**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                                                                                                                                                                                                     | **Quarterly  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                     |
| **for the quarterly period ended September 30, 2004**                                                                                                                                                                          |
| ** **                                                                                                                                                                                                                     |
| **or**                                                                                                                                                                                                                         |
| ** **                                                                                                                                                                                                                     |
| **o**                                                                                                                                                                                                                          | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                                                                                     |
| **for the transition period from                   to                 ** |

 

**CommissionFile Number 000-24085**

 

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**AXT, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

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

(Address of principal executive offices) (Zip code)

 

**(510)683-5900**

(Registrant’s telephone number, including area code)

 

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Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. YES ýNO o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES oNO ý

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate.

 

| **Class**                       | ** ** | **Outstanding at October 20, 2004** |
|---------------------------------|------------|-------------------------------------|
| Common  Stock, $0.001 par value |       | 23,118,235                          |

 

 

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AXT, INC.FORM 10-QTABLE OF CONTENTS

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

 

2

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**PARTI****. FINANCIALINFORMATION**

 

**Item1****. FinancialStatements**

 

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

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

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

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

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

 

Seeaccompanying notes to condensed consolidated financial statements.

 

4

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

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

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

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

 

**Note 1. Basis of Presentation**

 

Theaccompanying interimcondensed consolidated financialstatements of AXT, Inc. (“AXT” or the “Company”) are unaudited, and have been prepared in accordance with accountingprinciples generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, certain information and footnotedisclosure normally included in financial statements prepared in accordancewith accounting principles generallyaccepted in the United States of America have been condensed or omitted.In the opinion of management, the unaudited condensed consolidated financialstatements reflect all adjustments, consisting only of normal recurringadjustments, considered necessary to present fairly the financial position,results of operations and cash flows of AXT and its subsidiaries for allperiods 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 the Company’sconsolidated financial statements and the notes thereto included in its 2003Annual Report on Form 10-K and its Quarterly Reports on Form 10-Q filed withthe Securities and Exchange Commission on March 29, 2004, May 24, 2004 andAugust 5, 2004, respectively.

 

Revenues fromcontinuing operations increased modestly for the nine months ended September30, 2004 compared to the same period of fiscal 2003. In response to continuednet losses, the Company has taken measures including the shifting of productionto China, which was completed in September 2004, to reduce costs and increasecash flows. As of September 30, 2004, the Company had available cash, cashequivalents and liquid short-term investments of $32.9 million, excludingrestricted deposits. The Company believes that its existing cash and liquidinvestments, cash generated from operations, coupled with additional efforts toreduce expenditures in support of the continuing substrate business will besufficient to meet working capital expenditure requirements for the next twelvemonths. However, existing cash and liquid investments could decline during theremainder of 2004 due to a weakening of the economy, a loss in revenue, anunanticipated increase in expenses, or changes in our planned cash outlay.

 

If the Company’ssales decrease, the ability to generate cash from operations will be adverselyaffected which could adversely affect its future liquidity, requiring it to usecash at a more rapid rate than expected and to seek additional capital. Therecan be no assurance that such additional capital will be available or, ifavailable,that it will be at terms acceptable to the Company.

 

Certainreclassifications have been made to the prior years consolidated financialstatements to conform to current period presentation.

 

**Note****2. DiscontinuedOperations**

 

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

 

On September27, 2003 the Company completed a sale of substantially all of the assets of itsopto-electronics business to Lumei Optoelectronics, Corp. (“Lumei”) and DalianLuming Science and Technology Group, Co., Ltd. for the Chinese Renminbiequivalent of $9.6 million. Proceeds of $1.0 million were held in escrow for upto one year.  In September 2004, $225,000of the escrow funds were released to AXT; Lumei made claims against the escrowin the approximate amount of $0.5 million which the Company has contested andintends to vigorously pursue legal action against the claims.  The remaining $250,000 in escrow will be heldfor a second year in accordance with the terms of the agreement and will not berecorded as a gain from discontinued operations, if at all, until all claims,if any, are settled.  The Company retainsa building located in Monterey Park, CA, that it has on the market to sell.This asset has been classified as held for sale onthe condensed consolidated balance sheets as of September 30, 2004 and December31, 2003.

 

6

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

 

The Company’sfinancial statements have been presented to reflect the opto-electronicsbusiness as a discontinued operation for all periods presented. Operatingresults of the discontinued operation are as follows (in thousands):

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

 

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

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

 

Assets heldfor sale consist of a building and are carried at management’s estimated fairvalue less costs to sell.

 

7

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**Note****3. Accounting forStock Options**

 

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

 

As requiredunder SFAS 123 and Statement of Financial Accounting Standards No. 148 (SFAS148), “Accounting for Stock-Based Compensation Transition and Disclosure,” thepro forma effects of stock-based compensation on net income (loss) and net income (loss) per common share hadthe Company applied the fair value recognition principles of SFAS 123 toemployee stock options have been estimated at the date of grant using theBlack-Scholes option-pricing model.

 

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

 

The Companycalculated the 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:

 

| ** **                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|
| ** **                               | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Weighted average risk free interest rate |       | 2.0                                  | %          | 2.7 | % |
| Expected life (in years)                 |       | 5.0                                  |       | 5.0 |   |
| Dividend yield                           |       | —                               |       | — |   |
| Volatility                               |       | 70.5                                 | %          | 117.0 | % |

 

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

 

8

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Hadcompensation cost for the Company’s options been determined based on the fairvalue at the grant dates, as prescribed in SFAS 123 and SFAS 148, the Company’spro forma net loss and net loss per share would have been as follows (inthousands,except per share data):

 

| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss :                                                   |       |                                  |       |                                 |       |   |   |   |   |
| As reported                                                  |       | $                                     | (4,964     | )                                    | $          | (2,563 | ) | $ | (11,371 | ) | $ | (24,616 | ) |
| Stock-based compensation  determined under fair value method |       | (244                                  | )          | (1,996                               | )          | (1,090 | ) | (5,562 | ) |
| Pro forma net loss                                           |       | $                                     | (5,208     | )                                    | $          | (4,559 | ) | $ | (12,461 | ) | $ | (30,178 | ) |
| Net loss per share:                                          |       |                                  |       |                                 |       |   |   |   |   |
| As reported:                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Basic and diluted                                            |       | $                                     | (0.21      | )                                    | $          | (0.11 | ) | $ | (0.49 | ) | $ | (1.08 | ) |
| Pro forma net loss:                                          |       |                                  |       |                                 |       |   |   |   |   |
| Basic and diluted                                            |       | $                                     | (0.23      | )                                    | $          | (0.20 | ) | $ | (0.54 | ) | $ | (1.33 | ) |
| Shares used in per share calculation:                        |       |                                  |       |                                 |       |   |   |   |   |
| Basic and diluted                                            |       | 23,094                                |       | 22,857                               |       | 23,044 |   | 22,727 |   |

 

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

 

**Note****4. Investments**

 

The Companyclassifies its investment securities as available-for-sale securities asprescribed by Statement of Financial Accounting Standards No. 115 (SFAS 115) “Accounting for Certain Investments in Debt and EquitySecurities.” All investments are carried at fair market value, which isdetermined based on quoted market prices, with net unrealized gains and lossesincluded in comprehensive income, net of tax. A decline in the market value ofthe security below cost that is deemed other than temporary is charged toearnings, resulting in the establishment of a new cost basis for the security.The components of investments as of September 30, 2004 are as follows (inthousands):

 

| **Available for sale**      | ** ** | **Cost** | ** ** | **Unrealized  Gain /(loss)** | ** ** | **Aggregate  Fair value** | ** ** |
|-----------------------------|------------|----------|------------|------------------------------|------------|---------------------------|------------|
| Money market                |       | $        | 6,543      |                         | $          | —                    |       | $ | 6,543 |   |
| Corporate bonds             |       | 10,490   |       | (40                          | )          | 10,450                    |       |
| Government agency bonds     |       | 12,724   |       | (15                          | )          | 12,709                    |       |
| Corporate equity securities |       | 1,466    |       | 410                          |       | 1,876                     |       |
|                        |       | $        | 31,223     |                         | $          | 355                       |       | $ | 31,578 |   |
| Recorded as :               |       |     |       |                         |       |                      |       |
| Cash equivalents            |       | $        | 6,543      |                         |       |                      |       |   |
| Short-term investments      |       | 16,670   |       |                         |       |                      |       |
| Restricted deposits         |       | 8,365    |       |                         |       |                      |       |
|                        |       | $        | 31,578     |                         |       |                      |       |   |

 

**Note****5. Assets Held forSale**

 

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

 

9

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**Note****6. Inventories**

 

The componentsof inventory are as follows (in thousands):

 

| ** **      | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------|------------|-------------------------|------------|------------------------|------------|
| Inventories:    |       |                    |       |                   |       |
| Raw materials   |       | $                       | 5,469      |                   | $          | 7,086 |   |
| Work in process |       | 11,276                  |       | 16,027                 |       |
| Finished goods  |       | 1,260                   |       | 970                    |       |
|            |       | $                       | 18,005     |                   | $          | 24,083 |   |

 

**Note****7. Restructuring Charge**

 

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

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

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

 

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

 

The remainingrestructuring accrual for future lease payments related to abandoned facilitiesof $0.6 million and workforce reduction of $34,000, is expected to be paid outthrough 2006 and 2004, respectively, and is included on the accompanyingcondensed consolidated balance sheet as accrued restructuring.

 

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**Note****8. Net Loss PerShare**

 

Basic net loss per common share iscalculated by dividing net loss available to common stockholders by theweighted average number of common shares outstanding during the period. Dilutednet loss per common and common equivalent shares include the dilutive effect ofcommon stock equivalents outstanding during the period calculated using thetreasury stock method. Common stock equivalents consist of the shares issuableupon 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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Net loss                                                                         |       | $                                     | (4,964     | )                                    | $          | (2,563 | ) | $ | (11,371 | ) | $ | (24,616 | ) |
| Less: Preferred stock dividends                                                  |       | (44                                   | )          | (44                                  | )          | (132 | ) | (133 | ) |
| Net loss available to common stockholders                                        |       | $                                     | (5,008     | )                                    | $          | (2,607 | ) | $ | (11,503 | ) | $ | (24,749 | ) |
| Denominator:                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Denominator for basic net loss per share -  weighted average common shares       |       | 23,094                                |       | 22,857                               |       | 23,044 |   | 22,727 |   |
| Effect of dilutive securities:                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Common stock options                                                             |       | —                                |       | —                               |       | — |   | — |   |
| Denominator for dilutive net loss per  common share                              |       | 23,094                                |       | 22,857                               |       | 23,044 |   | 22,727 |   |
| Basic and diluted net loss per share                                             |       | $                                     | (0.22      | )                                    | $          | (0.11 | ) | $ | (0.50 | ) | $ | (1.09 | ) |
| Options excluded from diluted net loss per  share as the impact is anti-dilutive |       | 2,365                                 |       | 2,361                                |       | 2,365 |   | 2,411 |   |

 

**Note****9. ComprehensiveLoss**

 

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

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

 

**Note 1****0. SegmentInformation**

 

The Companyhas one operating segment comprising the design, development, manufacture anddistribution of high-performance compound semiconductor substrates. The Company’soperating segment reports to the Interim Chief Executive Officer.

 

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

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

 

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**Note 1****1. CorporateAffiliates**

 

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

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

 

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

 

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

 

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

 

**Note 1****2. Commitments andContingencies**

 

From time totime the Company is involved in judicial or administrative proceedingsconcerning matters arising in the ordinary course of our business. The Companydoes not expect that any of these matters, individually or in the aggregate,will have a material adverse effect on our business, financial condition, cashflows or results of operation.

 

On June 11,2003, Cree, Inc. filed a complaint in the United States Court for NorthernDistrict of California against the Company alleging patent infringement. Thecomplaint sought damages and injunction against infringement. On July 23, 2003,the Company filed a counter complaint in the United States Court for NorthernDistrict of California, denying any patent infringement and alleging that Cree’sactions were intentionally designed to interfere with the Company’s prospectivebusiness relationships. The Company reached an agreement with Cree resolvingthe disputes and signed a settlement agreement on March 5, 2004. The resolutionof the disputes did not have a material adverse impact on the Company’sconsolidated financial position or results of operations. All parties signed afinal release regarding all disputes on April 15, 2004.

 

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

 

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

 

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

 

The Companyindemnifies certain customers for attorney fees and damages and costs awardedagainst these parties in certain circumstances if its products are found toinfringe certain patents and they are sued by the patent holder and awardeddamages. There are limits on and exceptions to its potential liability forindemnification relating to intellectual patent infringement claims. TheCompany cannot estimate the amount of potential future payments, if any, thatit might be required to make as a result of these agreements. To date, theCompany has not paid any claim or been required to defend any action related toits indemnification obligations, and accordingly, the Company has not accruedany amounts for such indemnification obligations. However, we may recordcharges in the future as a result of these indemnification obligations.

 

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

 

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

 
| ** **                                    | ** ** | **Three****Months Ended****September 30****,** | ** ** | **Nine****Months Ended****September 30****,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **200****4**                                   | ** ** | **200****3**                                  | ** ** | **200****4** | ** ** | **200****3** | ** ** |
|                                          |       |                                           |       |                                          |       |   |   |   |   |
| Beginning accrued warranty and related  costs |       | $                                              | 135        |                                          | $          | — |   | $ | — |   | $ | — |   |
| Charged to cost of revenue                    |       | —                                         |       | —                                        |       | 135 |   | — |   |
| Actual warranty expenditures                  |       | —                                         |       | —                                        |       | — |   | — |   |
| Ending accrued warranty and related costs     |       | $                                              | 135        |                                          | $          | — |   | $ | 135 |   | $ | — |   |

 

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

 

The Company iscurrently negotiating a new joint venture investment in China for aGermanium business opportunity, and upon the fulfillment of certain conditions,the Company may invest up to US$1.0 million to the new joint venture byDecember 2004.

 

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**Note 13. Foreign Exchange Contracts andTransaction Gains/Losses**

 

The Companyuses short-term forward exchange contracts for hedging purposes to reduce theeffects of adverse foreign exchange rate movements. The Company has purchasedforeign exchange 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 September 30, 2004, the Company had no outstandingcommitments with respect to foreign exchange contracts.

 

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

 

**Note 14. Recent Accounting Pronouncements**

 

In January2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), *Consolidation of VariableInterest Entities*, which addresses consolidation by business enterprisesof variable interest entities, or VIEs, either that do not have sufficientequity investment at risk to permit the entity to finance its activitieswithout additional subordinated financial support, or in which the equityinvestors lack an essential characteristic of a controlling financial interest.In December 2003, the FASB completed deliberations of proposed modifications toFIN 46, or FIN 46(R), resulting in an effective date of no later than the firstinterim or annual period ending after March 15, 2004. The Company’s adoption ofFIN 46(R) did not have an impact on our results of operations or financialposition.

 

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

 

**Note 15. Subsequent Event**

 

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

 

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**ITEM2****. MANAGEMENT’SDISCUSSION AND ANALYSIS OF 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, andinclude statements concerning future sales returns and claims arising from ourrecent investigation into product testing and reporting practices; the adequacyof our reserves; future industry demand; our ability to regain lost marketshare; our ability to offer products that equal or exceed the quality providedby competitors; product pricing; cost savings as a result of our move to China;and intellectual property litigation. Statements concerning our financial position,business strategy and plans or objectives for future operations areforward-looking statements.

 

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 the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2003 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 first substratesales in 1990 and our substrate division currently sells gallium arsenide(GaAs) and indium phosphide (InP) substrates to manufacturers of semiconductordevices 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 tomanufacture germanium substrates for use in satellite solar cells but withdrewfrom this business during 2000 so that we could more profitably use our thenconstrained capacity. We are now trying to re-qualify our germanium substrateswith the few existing satellite solar cell system manufacturers.

 

Our totalrevenue from continuing operations was $8.5 million for the third quarter of2004, $9.5 million for the second quarter of 2004 and $9.8 million for thefirst quarter of 2004. In the third quarter of 2004 we incurred a loss fromcontinuing operations of $5.2 million compared with a loss of $4.1 million forthe second quarter of 2004 and a loss of $2.6 million for the first quarter of2004.  For the third quarter of 2004, ourrevenue from continuing operations remained flat at $8.5 million compared tothe third quarter of 2003. Our gross margin decreased from the third quarter of2003 to negative 26.2 percent primarily due to an approximately $1.4 millioncharge in connection with the settlement of our litigation in Japan andinterference actions in the United States with Sumitomo Electrical Industries,Ltd. and a $2.1 million inventory charge due to excess and obsolete inventory.

 

On June 24,2003, we announced the discontinuation of our opto-electronics division, whichwe had established as part of our acquisition of Lyte Optronics, Inc. in May1999. Accordingly, the results of operations of the opto-electronics divisionhave been segregated from continuing operations and are reported separately asdiscontinued operations in our consolidated statements of operations for allperiods presented (see Note 2 of the notes to our condensed consolidatedfinancial statements for details regarding the accounting for discontinuedoperations). The discontinued opto-electronics division manufactured blue,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.

 

On September27, 2003, we completed the sale of substantially all of the assets of ouropto-electronics business to Lumei Optoelectronics Corp. (“Lumei”) and DalianLuming Science and Technology Group, Co., Ltd. for the China Renminbi (RMB)equivalent of $9.6 million. During the first quarter of 2004, $7.8 million wasconverted to US dollars. The remaining funds were converted to US dollars inearly April 2004.  Proceeds of $1.0 millionwere held in escrow for up to one year. In September 2004, $225,000 of the escrow funds were released to AXT;Lumei made claims against the escrow in the

 

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approximate amount of $0.5 million which wehave contested and we intend to vigorously pursue legal action against theclaims.  The remaining $250,000 in escrowwill be held for a second year in accordance with the terms of the agreementand will not be recorded as a gain from discontinued operations until allclaims, if any, are settled.  We retain abuilding located in Monterey Park, CA, that we have on the market to sell. Thisasset has been classified as held for sale onthe condensed consolidated balance sheets as of September 30, 2004 and December31, 2003.

 

Our continuingbusiness, primarily sales of our substrate products, is dependant on thesemiconductor industry, which is highly cyclical and has historicallyexperienced downturns both as a result of economic changes and overcapacity. Weexperienced a growth period that lasted from our initiation of sales in 1990through the first half of 2001. In the second half of 2001, we experienced a$44.9 million, or 58.5% decrease in revenue compared with the first half as aresult of the rapid decline in the mobile and fiber optic telecommunicationsmarkets. Together with other industry participants, we experienced lowerrevenues, slower bookings, postponements and cancellation of orders. As such,we recorded losses in the third and fourth quarters of 2001.

 

During thefirst half of 2002 our revenues grew due to improvements in the wirelessmarket. In the second half of 2002 our revenue fell, however, because thesubstrate industry was still facing excess capacity that caused prices todecline, and because we experienced a loss of market share after twocompetitors developed technologies similar to ours. In addition, certaincustomers selected competitors’ products in order to diversify their supplysources and due to the belief that the competitors’ substrates offered bettersurface qualities. Full year 2002 revenue declined $63.9 million, or 58.8%compared with 2001. We recorded losses in each quarter of 2002 and incurredimpairment charges against fixed assets and inventory due to the decline indemand and prices. In reaction to the economic downturn, we initiated anaggressive effort to reduce substrate manufacturing costs. This included movingmuch of our substrate manufacturing operations to China, reducing capacity inour Fremont, CA facility and developing and investing in key low-cost rawmaterial sources.

 

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

 

During thefirst nine months of 2004, our revenue increased compared with the first ninemonths of 2003, primarily as a result of increased demand for HBLEDs. We haverecorded net losses in all three quarters of 2004. During the second quarter of2004, we announced plans to cease all production activities in the UnitedStates and to manufacture our products only in China.

 

We cannotpredict the level of future industry demand or of our ability to regain lostmarket share, but they have impacted our ability to sell our products andoperate profitably. If demand for our products remains depressed for anextended period, our business will be harmed as a result. Our businessperformance will be most influenced by market demand for compoundsemi-conductor substrates, our ability to offer products that equal or exceedthe quality provided by competitors, product pricing, our ability to realizecost-savings as a result of our shift of production to China, and our abilityto create and defend our intellectual property while not infringing on theintellectual property of others.

 

In April 2004,we determined that we had not followed requirements for testing of products and provisionof testing data and information relating to customer requirements for certainshipments made over the past several years. We have notified the affectedcustomers concerning our findings. We have established a reserve based on ourbest estimate of future returns related to this matter. Although actual returnsmay differ, we do not believe future claims in the aggregate will be material.We have recorded a reserve for sales returns of $745,000 and believe this isadequate to cover any product returns related to this matter, however, we areunable to assess the impact that this matter might have, if any, on our futurerevenues or gross margins. Approximately $155,000 of the $745,000 sales returnsreserve has been utilized as of September 30, 2004.  See “Item 4. Controls and Procedures” forfurther information.

 

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

 

In August2004, we announced the adoption of a stock repurchase program in accordancewith Rule 10b5-1 of the Securities Exchange Act of 1934 to provide for therepurchase of up to $2 million of our common stock.  Repurchases may be made from time to time inthe open market during the twelve-month period ending July 31, 2005, atprevailing market prices, although to date no repurchases have been made. As ofSeptember 30, 2004, we had 23.1 million shares of common stockoutstanding.  Repurchases, if any, willbe made under the program using our own cash resources.

 

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In October 2004, we announced that we had reached a tentativesettlement of the litigation in Japan and interference actions in the UnitedStates with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a globalintellectual property cross-licensing agreement. AXT expects to finalize thisagreement in the fourth quarter of 2004, subject to Board of Directors approvalfrom AXT and SEI.  Accordingly, werecorded a charge of approximately $1.4 million for the quarter ended September2004 in connection with this settlement, and are expected to make royalty paymentsto SEI on future sales of certain products.

 

Also inOctober 2004, a purported securities class action lawsuit was filed in theUnited States District Court for the Northern District of California: City ofHarper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362MJJ.  The lawsuit names the Company andits CEO, China Operations, as defendants, and is brought on behalf of a classof all purchasers of our securities from February 6, 2001 through April 27,2004.  The complaint alleges that ourannounced financial results during this period were false and misleading.  No specific amount of damages isclaimed.  We believe that there aremeritorious defenses against this lawsuit and intends to vigorously defendit.  However, due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation.  Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operation.

 

**Critical Accounting Policies and Estimates**

 

We have preparedour consolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America. As such, we have had tomake estimates, assumptions and judgments that affect the amounts reported onour financial statements. These estimates, assumptions and judgments aboutfuture events and their effects on our results cannot be determined withcertainty, and are made based upon our historical experience and on otherassumptions that are believed to be reasonable under the circumstances. Theseestimates may change as new events occur or additional information is obtained,and we may periodically be faced with uncertainties, the outcomes of which arenot within our control and may not be known for a prolonged period of time. Thediscussion and analysis of our results of operations and financial conditionare based upon these consolidated financial statements. We have identified thepolicies below as critical to our business operations and understanding of ourfinancial condition and results of operations. A critical accounting policy isone that is both material to the presentation of our financial statements andrequires us to make difficult, subjective or complex judgments that could havea material effect on our financial condition and results of operations. Theymay require us to make assumptions about matters that are highly uncertain atthe time of the estimate, and different estimates that we could have used, orchanges in the estimate that are reasonably likely to occur, may have amaterial impact on our financial condition or results of operations.

 

We believethat the following are our critical accounting policies:

 

***Revenue Recognition***

 

We recognizerevenue upon shipment of products to our customers provided that we havereceived a signed purchase order, the price is fixed or determinable, title hastransferred, collection of resulting receivables is probable, product returnsare reasonably estimable, there are no customer acceptance requirements andthere are no remaining obligations. We establish a reserve when there isuncertainty regarding customer acceptance. We assess the probability ofcollection based on a number of factors including past history with thecustomer and credit worthiness. We provide for future returns based onhistorical experience, current economic trends and changes in customer demandat the time revenue is recognized. During the first quarter of 2004, weincreased our reserve for sales returns by $745,000 related to our failure tofollow certain testing requirements and provision of testing data andinformation to certain customers. This reserve was based on discussions withsome of the affected customers and review of specific shipments made during thequarter. Except for sales in Japan and some sales in Taiwan, which in bothcases are denominated in Japanese yen, we denominate and collect ourinternational sales in U.S. dollars.

 

***Allowance forDoubtful Accounts***

 

Weperiodically review the likelihood of collecting our accounts receivable balancesand provide an allowance for doubtful accounts receivable primarily based uponthe age of these accounts. We provide a 100% allowance for U.S. receivables inexcess of 90 days and for foreign receivables in excess of 120 days. As ofSeptember 30, 2004, our accounts receivable balance was $5.2 million, which isnet of an allowance for doubtful accounts of $4.8 million.

 

***Warranty Reserve***

 

We maintain awarranty reserve based upon our claims experience during the prior twelvemonths. Such costs are accrued at the time revenue is recognized. As ofSeptember 30, 2004, accrued product warranties totaled $135,000.

 

***Inventory***

 

Inventoriesare stated at the lower of cost or market. Cost is determined using thestandard cost method. Finished goods

 

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and work-in-process inventories includematerial, labor and manufacturing overhead costs. We routinely evaluate thelevels of our inventory in light of current market conditions in order toidentify excess and obsolete inventory and we provide a valuation allowance forcertain inventories based upon the age and quality of the product. Competitivedelivery times are frequently less than the time required for us to manufacturea product, requiring us to build some work-in-process inventories inanticipation of orders. If orders are not obtained for the products built, theproducts will ultimately be deemed obsolete and we will establish a reserve fortheir value. We also review our inventory to ensure costs can be realized uponultimate sale to our customers. If we determine that the value of any items inending inventory exceeds the sales value less any related selling costs, areserve is established for the difference.

 

***Impairment ofLong-Lived Assets***

 

We evaluatethe recoverability of property, equipment, and intangible assets in accordancewith Statement of Financial Accounting Standards No. 144, or SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.” When events andcircumstances indicate that long-lived assets may be impaired, we compare thecarrying value of the long-lived assets to the projection of futureundiscounted cash flows attributable to such assets and 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.

 

***Investments***

 

We determinethe appropriate classification of investments at the time of purchase.Available-for-sale investments are carried at their fair value based on quotedmarket prices as of the balance sheet date. The amortized cost of securities isadjusted for amortization of premiums and accretion of discounts to maturity.Such amortization is included in “other (income) and expense, net.” Realizedgains or losses are determined on the specific identification method and arereflected in “other (income) and expense, net.” Net unrealized gains or lossesare recorded directly in stockholders’ equity. Those unrealized losses that aredeemed to be other than temporary are reflected in “interest and other income,net.” We also maintain minority investments in private companies which areaccounted for under the cost basis. These investments are reviewed for otherthan temporary declines in value on a quarterly basis. Reasons for other thantemporary declines in value include whether the related company would haveinsufficient cash flow to operate for the next twelve months, significantchanges in the operating performance and changes in market conditions.

 

***Income Taxes***

 

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

 

**Results of Operations**

 

The followingtable sets forth certain information relating to the operations of the Companyexpressed as a percentage of total revenues for the periods indicated:

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

 

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

 

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

 

Total GaAssubstrate revenue increased $156,000 or 2.3%, to $7.0 million for the three months endedSeptember 30, 2004 compared with $6.9 million for the three months endedSeptember 30, 2003. Sales of 5 inch and 6 inch diameter GaAs substrates were$193,000 for the three months ended September 30, 2004 compared with $1.7million for the three months ended September 30, 2003. InP substrate revenuedecreased $282,000, or 57%, to $214,000 for the three months ended September30, 2004 compared with $496,000 for the three months ended September 30, 2003.The increase in GaAs substrate revenue during the past year is due to marketgrowth in the HBLED market and to our ability to gain share among some Asiancustomers. The decrease in revenue from 5 inch and 6 inch diameter substratesis related to a loss in market share for these products, particularly amongcustomers in the United States.  Thesesubstrates are primarily used to manufacture devices for wirelesshandsets.  The decrease in InP substraterevenue was due to a decline in orders from customers who are qualifying ourChina-made products.

 

Internationalrevenue increased to 78.0% of total revenue from continuing operations for thethree months ended September 30, 2004 compared with 64.5% of total revenue fromcontinuing operations for the three months ended September 30, 2003. The increasewas primarily due to a greater share of our GaAs substrates being used inopto-electronics applications and the majority of our customers for theseapplications being in Asia.

 

*Gross margin.*Gross margin decreased to(26.2)% of total revenue for the three months ended September 30, 2004 comparedwith 5.9% of total revenue for the three months ended September 30, 2003. Thedecrease was primarily due to an approximately $1.4 million charge inconnection with the settlement of our litigation in Japan and interferenceactions in the United States with Sumitomo Electrical Industries, Ltd. and a$2.1 million inventory valuation charge due to excess and obsolete inventory.

 

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

 

*Research and development expenses.*Researchand development expenses increased $96,000, or 31.9%, to $397,000 for the threemonths ended September 30, 2004 compared with $301,000 for the three monthsended September 30, 2003. As a percentage of total revenue, research anddevelopment expenses were 4.7% for the three months ended September 30, 2004compared with 3.5% for the three months ended September 30, 2003.  We believe that continued investment inproduct development is critical to attaining our strategic objectives ofmaintaining and increasing our technology leadership, and as a result, weexpect research and development expenses to remain at the levels of recentquarters or increase in future periods. Research and development efforts during2004 were focused primarily on improving the yield and surface quality of ourGaAs substrates.

 

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

 

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

 

*Provision for income taxes.*Due to ourcontinuing operating losses in the United States and uncertainty regardingfuture profitability, in 2003 we recorded a full valuation allowance for ourUnited States losses against our net deferred tax assets of $34.6 million. We incurred a taxliability of $40,000 for our overseas businesses for the three months endedSeptember 30, 2004.

 

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**Nine months ended September 30, 2004 comparedwith nine months ended September 30,****2003**

 

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

 

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

 

Internationalrevenue increased to 78.0% of total revenue from continuing operations for thenine months ended September 30, 2004 compared with 65.0% of total revenue fromcontinuing operations for the nine months ended September 30, 2003. The increasewas primarily due to a greater share of our GaAs substrates being used inopto-electronics applications and the majority of our customers for theseapplications being in Asia.

 

*Gross margin.*Gross margin decreased to (3.1)%of total revenue for the nine months ended September 30, 2004 compared with5.7% of total revenue for the nine months ended September 30, 2003. Thedecrease was primarily due to a valuation charge of $2.1 million as a result ofthe write down of excess and obsolete inventory during the quarter and a chargeof approximately $1.4 million in connection with the settlement of thelitigation in Japan and interference actions in the United States with SumitomoElectric Industries, Ltd. taken in the third quarter of 2004.

 

*Selling, general and administrative expenses.*Selling,general and administrative expenses increased to $8.4 million for the ninemonths ended September 30, 2004 compared with $8.0 million for the nine monthsended September 30, 2003. The increase is due to an additional expense of$350,000 for legal fees related to the investigation by our Audit Committeeinto product testing and compliance practices in the second quarter of 2004. Asa percentage of revenue, selling, general and administrative expenses were30.3% for the nine months ended September 30, 2004 compared with 31.2% for thenine months ended September 30, 2003.

 

*Research and development expenses.*Researchand development expenses increased $40,000, or 3.8%, to $1.1 million for thenine months ended September 30, 2004 compared with $1.0 million for the ninemonths ended September 30, 2003. As a percentage of total revenue, research anddevelopment expenses were 3.9% for the nine months ended September 30, 2004compared with 4.1% for the nine months ended September 30, 2003.  We believe that continued investment inproduct development is critical to attaining our strategic objectives ofmaintaining and increasing our technology leadership, and as a result, weexpect research and development expenses to remain at current levels orincrease in future periods. Research and development efforts during 2004 werefocused primarily on improving the yield and surface quality of our GaAssubstrates.

 

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

 

*Other income and expense, net.*Other incomeincreased $1.5 million to $434,000 for the nine months ended September 30, 2004compared with other expense of $1.0 million for the nine months ended September30, 2003. The increase was mainly due to a one-time gain of $237,000 recordedin 2004 for a deposit on future purchases of goods forfeited by a privatecompany while in 2003, we recorded an impairment charge of $1.3 million relatedto a non-consolidated subsidiary. In addition, our investment in this companywas written off during the quarter for which we recorded a $210,000 assetimpairment charge.

 

*Provision for income taxes.*Due to ourcontinuing operating losses in the United States and uncertainty regardingfuture profitability, in 2003 we recorded a full valuation allowance for ourUnited States losses against our net deferred tax assets of $34.6 million. We incurred a taxliability of $177,000 for our overseas businesses for the nine months endedSeptember 30, 2004.

 

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**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 September 30,2004, our principal sources of liquidity were $32.9 million in cash and cashequivalents and short-term investments, excluding restricted deposits.

 

Cash and cashequivalents and short-term investments, excluding $1.5 million and $3.7 millionfor our investment in Finisar common stock as of September 30, 2004 andDecember 31, 2003, respectively, decreased $3.9 million to $31.4 million as of September 30, 2004 comparedwith $35.3 million as of December 31, 2003.

 

Cash and cashequivalents decreased $8.1 million to $16.2 million as of September 30, 2004compared with $24.3 million as of December 31, 2003. Short-term investmentsincreased by $2.0million to $16.7 million as of September 30, 2004 compared with $14.7 million as of December 31, 2003.The combined decrease in cash and cash equivalents and short-term investmentswas primarily due to payments of long-term debt of $2.8 million, purchase ofmachinery and equipment of $1.3 million, and the continual funding of ouroperations.

 

Net cash usedby operating activities of $0.6 million for the nine month period endedSeptember 30, 2004 was comprised primarily of our net loss adjusted fornon-cash items which netted to $10.7 million, consisting primarily ofdepreciation of $3.6 million, together with a $7.1 million net change in assetsand liabilities. The net change in assets and liabilities resulted primarilyfrom a decrease in accounts receivable and inventory partially offset by an increase inprepaid expenses and a decrease in accounts payable and accrued liabilities.

 

Net accountsreceivable decreased by $1.1 million, or 16.8%, to $5.2 million as of September30, 2004 compared with $6.3 million as of December 31, 2003. The decreasereflects better collections from customers and an additional sales returnsreserve of $745,000 recorded in the first quarter of 2004.

 

Netinventories decreased $6.1 million, or 25.2% to $18.0 million as of September30, 2004 compared with $24.1 million as of December 31, 2003. We adopted astrategy of using inventory to conserve cash beginning in 2001. We had a $2.1million inventory valuation charge due to excess and obsolete inventory. We donot expect to maintain the same rate of net inventory decrease as weexperienced in the first nine months of 2004.

 

Net cash usedby investing activities of $4.8 million for the nine months ended September 30,2004 included purchases of property and equipment of $1.3 million primarilyused to transfer production capacity to China for the substrate division, andpurchases of high grade investment securities with maturities of less than twoyears totaling $24.4 million. This was partially offset by sales of high gradeinvestment securities totaling $13.2 million and a change in the investmentsproviding our restricted cash of $7.6 million.

 

We do not haveany plans to initiate any major new capital spending projects through 2004. Weare currently completing certain projects at our China facilities and closingour remaining manufacturing facilities in Fremont, California. We expect toinvest approximately $2.0 million in capital projects in 2004. We believe thatour existing and planned facilities and equipment are sufficient to fulfillcurrent and expected future orders.

 

Net cash usedin financing activities of $2.6 million for the nine month period endedSeptember 30, 2004 consisted of payments of $2.8 million related to long-termborrowings, partially offset by proceeds of $270,000 through our employee stockcompensation 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 1.94% as ofSeptember 30, 2004. The bonds are traded in the public market. Repayment ofprincipal and interest under the bonds is supported by a letter of credit fromour bank and is paid on a quarterly basis. We have the option to redeem thebonds in whole or in part during their term. As of September 30, 2004, $8.2million was outstanding under these bonds.

 

As ofSeptember 30, 2004,the credit facility maintained by us with a bank included a letter of creditsupporting repayment of our industrial bonds with an outstanding amount of $8.4million. We have pledged and placed certain investment securities with anaffiliate of the bank as additional collateral for this facility. We have alsopledged certain investments for a credit facility for our workers compensationinsurance policy for portions of 2002 and 2003. Accordingly, $8.4 million of our cash and short-term investments arerestricted.

 

We arecurrently obligated on a note payable collateralized by certain buildings andland in China totaling $1.5 million as of September 30, 2004. The balance onthis note is due in December 2004.

 

We believethat we have adequate cash and investments to meet our needs over the next 12months. If our sales decrease, however, our ability to generate cash from operationswill be adversely affected which could adversely affect our future

 

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liquidity, require us to use more cash at amore rapid rate than expected, and require us to seek additional capital. Therecan be no assurance that such additional capital will be available or, ifavailable it will be at terms acceptable to us. Cash from operations could beaffected by various risks and uncertainties, including, but not limited tothose set forth below under “Risks Related to Our Business.”

 

Outstandingcontractual obligations as of September 30, 2004 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              |       | $                          | 9,708      |   | $ | 2,108 |   | $ | 1,420 |   | $ | 900 |   | $ | 5,280 |   |
| Operating Leases            |       | 6,699                      |       | 1,301 |   | 2,372 |   | 1,361 |   | 1,665 |   |
| Total                       |       | $                          | 16,407     |   | $ | 3,409 |   | $ | 3,792 |   | $ | 2,261 |   | $ | 6,945 |   |

 

We leasecertain office space, manufacturing facilities and property under long-termoperating leases expiring at various dates through March 2013. Total rentexpense under these operating leases was approximately $359,000 and $1.1million for the three month and nine month periods ended September 30, 2004,respectively.

 

**Recent Accounting Pronouncements**

 

In January2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46,or FIN 46, *Consolidation of VariableInterest Entities*, which addresses consolidation by businessenterprises of variable interest entities, or VIEs, either: (1) that do nothave sufficient equity investment at risk to permit the entity to finance itsactivities without additional subordinated financial support, or (2) in whichthe equity investors lack an essential characteristic of a controllingfinancial interest. In December 2003, the FASB completed deliberations ofproposed modifications to FIN 46, or FIN 46(R), resulting in an effective dateof no later than the first interim or annual period ending after March 15,2004. The Company’s adoption of FIN 46(R) did not have an impact on our resultsof operations or financial position.

 

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

 

**Risks Related to Our Business**

 

***We may incur claimsor other liabilities or obligations related to our failure******to follow requirementsfor testing of products and provision of testing data******and information relating to customerrequirements. Additionally, customers may******cancel or reduce future shipments inresponse to these failures.***

 

We haverecently determined that we had not followed requirements for testing of products and provisionof testing data and information relating to customer requirements. Seepreceding “Item 2. Management’s Discussion and Analysis of Financial Conditionand Results of Operation - Overview” and “Item 4. Controls and Procedures”below for further information. Although we are notifying affected customersconcerning our findings, there can be no assurance that we will not incurcustomer claims or other liabilities or obligations in connection with this matter,nor, if we receive any such claims, that we will not have to restate resultsfrom prior periods. In addition, revenue in future periods may be adverselyimpacted if customers cancel or reduce orders or decide not to continueordering from us as a result of this disclosure. We have been notified ofseveral cancellations of future orders by customers pending further informationregarding enhancements to our product testing and quality control systems. Inaddition, some customers are requiring additional qualification of our Chinaoperations before placing future orders with us. We cannot be sure that we willnot receive additional cancellations of orders by other customers, or fail towin expected future orders from customers, as a result of our disclosure of ourinvestigation conclusions, or that our customers will qualify our Chinaoperations and place future orders with us.

 

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***Because of power shortages in China, we may have to temporarily closeour China operations, which would adversely impact our ability to manufactureour products, meet customer orders, and result in reduced revenues for theperiod.***

 

The Chinesegovernment faced a power crunch over the summer and reported that power demandin 24 provinces outstripped supply in peak periods during the first four monthsof 2004. Instability in electrical supply caused sporadic outages amongresidential consumers. As a result, the Chinese government has called for toughmeasures to ease the energy shortage which is expected to last at least through2005.  Provinces have imposed powerbrownouts to reduce electricity demand and some companies in Beijing have beenordered to give their employees a week off to ease the pressure on powersupply. The plants, most of which are state-owned, were closed and reopened ona staggered schedule to reduce power consumption during the capital’s hottestmonths. As a result we closed most of our operations for a week in late July2004 in conformance with this policy.  Ifwe are required to make additional temporary closures of our Beijingoperations, we will be unable to manufacture our products, and will be unableto meet customer orders except from inventory on hand.  As a result, we could lose sales, adverselyimpacting our revenues, and our relationships with our customers could suffer,impacting our ability to generate future sales. In addition, if power is shut off at our Beijing operations at any time,either voluntarily or as a result of unplanned brownouts, during certain phasesof our manufacturing process including our crystal growth phase, the work inprocess may be ruined and rendered unusable, causing us to incur expense thatwill not be covered by revenue, and negatively impacting our cost of goods soldand gross margins.

 

***Intellectualproperty infringement claims may be costly to resolve and could divertmanagement attention.***

 

Other companies may hold or obtain patents on inventions or mayotherwise claim proprietary rights to technology necessary to our business. Themarkets in which 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, and havebeen sued by a substrate competitor concerning alleged patent infringement.

 

On October 8, 2004, we announced that we had reached a tentativesettlement of the litigation in Japan and interference actions in the UnitedStates with Sumitomo Electric Industries, Ltd. (“SEI”), which includes a globalintellectual property cross-licensing agreement. AXT expects to finalize thisagreement in the fourth quarter of 2004, subject to Board of Directors approvalfrom AXT and SEI.  Accordingly, werecorded a charge of approximately $1.4 million for the quarter ended September2004 in connection with this settlement, and are expected to make royaltypayments on future sales of certain products.

 

***If we fail to comply with environmental andsafety regulations, we may be subject to significant fines or cessation of ouroperations; in addition, we could be subject to suits for personal injuriescaused by hazardous materials.***

 

We are subject to federal, state and local environmental and safetylaws and regulations in all of our operating locations. These laws, rules andregulations govern the use, storage, discharge and disposal of hazardouschemicals during manufacturing, research and development, and salesdemonstrations. If we fail to comply with applicable regulations, we could besubject to substantial liability for clean-up efforts, personal injury andfines or suspension or cessation of our operations. In March 2001, we settled aclaim made by the California Occupational Safety and Health Administration, orCal-OSHA, in an investigation primarily regarding impermissible levels ofpotentially hazardous materials in certain areas of our manufacturing facilityin Fremont, California for $200,415, and we have recently been the target ofpress allegations and correspondence purportedly on behalf of current and/orformer employees concerning our environmental compliance programs and exposureof our employees to hazardous materials, and there is a possibility thatcurrent and/or former employees may bring litigation against us. Although wehave put in place engineering, administrative and personnel protectiveequipment programs to address these issues, our ability to expand or continueto operate our present locations could be restricted or we could be required toacquire costly remediation equipment or incur other significant expenses.Existing or future changes in laws or regulations in the United States andChina may require us to incur significant expenditures or liabilities, or mayrestrict our operations. In addition, our employees could be exposed tochemicals or other hazardous materials at our facilities and we may be subjectto lawsuits seeking damages for wrongful death or personal injuries allegedlycaused by exposure to chemicals or hazardous materials at our facilities.

 

If litigation is brought against us, litigation is inherently uncertainand while we would expect to defend ourselves vigorously, it is possible thatour business, financial condition, results of operations or cash flows, couldbe affected in any particular period by such litigation if brought against us.

 

***The semiconductorindustry is cyclical and has experienced a downturn which has******adversely impacted ouroperating results.***

 

Our continuing business depends in significant part upon manufacturersof electronic and opto-electronic semiconductor

 

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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 and capacity requirements, including capacity utilizing thelatest technology. The rate of changes in demand, including end demand, ishigh, and the effect of these changes upon us occurs quickly, exacerbating thevolatility of these cycles. These changes have affected the timing and amountsof customers’ capital equipment purchases and investments in new technology.These industry cycles create pressure on our net sales, gross margin and netincome.

 

The industryhas previously experienced periods of oversupply that result in significantlyreduced demand for semiconductor devices and components, including ourproducts, both as a result of general economic changes and overcapacity. Whenthese periods occur, our operating results and financial condition areadversely affected, and create pressure on our revenue, gross margins and netincome. Inventory buildups in telecommunications products and slower thanexpected sales of computer equipment resulted in overcapacity and led toreduced sales by our customers, and therefore reduced purchases of ourproducts. During periods of weak demand such as those experienced over the pastyears, customers typically reduce purchases, delay delivery of products and/orcancel orders of component parts such as our products. Increased pricecompetition has resulted, causing pressure on our net sales, gross margin andnet income. We experienced cancellations, price reductions, delays and pushouts of orders, which have resulted in reduced revenues. If the economicdownturn were to continue, or occur again in the future, further ordercancellations, reductions in order size or delays in orders will 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.

 

During periodsof 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. Itappears that the semiconductor industry is in the early stages of an upturn andincreasing demand. However, we cannot predict the sustainability of a recovery,if any, and the industry’s rate of growth in this recovery, if it occurs. If 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.

 

***If the economyrecovers and we are again in a period of high demand for our******products, we may beunable to expand our manufacturing capacity quickly enough******to meet increased demand, we maymake decisions to expand capacity that are not******profitable, and we may be unable tolower our costs or increase revenue.***

 

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

 

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

 

We have notover the past year been able to sustain growth, and may not be able to returnto historic growth levels in the current economic environment. Our net loss in2002 was the largest in our history and our losses continued during 2003. Webelieve we will endure losses for 2004.

 

We have andmay 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:

 

•                  declinein general economic conditions or downturns in the industry in which wecompete;

 

•                  fluctuationsin demand for our products;

 

•                  expansionof our manufacturing capacity;

 

•                  expansionof our operations in China;

 

•                  limitedavailability and increased cost of raw materials;

 

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•                  thevolume and timing of orders from our customers, and cancellations, push outsand delays of customer orders;

 

•                  fluctuationof our manufacturing yields;

 

•                  decreasesin the prices of our competitors’ products;

 

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

 

•                  increasesin our expenses, including expenses for research and development; and

 

•                  ourability to develop, manufacture and deliver high quality products in a timelyand cost-effective manner.

 

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

 

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

 

***Our results ofoperations may suffer if we do not effectively manage our******inventory.***

 

We must manageour inventory of component parts, work-in-process, and finished goods effectivelyto meet changing customer requirements, while keeping inventory costs down andimproving gross margins. Some of our products and supplies have in the past andmay in the future become obsolete while in inventory due to changing customerspecifications, or become excess inventory due to decreased demand for ourproducts and an inability to sell the inventory within a foreseeable period.Furthermore, if current costs of production increase or sales prices drop belowthe standard prices at which we value inventory, we may need to take a chargefor a reduction in inventory values. We have in the past, including during thecurrent quarter, had to take inventory valuation and impairment charges. If weare not able to manage successfully our inventory in the future, we may againneed to write off un-saleable, obsolete or excess inventory, which couldadversely affect our results of operations.

 

***Decreases in averageselling prices of our products may reduce gross margins.***

 

The market forcompound semiconductor substrates is characterized by pressures on averageselling prices resulting from factors such as increased competition orovercapacity. We may experience price pressures on our products, and if averageselling prices decline in the future, our revenues and gross margins coulddecline. We may be unable to reduce the cost of our products sufficiently tocounter the effect of lower selling prices and allow us to keep pace withcompetitive pricing pressures and our margins could be adversely affected.

 

***The disposal of ouropto-electronics business may fail to result in the******benefits we anticipate.***

 

We may notobtain the benefits we expect as a result of discontinuation of ouropto-electronics business, such as greater strategic focus on our corebusinesses. We may be required to return to the buyer some of the sale proceedswhich have been held in escrow should the buyer be successful in its claims ofapproximately $0.5 million that we breached representations or warranties thatwe made to it. Our building in Monterey Park may not be sold for the $1 millionat which we are carrying it on our balance sheet. We may incur additional costsassociated with the discontinued operations which could materially reduce ourshort term earnings.

 

***A reoccurrence ofSevere Acute Respiratory Syndrome (SARS) or the outbreak of a******different contagiousdisease may adversely impact our manufacturing operations******and some of our key suppliers andcustomers.***

 

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

 

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not be able to ship product to them, ourrevenue would decline and our financial performance would suffer.

 

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

 

Our operatingresults can vary significantly based upon the impact of changes in globaleconomic conditions on our customers. More specifically, the macro-economicenvironment that we faced in 2003 was more uncertain than in some priorperiods, lasted longer than expected and has materially and adversely affectedus and our operating results and may continue to do so. 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 businesses fluctuatewith general economic and business conditions, a softening of demand forproducts that use our substrates, caused by a weakening economy may result infurther or prolonged decreased revenues. Customers may find themselves facingexcess inventory from earlier purchases, and may defer or reconsider purchasingproducts due to the downturn in their business and in the general economy.

 

***If we do notsuccessfully develop new products to respond to rapidly changing******customer requirements,our ability to generate sales and obtain new customers******may suffer.***

 

Our successdepends 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. If we fail to offer new products orproduct enhancements or fail to achieve higher quality products, we may notgenerate sufficient revenue to offset our development costs and other expensesor meet our customers’ requirements. Other companies, including Triquent, areactively 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.

 

***Our operatingresults depend in large part on further customer acceptance of******our existing substrateproducts manufactured in China.***

 

As we are nowmanufacturing only in China, if the shift of our substrate manufacturingoperations to China is to be successful, we will need our customers to qualifyproducts manufactured in China. If we are unable to achieve qualifications forthese products, our China facility will be underutilized, our investments inChina will not be recouped and we will be unable to lower our costs by movingto China. We may lose sales of our products to competitors who are notmanufacturing in China, or whose operations in China have already beenqualified by customers. If customers do not fully qualify our China production,we may lose additional customers and fail to achieve revenue growth.

 

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 VGF grown substrates acrossmore competitors and we believe that we have lost revenue and market share as aresult of these customer decisions, which we may be unable to recover. If weare unable to retain our market share, our revenue and performance willdecline.

 

***Intense competitionin the markets for our products could prevent us from******increasing revenue and sustainingprofitability.***

 

The marketsfor 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:

 

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•                  greaterexperience in the business;

 

•                  moremanufacturing experience;

 

•                  extensiveintellectual property;

 

•                  broadername recognition; and

 

•                  significantlygreater financial, technical and marketing resources.

 

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

 

The level andintensity of competition has increased over the past year and we expectcompetition to continue to increase in the future. Competitive pressures causedby the current economic conditions have resulted in reductions in the prices ofour products, and continued or increased competition could reduce our marketshare, require us to further reduce the prices of our products, affect ourability to recover costs or result in reduced gross margins.

 

***Defects in ourproducts could diminish demand for our products.***

 

Our productsare complex and may contain defects. We have experienced quality controlproblems with some of our products over the past two years, which causedcustomers to return products to us, reduce orders for our products, or both. Ifwe continue to experience quality control problems, or experience these orother problems in new products, customers may cancel or reduce orders orpurchase products from our competitors and sales of our products could decline.Defects in our products could cause us to incur higher manufacturing costs andsuffer product returns and additional service expenses, all of which couldadversely impact our operating results.

 

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

 

***If we have lowproduct yields, the shipment of our products may be delayed and******our operating resultsmay be adversely impacted.***

 

Our productsare 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

 

•                  performanceof personnel involved in the manufacturing process.

 

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

 

***We derive asignificant portion of our revenue from international sales, and******our ability to sustainand increase our international sales involves******significant risks.***

 

Our revenuegrowth depends in part on the expansion of our international sales andoperations. International sales represented 78.0% of our total revenue for thenine months ended September 30, 2004 and 65.0% for the nine months endedSeptember 30, 2003. We expect that sales to customers outside the U.S. willcontinue to represent a significant portion of our revenue, particularly salesto customers in Asia.

 

Currently, anincreasing 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 relationships with suppliers and other local businesses,changes in U.S. and international laws and regulations including U.S. exportrestrictions, fluctuations in interest and currency exchange rates, the abilityto provide sufficient levels of technical support in different locations,cultural differences, shipping delays and terrorist acts or acts of war, amongother risks. Many of these challenges are present in China, which represents alarge potential market for semiconductor equipment and where

 

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AXT anticipates 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) price weakness forcertain semiconductor devices; and (v) political instability in regions wherewe have operations may also affect our business, financial condition andresults of operations.

 

Our dependenceon international sales involves a number of risks, including:

 

•                  changesin tariffs, import or export restrictions and other trade barriers;

 

•                  unexpectedchanges in regulatory requirements;

 

•                  longerperiods to collect accounts receivable;

 

•                  changesin export license requirements;

 

•                  politicaland economic instability;

 

•                  unexpectedchanges in diplomatic and trade relationships; and

 

•                  foreignexchange rate fluctuations.

 

Our sales aredenominated 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’ productsin these markets. Also, denominating some sales in Japanese yen subjects us tofluctuations in the exchange rates between the U.S. dollar and the Japaneseyen. The functional currencies of our Japanese and Chinese subsidiaries are thelocal currencies. We incur transaction gains or losses resulting fromconsolidation of expenses incurred in local currencies for these subsidiaries,as well as in translation of the assets and liabilities of these assets at eachbalance sheet date. If we do not effectively manage the risks associated withinternational sales, our revenue, cash flows and financial condition could beadversely affected.

 

***Demand for ourproducts may decrease if our customers experience difficulty******manufacturing, marketingor selling their products.***

 

Our productsare used as components in our customers’ products. Accordingly, demand for ourproducts is subject to factors affecting the ability of our customers tosuccessfully introduce and market their products, including:

 

•                  thecompetition our customers face in their particular industries;

 

•                  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.

 

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

 

***The financialcondition of our customers may affect their ability to pay******amounts owed to us.***

 

Many of ourcustomers are facing business downturns that have reduced their cash balancesand their prospects. We frequently allow our customers to pay for products weship to them within 30 to 120 days after delivery. Subsequent to our shipping aproduct, some customers have been unable to make payments as due, reducing ourcash balances and causing us to incur charges to allow for a possibility thatsome accounts might not be paid. At least three customers that owed us asignificant amount have filed for bankruptcy protection and we are unlikely toreceive a substantial portion or any of the amounts owed to us as part of abankruptcy settlement. Other customers may also be forced to file forbankruptcy. If our customers do not pay their accounts when due, we will berequired to incur charges that would reduce our earnings.

 

 

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***We purchase criticalraw materials and parts for our equipment from single or******limited sources, andcould lose sales if***

***these sources failto fill our needs.***

 

We depend on alimited number of suppliers for certain raw materials, components and equipmentused in manufacturing our products, including key materials such as quartztubing, polishing solutions, and paralytic boron nitride. Although several ofthese raw materials are purchased from suppliers in whom we hold an ownershipinterest, we generally purchase these materials through standard purchaseorders 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 costs andcause us to delay or reduce production of our products. If we have to delay orreduce production, we could fail to meet customer delivery schedules and ourrevenue and operating results could suffer.

 

***The loss of one ormore of our key substrate customers would significantly hurt******our operating results.***

 

A small numberof substrate customers have historically accounted for a substantial portion ofour total revenue. Five customers accounted for 35.9% and 33.8% of our totalrevenue for the three month and nine month periods ended September 30, 2004,respectively. One customer accounted for 11.5% and 10.1% of our revenue for thethree month and nine month periods ended September 30, 2004. We expect that asignificant portion of our future revenue will continue to be derived from alimited number of substrate customers. Our customers are not obligated topurchase a specified quantity of our products or to provide us with bindingforecasts of product purchases. In addition, our customers may reduce, delay orcancel orders at any time without any significant penalty, and during the pastyear, we have experienced slower bookings, significant push outs andcancellation of orders from some customers. In addition, due to the difficulteconomic environment, several of our previously large customers have stoppedoperations entirely. If we lose a major customer or if a customer cancels,reduces or delays orders, our revenue would decline. In addition, customersthat have accounted for significant revenue in the past may not continue togenerate revenue for us in any future period. Any delay in scheduled shipmentsof our products could cause net sales to fall below our expectations and theexpectations of market analysts or investors, causing our stock price todecline.

 

***Our substrateproducts have a long qualification cycle that makes it difficult******to plan our expenses andforecast 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 oreven years. In the current competitive and economic climate, the average salescycle for our products has lengthened even further and is expected to continueto make it difficult to accurately forecast our future sales. We anticipatethat sales of any future substrate products will also have lengthy sales cyclesand will, therefore, be subject to risks substantially similar to thoseinherent in the lengthy sales cycle of our current substrate products.

 

***If we are unable toprotect our intellectual property, we may lose valuable******assets or incur costlylitigation.***

 

We rely on acombination 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.

 

Despite ourefforts 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.

 

It is possiblethat pending or future United States or foreign patent applications made by uswill not be approved, that our issued patents will not protect our intellectualproperty, or that third parties will challenge the ownership rights or thevalidity of our patents. In addition, the laws of some foreign countries maynot protect our proprietary rights to as great an extent as do the laws of theUnited States and it may be more difficult to monitor the use of ourintellectual property. Our competitors

 

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may be able to legitimately ascertainnon-patented proprietary technology embedded in our systems. If this occurs, wemay not be able to prevent the development of technology substantially similarto ours.

 

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

 

For example,we have recently been involved in litigation with Sumitomo Electric Industries,Ltd. (“SEI”) in Japan as well as interference actions in the UnitedStates.  Although we have reached atentative settlement of these actions, as a result of the settlement we haveincurred an initial charge of approximately $1.4 million and will have to payongoing royalties to SEI on certain of our products.

 

***We need to continueto improve or implement our systems, procedures and******controls and may notreceive favorable attestation of our internal control******systems by our independent auditors.***

 

The newrequirements 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 attestation of these systems byour independent accountants. We are currently reviewing our internal controlprocedures and considering further documentation of such procedures that may benecessary. Although the guidelines for the evaluation and attestation ofinternal control systems have been finalized, the evaluation and attestationprocesses are new and untested. Therefore, we can give no assurances that oursystems will satisfy the new requirements of the Securities and ExchangeCommission or that we will receive a favorable review and attestation by ourindependent auditors.

 

In the past,periods of rapid growth and expansion has strained our management and otherresources. The expansion of our manufacturing capacity and the shift ofmanufacturing operations to China placed and continue to place a significantstrain on our operations and management resources. We recently upgraded ourinventory control systems and may implement additional systems relating toconsolidation of our financial results. If we fail to manage these changeseffectively, our operations may be disrupted.

 

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

 

***If we fail to manageperiodic contractions, we may utilize our cash balances******and our existing cashand cash equivalent balances could decline.***

 

We anticipatethat our existing cash resources will fund any anticipated operating losses, purchasesof capital equipment and provide adequate working capital for the next twelvemonths. However, our liquidity is affected by many factors including, amongothers, the extent to which we pursue additional capital expenditures, thelevel of our production, and other factors related to the uncertainties of theindustry and global economies. If we fail to manage our contractionssuccessfully we may draw down our cash reserves, which would adversely affectour operating results and financial condition, reduce our value and may impingeour ability to raise debt and equity funding in the future, at a time when wemay be required to raise additional cash. Accordingly, there can be noassurance that events in the future will not require us to seek additionalcapital, or, if so required, that such capital will be available on termsacceptable to us, if at all. As part of our effort to reduce costs, we may losekey staff, production resources, and technology that we will need to grow whenend markets recover. These events could reduce our ability to grow profitablyas markets recover.

 

We anticipatethat our existing cash resources will fund any anticipated operating losses,purchases of capital equipment and provide adequate working capital for thenext twelve months. Our liquidity is affected by many factors including, amongothers, the extent to which we pursue additional capital expenditures, thelevel of our production efforts, and other factors related to the uncertaintiesof the industry and global economies. Accordingly, there can be no assurancethat events in the future will not require us to seek additional capitalsooner, or, if so required, that such capital will be available on termsacceptable to us if at all.

 

***We have made and maycontinue to make strategic investments in raw materials******suppliers, which may notbe successful and may result in the loss of all or******part of our investment.***

 

Through fiscal2003, we have recorded minority investments in raw material suppliers in China,that provide us with opportunities to gain supply of key raw materials that areimportant to our substrate business, and other products at lower cost thanother suppliers. These affiliates each have a market beyond that provided byus.  We do not have influence over all ofthese companies, each of which is located in China, and in some we have

 

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made only a strategic, minority investment.We may not be successful in achieving the financial, technological orcommercial advantage upon which any given investment is premised, and we couldend up losing all or part of our investment.

 

***Any futureacquisitions may disrupt our business, dilute stockholder value or******distract managementattention.***

 

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

 

•                  wemay have difficulty assimilating the operations, products and personnel of theacquired businesses;

 

•                  ourongoing business may be disrupted;

 

•                  wemay incur unanticipated costs;

 

•                  ourmanagement may be unable to manage the financial and strategic position ofacquired or developed products, services and technologies;

 

•                  wemay be unable to maintain uniform standards, controls, procedures, andpolicies; and

 

•                  ourrelationships with employees and customers may be impaired as a result of anyintegration.

 

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

 

To the extentthat we issue shares of our stock or other rights to purchase stock inconnection with any future acquisitions, dilution to our existing stockholderswill result and our earnings per share may suffer. Any future acquisitions maynot generate additional revenue or provide any benefit to our business.

 

***If any of ourfacilities is damaged by actions such as fire, explosion, or******natural disaster, we maynot be able to manufacture our products.***

 

The ongoingoperation of our manufacturing and production facilities in California andChina is critical to our ability to meet demand for our products. If we are notable to use all or a significant portion of our facilities for prolongedperiods for any reason, we will not be able to manufacture products for ourcustomers. For example, a natural disaster, fire or explosion caused by our useof combustible chemicals and high temperatures during our manufacturingprocesses would render some or all of our facilities inoperable for anindefinite period of time. Actions outside of our control, such as earthquakes,could also damage our facilities, rendering them inoperable. Some of our manufacturingand research and development is currently performed at our Fremont, Californiafacilities, which are located near an active seismic fault line. If we areunable to operate our facilities and manufacture our products, we will losecustomers and revenue and our business will be harmed.

 

***Changes in China’spolitical, social and economic environment may affect our******financial performance.***

 

Our financialperformance may be affected by changes in China’s political, social andeconomic environment. The role of the Chinese central and local governments inthe 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.

 

China has fromtime 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.

 

 

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***The effect ofterrorist threats and actions on the general economy could******decrease our revenues.***

 

The UnitedStates continues to be on alert for terrorist activity. The potential near- andlong-term impact terrorist activities may have in regards to our suppliers,customers and markets for our products and the U.S. economy are uncertain.There may be embargos of ports or products, or destruction of shipments or ourfacilities, or attacks that affect our personnel. There may be other potentialadverse effects on our operating results due to a significant event that wecannot foresee. Since we perform substantially all of our manufacturingoperations in China, and a significant portion of our customers are locatedoutside of the Untied States, terrorist activity or threats against US-ownedenterprise are a particular concern to us.

 

***Our stock price hasbeen and may continue to be volatile.***

 

Our stockprice has fluctuated significantly since we began trading on the NASDAQNational Market. For the twelve months ended September 30, 2004, the high andlow closing sales prices of our common stock were $4.58 and $1.14,respectively. A number of factors could cause the price of our common stock tocontinue to fluctuate substantially, including:

 

•                  actualor anticipated fluctuations in our quarterly or annual operating results;

 

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

 

•                  announcementsof technological innovations by us or our competitors;

 

•                  newproduct introduction by us or our competitors;

 

•                  largecustomer orders or order cancellations; and

 

•                  theoperating and stock price performance of comparable companies.

 

In addition,the stock market in general has experienced extreme volatility that often hasbeen unrelated to the operating performance of particular companies. Thesebroad market and industry fluctuations may adversely affect the trading priceof our common stock, regardless of our actual operating performance.

 

***We have adoptedcertain anti-takeover measures that may make it more difficult******for a third party toacquire us.***

 

Our board ofdirectors has the authority to issue up to 2,000,000 shares of preferred stockand to determine the price, rights, preferences and privileges of those shareswithout any further vote or action by the stockholders. The rights of theholders of common stock will be subject to, and may be adversely affected by,the rights of the holders of any preferred stock that may be issued in the future.The issuance of shares of preferred stock, while potentially providingdesirable flexibility in connection with possible acquisitions and for othercorporate purposes, could have the effect of making it more difficult for athird party to acquire a majority of our outstanding voting stock. We have nopresent intention to issue shares of preferred stock.

 

On April 24,2001, our board of directors adopted a preferred stock purchase rights planintended to guard against certain takeover tactics. The adoption of this planwas not in response to any proposal to acquire us, and the board is not awareof any such effort. The existence of this plan could also have the effect ofmaking it more difficult for a third party to acquire a majority of ouroutstanding voting stock. In addition, certain provisions of our certificate ofincorporation may have the effect of delaying or preventing a change ofcontrol, which could adversely affect the market price of our common stock.

 

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

 

•                  thedivision of our board of directors into three separate classes, each with threeyear terms;

 

•                  theright of our board to elect a director to fill a space created by a boardvacancy or the expansion of the board;

 

•                  theability of our board to alter our bylaws;

 

•                  theability of our board to authorize the issuance of up to 2,000,000 shares ofblank check preferred 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 provisions prohibitlarge stockholders, in particular those owning 15% or more of the outstandingvoting stock, from consummating a merger or combination with a corporationunless:

 

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•                  662/3% of the shares of voting stock not owned by these large stockholdersapprove the merger or combination, or

 

•                  theboard of directors approves the merger or combination or the transaction whichresulted in the large stockholder owning 15% or more of our outstanding votingstock.

 

***Legislative actions,higher insurance costs and potential new accounting******pronouncements arelikely to cause our general and administrative expenses to******increase and impact our futurefinancial position and results of operations.***

 

In order tocomply with the newly adopted Sarbanes-Oxley Act of 2002, as well as proposedchanges to listing standards by NASDAQ, and proposed accounting changes by theSecurities and Exchange Commission, we may be required to increase our internalcontrols, hire additional personnel and additional outside legal, accountingand advisory services, all of which will cause our general and administrativecosts to increase. Insurers may increase premiums as a result of the highclaims rates they incurred over the past year, and our premiums for our variousinsurance policies, including our directors’ and officers’ insurance policies,increased during 2003. Proposed changes in the accounting rules, includinglegislative and other proposals 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.

 

**ITEM3*****.*QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**Foreign Currency 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 September 30, 2004, we had no outstanding commitments withrespect to foreign exchange contracts.

 

**Interest Rate 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  September 30,  2004** | ** ** | **Current  Interest  Rate** | ** ** | **Current  Interest  Income/  (Expense)** | ** ** | **Proforma  10% Interest  Rate Decline  Income/(Expense)** | ** ** | **Proforma  10% Interest  Rate Increase  Income/(Expense)** | ** ** |
|---------------------------|------------|----------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Cash and cash equivalents |       | $                                | 16,220     |                        | 1.60       | %                                         | $          | 260                                                        |       | $                                                           | 234        |   | $ | 285 |   |
| Bonds                     |       | 8,200                            |       | 1.94                        | %          | (159                                      | )          | (144                                                       | )          | (175                                                        | )          |
|                      |       |                             |       |                        |       | $                                         | 101        |                                                       | $          | 90                                                          |       | $ | 110 |   |
|                           |            |                                  |            |                             |            |                                           |            |                                                            |            |                                                             |            |  |  |  |  |

 

**Equity Risk**

 

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. In 2003, we recorded $2.0 million in charges toother expense to write down our investment in two private U.S. companies. InSeptember 2004, we recorded a $0.2 million charge to write down our investmentin one private U.S. company. As of September 30, 2004, the minority investmentswe continue to hold amounted to $1.8 million.

 

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**ITEM4*****.*CONTROLS AND PROCEDURES**

 

(a) Under the supervision and with theparticipation of our management, our Interim Chief Executive Officer and ChiefFinancial Officer have evaluated the effectiveness of our disclosure controlsand procedures, as such term is defined under Rule 13a-15(e) promulgated underthe Securities Exchange Act of 1934, as amended. Based upon that evaluation,our Interim Chief Executive Officer and our Chief Financial Officer concludedthat the our disclosure controls and procedures were effective as of the end ofthe period covered by this quarterly report.

 

In March 2004,as part of the Company’s implementation of our Code of Business Conduct andEthics, we learned of certain failures to comply with requirements for producttesting and the provision of testing data and information relating torequirements of certain customers. The Audit Committee of the Company’s Boardof Directors conducted an investigation into our product testing practices andprocedures, with the assistance of outside counsel.

 

Theinvestigation confirmed that certain requirements for product testing and theprovision of testing data and information relating to certain customerrequirements were not being complied with. We implemented measures to ensuregreater operational controls and compliance with customer requirements. As aresult of the investigation, the Audit Committee concluded that certainexecutive management changes should be implemented. Donald L. Tatzin, formerlyChief Financial Officer, has been appointed Interim Chief Executive Officer,Wilson W. Cheung, our Vice President, Corporate Controller, has been promotedto Chief Financial Officer. Morris Young, Ph.D., formerly our Chairman,President and Chief Executive Officer, will be responsible for improving and expandingthe Company’s China operation. He will also remain a director. The Board ofDirectors has also determined to separate the role of Chairman and ChiefExecutive Officer, and accordingly, Jesse Chen, a current AXT board member, hasbecome Chairman of the Board. In addition, the Audit Committee concluded thatadditional review of the organization and performance of operations, qualitycontrol and product testing would be conducted, resulting in possibleadditional changes in management and non-management functions. The AuditCommittee also instructed management to implement additional training programsfor employees involved in production, testing and quality assurance. The AuditCommittee believes that these measures will address the issues raised above andprovide the necessary operational oversight and assurance that the Company iscomplying with the requirements for product testing and the provision oftesting data and other customer information.

 

(b) No change in our internal control overfinancial reporting was made during the quarter ended September 30, 2004, thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II****OTHER INFORMATION**

 

**Item 1. Legal****Proceedings**

 

From time totime the Company is involved in judicial or administrative proceedingsconcerning matters arising in the ordinary course of business. The Company doesnot expect that any of these matters, individually or in the aggregate, willhave a material adverse effect on its business, financial condition, cash flowsor results of operation.

 

On June 11,2003, Cree, Inc. filed a complaint in the United States Court for NorthernDistrict of California against the Company alleging patent infringement. Thecomplaint sought damages and injunction against infringement. On July 23, 2003,the Company filed a counter complaint in the United States Court for NorthernDistrict of California, denying any patent infringement and alleging that Cree’sactions were intentionally designed to interfere with the Company’s prospectivebusiness relationships. The Company reached an agreement with Cree resolvingthe disputes between us and signed a settlement agreement on March 5, 2004. Theresolution of the disputes did not have a material adverse impact on theCompany’s consolidated financial position or results of operations. All partiessigned a final release regarding all disputes between them on April 15, 2004.

 

On October 15,2004, a purported securities class action lawsuit was filed in the UnitedStates District Court for the Northern District of California: City of HarperWoods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.  The lawsuit names the Company and its CEO,China Operations, as defendants, and is brought on behalf of a class of allpurchasers of the Company’s securities from February 6, 2001 through April 27,2004.  The complaint alleges that theCompany’s announced financial results during this period were false andmisleading.  No specific amount ofdamages is claimed.  The Company believesthat there are meritorious defenses against this lawsuit and intend tovigorously defend it.  However, due tothe inherent uncertainties of litigation, we cannot accurately predict theultimate outcome of the litigation.  Anyunfavorable outcome of the litigation could have an adverse impact on ourbusiness, financial condition and results of operation.

 

The Companyhas announced a tentative agreement with Sumitomo Electric Industries, Ltd. (“SEI”),a Japanese corporation, of a litigation commenced by SEI against AXT in Japanalleging infringement of certain SEI patents, and  an interference action between an AXT patentand an SEI reissue application brought in the United States, and is negotiatinga License Agreement (“Agreement”) with SEI in connection with the tentativesettlement.  Under the preliminary termsof the Agreement, AXT will make an initial payment to SEI in the amount ofJapanese Yen one hundred and forty-seven million (¥147,000,000) orapproximately US$1.4 million, and AXT will make on-going royalty paymentsthrough 2012 on certain products sold by AXT in Japan.  Additionally, the litigation in Japan andinterference proceedings in the U.S. will be dropped by both parties againstthe other and both parties will enter into a world-wide four-yearcross-licensing agreement for all intellectual property used by either companyrelated to compound semiconductor substrates, which will expire on December 31,2008.

 

**Item 2. Unregistered****Sales of Equity Securities and Use of Proceeds**

 

None

 

**Item 3. Defaults****upon Senior Securities**

 

None

 

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

 

None

 

**Item 5. Other Information**

 

None

 

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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.                                                        |
|                |       |                                                                                                                                                         |
| 31.1                |       | Certification by Interim 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 Interim Chief Executive  Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section  906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                         |
| 32.2                |       | Certification by Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.         |

 

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

 

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

 

(3)       Incorporatedby reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May30, 2001.

 

(4)       Incorporatedby reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SEC on August5, 2004.

 

(5)  Incorporated by reference to the exhibit as ofthe same number as filed with the SEC in our Form 8-K on May 30, 2001.

 

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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: November 5, 2004 | By:       | /s/ Donald L. Tatzin |
|                    |      | Donald L. Tatzin |
|                    |      | Interim Chief Executive Officer |
|                    |      | (Principal Executive Officer) |
|                    |      |   |
|                    |      | /s/ Wilson W. Cheung |
|                    |      | Wilson W. Cheung |
|                    |      | Chief Financial Officer |
|                    |      | (Principal Financial and Accounting  Officer) |

 

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**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                              |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |       | Restated Certificate of Incorporation                                                                                                                        |
|                |       |                                                                                                                                                         |
| 3.2(2)              |       | Certificate of Designation, Preferences and  Rights of Series A Preferred Stock                                                                              |
|                |       |                                                                                                                                                         |
| 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.                                                        |
|                |       |                                                                                                                                                         |
| 31.1                |       | Certification by Interim 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 Interim Chief Executive  Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section  906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                         |
| 32.2                |       | Certification by Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.         |

 

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

 

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

 

(3)       Incorporatedby reference to Exhibit 3.4 to registrant’s Form 8-K filed with the SEC on May30, 2001.

 

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

 

(5)  Incorporated by reference to the exhibit as ofthe same number as filed with the SEC in our Form 8-K on May 30, 2001.

 

 

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