed with the Securitiesand Exchange Commission on March 18, 2005 and May 6, 2005, respectively.

 

Revenues from continuing operations decreased for the three monthperiod ended June 30, 2005 compared to the same period of fiscal 2004. Inresponse to continued net losses, we have taken measures including the shiftingof production to China to reduce costs and control cash flows. As of June 30,2005, we had available cash, cash equivalents and short-term investments of $25.0million, excluding restricted deposits. We believe that our existing cash and cashequivalents and short-term investments, together with additional efforts toreduce expenditures in support of the continuing substrate business will besufficient to meet working capital requirements for the next twelve months.However, existing cash and cash equivalents and short-term investments coulddecline during the remainder of 2005 due to a weakening of the economy, a lossin revenue, an unanticipated increase in expenses, or changes in our plannedcash outlay.

 

If our performance fails to improve, we will continue to use cash andmay at some time be forced to seek additional capital. There can be noassurance that additional capital will be available or, if available to us, that it will be at terms acceptableto us.

 

**Note 2. DiscontinuedOperations and related Assets Held for Sale**

 

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our May 1999 acquisition of LyteOptronics, Inc.. The discontinued opto-electronics division manufacturedblue, cyan, and green high-brightness light emitting diodes (HBLEDs) for theillumination markets, including full-color displays, wireless handsetbacklighting and traffic signals, and also manufactured vertical cavity surfaceemitting lasers (VCSELs) and laser diodes for fiber optic communications andstorage area networks. Accordingly, the results of operations of theopto-electronics division have been segregated from continuing operations andare reported separately as discontinued operations in our condensedconsolidated statements of operations for all periods presented.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0million was held in escrow to satisfy any claims that the purchasers might makefor breaches of representations or warranties by us. Of this total escrow,$750,000 could be released after the one year anniversary of the sale of theopto-electronics business and the remainder could be released after the secondanniversary of the sale. Given the difficult negotiations we encountered withthe acquiring company when negotiating the sale of the opto-electronicsbusiness, as well as the historical operating problems of the business, wedetermined there was significant uncertainty regarding the recoverability ofthe escrowed amounts. Accordingly, we did not recognize the cash held in escrowin recording the sale of the opto-electronics division, and have only recordedamounts as and when they are received. To date, we have resolved all claimsmade against the first $750,000 held in escrow, and have 

 

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received approximately $719,000from the escrow. Accordingly, we recorded a gain on discontinued operations forthe six month period ended June 30, 2005 of $300,000. We also recorded a gainon discontinued operations of $58,000 in property tax refunds for the sameperiod. The remaining $250,000 held in escrow will not be released untilSeptember 2005, if the buyer makes no claims against it by such date.

 

InJune 2005, we completed the sale of a building located in Monterey Park,California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the condensed consolidated balance sheets as ofDecember 31, 2004. We received net proceeds on the sale of the property ofapproximately $1.3 million and accordingly recorded a gain on sale of $53,000for the quarter ended June 30, 2005.

 

Ourcondensed consolidated 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 June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                        | ** ** | **2005**                        | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                           |       | $                               | —     |                          | $          | — |   | $ | — |   | $ | — |   |
| Cost of revenue                                                   |       | —                          |       | —                        |       | — |   | — |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| Gross loss                                                        |       | —                          |       | —                        |       | — |   | — |   |
| Operating expenses:                                               |       |                            |       |                          |       |   |   |   |   |
| Selling, general and administrative                               |       | —                          |       | (222                          | )          | — |   | (222 | ) |
| Research and development                                          |       | —                          |       | —                        |       | — |   | — |   |
| Impairment costs                                                  |       | —                          |       | —                        |       | — |   | — |   |
| Total operating expenses                                          |       | —                          |       | (222                          | )          | — |   | (222 | ) |
| Gain (loss) from operations                                       |       | —                          |       | 222                           |       | — |   | 222 |   |
| Interest expense                                                  |       | —                          |       | —                        |       | — |   | — |   |
| Gain (loss) before benefit for income taxes  and loss on disposal |       | —                          |       | 222                           |       | — |   | 222 |   |
| Income tax (benefit)                                              |       | —                          |       | —                        |       | — |   | — |   |
| Gain on disposal                                                  |       | 53                              |       | —                        |       | 411 |   | — |   |
| Net income (loss)                                                 |       | $                               | 53         |                          | $          | 222 |   | $ | 411 |   | $ | 222 |   |

 

The carryingvalue of the assets and liabilities of the discontinued opto-electronicsbusiness included in the condensed consolidated balance sheets are as follows(in thousands):

 
| ** **                       | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------|------------|-------------------|------------|-----------------------|------------|
| Current assets:                  |       |              |       |                  |       |
| Cash                             |       | $                 | 522        |                  | $          | 537 |   |
| Accounts receivable, net         |       | 19                |       | 19                    |       |
| Assets held for sale             |       | —            |       | 1,250                 |       |
| Total current assets             |       | 541               |       | 1,806                 |       |
| Other assets                     |       | —            |       | 200                   |       |
| Total assets                     |       | $                 | 541        |                  | $          | 2,006 |   |
| Current liabilities:             |       |              |       |                  |       |
| Accrued liabilities              |       | $                 | 318        |                  | $          | 359 |   |
| Total liabilities                |       | 318               |       | 359                   |       |
| Net assets                       |       | 223               |       | 1,647                 |       |
| Total liabilities and net assets |       | $                 | 541        |                  | $          | 2,006 |   |

 

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

 

Weaccount for stock-based employee compensation arrangements using the intrinsic valuemethod as prescribed in Accounting Principles Board Opinion No. 25, *“Accounting for Stock Issued to Employees,”*and related interpretations thereof. Accordingly, compensation cost for stockoptions is measured as the excess, if any, of the market price of AXT’s stockat the date of grant over the stock option exercise price. The following tableillustrates the effect on our net loss and net loss per share if we had appliedthe fair value recognition provisions of Statement of Financial Accounting Standards(SFAS) No. 123, *“Accounting forStock-Based Compensation,”* as amended by SFAS No. 148, *“Accounting for Stock-Based Compensation Transitionand Disclosure,”* to options granted under our stock option plans.For purposes of this pro forma disclosure, the value of the options isestimated using the Black-Scholes option pricing model and amortized to expenseover the options’ vesting periods. Because the estimated value is determined asof the date of grant, the actual value ultimately 

 

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realized by the employeemay be significantly different.

 

Had compensation cost for our options been determined based on the fairvalue at the grant dates, as prescribed in SFAS 123 and SFAS 148, our pro formanet loss and net loss per share would have been as summarized below (inthousands except per share data):

 
| ** **                                                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                    | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss :                                                                                    |       |                             |       |                           |       |   |   |   |   |
| As reported                                                                                   |       | $                                | (3,279     | )                              | $          | (3,847 | ) | $ | (7,402 | ) | $ | (6,407 | ) |
| Less: Stock-based employee compensation  expense (income) included in net loss as reported    |       | 2                                |       | —                         |       | (3 | ) | — |   |
| Less: Stock-based compensation expense  using the fair value based method, net of related tax |       | (232                             | )          | (253                           | )          | (467 | ) | (846 | ) |
| Pro forma net loss                                                                            |       | $                                | (3,509     | )                              | $          | (4,100 | ) | $ | (7,872 | ) | $ | (7,251 | ) |
| Basic and diluted net loss per share:                                                         |       |                             |       |                           |       |   |   |   |   |
| As reported                                                                                   |       | $                                | (0.14      | )                              | $          | (0.17 | ) | $ | (0.32 | ) | $ | (0.28 | ) |
| Pro forma                                                                                     |       | $                                | (0.15      | )                              | $          | (0.18 | ) | $ | (0.34 | ) | $ | (0.31 | ) |
| Shares used in computing basic and diluted  net loss per share                                |       | 23,079                           |       | 23,045                         |       | 23,113 |   | 23,020 |   |

 

We calculatedthe fair value of each option grant on the date of grant using theBlack-Scholes option pricing model as prescribed by SFAS 123 using thefollowing assumptions:

 
| ** **                               | ** ** | **Six Months Ended   June 30,** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Weighted average risk free interest rate |       | 3.72                            | %          | 1.68 | % |
| Expected life (in years)                 |       | 5.0                             |       | 5.0 |   |
| Dividend yield                           |       | —                          |       | — |   |
| Volatility                               |       | 93.2                            | %          | 85.3 | % |

 

Theweighted average grant date fair value of options granted during the six monthperiod ended June 30, 2005 and 2004 were $0.86 and $1.97 per share,respectively.

 

Ananalysis of historical information is used to determine the above assumptions,to the extent that historical information is relevant, based on the terms ofthe grants being issued in any given period. Assumptions related to theEmployee Stock Purchase Plan are not presented as the related compensationexpense amounts are insignificant.

 

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**Note 4. Cash, CashEquivalents and Short-Term Investments**

** **

Ourcash, cash equivalents and short term investments are classified as follows (inthousands):

 
| ** **                                               | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                               | ** ** | **Amortized  Cost**         | ** ** | **Gross   Unrealized   Gain**   | ** ** | **Gross  Unrealized (Loss)** | ** ** | **Fair   Value** | ** ** | **Amortized   Cost** | ** ** | **Gross   Unrealized  Gain** | ** ** | **Gross   Unrealized   (Loss)** | ** ** | **Fair   Value** | ** ** |
| **Classified  as:**                                      |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                                     |       | $                           | 6,690      |                            | $          | — |   | $ | — |   | $ | 6,690 |   | $ | 8,638 |   | $ | — |   | $ | — |   | $ | 8,638 |   |
| Cash equivalents:                                        |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market fund                                        |       | 645                         |       | —                          |       | — |   | 645 |   | 1,681 |   | — |   | — |   | 1,681 |   |
| US Treasury and agency securities                   |       | —                      |       | —                          |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Commercial paper                                         |       | 4,777                       |       | —                          |       | — |   | 4,777 |   | 398 |   | — |   | — |   | 398 |   |
| Repurchase agreements                                    |       | 3,000                       |       | —                          |       | — |   | 3,000 |   | 1,400 |   | — |   | — |   | 1,400 |   |
| Total cash equivalents                                   |       | 8,422                       |       | —                          |       | — |   | 8,422 |   | 3,479 |   | — |   | — |   | 3,479 |   |
| Total cash and cash equivalents                          |       | 15,112                      |       | —                          |       | — |   | 15,112 |   | 12,117 |   | — |   | — |   | 12,117 |   |
|                                                     |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Short-term investments:                                  |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency securities                        |       | 4,481                       |       | —                          |       | (12 | ) | 4,469 |   | 10,468 |   | — |   | (16 | ) | 10,452 |   |
| Asset-backed securities                                  |       | 3,796                       |       | —                          |       | (13 | ) | 3,783 |   | 4,410 |   | — |   | (25 | ) | 4,385 |   |
| Commercial paper                                         |       | 493                         |       | —                          |       | — |   | 493 |   | 1,708 |   | — |   | (1 | ) | 1,707 |   |
| Corporate bonds                                          |       | 7,791                       |       | —                          |       | (23 | ) | 7,768 |   | 8,737 |   | — |   | (30 | ) | 8,707 |   |
| Corporate equity securities                              |       | 1,467                       |       | 116                             |       | — |   | 1,583 |   | 1,465 |   | 1,561 |   | — |   | 3,026 |   |
| Total short-term investments                             |       | 18,028                      |       | 116                             |       | (48 | ) | 18,096 |   | 26,788 |   | 1,561 |   | (72 | ) | 28,277 |   |
| Total cash, cash equivalents and short-term  investments |       | $                           | 33,140     |                            | $          | 116 |   | $ | (48 | ) | $ | 33,208 |   | $ | 38,905 |   | $ | 1,561 |   | $ | (72 | ) | $ | 40,394 |   |
| **Contractual  maturities on short-term investments:**   |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Due within 1 year                                        |       | $                           | 14,034     |                            |       |   |   |   | $ | 14,118 |   | $ | 21,879 |   |   |   |   |   | $ | 23,394 |   |
| Due after 1 through 5 years                              |       | 3,994                       |       |                            |       |   |   | 3,978 |   | 4,909 |   |   |   |   |   | 4,883 |   |
|                                                     |       | $                           | 18,028     |                            |       |   |   |   | $ | 18,096 |   | $ | 26,788 |   |   |   |   |   | $ | 28,277 |   |

 

Theshort-term investments amounts include $8.2 million recorded as restricteddeposits on the condensed consolidated balance sheets as of June 30, 2005 andDecember 31, 2004, respectively.

 

Wemanage our short-term investments as a single portfolio of highly marketablesecurities that is intended to be available to meet our current cashrequirements. As of June 30, 2005 and December 31, 2004, we had no grossrealized gains or losses on sales of our available-for-sale securities.

 

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debt andequity securities as a result of an increase in interest rates during 2004 andthe first half of 2005. We have determined that the gross unrealized losses onour available-for-sale securities as of June 30, 2005 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. The following table provides a breakdown of our available-for-salesecurities with unrealized losses as of June 30, 2005 (in thousands):

 

9

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| ** **                        | ** ** | **In Loss Position   < 12 months** | ** ** | **In Loss Position   > 12 months** | ** ** | **Total In   Loss Position** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **Fair   Value**                                          | ** ** | **Gross  Unrealized  (Loss)**                             | ** ** | **Fair   Value**                       | ** ** | **Gross  Unrealized   (Loss)** | ** ** | **Fair   Value** | ** ** | **Gross   Unrealized   (Loss)** | ** ** |
| Short-term investments:           |       |                                                      |       |                                                      |       |                                   |       |   |   |   |   |   |   |
| US Treasury and agency securities |       | $                                                         | 3,469      |                                                      | $          | (12                                    | )          | $ | — |   | $ | — |   | $ | 3,469 |   | $ | (12 | ) |
| Asset-backed securities           |       | 1,231                                                     |       | (4                                                        | )          | 2,552                                  |       | (9 | ) | 3,783 |   | (13 | ) |
| Corporate bonds                   |       | 6,342                                                     |       | (18                                                       | )          | 1,426                                  |       | (5 | ) | 7,768 |   | (23 | ) |
| Total in loss position            |       | $                                                         | 11,042     |                                                      | $          | (34                                    | )          | $ | 3,978 |   | $ | (14 | ) | $ | 15,020 |   | $ | (48 | ) |

 

**Note5. Inventories, Net**

 

The componentsof inventories are summarized below (in thousands):

 
| ** **        | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------|------------|--------------------|------------|------------------------|------------|
| Inventories, net: |       |               |       |                   |       |
| Raw materials     |       | $                  | 4,896      |                   | $          | 4,416 |   |
| Work in process   |       | 9,763              |       | 10,474                 |       |
| Finished goods    |       | 677                |       | 1,572                  |       |
|              |       | $                  | 15,336     |                   | $          | 16,462 |   |

 

**Note 6. Restructuring Charges**

 

Our restructuring accrual is as follows (in thousands):

 
| **For  the three month period ended   June 30, 2005**  | ** ** | **Restructuring  Accrual as of   March 31,   2005** | ** ** | **Additions/   Reversals** | ** ** | **Payments** | ** ** | **Restructuring   Accrual as of  June 30, 2005** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------|------------|--------------|------------|-------------------------------------------------------|------------|
| Future lease payments related to abandoned  facilities |       | $                                                        | 462        |                       | $          | 169          |       | $                                                     | (144       | ) | $ | 487 |   |
| Workforce reduction                                    |       | 86                                                       |       | (30                        | )          | (56          | )          | —                                                |       |
| Japan office closure                                   |       | —                                                   |       | 98                         |       | (81          | )          | 17                                                    |       |
| Total                                                  |       | $                                                        | 548        |                       | $          | 237          |       | $                                                     | (281       | ) | $ | 504 |   |

 

 
| **For  the six month period ended   June 30, 2005**    | ** ** | **Restructuring  Accrual as of   December 31,  2004** | ** ** | **Additions/   Reversals** | ** ** | **Payments** | ** ** | **Restructuring   Accrual as of   June 30, 2005** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------|------------|--------------|------------|--------------------------------------------------------|------------|
| Future lease payments related to abandoned  facilities |       | $                                                          | 552        |                       | $          | 208          |       | $                                                      | (273       | ) | $ | 487 |   |
| Workforce reduction                                    |       | —                                                     |       | 56                         |       | (56          | )          | —                                                 |       |
| Japan office closure                                   |       | —                                                     |       | 98                         |       | (81          | )          | 17                                                     |       |
| Total                                                  |       | $                                                          | 552        |                       | $          | 362          |       | $                                                      | (410       | ) | $ | 504 |   |

 

OnMarch 14, 2005, we announced that we would be reducing the workforce at ourBeijing, China manufacturing facility by approximately 100 positions orapproximately 15%. This measure was taken as part of our ongoing effort toreduce our cost structure and bring capacity in line with current marketdemand. In March 2005, we recorded a restructuring charge of $86,000 relatingto the reduction in work force, which we completed in June 2005. On an annualbasis, we anticipate payroll and related expense savings of approximately $0.3million relating to this reduction in force.

 

Forthe three and six month periods ended June 30, 2005 we recordedrestructuring charges of $169,000 and $208,000, respectively, related to lease costs associated with facilitieslocated in California that are no longer required to support production. Theremaining restructuring accrual for future lease payments related to abandoned U.S.facilities of $487,000, is expected to be paid out through 2006, and isincluded on the accompanying condensed consolidated balance sheet as accruedrestructuring.

 

10

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OnApril 28, 2005, we closed our Japan office as part of our ongoing effort toreduce our cost structure. In the three month period ended June 30, 2005 werecorded a restructuring charge of $98,000 relating to the closure of our Japanoffice of which $17,000 is in the restructuring accrual balance at June 30,2005. On an annual basis, we anticipate payroll and related expense savings ofapproximately $0.3 million relating to the closure of our Japan office. Theremaining restructuring accrual for our Japan office closure of $17,000 is expectedto be paid out through 2005, and is included on the accompanying condensedconsolidated balance sheet as accrued restructuring.

 

**Note 7. Net Loss Per Share**

 

Basic netloss per common share is calculated by dividing net loss available tocommon stockholders by the weighted average number of common shares outstandingduring the period. Diluted net loss per common and common equivalent sharesinclude the dilutive effect of common stock equivalents outstanding during theperiod calculated using the treasury stock method. Common stock equivalentsconsist of the shares issueable upon the exercise of stock options.

 

Areconciliation of the numerators and denominators of the basic and diluted netloss per share calculations is as follows (in thousands, except per share data):

 
| ** **                                                                       | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                          | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                       |       |                              |       |                            |       |   |   |   |   |
| Net loss                                                                         |       | $                                 | (3,279     | )                               | $          | (3,847 | ) | $ | (7,402 | ) | $ | (6,407 | ) |
| Less: Preferred stock dividends                                                  |       | (44                               | )          | (44                             | )          | (88 | ) | (88 | ) |
| Net loss available to common stockholders                                        |       | $                                 | (3,323     | )                               | $          | (3,891 | ) | $ | (7,490 | ) | $ | (6,495 | ) |
| Denominator:                                                                     |       |                              |       |                            |       |   |   |   |   |
| Denominator for basic net loss per share -  weighted average common shares       |       | 23,079                            |       | 23,045                          |       | 23,113 |   | 23,020 |   |
| Effect of dilutive securities:                                                   |       |                              |       |                            |       |   |   |   |   |
| Common stock options                                                             |       | —                            |       | —                          |       | — |   | — |   |
| Denominator for dilutive net loss per  common share                              |       | 23,079                            |       | 23,045                          |       | 23,113 |   | 23,020 |   |
| Basic and diluted net loss per share                                             |       | $                                 | (0.14      | )                               | $          | (0.17 | ) | $ | (0.32 | ) | $ | (0.28 | ) |
| Options excluded from diluted net loss per  share as the impact is anti-dilutive |       | 2,492                             |       | 1,916                           |       | 2,492 |   | 1,916 |   |

 

**Note8. Comprehensive Loss**

 

The componentsof comprehensive loss are as follows (in thousands):

 
| ** **                                         | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **2005**                          | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |       |                              |       |                            |       |   |   |   |   |
| Net loss                                           |       | $                                 | (3,279     | )                               | $          | (3,847 | ) | $ | (7,402 | ) | $ | (6,407 | ) |
| Foreign currency translation (loss) gain           |       | (74                               | )          | 1                               |       | (218 | ) | (57 | ) |
| Unrealized loss on available for sale  investments |       | (200                              | )          | (296                            | )          | (1,421 | ) | (1,452 | ) |
| Comprehensive loss                                 |       | $                                 | (3,553     | )                               | $          | (4,142 | ) | $ | (9,041 | ) | $ | (7,916 | ) |

 

**Note9. Segment Information and Foreign Operations**

 

***SegmentInformation***

 

Weoperate in one segment for the design, development, manufacture anddistribution of high-performance compound semiconductor substrates and sale ofmaterials. In accordance with SFAS No. 131, *“Disclosures about Segments of an Enterprise andRelated Information,”* our chief operating decision-maker has beenidentified as the Chief Executive Officer, who reviews operating results tomake decisions about allocating resources and assessing performance for theCompany. All material operating units qualify for aggregation underSFAS No. 131 due to their identical customer base and similarities ineconomic characteristics, nature of products and services, and procurement,manufacturing and distribution processes. Since we operate in one segment, allfinancial segment and product line information required bySFAS No. 131 can be found in the 

 

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condensed consolidatedfinancial statements.

 

***GeographicalInformation***

 

Thefollowing table represents revenue amounts (in thousands) reported for productsshipped to customers in the corresponding geographic region:

 
| ** **             | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **             | ** ** | **2005**                          | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenues:          |       |                              |       |                            |       |   |   |   |   |
| North America*         |       | $                                 | 1,310      |                            | $          | 2,180 |   | $ | 2,282 |   | $ | 4,288 |   |
| Europe                 |       | 1,802                             |       | 2,287                           |       | 3,584 |   | 3,702 |   |
| Japan                  |       | 559                               |       | 1,023                           |       | 799 |   | 2,259 |   |
| Taiwan                 |       | 402                               |       | 2,539                           |       | 2,058 |   | 5,683 |   |
| Asia Pacific and other |       | 1,959                             |       | 1,495                           |       | 3,943 |   | 3,368 |   |
| Consolidated           |       | $                                 | 6,032      |                            | $          | 9,524 |   | $ | 12,666 |   | $ | 19,300 |   |

 

----

*                    Primarilythe United States

 

Long-livedassets consist primarily of property, plant and equipment, and are attributedto the geographic location in which they are located. Long-lived assets bygeographic region were as follows (in thousands):

 
| ** **         | ** ** | **As of**      | ** ** |
|--------------------|------------|---------------------|------------|
| ** **         | ** ** | **June 30,   2005** | ** ** | **December 31,  2004** | ** ** |
| Long-lived assets: |       |                |       |   |   |
| North America      |       | $                   | 6,738      |   | $ | 7,163 |   |
| Asia Pacific       |       | 10,818              |       | 11,882 |   |
|               |       | $                   | 17,556     |   | $ | 19,045 |   |

*** ***

***SignificantCustomers***

 

Onecustomer represented 14.6% and 9.6% of revenues for the three month periodsended June 30, 2005 and 2004, respectively. One customer represented 12.2% and 9.5%of revenues for the six month periods ended June 30, 2005 and 2004,respectively. Our top five customers represented 38.7% and 35.6% of revenue forthe three month periods ended June 30, 2005, and 2004, respectively. Ourtop five customers represented 39.8% and 34.6% of revenue for the six monthperiods ended June 30, 2005, and 2004, respectively.

 

**Note10. Corporate Affiliates**

 

Wehave made strategic investments in private companies located in China in orderto gain access to raw materials at a competitive cost that are critical to oursubstrate business. Our investments in these private corporate affiliates aresummarized below (in thousands):

 
| ** **                                     | ** ** | **Investment Balance   As of** | ** ** | ** **                   | ** ** | ** **              | ** ** |
|------------------------------------------------|------------|------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| **Affiliate**                                  | ** ** | **June 30,  2005**                  | ** ** | **December 31,   2004** | ** ** | **Accounting   Method** | ** ** | **Ownership   Percentage** | ** ** |
| Beijing Ji Ya Semiconductor Material Co.,  Ltd |       | $                                        | 1,071      |                         | $          | 1,071                   |       | Consolidated |   | 51 | % |
| Nanjing Jin Mei Gallium Co., Ltd               |       | 616                                      |       | 616                          |       | Consolidated            |       | 88 |   |
| Beijing BoYu Manufacturing Co., Ltd            |       | 409                                      |       | 409                          |       | Consolidated            |       | 70 |   |
| Xilingol Tongli Ge Co. Ltd                     |       | 843                                      |       | 863                          |       | Equity                  |       | 25 |   |
| Emeishan Jia Mei High Pure Metals Co., Ltd     |       | 581                                      |       | 593                          |       | Equity                  |       | 25 |   |
|                                                |            |                                          |            |                              |            |                         |            |  |  |  |  |

 

Theinvestment balances for the two affiliates accounted for under the equitymethod are included in other assets in the condensed consolidated balancesheets. We own 25% of the ownership interests in each of these affiliates.These two affiliates are not considered variable interest entities because:

 

•                       bothaffiliates have sustainable businesses of their own;

 

•                       our votingpower is proportionate to our ownership interests;

 

12

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•                       we onlyrecognize our respective share of the losses and/or residual returns generatedby the affiliates if they occur, or both and

 

•                       we do nothave controlling financial interests in either affiliate, do not maintainoperational or management control, nor control of the board of directors, andare not required to provide additional investment or financial support toeither affiliate.

 

Undistributedretained earnings relating to our corporate affiliates were $1.8 million and$1.4 million as of June 30, 2005 and 2004, respectively. Net income recordedfrom our corporate affiliates were $243,000 and $382,000 for the three monthperiods ended June 30, 2005 and 2004, respectively. Net income recordedfrom our corporate affiliates were $332,000 and $612,000 for the six monthperiods ended June 30, 2005 and 2004, respectively.

 

The minorityinterest for those affiliates that are consolidated is included within “Otherlong-term liabilities” in the condensed consolidated balance sheets and within “Otherexpense (income)” on the condensed consolidated statements of operations.

 

We have considered investments in other joint ventures, including a newjoint venture investment in China for a germanium business opportunity.  If agreement is reached with the otherparties concerning the formation of this joint venture, we may, upon thefulfillment of certain conditions, invest up to $1.0 million in the new jointventure in 2005.

 

**Note11. Commitments and Contingencies**

 

***LegalMatters***

 

OnOctober 15, 2004, a purported securities class action lawsuit was filed in theUnited States Court for the Northern District of California. City of HarperWoods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.  The Court consolidated the case with asubsequent related case and appointed a lead plaintiff.  On April 5, 2005, the lead plaintiff filed aconsolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362MJJ.  The lawsuit complaint names AXT,Inc. and our chief technology officer, as defendants, and is brought on behalfof a class of all purchasers of our securities from February 6, 2001 throughApril 27, 2004. The complaint alleges that we announced financial resultsduring this period that were false and misleading. No specific amount ofdamages is claimed.  We believe thatthere are meritorious defenses against this litigation and intend to vigorouslydefend it. However, due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

 

OnJune 1, 2005, a lawsuit was filed in the Superior Court of California, Countyof Alameda, Zhao et. Al. vs. American Xtal Technology, et. Al., No. R605215713.  The lawsuit complaint namesAXT and its chief technology officer and former interim chief executive officer,and is brought on behalf of two former employees and their minor child.  The complaint alleges personal injury,general negligence, intentional tort, wage loss and other damages, includingpunitive damages, as a result of exposure of defendants, including the minorchild in utero, to high levels of gallium arsenide in gallium arsenide wafers,and methanol.  The complaint seeksdamages of $10 million each for pain, suffering and inconvenience, and foremotion distress, special damages to be determined, and punitive damages in theamount of $10 million.  We believe thatthere are meritorious defenses against this litigation and intend to vigorouslydefend it.  However, due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation. Any unfavorable outcome of the litigation could have anadverse impact on our business, financial condition and results of operations.

 

***ContractCommitment***

 

Wehave entered into contracts to supply several large customers with GaAs wafers.The contracts guaranteed delivery of a certain number of wafers betweenJanuary 1, 2001 and December 31, 2004 with a current contract valueof $130,000. The contract sales prices are subject to review quarterly and canbe adjusted in the event that raw material prices change. In the event ofnon-delivery of the determined wafer quantities in any monthly delivery period,we could be subject to non-performance penalties of between 5% and 10% of thevalue of the delinquent monthly deliveries. We have not received any claims fornon-performance penalties due to non-delivery. Partial prepayments received forthese supply contracts totaling $125,000 and $130,000 are included in accruedliabilities in the accompanying condensed consolidated balance sheets as of June30, 2005 and December 31, 2004, respectively. As of June 30, 2005, we havemet all of our current delivery obligations under these contracts and expect tocontinue to meet delivery requirements during the remainder of the contractterms.

 

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***IndemnificationAgreements***

 

Weenter into standard indemnification arrangements in the ordinary course ofbusiness. Pursuant to these arrangements, we indemnify, hold harmless, andagree to reimburse the indemnified parties for losses suffered or incurred bythe indemnified party, generally their business partners or customers, inconnection with any U.S. patent, or any copyright or other intellectualproperty infringement claim by any third party with respect to our products.The term of these indemnification agreements is generally perpetual anytimeafter the execution of the agreement. The maximum potential amount of futurepayments we could be required to make under these agreements is unlimited. We havenever incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value ofthese agreements is minimal.

 

Wehave entered into indemnification agreements with our directors and officersthat may require us to indemnify our directors and officers against liabilitiesthat may arise by reason of their status or service as directors or officers,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.

 

***ProductWarranty***

 

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represent the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts thatfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balances and update these based on the historical warranty cost trends.The following table reflects the change in our warranty accrual during thethree month and six month periods ended June 30, 2005 and 2004 (in thousands):

 
| ** **                                    | ** ** | **Three****Months Ended June****30****,** | ** ** | **Six****Months Ended June****30****,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                          |       |                                      |       |                                    |       |   |   |   |   |
| Beginning accrued warranty and related  costs |       | $                                         | 135        |                                    | $          | 135 |   | $ | 135 |   | $ | — |   |
| Charged to cost of revenue                    |       | (53                                       | )          | —                                  |       | (53 | ) | 135 |   |
| Actual warranty expenditures                  |       | —                                    |       | —                                  |       | — |   | — |   |
| Ending accrued warranty and related costs     |       | $                                         | 82         |                                    | $          | 135 |   | $ | 82 |   | $ | 135 |   |

 

***SalesReturns***

*** ***

InMarch 2004, we increased our reserve for repair and replacement costs by$745,000, after determining that we had not followed certain requirements fortesting of products and provision of testing data and information relating tocustomer requirements for certain shipments made over the past several years.Approximately $487,000 of the $745,000 sales returns reserve has been utilizedas of June 30, 2005. We will continue to monitor the returns for thisspecific reserve.

 

**Note12. Foreign Exchange Contracts and Transaction Gains/Losses**

 

Weuse short-term forward exchange contracts for hedging purposes to reduce theeffects of adverse foreign exchange rate movements. We have purchased foreignexchange contracts to hedge against certain trade accounts receivabledenominated in Japanese yen. The change in the fair value of the forwardcontracts is recognized as part of the related foreign currency transactions asthey occur. As of June 30, 2005, we had no outstanding commitments withrespect to foreign exchange contracts.

 

Weincurred a foreign currency transaction exchange loss of $29,000 for the threemonth period ended June 30, 2005, and a foreign currency exchange loss of $75,000for the three month period ended June 30, 2004. We incurred a foreign currencytransaction exchange loss of $49,000 for the six month period ended June 30,2005, and a foreign currency exchange loss of $11,000 for the six month periodended June 30, 2004.

 

**Note13. Recent Accounting Pronouncements**

 

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123(revised 2004) (“SFAS 123R”), *“Share-BasedPayment,”* which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value. SFAS 123Rwas originally effective for all interim periods beginning after June 15,2005. Early adoption is encouraged and retroactive application of theprovisions of SFAS 123R to

 

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thebeginning of the fiscal year that includes the effective date is permitted, butnot required.

 

In March 2005, the U.S. Securities and ExchangeCommission, (“ SEC”), released Staff Accounting Bulletin 107 (“SAB107”), *“Share-Based Payments”* . Theinterpretations in SAB 107 express views of the SEC staff, regarding theinteraction between SFAS 123R and certain SEC rules and regulations, andprovide the staff’s views regarding the valuation of share-based paymentarrangements for public companies. In particular, SAB 107 provides guidancerelated to share-based payment transactions with nonemployees, the transitionfrom nonpublic to public entity status, valuation methods (includingassumptions such as expected volatility and expected term), the accounting forcertain redeemable financial instruments issued under share-based paymentarrangements, the classification of compensation expense, non-GAAP financialmeasures, first-time adoption of SFAS 123R in an interim period, capitalizationof compensation cost related to share-based payment arrangements, theaccounting for income tax effects of share-based payment arrangements uponadoption of SFAS 123R, the modification of employee share options prior toadoption of SFAS 123R and disclosures in Management’s Discussion and Analysissubsequent to adoption of SFAS 123R.

 

In April 2005, the SEC approved a new rule thatdelays the effective date of SFAS 123R to the first annual or interim reportingperiod for fiscal years beginning on or after June 15, 2005.  SFAS123R will be effective for us beginningwith the first quarter of fiscal 2006. We are currently evaluating the impact of SFAS 123R on ourfinancial position and results of operations. See Note 3. *Accountingfor Stock-Based Compensation*for information related to the pro forma effects on our reported net loss andnet loss per share when applying the fair value recognition provisions of theprevious SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* to stock-based employee compensation.

 

InNovember 2004, the FASB issued SFAS No. 151, *Inventory Costs*,*an amendment of ARB No. 43, Chapter 4.* This Statementamends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter4, previously stated that “...under some circumstances, items such as idlefacility expense, excessive spoilage, double freight, and rehandling costs maybe so abnormal as to require treatment as current period charges....” ThisStatement requires that those items be recognized as current period chargesregardless of whether they meet the criterion of “so abnormal.” In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities. The provisions of this Statement are effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The adoptionof this Statement is not expected to have a material effect on our consolidatedfinancial position, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153 (SFAS 153), *“Exchanges of Nonmonetary Assets—An Amendment of APBOpinion No. 29, Accounting for Nonmonetary Transactions.”*SFAS 153 eliminates the exception from fair value measurement for nonmonetaryexchanges of similar productive assets in paragraph 21(b) of APBOpinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces itwith an exception for exchanges that do not have commercial substance.SFAS 153 specifies that a nonmonetary exchange has commercial substance ifthe future cash flows of the entity are expected to change significantly as aresult of the exchange. SFAS 153 is effective for the fiscal periodsbeginning after June 15, 2005. We do not expect the adoption of SFAS 153to have a material impact on our consolidated financial position, results ofoperations or cash flows.

 

15

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

 

ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations includes a number of forward-looking statements made pursuant to theprovisions of Section 21E of the Securities Exchange Act of 1934. Theseforward-looking statements are based upon management’s current views withrespect to future events and financial performance, and are subject to certainrisks and uncertainties that could cause actual results to differ materiallyfrom historical results or those anticipated. Such risks and uncertaintiesinclude those set forth under “Risks Related to our Business” below.Forward-looking statements may be identified by the use of terms such as “anticipates,”“believes,” “estimates,” “expects,” “intends,” and similar expressions. Statementsconcerning our future or expected financial results and condition, businessstrategy and plans or objectives for future operations are forward-lookingstatements.

 

Theseforward-looking statements are not guarantees of future performance. Readersare cautioned not to place undue reliance on these forward-looking statements,which speak only as of the date hereof. This discussion should be read inconjunction with Management’s Discussion and Analysis of Financial Conditionand Results of Operations included in our Annual Report on Form 10-K for theyear ended December 31, 2004 and the condensed consolidated financialstatements included elsewhere in this report.

 

**Overview**

 

We werefounded in 1986 to commercialize and enhance our proprietary vertical gradientfreeze (VGF) technique for producing high-performance compound semiconductorsubstrates. As a result of the discontinuance of our opto-electronics division,and the sale of substantially all of the assets of this business in 2003, wenow have one operating segment: our substrate division. We made our firstsubstrate sales in 1990 and our substrate division currently sells galliumarsenide (GaAs) and indium phosphide (InP) substrates to manufacturers ofsemiconductor devices for use in applications such as fiber optic and wirelesstelecommunications, light emitting diodes (LEDs) and lasers. We also sell rawmaterials including gallium and germanium through our participation inmajority- and minority-owned joint ventures. We have the capability to manufacturegermanium substrates for use in satellite solar cells but withdrew from thisbusiness during 2000 so that we could more profitably use our then constrainedcapacity. We are now trying to re-qualify our germanium substrates with the fewexisting satellite solar cell system manufacturers.

 

***DiscontinuedOpto-Electronics Business***

*** ***

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our acquisition of LyteOptronics, Inc. in May 1999. The discontinued opto-electronicsdivision manufactured blue, cyan, and green high-brightness light emittingdiodes (HBLEDs) for the illumination markets, and also manufactured verticalcavity surface emitting lasers (VCSELs) and laser diodes for fiber optic communicationsand storage area networks. Accordingly, the results of operations of theopto-electronics division have been segregated from continuing operations andare reported separately as discontinued operations in our condensedconsolidated statements of operations for all periods presented. See Note 2 toour condensed consolidated financial statements for details regarding theaccounting for discontinued operations.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0million was held in escrow to satisfy any claims that the purchaser might makefor breaches of representations or warranties by us. Of this total escrow$750,000 could be released after the one year anniversary of the sale of theopto-electronics business and the remainder could be released after the secondanniversary of the sale. Given the difficult negotiations we encountered withthe acquiring company when negotiating the sale of the opto-electronicsbusiness, as well as the historical operating problems of the business, wedetermined there was significant uncertainty regarding the recoverability ofthe escrowed amounts. Accordingly, we did not recognize the cash held in escrowin recording the sale of the opto-electronics division, and have only recordedamounts as and when they are received. As of June 30, 2005, we have resolvedall claims made against the first $750,000 held in escrow by the acquiringcompany, and have received all but $31,000 of the first $750,000 held inescrow. As of June 30, 2005, we have $250,000 in escrow which will not beeligible for release until September 2005.

 

InJune 2005, we completed the sale of a building located in Monterey Park,California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the condensed consolidated balance sheets as ofDecember 31, 2004. We received net proceeds on the sale of the property ofapproximately $1.3 million and accordingly recorded a gain on sale of $53,000 inthe quarter ended June 30, 2005.

 

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***RestructuringCharges***

 

During the second quarter of 2004, we announced plans to cease allproduction activities in the United States and to manufacture our products onlyin China. In June 2004, we incurred a restructuring charge of $1.1 million as aresult of our decision to close down our remaining manufacturing facilities inthe United States. In the third and fourth quarter of 2004, we incurredadditional restructuring charges of $231,000 for a total of $1.3 million in2004. These charges comprised costs related to the reduction in work forceeffected in June 2004, and lease costs associated with the facilitieslocated in California that are no longer required to support production. Inaggregate, we eliminated 50 positions, 47 of which were production workers. Onan annual basis, we anticipate payroll and related expense savings of $1.5million. On March 14, 2005, we announced a reduction of our workforce at ourBeijing, China manufacturing facility of approximately 100 positions or approximately15%. This measure was taken as part of our ongoing effort to reduce our coststructure and bring capacity in line with current market demand. We recorded arestructuring charge of $56,000 in the six month period ended June 30, 2005relating to the reduction in force, which we completed in March 2005. On anannual basis, we anticipate payroll and related expense savings ofapproximately $0.3 million relating to this reduction in force.

 

Forthe three and six month periods ended June 30, 2005, we recordedrestructuring charges of $169,000 and $208,000, respectively, related to lease costs associated with facilitieslocated in California that are no longer required to support production. Theremaining restructuring accrual for future lease payments related to abandoned U.S.facilities of $487,000, is expected to be paid out through 2006, and isincluded on the accompanying condensed consolidated balance sheet as accruedrestructuring.

 

InApril, 2005, we closed our Japan office as part of our ongoing effort to reduceour cost structure. In the three month period ended June, 2005 we recorded arestructuring charge of $98,000 relating to the closure of our Japan office ofwhich $17,000 is in the restructuring accrual balance at June 30, 2005. On anannual basis, we anticipate payroll and related expense savings ofapproximately $0.3 million relating to the closure of our Japan office. Theremaining restructuring accrual for our Japan office closure of $17,000 isexpected to be paid out through 2005 and is included on the accompanyingcondensed consolidated balance sheet as accrued restructuring.

 

Forthe remainder of 2005, we will continue to reduce costs by qualifying new lowercost suppliers, moving more of our administrative functions to China where ourcosts are lower, and streamlining our organization structure and costs in theUnited States and China to bring them in line with our current business.

 

**CriticalAccounting Policies and Estimates**

 

We have prepared our condensed consolidated financial statements inaccordance with accounting principles generally accepted in the United Statesof America. As such, we have had to make estimates, assumptions and judgmentsthat affect the amounts reported on our financial statements. These estimates,assumptions and judgments about future events and their effects on our resultscannot be determined with certainty, and are made based upon our historicalexperience and on other assumptions that are believed to be reasonable underthe circumstances. These estimates may change as new events occur or additionalinformation is obtained, and we may periodically be faced with uncertainties,the outcomes of which are not within our control and may not be known for aprolonged period of time. The discussion and analysis of our results ofoperations and financial condition are based upon these condensed consolidatedfinancial statements. We have identified the policies below as critical to ourbusiness operations and understanding of our financial condition and results ofoperations. A critical accounting policy is one that is both material to thepresentation of our financial statements and requires us to make difficult,subjective or complex judgments that could have a material effect on ourfinancial condition and results of operations. They may require us to makeassumptions about matters that are highly uncertain at the time of theestimate, and different estimates that we could have used, or changes in theestimate that are reasonably likely to occur, may have a material impact on ourfinancial condition or results of operations.

 

We believethat the following are our critical accounting policies:

 

***Revenue Recognition***

 

We manufacture and sell high-performance compound semiconductorsubstrates and sell certain raw materials including gallium, germanium dioxide,and pBN crucibles. After we ship our products, there are no remainingobligations or customer acceptance requirements that would preclude recognitionof the revenue earned on the sale. Our products are typically sold pursuant toa purchase order placed by our customers, and our terms and conditions of saledo not require customer acceptance. We recognize revenue upon shipment andtransfer of title of products to our customers, which is either upon 

 

17

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shipment from our dock, receipt at the customer’s dock, or removal fromconsignment inventory at the customer’s location, provided that we havereceived a signed purchase order, the price is fixed or determinable, title andrisk of ownership have transferred, collection of resulting receivables isprobable, and product returns are reasonably estimable. We do not providetraining, installation or commissioning services. Additionally, we do notprovide discounts or other incentives to customers except for one customer withwhom we agreed in the fourth quarter of 2004 to provide a certain amountof cumulative discounts on future product purchases from us. We will recognizethese discounts in future periods as a reduction in revenue as products aresold to this customer.

 

We provide for future returns based on historical experience, currenteconomic trends and changes in customer demand at the time revenue isrecognized. In the first quarter of 2004, we recorded a reserve for sales returnsof $745,000 related to our failure to follow certain testing requirements andprovision of testing data and information to certain customers. This reservewas based on discussions with some of the affected customers and review ofspecific shipments. Approximately $487,000 of the $745,000 sales returnsreserve had been utilized as of June 30, 2005. We will continue to monitorthe returns for this specific reserve.

 

***Allowance for Doubtful Accounts***

 

We periodically review the likelihood of collection on our accountsreceivable balances and provide an allowance for doubtful accounts receivableprimarily based upon the age of these accounts. We provide a 100% allowance forU.S. receivables in excess of 90 days and for foreign receivables in excess of120 days. We assess the probability of collection based on a number of factors,including the length of time a receivable balance has been outstanding, ourpast history with the customer and their credit worthiness.

 

As of June 30, 2005 and December 31, 2004, our accountsreceivable balance was $5.0 million and $4.0 million, respectively, which wasnet of an allowance for doubtful accounts of $0.5 million and $1.1 million,respectively.  If actual uncollectibleaccounts differ substantially from our estimates, revisions to the estimatedallowance for doubtful accounts would be required, which could have a materialimpact on our financial results for the period.

 

***Warranty Reserve***

 

We maintain a warranty reserve based upon our claims experience duringthe prior twelve months. Warranty costs are accrued at the time revenue isrecognized. As of June 30, 2005, accrued product warranties totaled $82,000.If actual warranty costs differ substantially from our estimates, revisions tothe estimated warranty liability would be required, which could have a materialimpact on our financial condition and results of operations.

 

***Inventory Valuation***

 

Inventories are stated at the lower of cost or market. Cost isdetermined using the weighted average cost method. Our inventory consists ofraw materials as well as finished goods and work-in-process that includematerial, labor and manufacturing overhead costs. Given the nature of oursubstrate products, and the materials used in the manufacturing process, thewafers and ingots comprising work-in-process may be held in inventory for up totwo years and three years, respectively, as the risk of obsolescence for thesematerials is low. We routinely evaluate the levels of our inventory in light ofcurrent market conditions in order to identify excess and obsolete inventoryand provide a valuation allowance for certain inventories based upon the ageand quality of the product and the projections for sale of the completedproducts. As of June 30, 2005, we had an inventory reserve of $17.5 millionfor excess and obsolete inventory. The majority of this inventory has not beenscrapped. If actual demand for our products were to be substantially lower thanestimated, additional inventory adjustments for excess or obsolete inventorymight be required, which could have a material impact on our business,financial condition and results of operations.

 

***Impairment of Investments***

 

We classify our investments in debt and equity securities asavailable-for-sale securities as prescribed by Statement of FinancialAccounting Standards (SFAS) No. 115, *“Accountingfor Certain Investments in Debt and Equity Securities.”* Allavailable-for-sale securities with a quoted market value below cost (oradjusted cost) are reviewed in order to determine whether the decline isother-than-temporary. Factors considered in determining whether a loss istemporary include the magnitude of the decline in market value, the length oftime the market value has been below cost (or adjusted cost), credit quality,and our ability and intent to hold the securities for a period of timesufficient to allow for any anticipated recovery in market value.

 

18

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We invest in equity instruments of privately-held companies forbusiness and strategic purposes. These investments are classified as otherassets and are accounted for under the cost method as we do not have theability to exercise significant influence over their operations. We monitor ourinvestments for impairment and record reductions in carrying value when eventsor changes in circumstances indicate that the carrying value may not berecoverable. Determination of impairment is highly subjective and is based on anumber of factors, including an assessment of the strength of 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.

 

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

 

We evaluate the recoverability of property, equipment, and intangible assetsin accordance with SFAS No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets.”* When eventsand circumstances indicate that long-lived assets may be impaired, we comparethe carrying value of the long-lived assets to the projection of futureundiscounted cash flows attributable to such assets. In the event that thecarrying value exceeds the future undiscounted cash flows, we record animpairment charge against income equal to the excess of the carrying value overthe asset’s fair value.

 

***Employee Stock Options***

 

We grant options to substantially all management employees and believethat this broad-based program helps us to attract, motivate, and retain highquality employees, to the ultimate benefit of our stockholders. We currently accountfor share-based payments to employees using the intrinsic value method underAPB Opinion No. 25 and, as such, generally recognize no compensation costfor employee stock options. Statement of Financial Accounting StandardsNo. 123 (revised), “Share-Based Payment” (SFAS 123R) will be effective forus beginning with the first quarter of fiscal 2006.  The adoption of SFAS No. 123R is expected toresult in a material increase in expense during fiscal 2006 based on unvestedoptions outstanding as of June 30, 2005 and current compensation plans.While the effect of adoption depends on the level of share-based paymentsgranted in the future and unvested grants on the date we adopt SFAS 123(R), theeffect of this accounting standard on our prior operating results wouldapproximate the effect of SFAS 123 as described in the disclosure of pro formanet loss and net loss per share. See Note 3 to our condensed consolidatedfinancial statements.

 

***Income Taxes***

 

We account for income taxes in accordance with SFAS No. 109(SFAS 109), *“Accounting for Income Taxes,”*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 geographic composition ofworldwide earnings and tax regulations governing each region, particularlyChina. The calculation of tax liabilities involves significant judgment inestimating the impact of uncertainties in the application of complex tax laws,particularly in foreign countries such as China.

 

**Resultsof Operations**

 

**Revenue**

 
| ** **    | ** ** | **Three Months Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                                 | 4,487      |         | $          | 7,498          |       | $ | (3,011 | ) | (40.2 | )% |
| InP           |       | 280                               |       | 533          |       | (253           | )          | (47.5 | ) |
| Raw Materials |       | 1,256                             |       | 1,473        |       | (217           | )          | (14.7 | ) |
| Other         |       | 9                                 |       | 20           |       | (11            | )          | (55.0 | ) |
| Total revenue |       | $                                 | 6,032      |         | $          | 9,524          |       | $ | (3,492 | ) | (36.7 | )% |

 

Revenue fromcontinuing operations decreased $3.5 million, or 36.7%, to $6.0 million for thethree month period ended June 30, 2005 compared with $9.5 million for the threemonth period ended June 30, 2004.

 

19

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Total GaAssubstrate revenue decreased $3.0 million, or 40.2%, to $4.5 million for thethree month period ended June 30, 2005 compared with $7.5 million for the threemonth period ended June 30, 2004. Sales of 2 inch and 3 inch diameter GaAssubstrates were $2.5 million for the three month period ended June 30, 2005compared with $4.3 million for the three month period ended June 30, 2004. Thedecrease in GaAs substrate revenue is due to existing quality issues, the continuingpricing pressures causing prices to decline, overall lower demand from ourwireless application customers and a decline in orders from customers who arequalifying our China-grown products. InP substrate revenue decreased $253,000,or 47.5%, to $280,000 for the three month period ended June 30, 2005 comparedwith $533,000 for the three month period ended June 30, 2004. The decrease inInP substrate revenue was due to a decline in orders from customers who arequalifying our China-grown products.

 
| ** **    | ** ** | **Six Months Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|---------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2005**                        | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**  | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                               | 9,680      |         | $          | 15,536         |       | $ | (5,856 | ) | (37.7 | )% |
| InP           |       | 417                             |       | 1,049        |       | (632           | )          | (60.2 | ) |
| Raw Materials |       | 2,552                           |       | 2,675        |       | (123           | )          | (4.6 | ) |
| Other         |       | 17                              |       | 40           |       | (23            | )          | (57.5 | ) |
| Total revenue |       | $                               | 12,666     |         | $          | 19,300         |       | $ | (6,634 | ) | (34.4 | )% |

 

Revenue fromcontinuing operations decreased $6.6 million, or 34.4%, to $12.7 million forthe six month period ended June 30, 2005 compared with $19.3 million for thesix month period ended June 30, 2004.

 

Total GaAssubstrate revenue decreased $5.9 million, or 37.7%, to $9.7 million for the sixmonth period ended June 30, 2005 compared with $15.5 million for the six monthperiod ended June 30, 2004. Sales of 2 inch and 3 inch diameter GaAs substrateswere $6.3 million for the six month period ended June 30, 2005 compared with $9.3million for the six month period ended June 30, 2004. The decrease in GaAssubstrate revenue is due to existing quality issues, the continuing pricingpressures causing prices to decline, overall lower demand from our wirelessapplication customers and a decline in orders from customers who are qualifyingour China-grown products. InP substrate revenue decreased $632,000, or 60.2%,to $417,000 for the six month period ended June 30, 2005 compared with $1.0million for the six month period ended June 30, 2004. The decrease in InPsubstrate revenue was due to a decline in orders from customers who arequalifying our China-grown products.

 

***Revenueby Geographic Region***

 
| ** **                                | ** ** | **Three Months Ended   June 30,** | *** *** | **Increase** | ** **   | ** **     | ** ** |
|-------------------------------------------|------------|-----------------------------------|--------------|--------------|--------------|----------------|------------|
| ** **                                | ** ** | **2005**                          | ** **   | **2004**     | *** *** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**    | *** *** | ** **   | ** **   | ** **     | ** ** |
| North America *                           |       | $                                 | 1,310        |         | $            | 2,180          | * *   | $ | (870 | ) | (39.9 | )% |
| *% of  total revenue*                     | * *   | *22*                              | *%*          | *23*         | *%*          |           |       |   |   |
| Europe                                    |       | 1,802                             |         | 2,287        | * *     | (485           | )          | (21.2 | ) |
| *% of  total revenue*                     | * *   | *30*                              | *%*          | *24*         | *%*          |           |       |   |   |
| Japan                                     |       | 559                               |         | 1,023        | * *     | (464           | )          | (45.4 | ) |
| *% of  total revenue*                     | * *   | *9*                               | *%*          | *11*         | *%*          |           |       |   |   |
| Taiwan                                    |       | 402                               |         | 2,539        | * *     | (2,137         | )          | (84.2 | ) |
| *% of  total revenue*                     | * *   | *7*                               | *%*          | *27*         | *%*          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 1,959                             |         | 1,495        | * *     | 464            |       | 31.0 |   |
| *% of  total revenue*                     | * *   | *32*                              | *%*          | *16*         | *%*          |           |       |   |   |
| Total revenue                             |       | $                                 | 6,032        |         | $            | 9,524          | * *   | $ | (3,492 | ) | (36.7 | )% |

 

----

*                 Primarilythe United States

 

Asia Pacific revenueincreased to 32% of total revenue from continuing operations for the threemonth period ended June 30, 2005 compared with 16% of total revenue fromcontinuing operations for the three month period ended June 30, 2004. Theincrease was primarily due to increased sales of GaAs substrates to customersin China and Singapore which are being 

 

20

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used inopto-electronics applications. The overall decrease in other geographic areasfor our GaAs substrates is due to existing quality issues, continuing pricingpressures causing prices to decline, overall lower demand from our wirelessapplication customers, and delays in orders from customers who are qualifyingour China-grown products.

 
| ** **                                | ** ** | **Six Months Ended   June 30,** | *** *** | **Increase** | ** **   | ** **     | ** ** |
|-------------------------------------------|------------|---------------------------------|--------------|--------------|--------------|----------------|------------|
| ** **                                | ** ** | **2005**                        | ** **   | **2004**     | *** *** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**  | *** *** | ** **   | ** **   | ** **     | ** ** |
| North America *                           |       | $                               | 2,282        |         | $            | 4,288          | * *   | $ | (2,006 | ) | (46.8 | )% |
| *% of  total revenue*                     | * *   | *18*                            | *%*          | *22*         | *%*          |           |       |   |   |
| Europe                                    |       | 3,584                           |         | 3,702        | * *     | (118           | )          | (3.2 | ) |
| *% of  total revenue*                     | * *   | *28*                            | *%*          | *19*         | *%*          |           |       |   |   |
| Japan                                     |       | 799                             |         | 2,259        | * *     | (1,460         | )          | (64.6 | ) |
| *% of  total revenue*                     | * *   | *7*                             | *%*          | *12*         | *%*          |           |       |   |   |
| Taiwan                                    |       | 2,058                           |         | 5,683        | * *     | (3,625         | )          | (63.8 | ) |
| *% of  total revenue*                     | * *   | *16*                            | *%*          | *30*         | *%*          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 3,943                           |         | 3,368        | * *     | 575            |       | 17.1 |   |
| *% of  total revenue*                     | * *   | *31*                            | *%*          | *17*         | *%*          |           |       |   |   |
| Total revenue                             |       | $                               | 12,666       |         | $            | 19,300         | * *   | $ | (6,634 | ) | (34.4 | )% |

 

----

*                 Primarilythe United States

 

Internationalrevenue increased to 82% of total revenue from continuing operations for the sixmonth period ended June 30, 2005 compared with 78% of total revenue fromcontinuing operations for the six month period ended June 30, 2004. AsiaPacific revenue increased to 31% of total revenue from continuing operationsfor the six month period ended June 30, 2005 compared with 17% of total revenuefrom continuing operations for the six month period ended June 30, 2004. Theincrease was primarily due to increased sales of GaAs substrates to customersin China and Singapore which are being used in opto-electronics applications.  The overall decrease in other geographicareas for our GaAs substrates is due to existing quality issues, continuingpricing pressures causing prices to decline, overall lower demand from ourwireless application customers, and delays in orders from customers who arequalifying our China-grown products.

 

***GrossMargin***

 
| ** **        | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                                   | 127        |         | $          | 829            |       | $ | (702 | ) | (84.7 | )% |
| *Gross  Margin %* | * *   | *2.1*                               | *%*        | *8.7*        | *%*        |           |       |   |   |
|                   |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

*Gross margin.*Gross margin decreased to 2.1%of total revenue for the three month period ended June 30, 2005 compared with 8.7%of total revenue for the three month period ended June 30, 2004. Gross marginin the three month period ended June 30, 2005 was negatively impacted by a$765,000 charge to cost of revenues as a result of an inventory valuation adjustment.There was no such adjustment in the three month period ended June 30, 2004.  The impact of the charge in the three monthperiod ended June 30, 2005 was to reduce gross margin from 14.8% to 2.1%. Ouraverage selling prices have dropped, our revenue is down, and given our currentexcess capacity, our gross margins are not expected to improve significantlyfor the remainder of 2005.

*** ***
| ** **        | ** ** | **Six Months  Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------|------------|----------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **2005**                         | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**   | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                                | 406        |         | $          | 1,362          |       | $ | (956 | ) | (70.2 | )% |
| *Gross  Margin %* | * *   | *3.2*                            | *%*        | *7.1*        | *%*        |           |       |   |   |
|                   |            |                                  |            |              |            |                |            |  |  |  |  |  |

 

21

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*Gross margin.*Gross margin decreased to 3.2%of total revenue for the six month period ended June 30, 2005 compared with 7.1%of total revenue for the six month period ended June 30, 2004. Gross margin forthe six month period ended June 30, 2005 was negatively impacted by a $765,000charge to cost of revenues as a result of an inventory valuation adjustment.There was no such adjustment for the six month period ended June 30, 2004. Theimpact of the charge in the six month period ended June 30, 2005 was to reducegross margin from 9.2% to 3.2%. Our average selling prices have dropped, ourrevenue is down, and given our current excess capacity, our gross margins arenot expected to improve significantlyfor the remainder of 2005.

 

***Selling,General and Administrative Expenses***

*** ***
| ** **                                    | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative  expenses |       | $                                   | 2,716      |         | $          | 3,203          |       | $ | (487 | ) | (15.2 | )% |
| *% of  total revenue*                         | * *   | *45.0*                              | *%*        | *33.6*       | *%*        |           |       |   |   |
|                                               |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

Selling,general and administrative expenses decreased $487,000 to $2.7 million for thethree month period ended June 30, 2005 compared with $3.2 million for the threemonth period ended June 30, 2004. The reasons for this decrease was that the threemonth period ended June 30, 2004 included $350,000 of legal fees related to theinvestigation by our Audit Committee into product testing and compliancepractices and $300,000 of audit and Sarbanes-Oxley related expenses. For the threemonth period ended June 30, 2005 we had $548,000 of expenses relating to the decommissioningof our Fremont, California facilities, which was partially offset by areduction in the allowance for doubtful accounts of $270,000.

 
| ** **                                    | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative  expenses |       | $                                 | 6,968      |         | $          | 5,973          |       | $ | 995 |   | 16.7 | % |
| *% of  total revenue*                         | * *   | *55.0*                            | *%*        | *30.9*       | *%*        |           |       |   |   |
|                                               |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

Selling,general and administrative expenses increased $995,000 to $7.0 million for thesix month period ended June 30, 2005 compared with $6.0 million for the sixmonth period ended June 30, 2004. The increase was primarily due to $1.8million of expenses for the six month period ended June 30, 2005 relating tothe decommissioning of our Fremont, California facilities, offset by $350,000 oflegal fees related to the investigation by our Audit Committee into producttesting and compliance practices and $300,000 of audit and Sarbanes-Oxleyrelated expenses for the six month period ended June 30, 2004.

 

***Researchand Development***

*** ***
| ** **               | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                   | 423        |         | $          | 350            |       | $ | 73 |   | 20.9 | % |
| *% of  total revenue*    | * *   | *7.0*                               | *%*        | *3.7*        | *%*        |           |       |   |   |
|                          |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

Research anddevelopment expenses increased $73,000, or 20.9%, to $423,000 for the threemonth period ended June 30, 2005 compared with $350,000 for the three monthperiod ended June 30, 2004. During the three month period ended June 30, 2005we incurred $64,000 in severance pay to employees that had been performingresearch and development activities.

 

22

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| ** **               | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                 | 785        |         | $          | 691            |       | $ | 94 |   | 13.6 | % |
| *% of  total revenue*    | * *   | *6.2*                             | *%*        | *3.6*        | *%*        |           |       |   |   |
|                          |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

Research anddevelopment expenses increased $94,000, or 13.6%, to $785,000 for the six monthperiod ended June 30, 2005, compared with $691,000 for the six month periodended June 30, 2004. During the six month period ended June 30, 2005, we incurred$64,000 in severance pay to employees that had been performing research anddevelopment activities. We believe that continued investment in productdevelopment is critical to attaining our strategic objectives of maintainingand increasing our technology leadership, and have appointed Dr. Morris Youngas our Chief Technology Officer.  As aresult, we expect research and development expenses to remain at the levels ofrecent quarters or to increase in future periods. Research and developmentefforts during the first six months of 2005 were focused primarily on improvingthe yield and surface quality of our GaAs substrates, and we expect theseactivities to continue.

 

***RestructuringCharges***

 
| ** **            | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring charges |       | $                                   | 237        |         | $          | 1,077          |       | $ | (840 | ) | 78.0 | % |
| *% of  total revenue* | * *   | *3.9*                               | *%*        | 11.3         | %          |           |       |   |   |
|                       |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

During the three month period ended June 30, 2005, we recordedrestructuring charges of $237,000 of which $169,000 related to lease costs associated with facilitieslocated in California that are no longer required to support production, and $98,000related to the closure of our Japanoffice.  Offsetting these charges, we hada credit adjustment of $30,000 related to the reduction in our China workforce effected in March 2005.

 

In June 2004, we incurred a restructuring charge of $1.1 millionas a result of our decision to close down our remaining manufacturingfacilities in the United States.

*** ***
| ** **            | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring charges |       | $                                 | 362        |         | $          | 1,077          |       | $ | (715 | ) | 66.4 | % |
| *% of  total revenue* | * *   | *2.9*                             | *%*        | 5.6          | %          |           |       |   |   |
|                       |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

During the six month period ended June 30, 2005, we recordedrestructuring charges of $362,000, of which $208,000 related to lease costs associated with facilitieslocated in California that are no longer required to support production, $98,000related to the closure of our Japanoffice, and $56,000 related to the reduction in our China work forceeffected in March 2005.

 

***InterestIncome, net***

*** ***
| ** **            | ** ** | **Three Months  Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                           | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**     | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                                  | 131        |         | $          | 54             |       | $ | 77 |   | 142.6 | % |
| *% of  total revenue* |       | 2.2                                | %          | 0.6          | %          |           |       |   |   |
|                       |            |                                    |            |              |            |                |            |  |  |  |  |  |

 

23

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Interestincome, net increased $77,000 to $131,000 for the three month period ended June30, 2005 compared with $54,000 for the three month period ended June 30, 2004as a result of lower debt levels as we continued to pay down our debt.

 
| ** **            | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                                 | 250        |         | $          | 78             |       | $ | 172 |   | 220.5 | % |
| *% of  total revenue* |       | 2.0                               | %          | 0.4          | %          |           |       |   |   |
|                       |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

Interestincome, net increased $172,000 to $250,000 for the six month period ended June30, 2005 compared with $78,000 for the six month period ended June 30, 2004 asa result of our lower debt levels as we continued to pay down our debt.

 

***OtherIncome and Expense, net***

 
| ** **                  | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                  | ** ** | **($ in thousands)**      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense), net |       | $                                   | (196       | )            | $          | (225           | )          | $ | (29 | ) | (12.9 | )% |
| *% of  total revenue*       |       | (3.2                                | )%         | (2.4         | )%         |           |       |   |   |
|                             |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

Other expensewas $196,000 for the three month period ended June 30, 2005 compared with otherexpense of $225,000 for the three month period ended June 30, 2004. The decreasein other expense was mainly due to foreign exchange losses related to theJapanese yen and a decrease in the minority interest’s share in our jointventures.

 
| ** **                  | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                  | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                  | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense), net |       | $                                 | (301       | )            | $          | (191           | )          | $ | 110 |   | 57.6 | % |
| *% of  total revenue*       |       | (2.4                              | )%         | (1.0         | )%         |           |       |   |   |
|                             |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

Other expensewas $301,000 for the six month period ended June 30, 2005 compared with other expenseof $191,000 for the six month period ended June 30, 2004. The increase in otherexpense was mainly due to foreign exchange losses related to the Japanese yen,an increase in the minority interest’s share in our joint ventures, and a losson disposal of equipment.

 

***Provisionfor Income Taxes***

*** ***
| ** **                 | ** ** | **Three Months  Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                           | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**     | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                  | 18         |         | $          | 97             |       | $ | (79 | ) | (81.4 | )% |
| *% of  total revenue*      | * *   | *0.3*                              | *%*        | *1.0*        | *%*        |           |       |   |   |
|                            |            |                                    |            |              |            |                |            |  |  |  |  |  |

 

We providedfor income taxes of $18,000 for our overseas businesses for the three monthperiod ended June 30, 2005 compared to $97,000 for the three month period endedJune 30, 2004.

 

24

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| ** **                 | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**    | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                 | 53         |         | $          | 137            |       | $ | (84 | ) | (61.3 | )% |
| *% of  total revenue*      | * *   | *0.4*                             | *%*        | *0.7*        | *%*        |           |       |   |   |
|                            |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

We providedfor income taxes of $53,000 for our overseas businesses for the six monthperiod ended June 30, 2005 compared to $137,000 for the six month period endedJune 30, 2004.

 

***Gainfrom Discontinued Operations***

 
| ** **                        | ** ** | **Three Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **2005**                            | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **$ in thousands)**       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                                   | 53         |         | $          | 222            |       | $ | (169 | ) | (76.1 | )% |
| *% of  total revenue*             | * *   | *0.9*                               | *%*        | *2.3*        | *%*        |           |       |   |   |
|                                   |            |                                     |            |              |            |                |            |  |  |  |  |  |

 

Duringthe three month period ended June 30, 2005, we received net proceeds ofapproximately $1.3 million from the sale of a building located in MontereyPark, California and recorded a gain of $53,000. For the three month periodended June 30, 2004, we recorded a gain of $222,000 as a result of our reversalof accrued liabilities of general and administrative expenses no longerrequired in connection with legal fees and cleanup costs.

 
| ** **                        | ** ** | **Six Months   Ended   June 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **2005**                          | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **$ in thousands)**     | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                                 | 411        |         | $          | 222            |       | $ | 189 |   | 85.1 | % |
| *% of  total revenue*             | * *   | *3.2*                             | *%*        | *1.2*        | *%*        |           |       |   |   |
|                                   |            |                                   |            |              |            |                |            |  |  |  |  |  |

 

For the six month period ended June 30, 2005, the gain fromdiscontinued operations is made up of a gain of $300,000 which was theremaining portion of the first $750,000 held in escrow due to us from the saleof our opto-electronics business, $58,000 in property tax refunds, and a gainof $53,000 from the sale of a building located in Monterey Park, California. Forthe six month period ended June 30, 2004, we recorded a gain of $222,000 as aresult of our reversal of accrued liabilities of general and administrativeexpenses no longer required in connection with legal fees and cleanup costs.

 

**Liquidity and Capital Resources**

 

We considercash and cash equivalents and short-term investments as liquid and availablefor use. Short-term investments are comprised of government bonds andhigh-grade commercial debt instruments. Also included in short-term investmentsis our investment in common stock of Finisar Corporation. As of June 30, 2005,our principal sources of liquidity were $25.0 million in cash and cashequivalents and short-term investments, excluding restricted deposits.

 

Cash and cashequivalents and short-term investments decreased $7.2 million to $25.0 million as of June 30, 2005 comparedwith $32.2 million as of December 31, 2004. Of this decrease, $1.5 million wasthe decrease in our investment in Finisar common stock from $2.7 million as ofDecember 31, 2004 to $1.2 million as of June 30, 2005, and $1.9 million was ourpayment to Sumitomo Electric Industries, Ltd. consisting of $1.4 million inconnection with our settlement agreement and $0.5 million relating to our cross-licensefee.

 

Net cash usedby operating activities of $5.5 million for the six month period ended June 30,2005 was comprised primarily of our net loss of $7.4 million, adjusted fornon-cash items consisting primarily of depreciation of $2.1 million, andpartially offset by a net increase of $811,000 in assets and liabilities. Thenet increase in assets and liabilities resulted primarily from an increase inaccounts receivable, net and a decrease in accrued liabilities partially offset by a decrease in inventory,net.

 

25

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Net accountsreceivable increased by $1.0 million, or 22.8%, to $5.0 million as of June 30, 2005compared with $4.0 million as of December 31, 2004. The increase was primarilya result of the decrease in the allowance for doubtful accounts as we recoveredsome accounts that were fully reserved and some accounts improved in aging thatled to a decrease in the allowance.

 

Netinventories decreased $1.2 million, or 6.8% to $15.3 million as of June 30,2005 compared with $16.5 million as of December 31, 2004, primarily due to a $765,000inventory valuation adjustment.

 

Net cashprovided by investing activities of $9.1 million for the six month period endedJune 30, 2005 included the sales of investment securities totaling $14.0million, and proceeds from assets held for sale of $1.3 million partiallyoffset by purchases of investment securities of $5.4 million and purchases ofproperty, plant and equipment, net of $0.8 million.

 

We do not haveany plans to initiate any major new capital spending projects through 2005. Weare currently completing certain projects at our China facilities and closingour remaining manufacturing facilities in Fremont, California. We expect toinvest approximately $0.4 million in capital projects for the remainder of 2005.We believe that our existing and planned facilities and equipment aresufficient to fulfill current and expected future orders.

 

Net cash usedin financing activities of $433,000 for the six month period ended June 30,2005 consisted of payments of $300,000 related to long-term borrowings and $193,000to repurchase our common stock, partially offset by proceeds of $60,000 throughour employee stock purchase and stock option programs.

 

Our mainFremont, California manufacturing facility is financed by long-term borrowings,which were refinanced by taxable variable rate revenue bonds in 1998. Thesebonds mature in 2023 and bear interest at a variable rate that was 3.42% as of June30, 2005. The bonds are traded in the public market. Repayment of principal andinterest under the bonds is supported by a letter of credit from our bank andis paid on a quarterly basis. We have the option to redeem the bonds in wholeor in part during their term. As of June 30, 2005, $7.8 million was outstandingunder these bonds.

 

As of June 30,2005, thecredit facility maintained by us with a bank included a letter of credit supportingrepayment of our industrial bonds with an outstanding amount of $8.2 million.We have pledged and placed certain investment securities with an affiliate ofthe bank as additional collateral for this facility.

 

We believethat we have adequate cash and investments to meet our needs over the next 12months. If our performance fails to improve, we will continue to use cash andmay at some time be forced to seek additional capital. There can be noassurance that such additional capital will be available or, if available itwill be at terms acceptable to us. Cash from operations could be affected byvarious risks and uncertainties, including, but not limited to those set forthbelow under “Risks Related to Our Business.”

 

Outstandingcontractual obligations as of June 30, 2005 are summarized as follows (inthousands):

 
| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1-3   years** | ** ** | **3-5   years** | ** ** | **More than   5 years** | ** ** |
| Long-term debt               |       | $                          | 7,750      |   | $ | 450 |   | $ | 1,420 |   | $ | 900 |   | $ | 4,980 |   |
| Operating leases             |       | 6,114                      |       | 1,200 |   | 2,060 |   | 1,508 |   | 1,346 |   |
| Purchase obligation          |       | 1,017                      |       | 1,017 |   | — |   | — |   | — |   |
| Total                        |       | $                          | 14,881     |   | $ | 2,667 |   | $ | 3,480 |   | $ | 2,408 |   | $ | 6,326 |   |

 

We leasecertain office space, manufacturing facilities and property under long-termoperating leases expiring at various dates through March 2013. Total rent paymentsunder these operating leases were approximately $722,000 and $705,000 for the sixmonth periods ended June 30, 2005 and 2004, respectively.

 

**RecentAccounting Pronouncements**

 

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123(revised 2004) (“SFAS 123R”), *“Share-BasedPayment,”* which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value. SFAS 123Rwas originally effective for all interim periods beginning after June 15,2005. Early adoption is encouraged and retroactive application of theprovisions of SFAS 123R to the beginning of the fiscal year that includes theeffective date is permitted, but not required.

 

In March 2005 the U.S. Securities and ExchangeCommission, or SEC, released Staff Accounting Bulletin 107, *“Share-Based Payments,”* or SAB 107. Theinterpretations in SAB 107 express views of the SEC staff, or staff, regardingthe 

 

26

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interactionbetween SFAS 123R and certain SEC rules and regulations, and provide the staff’sviews regarding the valuation of share-based payment arrangements for publiccompanies. In particular, SAB 107 provides guidance related to share-basedpayment transactions with nonemployees, the transition from nonpublic to publicentity status, valuation methods (including assumptions such as expectedvolatility and expected term), the accounting for certain redeemable financialinstruments issued under share-based payment arrangements, the classificationof compensation expense, non-GAAP financial measures, first-time adoption ofSFAS 123R in an interim period, capitalization of compensation cost related toshare-based payment arrangements, the accounting for income tax effects ofshare-based payment arrangements upon adoption of SFAS 123R, the modificationof employee share options prior to adoption of SFAS 123R and disclosures inManagement’s Discussion and Analysis subsequent to adoption of SFAS 123R.

 

InNovember 2004, the FASB issued SFAS No. 151, *Inventory Costs*,*an amendment of ARB No. 43, Chapter 4.* This Statementamends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarifythe accounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4,previously stated that “...under some circumstances, items such as idle facilityexpense, excessive spoilage, double freight, and rehandling costs may be soabnormal as to require treatment as current period charges....” This Statementrequires that those items be recognized as current period charges regardless ofwhether they meet the criterion of “so abnormal.” In addition, this Statementrequires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. Theprovisions of this Statement are effective for inventory costs incurred duringfiscal years beginning after June 15, 2005. The adoption of this Statementis not expected to have a material effect on our consolidated financialposition, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153 (SFAS 153), *“Exchanges of Nonmonetary Assets—An Amendment of APBOpinion No. 29, Accounting for Nonmonetary Transactions.”*SFAS 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets inparagraph 21(b) of APB Opinion No. 29, “Accounting forNonmonetary Transactions,” and replaces it with an exception for exchanges thatdo not have commercial substance. SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. SFAS 153 iseffective for the fiscal periods beginning after June 15, 2005. We do notexpect the adoption of SFAS 153 to have a material impact on ourconsolidated financial position, results of operations or cash flows.

 

In April 2005, the SEC approved a new rule thatdelays the effective date of SFAS 123R to the first annual or interim reportingperiod for fiscal years on or after June 15, 2005.  SFAS123R will be effective for us beginningwith the first quarter of fiscal 2006. We are currently evaluating the impact of SFAS 123R on ourfinancial position and results of operations. See Note 3. *Accountingfor Stock-Based Compensation*for information related to the pro forma effects on our reported net loss andnet loss per share when applying the fair value recognition provisions of theprevious SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* to stock-based employee compensation.

 

**Risks Related to OurBusiness**

** **

***Wemay incur claims or other liabilities or obligations related to our failure tofollow requirements for testing of products and provision of testing data andinformation relating to customer requirements. Additionally, customers maycancel or reduce future shipments in response to these failures, or requirere-qualifications.***

*** ***

Duringthe first quarter of 2004, we determined that we had not followed requirementsfor testing of products and provision of testing data and information relatingto customer requirements. We notified affected customers concerning ourfindings, however, there can be no assurance that we will not incur customerclaims or other liabilities or obligations in connection with this matter, nor,if we receive any such claims, that we will not have to restate results fromprior periods. In addition, revenue in future periods may be adversely impactedif customers decide not to order from us as a result of this disclosure. Weexperienced several cancellations of future orders by customers pending furtherinformation regarding enhancements to our product testing and quality controlsystems. In addition, some customers are requiring additional qualification ofour China operations before placing future orders with us. We cannot be surethat we will not receive additional cancellations of orders by other customers,or fail to win expected future orders from customers, as a result of ourdisclosure of our investigation conclusions, or that our customers will qualifyour China operations and place future orders with us.

 

***Becauseof power shortages in China, we may have to temporarily close our Chinaoperations, which would adversely impact our ability to manufacture ourproducts, meet customer orders, and result in reduced revenues.***

*** ***

TheChinese government faced a power crunch over the summer of 2004 and reportedthat power demand in 24 provinces

 

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outstripped supply inpeak periods during the first four months of 2004. Instability in electricalsupply caused sporadic outages among residential and commercial consumers. As aresult, the Chinese government implemented tough measures in 2004 to ease theenergy shortage which is expected to last at least through 2005. Provincesimposed power brownouts during 2004 to reduce electricity demand and somecompanies in Beijing were ordered to give their employees a week off to easethe pressure on power supply. The plants, most of which are state-owned, wereclosed and reopened on a staggered schedule to reduce power consumption duringthe capital’s hottest months during 2004. As a result we closed most of ouroperations for a week in late July 2004 in conformance with thispolicy. Some shortages have already been reported in 2005 and the powershortages may be more severe than during 2004. If we are required to makeadditional temporary closures of our Beijing and joint venture operationsduring 2005, we may be unable to manufacture our products, and would then beunable to meet customer orders except from inventory on hand. As a result, wecould lose sales, adversely impacting our revenues, and our relationships withour customers could suffer, impacting our ability to generate future sales. Inaddition, if power is shut off at our Beijing operations at any time, eithervoluntarily or as a result of unplanned brownouts, during certain phases of ourmanufacturing process including our crystal growth phase, the work in processmay be ruined and rendered unusable, causing us to incur expense that will notbe covered by revenue, and negatively impacting our cost of goods sold andgross margins. We are attempting to partially mitigate the potential effects ofpower outages by building inventory in anticipation of power outages during thesummer. This inventory build is prepared to accommodate forecast demand ratherspecific customer orders. If the inventory we build is not ordered bycustomers, we may have to scrap these products and incur a cost which willreduce our gross margins.

 

***Ouroperating results depend in large part on further customer acceptance of ourexisting substrate products manufactured in China.***

*** ***

Aswe are now manufacturing only in China, if the shift of our substratemanufacturing operations to China is to be successful, we will need ourcustomers to qualify products manufactured in China. If we are unable toachieve qualifications for these products, our China facility will beunderutilized, our investments in China will not be recouped and we will beunable to lower our costs by moving to China. We may lose sales of our productsto competitors who are not manufacturing in China, or whose operations in Chinahave already been qualified by customers. If customers do not fully qualify ourChina production, we may lose additional customers and fail to achieve revenuegrowth.

 

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

 

***Defectsin our products could diminish demand for our products.***

*** ***

Ourproducts are complex and may contain defects. We have experienced qualitycontrol problems with some of our products which caused customers to returnproducts to us, reduce orders for our products, or both. If we continue toexperience quality control problems, or experience these or other problems innew products, customers may cancel or reduce orders or purchase products fromour competitors and sales of our products could decline. Defects in our productscould cause us to incur higher manufacturing costs and suffer product returnsand additional service expenses, all of which could adversely impact ouroperating results.

 

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

 

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

 

Weare subject to federal, state and local environmental and safety laws andregulations in all of our operating locations, including laws and regulationsof China. These laws, rules and regulations govern the use, storage,discharge and disposal of hazardous chemicals during manufacturing, researchand development, and sales demonstrations. If we fail to comply with applicableregulations, we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our operations. InMarch 2001, we settled a claim made by the California Occupational Safetyand Health Administration, or Cal-OSHA, in an investigation primarily regardingimpermissible levels of potentially hazardous materials in certain areas of ourmanufacturing facility in Fremont, California for $200,415, and during 2004 wewere the target of press allegations and correspondence purportedly on behalfof current and/or former employees concerning our environmental complianceprograms and exposure of our employees to hazardous materials.  In June 2005, a complaint was 

 

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filed against us and acurrent and former officer, alleging personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure of defendants, who are former employees of AXT, including aminor child in utero, to high levels of gallium arsenide in gallium arsenidewafers, and methanol.  There is apossibility that other current and/or former employees may bring additionallitigation against us. Although we have put in place engineering,administrative and personnel protective equipment programs to address theseissues, our ability to expand or continue to operate our present locationscould be restricted or we could be required to acquire costly remediationequipment or incur other significant expenses. Existing or future changes inlaws or regulations in the United States and China may require us to incursignificant expenditures or liabilities, or may restrict our operations. Inaddition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damagesfor wrongful death or personal injuries allegedly caused by exposure tochemicals or hazardous materials at our facilities.

 

Litigationis inherently uncertain and while we would expect to defend ourselvesvigorously, it is possible that our business, financial condition, results ofoperations or cash flows could be affected in any particular period by suchlitigation now pending, and any additional litigation if brought against us.

 

***ProblemsIncurred by Our Joint Ventures or Venture Partners Could Result in a MaterialAdverse Impact on Our Financial Condition or Results of Operations***

 

Wehave invested in five joint venture operations in China that produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium,germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. Wepurchase the materials produced by these ventures for our use and sell otherportions of their production to third parties. Our ownership interest in theseentities ranges from 25 percent to 88 percent. We consolidate the threeventures in which we own a majority interest and employ equity accounting forthe two joint ventures in which we have a 25 percent interest. Several of theseventures occupy facilities within larger facilities owned and/or operated byone of the other venture partners. Several of these venture partners areengaged in other manufacturing activities at or near the same facility. In somefacilities, we share access to certain functions, including water, treatment ofhazardous waste or air quality treatment. If any of our joint venture partnersin any of these five ventures experience problems with their operations,disruptions of our joint venture operations could result, having a materialadverse effect on the financial condition and results of operation of our jointventures, and correspondingly on our financial condition or results ofoperations.

 

Inaddition, if any of our joint ventures or venture partners with whom our jointventures share facilities are deemed to have violated applicable laws,rules or regulations governing the use, storage, discharge or disposal ofhazardous chemicals during manufacturing, research and development, or salesdemonstrations, the operations of our joint ventures could be adverselyaffected and we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our joint ventureoperations as a result of the actions of the joint ventures or other venturepartners. Employees working at the operations of our joint ventures or theoperations of any of the other venture partners could bring litigation againstus as a result of actions taken at the joint venture or venture partnerfacilities, even though we are not directly controlling the operations,including actions for exposure to chemicals or other hazardous materials at thefacilities of our joint ventures or the facilities of any venture partner thatare shared by our joint ventures. If litigation is brought against us,litigation is inherently uncertain and while we would expect to defendourselves vigorously, it is possible that our business, financial condition,results of operations or cash flows could be affected in any particular periodby such litigation if brought against us, particularly if, as a non-Chinesecompany, litigation with us is deemed advantageous. Even if we are not deemedresponsible for the actions of the joint ventures or venture partners,litigation could be costly, time consuming to defend and divert managementattention; in addition, pursuit of us could occur if we are deemed to be themost financially viable of the partners.

 

Going forward, webelieve that investing in additional joint ventures will be important toremaining competitive in our marketplace and ensuring a supply of critical rawmaterials. However, we may not be able to identify complementary joint ventureopportunities or, even once opportunities are identified, we may not be able toreach agreement on the terms of the venture with the other venture partners.Additional joint ventures could cause us to incur contingent liabilities orother expenses, any of which could adversely affect our financial condition andoperating results.

 

Sinceall of our joint venture activity is expected to occur in China, theseactivities could subject us to a number of risks associated with conductingoperations internationally, including:

 

•        Difficultiesin managing geographically disparate operations;

 

•        Difficultiesin enforcing agreements through non-U.S. legal systems;

 

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•        Unexpectedchanges in regulatory requirements that may limit our ability to export theventure products or sell into particular jurisdictions or impose multipleconflicting tax laws and regulations;

 

•        Politicaland economic instability, civil unrest or war;

 

•        Terroristactivities that impact international commerce;

 

•        Difficultiesin protecting our intellectual property rights, particularly in countries wherethe laws and practices do not protect proprietary rights to as great an extentas do the laws and practices of the United States;

 

•        Changinglaws and policies affecting economic liberalization, foreign investment,currency convertibility or exchange rates, taxation or employment; and

 

•        Nationalizationof foreign owned assets, including intellectual property.

 

***Intellectualproperty infringement claims may be costly to resolve and could divert managementattention.***

*** ***

Othercompanies may hold or obtain patents on inventions or may otherwise claimproprietary rights to technology necessary to our business. The markets inwhich we compete are comprised of competitors who in some cases holdsubstantial patent portfolios covering aspects of products that could besimilar to ours. We could become subject to claims that we are infringingpatent, trademark, copyright or other proprietary rights of others. Forexample, we have previously been involved in two separate lawsuits allegingpatent infringement.

 

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

 

OnOctober 8, 2004, we announced that we had reached a tentative settlementof the litigation in Japan and interference actions in the United States withSumitomo Electric Industries, Ltd. (“SEI”), which includes a global intellectualproperty cross-licensing agreement. AXT and SEI finalized this agreement onDecember 2, 2004. Accordingly, we recorded a charge of approximately $1.4million for the quarter ended September 30, 2004 in connection with thissettlement, and are expected to make royalty payments on future sales ofcertain products. The litigation was withdrawn in January 2005 and we abandonedthe interference proceeding.

 

***Thesemiconductor industry is cyclical and has experienced a downturn which hasadversely impacted our operating results.***

*** ***

Ourcontinuing business depends in significant part upon manufacturers ofelectronic and opto-electronic semiconductor devices, as well as the currentand anticipated market demand for such devices and products using such devices.As a supplier to the semiconductor industry, we are subject to the businesscycles that characterize the industry. The timing, length and volatility ofthese cycles are difficult to predict. The semiconductor industry hashistorically been cyclical because of sudden changes in demand forsemiconductors, the manufacturing capacity of these semiconductors and changesin the technology employed in the semiconductors. The rate of changes indemand, including end demand, is high, and the effect of these changes upon usoccurs quickly, exacerbating the volatility of these cycles. These changes haveaffected the timing and amounts of customers’ purchases and investments in newtechnology. These industry cycles create pressure on our revenue, gross marginand net income (loss).

 

Theindustry has in the past experienced periods of oversupply that result insignificantly reduced demand and prices for semiconductor devices andcomponents, including our products, both as a result of general economicchanges and overcapacity. When these periods occur, our operating results andfinancial condition are adversely affected, and create pressure on our revenue,gross margins and net income. Inventory buildups in telecommunications productsand slower than expected sales of computer equipment resulted in overcapacityand led to reduced sales by our customers, and therefore reduced purchases ofour products. During periods of weak demand such as those experienced over thepast years, customers typically reduce purchases, delay delivery of productsand/or cancel orders of component parts such as our products.

 

Increasedprice competition has resulted, causing pressure on our net sales, gross marginand net income. We experienced

 

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cancellations, pricereductions, delays and push outs of orders, which have resulted in reducedrevenues. If the economic downturn occurred again, further order cancellations,reductions in order size or delays in orders could occur and would materiallyadversely affect our business and results of operations. Actions to reduce ourcosts, such as those we have recently taken, may be insufficient to align ourstructure with prevailing business conditions. We may be required to undertakeadditional cost-cutting measures, and may be unable to invest in marketing,research and development and engineering at the levels we believe are necessaryto maintain our competitive position. Our failure to make these investmentscould seriously harm our business.

 

Duringperiods of increasing demand for semiconductor devices, we must have sufficientmanufacturing capacity and inventory to meet customer demand, and must be ableto attract, hire, train and retain qualified employees to meet demand. If weare unable to effectively manage our resources and production capacity duringan industry upturn, there could be a material adverse effect on our business,financial condition and results of operations.

 

***Ourresults of operations may suffer if we do not effectively manage our inventory.***

 

Wemust manage our inventory of component parts, work-in-process, and finishedgoods effectively to meet changing customer requirements, while keepinginventory costs down and improving gross margins. Some of our products andsupplies have in the past and may in the future become obsolete while ininventory due to changing customer specifications, or become excess inventorydue to decreased demand for our products and an inability to sell the inventorywithin a foreseeable period. Furthermore, if current costs of productionincrease or sales prices drop below the standard prices at which we valueinventory, we may need to take a charge for a reduction in inventory values. Wehave in the past, including during 2004, had to take inventory valuation and impairmentcharges. If we are not able to manage successfully our inventory in the future,we may again need to write off un-saleable, obsolete or excess inventory, whichcould adversely affect our results of operations.

 

Duringthe first half of 2005, we increased work-in-process inventory in order toavoid the effects of probable power shortages in China. We prepared thisinventory in accordance with our forecast of demand rather than againstspecific customer orders. If we did not forecast correctly, customers may notorder the inventory we manufactured, and we will incur a cost with nooffsetting revenue. Ultimately, we would have to incur a charge for the valueof unused inventory.

 

***Decreasesin average selling prices of our products may reduce gross margins.***

*** ***

Themarket for compound semiconductor substrates is characterized by pressures onaverage selling prices resulting from factors such as increased competition orovercapacity. We have experienced and expect to continue to experience pricepressures on our products, and if average selling prices decline in the future,our revenues and gross margins could decline. We may be unable to reduce thecost of our products sufficiently to counter the effect of lower selling pricesand allow us to keep pace with competitive pricing pressures and our marginscould be adversely affected.

 

***Theimpact of changes in global economic conditions on our customers may cause usto fail to meet expectations, which would negatively impact the price of ourstock.***

*** ***

Ouroperating results can vary significantly based upon the impact of changes inglobal economic conditions on our customers. The revenue growth andprofitability of our business depends on the overall demand for our substrates,and we are particularly dependant on the market conditions for the wireless,solid-state illumination, fiber optics and telecommunications industries.Because our sales are primarily to major corporate customers whose businessesfluctuate with general economic and business conditions, a softening of demandfor products that use our substrates, caused by a weakening economy may resultin decreased revenues. Customers may find themselves facing excess inventoryfrom earlier purchases, and may defer or reconsider purchasing products due tothe downturn in their business and in the general economy.

 

***Ifwe have low product yields, the shipment of our products may be delayed and ouroperating results may be adversely impacted.***

 

Ourproducts are manufactured using complex technologies, and the number of usablesubstrates we can produce can fluctuate as a result of many factors, including:

 

•             impuritiesin the materials used;

 

•             contaminationof the manufacturing environment;

 

•             substratebreakage;

 

•             equipmentfailure, power outages or variations in the manufacturing process; and

 

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•             performanceof personnel involved in the manufacturing process.

 

Ifour yields decrease, our revenue could decline if we are unable to produceneeded product on time while our manufacturing costs remain fixed, or couldincrease. We have experienced product shipment delays and difficulties inachieving acceptable yields on both new and older products, and delays and pooryields have adversely affected our operating results. We may experience similarproblems in the future and we cannot predict when they may occur or theirseverity. In particular, many of our manufacturing processes are new and arestill being refined, which can result in lower yields.

 

***Ifwe do not successfully develop new products to respond to rapidly changingcustomer requirements, our ability to generate revenue, obtain new customers,and retain existing customers may suffer.***

*** ***

Oursuccess depends on our ability to offer new products and product features thatincorporate leading technology and respond to technological advances. Inaddition, our new products must meet customer needs and compete effectively onquality, price and performance. The life cycles of our products are difficultto predict because the markets for our products are characterized by rapidtechnological change, changing customer needs and evolving industry standards.If our competitors introduce products employing new technologies or performancecharacteristics, our existing products could become obsolete and unmarketable.During the past two years, we have seen our competitors selling more substratesmanufactured using a crystal growth technology similar to ours, which haseroded our technological differentiation. Other companies, including Triquent,are actively developing substrate materials that could be used to manufacturedevices that could provide the same high-performance, low-power capabilities asGaAs- and InP-based devices at competitive prices. If these substrate materialsor VGF-derived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

 

Thedevelopment of new products can be a highly complex process, and we mayexperience delays in developing and introducing new products. Any significantdelays could cause us to fail to timely introduce and gain market acceptance ofnew products. Further, the costs involved in researching, developing andengineering new products could be greater than anticipated. If we fail to offernew products or product enhancements or fail to achieve higher qualityproducts, we may not generate sufficient revenue to offset our developmentcosts and other expenses or meet our customers’ requirements.

 

***Intensecompetition in the markets for our products could prevent us from increasingrevenue and sustaining profitability.***

*** ***

Themarkets for our products are intensely competitive. We face competition for oursubstrate products from other manufacturers of substrates, such as Freiberger,Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor devicemanufacturers that produce substrates for their own use, and from companies,such as Triquent, that are actively developing alternative materials to GaAsand some semiconductor devices are being marketed using these materials. Webelieve that at least two of our competitors are shipping high volumes of GaAssubstrates manufactured using a technique similar to our VGF technique. Othercompetitors may develop and begin using similar technology. If we are unable tocompete effectively, our revenue may not increase and we may be unable to beprofitable. We face many competitors that have a number of significantadvantages over us, including:

 

•             greaterexperience in the business;

 

•             moremanufacturing experience;

 

•             extensiveintellectual property;

 

•             broader namerecognition; and

 

•             significantlygreater financial, technical and marketing resources.

 

Ourcompetitors could develop new or enhanced products that are more effective thanour products are.

 

Thelevel and intensity of competition has increased over the past year and weexpect competition to continue to increase in the future. Competitive pressurescaused by the current economic conditions have resulted in reductions in theprices of our products, and continued or increased competition could reduce ourmarket share, require us to further reduce the prices of our products, affectour ability to recover costs or result in reduced gross margins.

 

***Demandfor our products may decrease if our customers experience difficultymanufacturing, marketing or selling their products.***

*** ***

Ourproducts are used as components in our customers’ products. Accordingly, demandfor our products is subject to factors affecting the ability of our customersto successfully introduce and market their products, including:

 

•             thecompetition our customers face in their particular industries;

 

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•             thetechnical, manufacturing, sales and marketing and management capabilities ofour customers;

 

•             thefinancial and other resources of our customers; and

 

•             theinability of our customers to sell their products if they infringe third partyintellectual property rights.

 

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

 

***Thefinancial condition of our customers may affect their ability to pay amountsowed to us.***

*** ***

Manyof our customers are facing business downturns that have reduced their cashbalances and their prospects. We frequently allow our customers to pay forproducts we ship to them within 30 to 120 days after delivery. Subsequent toour shipping a product, some customers have been unable to make payments asdue, reducing our cash balances and causing us to incur charges to allow for apossibility that some accounts might not be paid. During 2004, a customer ofone agent filed for bankruptcy protection. We incurred a charge equal to theamount owed us and believe that there is a substantial likelihood that we willbe able to recoup little, if any, of the this amount. Other customers may alsobe forced to file for bankruptcy. If our customers do not pay their accountswhen due, we will be required to incur charges that would reduce our earnings.

 

***Wepurchase critical raw materials and parts for our equipment from single orlimited sources, and could lose sales if these sources fail to fill our needs.***

*** ***

Wedepend on a limited number of suppliers for certain raw materials, componentsand equipment used in manufacturing our products, including key materials suchas quartz tubing, polishing solutions, and paralytic boron nitride. Althoughseveral of these raw materials are purchased from suppliers in whom we hold anownership interest, we generally purchase these materials through standardpurchase orders and not pursuant to long-term supply contracts and no supplierguarantees supply of raw materials or equipment to us. If we lose any of ourkey suppliers, our manufacturing efforts could be significantly hampered and wecould be prevented from timely producing and delivering products to ourcustomers. We have in the past experienced delays obtaining critical rawmaterials and spare parts, including gallium, due to shortages of thesematerials. Although we hope to alleviate some of these delays and shortages asa result of our interests in our joint ventures, we may experience delays dueto shortages of materials and may be unable to obtain an adequate supply ofmaterials. These shortages and delays could result in higher materials costsand cause us to delay or reduce production of our products. If we have to delayor reduce production, we could fail to meet customer delivery schedules and ourrevenue and operating results could suffer.

 

***Wehave made and may continue to make strategic investments in raw materialssuppliers, which may not be successful and may result in the loss of all orpart of our investment.***

*** ***

Wehave made investments through our five joint ventures in raw material suppliersin China, that provide us with opportunities to gain supply of key rawmaterials that are important to our substrate business. These affiliates eachhave a market beyond that provided by us. We do not have influence over all ofthese companies, each of which is located in China, and in some we have madeonly a strategic, minority investment. We may not be successful in achievingthe financial, technological or commercial advantage upon which any giveninvestment is premised, and we could end up losing all or part of ourinvestment.

 

***Theloss of one or more of our key substrate customers would significantly hurt ouroperating results.***

*** ***

Asmall number of substrate customers have historically accounted for asubstantial portion of our total revenue. Our top five customers represented 39.8%and 34.6% of revenue for the six month periods ended June 30, 2005, and2004, respectively. We expect that a significant portion of our future revenuewill continue to be derived from a limited number of substrate customers. Ourcustomers are not obligated to purchase a specified quantity of our products orto provide us with binding forecasts of product purchases. In addition, ourcustomers may reduce, delay or cancel orders at any time without anysignificant penalty, and during the past year, we have experienced slowerbookings, significant push outs and cancellation of orders from some customers.In addition, several of our previously large customers have stopped operationsentirely. If we lose a major customer or if a customer cancels, reduces ordelays orders, our revenue would decline. In addition, customers that haveaccounted for significant revenue in the past may not continue to generaterevenue for us in any future period. Any delay in scheduled shipments of ourproducts could cause revenue to fall below our expectations and theexpectations of 

 

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market analysts orinvestors, causing our stock price to decline.

 

***Oursubstrate products have a long qualification cycle that makes it difficult toplan our expenses and forecast our results.***

*** ***

Customerstypically place orders with us for our substrate products three months to ayear or more after our initial contact with them. The sale of our products maybe subject to delays due to our customers’ lengthy internal budgeting, approvaland evaluation processes. During this time, we may incur substantial expensesand expend sales, marketing and management efforts while the customers evaluateour products. These expenditures may not result in sales of our products. If wedo not achieve anticipated sales in a period as expected, we may experience anunplanned shortfall in our revenue. As a result, we may not be able to coverexpenses, causing our operating results to vary. In addition, if a customerdecides not to incorporate our products into its initial design, we may nothave another opportunity to sell products to this customer for many months or evenyears. In the current competitive and economic climate, the average sales cyclefor our products has lengthened even further and is expected to continue tomake it difficult to accurately forecast our future sales. We anticipate thatsales of any future substrate products will also have lengthy sales cycles andwill, therefore, be subject to risks substantially similar to those inherent inthe lengthy sales cycle of our current substrate products.

 

***Ifwe are unable to protect our intellectual property, we may lose valuable assetsor incur costly litigation.***

*** ***

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

 

Despiteour efforts to protect our intellectual property, a third party could developproducts or processes similar to ours. Our means of protecting our proprietaryrights may not be adequate and our competitors may independently developsimilar technology, duplicate our products or design around our patents. Webelieve that at least two of our competitors have begun to ship GaAs substratesproduced using a process similar to our VGF technique. Our competitors may alsodevelop and patent improvements to the VGF technology upon which we rely, andthus may limit any exclusivity we enjoy by virtue of our patents or tradesecrets.

 

Itis possible that pending or future United States or foreign patent applicationsmade by us will not be approved, that our issued patents will not protect ourintellectual property, or that third parties will challenge the ownershiprights or the validity of our patents. In addition, the laws of some foreigncountries may not protect our proprietary rights to as great an extent as dothe laws of the United States and it may be more difficult to monitor the useof our intellectual property. Our competitors may be able to legitimatelyascertain non-patented proprietary technology embedded in our systems. If thisoccurs, we may not be able to prevent the development of technologysubstantially similar to ours.

 

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

 

Forexample, we have recently been involved in litigation with Sumitomo ElectricIndustries, Ltd. (“SEI”) in Japan as well as interference actions in the UnitedStates. We and SEI approved a settlement of this litigation during the fourthquarter of 2004 and the litigation was withdrawn and we abandoned theinterference proceeding. We incurred an initial charge of approximately $1.4million and will have to pay ongoing royalties to SEI on certain of ourproducts.

 

***Wederive a significant portion of our revenue from international sales, and ourability to sustain and increase our international sales involves significantrisks.***

*** ***

Ourrevenue growth depends in part on the expansion of our international sales andoperations. International sales represented 82% and 78% of our total revenuefor the six month periods ended June 30, 2005 and 2004, respectively. Weexpect that sales to customers outside the U.S. will continue to represent asignificant portion of our revenue, particularly sales to customers in Asia.

 

Currently,an increasing percentage of our sales are to customers headquartered in Asia.Certain manufacturing facilities and suppliers are also located outside theU.S. Managing our global operations presents challenges, including periodicregional economic downturns, trade balance issues, varying business conditionsand demands, political instability, variations in enforcement of intellectualproperty and contract rights in different jurisdictions, differences in theability to develop 

 

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relationships withsuppliers and other local businesses, changes in U.S. and international lawsand regulations including U.S. export restrictions, fluctuations ininterest and currency exchange rates, the ability to provide sufficient levelsof technical support in different locations, cultural differences, shippingdelays and terrorist acts or acts of war, among other risks. Many of thesechallenges are present in China, which represents a large potential market forsemiconductor equipment and where we anticipate significant opportunity forgrowth. Global uncertainties with respect to: (i) economic growth rates invarious countries; (ii) sustainability of demand for electronics products;(iii) capital spending by semiconductor manufacturers; (iv) priceweakness for certain semiconductor devices; and (v) political instabilityin regions where we have operations may also affect our business, financialcondition and results of operations.

 

Ourdependence on international sales involves a number of risks, including:

 

•             changes intariffs, import or export restrictions and other trade barriers;

 

•             unexpectedchanges in regulatory requirements;

 

•             longerperiods to collect accounts receivable;

 

•             changes inexport license requirements;

 

•             politicaland economic instability;

 

•             unexpectedchanges in diplomatic and trade relationships; and

 

•             foreignexchange rate fluctuations.

 

Oursales are denominated in U.S. dollars, except for sales to our Japanese and someTaiwanese customers, which are denominated in Japanese yen. Thus, increases inthe value of the U.S. dollar could increase the price of our products innon-U.S. markets and make our products more expensive than competitors’products in these markets. Also, denominating some sales in Japanese yensubjects us to fluctuations in the exchange rates between the U.S. dollar andthe Japanese yen. The functional currencies of our Japanese and Chinesesubsidiaries are the local currencies. We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for thesesubsidiaries, as well as in translation of the assets and liabilities of theseassets at each balance sheet date. If we do not effectively manage the risksassociated with international sales, our revenue, cash flows and financialcondition could be adversely affected.

 

***Weneed to continue to improve or implement our systems, procedures and controlsand may not receive a favorable attestation report on our internal controlsystems by our independent registered public accounting firm.***

 

Therequirements adopted by the Securities and Exchange Commission in response tothe passage of the Sarbanes-Oxley Act of 2002 will require annual review andevaluation of our internal control systems, and an attestation of these systemsby our independent registered public accounting firm beginning with our fiscalyear ending December 31, 2006. We are currently reviewing our internal controlprocedures and considering further documentation of such procedures that may benecessary. We are currently evaluating the extent to which any of our jointventures may also be required to comply, if at all.  We can give no assurances that our systemswill satisfy the new requirements of the Securities and Exchange Commission, orif required, that any of the systems of our joint ventures will meet suchrequirements, or that we will receive a favorable review and attestation by ourindependent registered public accounting firm.

 

Inaddition, the shift of our manufacturing operations to China has placed andcontinues to place a significant strain on our operations and managementresources. We have upgraded our inventory control systems and may implementadditional systems relating to consolidation of our financial results, butcontinue to rely on certain manual processes in our operations and inconnection with consolidation of our financial results. If we fail to managethese changes effectively, our operations may be disrupted.

 

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

 

35

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***Legislativeactions, higher insurance costs and potential new accounting pronouncements arelikely to cause our general and administrative expenses to increase and impactour future financial position and results of operations.***

*** ***

Inorder to comply with rules and regulations adopted pursuant to theSarbanes-Oxley Act of 2002 by the SEC, as well as changes to listing standardsadopted by NASDAQ, and accounting changes adopted affecting accounting forstock-based compensation we may be required to increase our internal controls,hire additional personnel and additional outside legal, accounting and advisoryservices, all of which will cause our general and administrative costs toincrease. Insurers may increase premiums as a result of the high claims ratesthey incurred over the past year. Changes in the accounting rules, includinglegislative and other rules to account for employee stock options as acompensation expense among others, could materially increase the expense thatwe report under generally accepted accounting principles and adversely affectour operating results.

 

***Ifwe fail to manage periodic contractions, we may utilize our cash balances andour existing cash and cash equivalent balances could decline.***

*** ***

Weanticipate that our existing cash resources will fund any anticipated operatinglosses, purchases of capital equipment and provide adequate working capital forthe next twelve months. However, our liquidity is affected by many factorsincluding, among others, the extent to which we pursue additional capitalexpenditures, the level of our production, and other factors related to theuncertainties of the industry and global economies. If we fail to manage ourcontractions successfully we may draw down our cash reserves, which wouldadversely affect our operating results and financial condition, reduce ourvalue and may impinge our ability to raise debt and equity funding in thefuture, at a time when we may be required to raise additional cash.Accordingly, there can be no assurance that events in the future will notrequire us to seek additional capital, or, if so required, that such capitalwill be available on terms acceptable to us, if at all. As part of our effortto reduce costs, we may lose key staff, production resources, and technologythat we will need to grow when end markets recover. These events could reduceour ability to grow profitably as markets recover.

 

Weanticipate that our existing cash resources will fund any anticipated operatinglosses, purchases of capital equipment and provide adequate working capital forthe next twelve months. Our liquidity is affected by many factors including,among others, the extent to which we pursue additional capital expenditures,the level of our production efforts, and other factors related to theuncertainties of the industry and global economies. Accordingly, there can beno assurance that events in the future will not require us to seek additionalcapital sooner, or, if so required, that such capital will be available onterms acceptable to us if at all.

 

***Changesin China’s political, social and economic environment may affect our financialperformance.***

*** ***

Ourfinancial performance may be affected by changes in China’s political, socialand economic environment. The role of the Chinese central and local governmentsin the Chinese economy is significant. Chinese policies toward economicliberalization, and laws and policies affecting technology companies, foreigninvestment, currency exchange rates and other matters could change, resultingin greater restrictions on our ability to do business and operate ourmanufacturing facilities in China. Any imposition of surcharges or any increasein Chinese tax rates could hurt our operating results. The Chinese governmentcould revoke, terminate or suspend our license for national security andsimilar reasons without compensation to us. If the government of China were totake any of these actions, we would be prevented from conducting all or part ofour business. Any failure on our part to comply with governmental regulationscould result in the loss of our ability to manufacture our products in China.

 

Chinahas from time to time experienced instances of civil unrest and hostilities.Confrontations have occurred between the military and civilians. Events of thisnature could influence the Chinese economy, result in nationalization offoreign-owned operations such as ours, and could negatively affect our abilityto operate our facilities in China.

 

***We may face additional risks as a result of the revaluation of theChinese currency.***

 

In July 2005, the People’s Republic of China agreed to a shift inChinese currency policy and established a 2% revaluation of the renminbi, and the renminbi will now be referencedto a basket of currencies, with a daily trading band of +/-0.3%.  Depending on market conditions and the state of the Chinese economy, itis possible that China will make more adjustments in the future.  Over the next five to ten years, China maymove to a managed float system, with opportunistic interventions.  This reserve diversification may negativelyimpact the United States dollar and U.S. interest rates, which could in turnnegatively impact the Company’s operating results and financial condition.  A significant percentage of our sales aremade to customers located outside of the United States, particularly Asia.  Our sales are denominated in U.S.dollars, except for sales to our Japanese and some Taiwanese customers, whichare denominated in Japanese yen. Thus, increases in the value of the U.S.dollar could increase the price of our products in non-U.S. markets and makeour products 

 

36

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more expensive than competitors’ products in these markets.  The functional currencies of our Chinesesubsidiaries, including our joint ventures, are the local currency; since mostof our operations are conducted in China, many of our costs are incurred inChinese currency, which subjects us to fluctuations in the exchange ratesbetween the U.S. dollar and the Chinese renminbi. We incur transaction gains orlosses resulting from consolidation of expenses incurred in local currenciesfor these subsidiaries, as well as in translation of the assets and liabilitiesof these assets at each balance sheet date. These risks may be increased by the fluctuation and revaluation of theChinese renminbi.  If we do noteffectively manage the risks associated with this currency risk, our revenue,cash flows and financial condition could be adversely affected.

 

***Areoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of adifferent contagious disease may adversely impact our manufacturing operationsand some of our key suppliers and customers.***

*** ***

Themajority of our substrate manufacturing activities are conducted in China. Inaddition, we source key raw materials, including gallium, from our jointventures and other suppliers in China. The 2003 SARS outbreak was most notablein China and a small number of cases were reported in 2004. One employee at ourLED production facility in China contracted SARS in late April 2003prompting us to close the facility for ten days. There was no significantimpact to our ability to fill customer orders. If there were to be anotheroutbreak of SARS or a different contagious disease and if our employeescontracted the disease, we may be required to temporarily close ourmanufacturing operations. Similarly, if one of our key suppliers is required toclose for an extended period, we may not have enough raw material inventory tocontinue manufacturing operations. In addition, while we possess managementskills among our China staff that enable us to maintain our manufacturingoperations with minimal on-site supervision from our US-based staff, ourbusiness could also be harmed if travel to or from Asia and the United Statesis restricted or inadvisable, as it was during parts of 2003. None of our substratecompetitors is as dependent on manufacturing facilities in China as we are. Ifour manufacturing operations were closed for a significant period, we couldlose revenue and market share during that period which would depress ourfinancial performance and could be difficult to recapture. Finally, if one ofour key customers is required to close for an extended period, we may not beable to ship product to them, our revenue would decline and our financialperformance would suffer.

 

***Theeffect of terrorist threats and actions on the general economy could decreaseour revenues.***

*** ***

TheUnited States continues to be on alert for terrorist activity. The potentialnear- and long-term impact terrorist activities may have in regards to oursuppliers, customers and markets for our products and the U.S. economy areuncertain. There may be embargos of ports or products, or destruction ofshipments or our facilities, or attacks that affect our personnel. There may beother potential adverse effects on our operating results due to a significantevent that we cannot foresee. Since we perform substantially all of ourmanufacturing operations in China, and a significant portion of our customersare located outside of the Untied States, terrorist activity or threats againstUS-owned enterprise are a particular concern to us.

 

***Ifany of our facilities is damaged by actions such as fire, explosion, or naturaldisaster, we may not be able to manufacture our products.***

*** ***

Theongoing operation of our manufacturing and production facilities in China iscritical to our ability to meet demand for our products. If we are not able touse all or a significant portion of our facilities for prolonged periods forany reason, we will not be able to manufacture products for our customers. Forexample, a natural disaster, fire or explosion caused by our use of combustiblechemicals and high temperatures during our manufacturing processes would rendersome or all of our facilities inoperable for an indefinite period of time.Actions outside of our control, such as earthquakes, could also damage ourfacilities, rendering them inoperable. If we are unable to operate ourfacilities and manufacture our products, we will lose customers and revenue andour business will be harmed.

 

***Unpredictablefluctuations in our operating results could disappoint analysts or ourinvestors, which could cause our stock price to decline.***

*** ***

Wehave not over the past year been able to sustain growth, and may not be able toreturn to historic growth levels in the current economic environment. Our netloss in 2002 was the largest in our history and our losses continued during2003, 2004, and the first two quarters of 2005.

 

Wehave and may continue to experience significant fluctuations in our revenue andearnings. Our quarterly and annual revenue and operating results have variedsignificantly in the past and may vary significantly in the future due to anumber of factors, including:

 

•             our abilityto develop, manufacture and deliver high quality products in a timely andcost-effective manner;

 

37

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•             decline ingeneral economic conditions or downturns in the industry in which we compete;

 

•             fluctuationsin demand for our products;

 

•             expansion ofour manufacturing capacity;

 

•             expansion ofour operations in China;

 

•             limitedavailability and increased cost of raw materials;

 

•             the volumeand timing of orders from our customers, and cancellations, push outs anddelays of customer orders;

 

•             fluctuationof our manufacturing yields;

 

•             decreases inthe prices of our competitors’ products;

 

•             costsincurred in connection with any future acquisitions of businesses ortechnologies; and

 

•             increases inour expenses, including expenses for research and development.

 

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

 

Asubstantial percentage of our operating expenses are fixed in the short termand we may be unable to adjust spending to compensate for an unexpectedshortfall in revenues. As a result, any delay in generating revenue could causeour operating results to be below the expectations of market analysts orinvestors, which could also cause our stock price to fall.

 

***Ourstock price has been and may continue to be volatile.***

*** ***

Ourstock price has fluctuated significantly since we began trading on the NASDAQNational Market. For the twelve months ended December 31, 2004, the highand low closing sales prices of our common stock were $4.68 and $1.05,respectively, and for the six months ended June 30, 2005, the high and lowclosing sales prices of our common stock were $1.52 and $1.10, respectively. Anumber of factors could cause the price of our common stock to continue tofluctuate substantially, including:

 

•             actual oranticipated fluctuations in our quarterly or annual operating results;

 

•             changes inexpectations about our future financial performance or changes in financialestimates of securities analysts;

 

•             announcementsof technological innovations by us or our competitors;

 

•             new productintroduction by us or our competitors;

 

•             largecustomer orders or order cancellations; and

 

•             theoperating and stock price performance of comparable companies.

 

Inaddition, the stock market in general has experienced extreme volatility thatoften has been unrelated to the operating performance of particular companies.These broad market and industry fluctuations may adversely affect the tradingprice of our common stock, regardless of our actual operating performance.

 

38

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***Wehave adopted certain anti-takeover measures that may make it more difficult fora third party to acquire us.***

*** ***

Ourboard of directors has the authority to issue up to 2,000,000 shares ofpreferred stock and to determine the price, rights, preferences and privilegesof those shares without any further vote or action by the stockholders. Therights of the holders of common stock will be subject to, and may be adverselyaffected by, the rights of the holders of any preferred stock that may beissued in the future. The issuance of shares of preferred stock, whilepotentially providing desirable flexibility in connection with possibleacquisitions and for other corporate purposes, could have the effect of makingit more difficult for a third party to acquire a majority of our outstandingvoting stock. We have no present intention to issue shares of preferred stock.

 

Wehave adopted a preferred stock purchase rights plan intended to guard againstcertain takeover tactics. The adoption of this plan was not in response to anyproposal to acquire us, and the board is not aware of any such effort. Theexistence of this plan could also have the effect of making it more difficultfor a third party to acquire a majority of our outstanding voting stock. Inaddition, certain provisions of our certificate of incorporation may have theeffect of delaying or preventing a change of control, which could adverselyaffect the market price of our common stock.

 

Inaddition, provisions in our amended and restated certificate of incorporationand bylaws may have the effect of delaying or preventing a merger, acquisitionor change of control of us, or changes in our management, including:

 

•             the divisionof our board of directors into three separate classes, each with three yearterms;

 

•             the right ofour board to elect a director to fill a space created by a board vacancy or theexpansion of the board;

 

•             the abilityof our board to alter our bylaws;

 

•             the abilityof our board to authorize the issuance of up to 2,000,000 shares of blank checkpreferred stock; and

 

•             therequirement that only our board or the holders of at least 10% of ouroutstanding shares may call a special meeting of our stockholders.

 

Furthermore,because we are incorporated in Delaware, we are subject to the provisions ofSection 203 of the Delaware General Corporation Law. These provisionsprohibit large stockholders, in particular those owning 15% or more of theoutstanding voting stock, from consummating a merger or combination with acorporation unless:

 

•             662/3%of the shares of voting stock not owned by these large stockholders approve themerger or combination, or

 

•             the board ofdirectors approves the merger or combination or the transaction which resultedin the large stockholder owning 15% or more of our outstanding voting stock.

 

39

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**ITEM 3*.*QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**ForeignCurrency Risk**

 

We useshort-term forward exchange contracts for hedging purposes to reduce theeffects of adverse foreign exchange rate movements. We have purchased foreignexchange contracts to hedge against certain trade accounts receivabledenominated in Japanese yen. The change in the fair value of the forwardcontracts is recognized as part of the related foreign currency transactions asthey occur. As of June 30, 2005, we had no outstanding commitments with respectto foreign exchange contracts.

 

**InterestRate Risk**

 

Cash and cashequivalents earning interest and certain variable rate debt instruments aresubject to interest rate fluctuations. The following table sets forth theprobable impact of a 10% change in interest rates (in thousands):

 
| **Instrument**                            | ** ** | **Balance as of   June 30,  2005** | ** ** | **Current   Interest   Rate** | ** ** | **Projected   Annual Interest   Income/   (Expense)** | ** ** | **Proforma 10%   Interest Rate   Decline   Income/(Expense)** | ** ** | **Proforma 10%   Interest Rate  Increase   Income/(Expense)** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|-------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Cash and cash equivalents                 |       | $                                            | 15,112     |                          | 0.50       | %                                                          | $          | 76                                                                      |       | $                                                                       | 68         |   | $ | 84 |   |
| Investment in debt and equity instruments |       | 18,096                                       |       | 1.40                          |       | 253                                                        |       | 228                                                                     |       | 279                                                                     |       |
| Long-term debt                            |       | (7,750                                       | )          | 3.17                          |       | (246                                                       | )          | (221                                                                    | )          | (271                                                                    | )          |
|                                      |       |                                         |       |                          |       | $                                                          | 83         |                                                                    | $          | 75                                                                      |       | $ | 92 |   |
|                                           |            |                                              |            |                               |            |                                                            |            |                                                                         |            |                                                                         |            |  |  |  |  |

 

**EquityRisk**

 

We alsomaintain minority investments in private and publicly traded companies. Theseinvestments are reviewed for other than temporary declines in value on aquarterly basis. Reasons for other than temporary declines in value includewhether the related company would have insufficient cash flow to operate forthe next twelve months, significant changes in the operating performance andchanges in market conditions. For the six month period ended June 30, 2005, werecorded a $1.4 million charge to write down our investment in one public U.S.company. As of June 30, 2005, the minority investments we continue to holdamounted to $3.0 million.

 

**ITEM 4*.*CONTROLSAND PROCEDURES**

 

(a) Under thesupervision and with the participation of our management, our Chief ExecutiveOfficer and Chief Financial Officer have evaluated the effectiveness of ourdisclosure controls and procedures, as such term is defined under Rule13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended.Based upon that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that the our disclosure controls and procedures wereeffective as of the end of the period covered by this quarterly report.

 

(b) During thequarter ended June 30, 2005, we appointed an internal auditor directlyresponsible to the Audit Committee of the Board of Directors of the company,responsible for internal audit activities, including performing an independentappraisal of the various operations and systems of control within AXT and itssubsidiaries and joint ventures and to assist management by providingindependent analyses, appraisal, advice and recommendations concerningaccounting, asset management, information management and control systems andsuch other similar activities.

 

40

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**PARTII OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

From time totime we may 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.

 

OnOctober 15, 2004, a purported securities class action lawsuit was filed inthe United States Court for the Northern District of California. City of HarperWoods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362MJJ. The lawsuit names AXT, Inc. and our chief executive officer, Chinaoperations, as defendants, and is brought on behalf of a class of allpurchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. On February 4, 2005, the Court consolidated the case with arelated case making similar allegations, and appointed a lead plaintiff, whowill file a consolidated complaint. We believe that there are meritoriousdefenses against this litigation and intends to vigorously defend it. However,due to the inherent uncertainties of litigation, we cannot accurately predict theultimate outcome of the litigation. Any unfavorable outcome of the litigationcould have an adverse impact on our business, financial condition and resultsof operations.

 

OnJune 1, 2005, a lawsuit was filed in the Superior Court of California, County ofAlameda, Zhao et. Al. vs. American Xtal Technology, et. Al., No. R605215713.  The lawsuit complaint namesAXT and its chief technology officer and former interim chief executiveofficer, and is brought on behalf of two former employees and their minor child.  The complaint alleges personal injury,general negligence, intentional tort, wage loss and other damages, includingpunitive damages, as a result of exposure of defendants, including the minorchild in utero, to high levels of gallium arsenide in gallium arsenide wafers,and methanol.  The complaint seeksdamages of $10 million each for pain, suffering and inconvenience, and foremotion distress, special damages to be determined, and punitive damages in theamount of $10 million.  We believe thatthere are meritorious defenses against this litigation and intend to vigorouslydefend it.  However, due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation. Any unfavorable outcome of the litigation could have anadverse impact on our business, financial condition and results of operations.

 

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

 

During the three month period ended June 30, 2005, we repurchased thefollowing shares of our common stock:

 
| **Period**                           | ** ** | **Total Number of  Shares Purchased** | ** ** | **Average Price   Paid Per Share** | ** ** | **Total Number of   Shares Purchased  as Part of a   Publicly   Announced Plan   or Program (1)** | ** ** | **Approximate   Dollar Value of  Shares That May  Yet Be   Purchased Under   the Plan or   Program** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| April 1, 2005 through April 30, 2005 |       | 57,200                                |       | 1.21                               |       | 57,200                                                                                            |       | 1,902,067                                                                                            |       |
| May 1, 2005 through May 31, 2005     |       | 41,200                                |       | 1.22                               |       | 41,200                                                                                            |       | 1,851,922                                                                                            |       |
| June 1, 2005 through June 30, 2005   |       | 36,500                                |       | 1.23                               |       | 36,500                                                                                            |       | 1,807,145                                                                                            |       |
| Total                                |       | 134,900                               |       | $                                  | 1.22       |                                                                                              | 134,900    |                                                                                                 | $          | 1,807,145 |   |
|                                      |            |                                       |            |                                    |            |                                                                                                   |            |                                                                                                      |            |  |  |

 

----

(1)  Pursuant to a Plan publicly announced onAugust 25, 2004 in accordance with Rule 10b5-1 of the Securities Exchange Actof 1934 to provide for the repurchase of up to $2 million of the Company’scommon stock. Repurchases will be made from time to time in the open marketduring the twelve-month period ending July 31, 2005, at prevailing marketprices. Repurchases will be made under the program using the Company’s own cashresources.  The Board of Directorsapproved the extension of this Plan through July 31, 2006.

 

**Item3. Defaults upon Senior Securities**

 

None

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

AXT held itsannual meeting of stockholders at its headquarters in Fremont, California onJune 28, 2005.  Of the 23,199,454 sharesoutstanding as of the record date, 21,695,589 shares were represented in personor by proxy at the meeting.  

 

41

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Proxies weresolicited by the Company pursuant to Regulation 14A under the SecuritiesExchange Act of 1934, as amended.  At themeeting, AXT’s stockholders voted on the following matters:

 

(1)     Proposal to elect two class Idirectors to hold office for a three-year term and one class II director tohold office until the annual meeting to be held in 2006, and until their respectivesuccessors are elected and qualified.

 
| **Class  I directors** | ** ** | **For**    | ** ** | **Against** | ** ** |
|------------------------|------------|------------|------------|-------------|------------|
| Morris S. Young        |       | 21,342,742 |       | 352,847     |       |
| David C. Chang         |       | 21,585,965 |       | 109,624     |       |

 
| **Class II director** | ** ** | **For**    | ** ** | **Against** | ** ** |
|-----------------------|------------|------------|------------|-------------|------------|
| Phillip C.S. Yin      |       | 21,585,702 |       | 109,887     |       |

 

In addition,Leonard LeBlanc and Jesse Chen continued to serve the term of office as acontinuing director after the meeting.

 

(2)     Proposal to ratify the appointmentof Burr, Pilger & Mayer LLP as our independent registered public accountingfirm for the fiscal year ending December 31, 2005.

 
| ** **                   | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------------------------|------------|------------|------------|-------------|------------|-------------|------------|
| Burr, Pilger & Mayer LLP |       | 21,558,386 |       | 16,576      |       | 120,627     |       |

 

**Item 5. Other Information**

 

None

 

42

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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                                                                      |
|               |       |                                                                                                                                                 |
| 3.3(3)             |       | Second  Amended and Restated Bylaws                                                                                                                  |
|               |       |                                                                                                                                                 |
| 3.4(4)             |       | Certificate  of Amendment to the Restated Certificate of Incorporation                                                                               |
|               |       |                                                                                                                                                 |
| 4.2(5)             |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare  Trust Company, Inc.                                               |
|               |       |                                                                                                                                                 |
| 10.17(6)           |       | Offer letter  to Mr. Philip C.S. Yin                                                                                                                 |
|               |       |                                                                                                                                                 |
| 10.17(7)           |       | Offer letter  to Mr. Minsheng Lin.*                                                                                                                  |
|               |       |                                                                                                                                                 |
| 10.18(8)           |       | Employment  agreement between the Company and Mr. Wilson W. Cheung.*                                                                                 |
|               |       |                                                                                                                                                 |
| 10.19(9)           |       | Agreement  respecting severance payment between the Company and Dr. Morris S. Young.*                                                                |
|               |       |                                                                                                                                                 |
| 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)          Incorporated byreference to the exhibit of the same number filed with the SEC with our AnnualReport on Form 10-K for the year ended December 31, 1998.

 

(2)          Incorporated byreference to Exhibit 2.1 to registrant’s Form 8-K filed with the SEC on June14, 1999.

 

(3)          Incorporated byreference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30,2001.

 

(4)          Incorporated byreference to Exhibit 3.4 to registrant’s Form 10-Q filed with SEC on August 5,2004.

 

(5)          Incorporated byreference to the exhibit as of the same number as filed with the SEC in ourForm 8-K on May 30, 2001.

 

(6)          Incorporated byreference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March17, 2005.

 

(7)          Incorporated byreference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on June30, 2005.

 

(8)          Incorporated byreference to Exhibit 99.2 to registrant’s Form 8-K filed with the SEC on June30, 2005.

 

(9)          Incorporated byreference to Exhibit 99.1 to registrant’s Form 8-K filed with the SEC on March30, 2005.

 

*Management contract or compensatory plan.

 

43

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this Report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                   | AXT, INC. |
|------------------------|-----------|
|                   |      |
| Dated: August  9, 2005 | By:       | /s/ Philip  C. S. Yin |
|                   |      | Philip C. S.  Yin |
|                   |      | Chief  Executive Officer |
|                   |      | (Principal  Executive Officer) |
|                   |      |
|                   |      | /s/ Wilson  W. Cheung |
|                   |      | Wilson W.  Cheung |
|                   |      | Chief  Financial Officer |
|                   |      | (Principal  Financial and Accounting Officer) |

 

44

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**EXHIBIT INDEX**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                      |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)             |       | Restated  Certificate of Incorporation                                                                                                               |
|               |       |                                                                                                                                                 |
| 3.2(2)             |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock                                                                      |
|               |       |                                                                                                                                                 |
| 3.3(3)             |       | Second  Amended and Restated Bylaws                                                                                                                  |
|               |       |                                                                                                                                                 |
| 3.4(4)             |       | Certificate  of Amendment to the Restated Certificate of Incorporation                                                                               |
|               |       |                                                                                                                                                 |
| 4.2(5)             |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and ComputerShare Trust  Company, Inc.                                               |
|               |       |                                                                                                                                                 |
| 10.17(6)           |       | Offer letter  to Mr. Philip C.S. Yin                                                                                                                 |
|               |       |                                                                                                                                                 |
| 10.18(7)           |       | Offer letter  to Mr. Minsheng Lin.*                                                                                                                  |
|               |       |                                                                                                                                                 |
| 10.19(8)           |       | Employment  agreement between the Company and Mr. Wilson W. Cheung.*                                                                                 |
|               |       |                                                                                                                                                 |
| 10.20(9)           |       | Agreement  respecting severance payment between the Company and Dr. Morris S. Young.*                                                                |
|               |       |                                                                                                                                                 |
| 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)   Incorporated by reference tothe exhibit as of the same number as filed with the SEC in our Annual Report onForm 10-K for the year ended December 31, 1998.

 

(2)   Incorporated by reference toExhibit 2.1 to registrant’s Form 8-K filed with the SEC on June 14, 1999.

 

(3)   Incorporated by reference toExhibit 3.4 to registrant’s Form 8-K filed with the SEC on May 30, 2001.

 

(4)   Incorporated by reference toExhibit 3.4 to registrant’s Form 10-Q filed with SEC on August 5, 2004.

 

(5)   Incorporated by reference tothe exhibit as of the same number as filed with the SEC in our Form 8-K on May30, 2001.

 

(6)   Incorporated by reference to Exhibit99.1 to registrant’s Form 8-K filed with the SEC on March 17, 2005

 

(7)   Incorporated by reference to Exhibit99.1 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

 

(8)   Incorporated by reference toExhibit 99.2 to registrant’s Form 8-K filed with the SEC on June 30, 2005.

 

(9)   Incorporated by reference toExhibit 99.1 to registrant’s Form 8-K filed with the SEC on March 30, 2005.

 

*Management contract or compensatory plan.

 

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