**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

**x****               ****Quarterly reportpursuant to Section 13 or 15(d) of the Securities Exchange Act of1934**

 

**for the quarterly period ended June 30,2006**

 

**or**

 

**o****                  ****Transition reportpursuant to Section 13 or 15(d) of the Securities Exchange Act of1934**

 

**forthe transition periodfrom          to**

 

**Commission File Number 000-24085**

 

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**AXT, INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

**4281 Technology Drive, Fremont, California94538**

(Address of principal executiveoffices) (Zip code)

 

**(510) 683-5900**

(Registrant’s telephone number,including area code)

 

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Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES  x  NO  o

 

Indicateby checkmark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Act. (Check one):

Largeaccelerated filer o                                                                                                                                  Acceleratedfiler  o                                                                                       Non-acceleratedfiler x

 

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

 

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

 

| **Class**                      | ** ** | **Outstanding at August 6, 2006** |
|--------------------------------|------------|-------------------------------------------------------|
| Common Stock, $0.001 par value |       | 23,125,428                                            |

 

 

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AXT, INC.FORM 10-QTABLE OF CONTENTS

 
| ** **                                                                                                      | **Page** |
|-----------------------------------------------------------------------------------------------------------------|----------|
| PART I. FINANCIAL INFORMATION                                                                              | 3        |
| Item 1. Financial Statements (unaudited)                                                                        | 3        |
| Condensed Consolidated Balance Sheets as of  June 30, 2006 and December 31, 2005                      | 3        |
| Condensed Consolidated Statements of  Operations for the three and six months ended June 30, 2006 and 2005 | 4        |
| Condensed Consolidated Statements of Cash  Flows for the six months ended June 30, 2006 and 2005           | 5        |
| Notes To Condensed Consolidated Financial  Statements                                                           | 6        |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations             | 17       |
| Item 3. Quantitative and Qualitative Disclosures  About Market Risk                                             | 31       |
| Item 4. Controls and Procedures                                                                                 | 31       |
| PART II. OTHER INFORMATION                                                                                 |     |
| Item 1. Legal Proceedings                                                                                       | 32       |
| Item 1A. Risk Factors                                                                                           | 32       |
| Item 2. Unregistered Sales of Equity  Securities and Use of Proceeds                                            | 45       |
| Item 3. Defaults Upon Senior Securities                                                                         | 45       |
| Item 4. Submission of Matters to a Vote of  Security Holders                                                    | 45       |
| Item 5. Other Information                                                                                       | 45       |
| Item 6. Exhibits                                                                                                | 46       |
| Signatures                                                                                                      | 47       |

 

2

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**PART I.FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

AXT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per sharedata)

 
| ** **                                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                               | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Assets:                                                                                                                                                                                  |       |              |       |                  |       |
| Current  assets:                                                                                                                                                                         |       |              |       |                  |       |
| Cash and  cash equivalents                                                                                                                                                               |       | $                 | 11,053     |                  | $          | 17,472 |   |
| Investments                                                                                                                                                                              |       | 6,199             |       | 5,555                 |       |
| Accounts  receivable, net of allowances of $631 and $619 as of June 30, 2006 and December 31,  2005, respectively                                                              |       | 7,429             |       | 5,226                 |       |
| Inventories,  net                                                                                                                                                                        |       | 16,192            |       | 16,156                |       |
| Prepaid  expenses and other current assets                                                                                                                                               |       | 3,602             |       | 1,801                 |       |
| Total  current assets                                                                                                                                                                    |       | 44,475            |       | 46,210                |       |
| Property,  plant and equipment, net                                                                                                                                                      |       | 16,648            |       | 17,306                |       |
| Restricted  deposits                                                                                                                                                                     |       | 7,300             |       | 7,450                 |       |
| Other assets                                                                                                                                                                             |       | 3,743             |       | 3,832                 |       |
| Total assets                                                                                                                                                                             |       | $                 | 72,166     |                  | $          | 74,798 |   |
|                                                                                                                                                                                     |       |              |       |                  |       |
| Liabilities  and stockholders’ equity:                                                                                                                                              |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                                    |       |              |       |                  |       |
| Accounts  payable                                                                                                                                                                        |       | $                 | 3,453      |                  | $          | 3,070 |   |
| Accrued  liabilities                                                                                                                                                                     |       | 3,023             |       | 3,533                 |       |
| Accrued  restructuring                                                                                                                                                                   |       | —            |       | 465                   |       |
| Current  portion of long-term debt                                                                                                                                                       |       | 450               |       | 300                   |       |
| Income taxes  payable                                                                                                                                                                    |       | 2,508             |       | 2,495                 |       |
| Total  current liabilities                                                                                                                                                               |       | 9,434             |       | 9,863                 |       |
| Long-term  debt, net of current portion                                                                                                                                                  |       | 6,952             |       | 7,420                 |       |
| Other  long-term liabilities                                                                                                                                                             |       | 1,958             |       | 1,897                 |       |
| Total  liabilities                                                                                                                                                                       |       | 18,344            |       | 19,180                |       |
| Commitments  and contingencies (Note 11)                                                                                                                                            |       |              |       |                  |       |
| Stockholders’  equity:                                                                                                                                                              |       |              |       |                  |       |
| Preferred  stock, $0.001 par value per share; 2,000 shares authorized; 883 shares issued  and outstanding as of June 30, 2006 and December 21, 2005,  respectively.            |       | 3,532             |       | 3,532                 |       |
| Common  stock, $0.001 par value per share; 70,000 shares authorized; 23,121 and  22,977 shares issued and outstanding as of June 30, 2006 and December 31,  2005, respectively |       | 23                |       | 23                    |       |
| Additional  paid-in capital                                                                                                                                                              |       | 156,182           |       | 155,441               |       |
| Accumulated  deficit                                                                                                                                                                     |       | (107,855          | )          | (104,776              | )          |
| Accumulated  other comprehensive income                                                                                                                                                  |       | 1,940             |       | 1,398                 |       |
| Total  stockholders’ equity                                                                                                                                                         |       | 53,822            |       | 55,618                |       |
| Total  liabilities and stockholders’ equity                                                                                                                                         |       | $                 | 72,166     |                  | $          | 74,798 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

3

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS

(Unaudited, in thousands, except per sharedata)

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                     | ** ** | **2006**               | ** ** | **2005**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Revenue                                                        |       | $                      | 10,355     |                 | $          | 6,032 |   | $ | 18,826 |   | $ | 12,666 |   |
| Cost of  revenue                                               |       | 7,596                  |       | 5,905                |       | 14,557 |   | 12,260 |   |
| Gross profit                                                   |       | 2,759                  |       | 127                  |       | 4,269 |   | 406 |   |
| Operating  expenses:                                           |       |                   |       |                 |       |   |   |   |   |
| Selling,  general and administrative                           |       | 3,853                  |       | 2,716                |       | 7,083 |   | 6,968 |   |
| Research and  development                                      |       | 571                    |       | 423                  |       | 1,105 |   | 785 |   |
| Restructuring                                                  |       | —                 |       | 237                  |       | (2 | ) | 362 |   |
| Total  operating expenses                                      |       | 4,424                  |       | 3,376                |       | 8,186 |   | 8,115 |   |
| Loss from  operations                                          |       | (1,665                 | )          | (3,249               | )          | (3,917 | ) | (7,709 | ) |
| Interest  income, net                                          |       | 111                    |       | 131                  |       | 239 |   | 250 |   |
| Other income  (expense), net                                   |       | 814                    |       | (196                 | )          | 1,052 |   | (301 | ) |
| Loss before  provision for income taxes                        |       | (740                   | )          | (3,314               | )          | (2,626 | ) | (7,760 | ) |
| Provision  for income taxes                                    |       | 138                    |       | 18                   |       | 456 |   | 53 |   |
| Loss from  continuing operations                               |       | (878                   | )          | (3,332               | )          | (3,082 | ) | (7,813 | ) |
| Discontinued  operations:                                      |       |                   |       |                 |       |   |   |   |   |
| Gain from  discontinued operations, net of tax                 |       | 2                      |       | —               |       | 3 |   | 58 |   |
| Gain from  disposal, net of tax                                |       | —                 |       | 53                   |       | — |   | 353 |   |
| Net loss                                                       |       | $                      | (876       | )                    | $          | (3,279 | ) | $ | (3,079 | ) | $ | (7,402 | ) |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Basic and  diluted loss per share:                             |       |                   |       |                 |       |   |   |   |   |
| Loss from  continuing operations                               |       | $                      | (0.04      | )                    | $          | (0.14 | ) | $ | (0.14 | ) | $ | (0.34 | ) |
| Gain from  discontinued operations, net of tax                 |       | 0.00                   |       | 0.00                 |       | 0.00 |   | 0.02 |   |
| Net loss                                                       |       | $                      | (0.04      | )                    | $          | (0.14 | ) | $ | (0.14 | ) | $ | (0.32 | ) |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Shares used  in computing basic and diluted net loss per share |       | 23,052                 |       | 23,079               |       | 23,019 |   | 23,113 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

4

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AXT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS

(Unaudited, in thousands)

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                   | ** ** | **June 30,**    | ** ** |
| ** **                                                                   | ** ** | **2006**             | ** ** | **2005** | ** ** |
|                                                                         |       |                 |       |   |   |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                       |       |                 |       |   |   |
| Net loss                                                                     |       | $                    | (3,079     | ) | $ | (7,402 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                 |       |   |   |
| Depreciation                                                                 |       | 1,761                |       | 2,068 |   |
| Amortization  of marketable securities premium/discount                      |       | (30                  | )          | 152 |   |
| Non-cash  restructuring charge                                               |       | —               |       | 362 |   |
| Loss on  disposal of property, plant and equipment                           |       | 67                   |       | 217 |   |
| Stock-based  compensation                                                    |       | 443                  |       | (2 | ) |
| Realized  gain on sale of investments                                        |       | (1,438               | )          | — |   |
| Gain on  disposal of discontinued operations                                 |       | —               |       | (53 | ) |
| Changes in  assets and liabilities:                                          |       |                 |       |   |   |
| Accounts  receivable, net                                                    |       | (2,203               | )          | (921 | ) |
| Inventories,  net                                                            |       | (36                  | )          | 1,126 |   |
| Prepaid  expenses and other current assets                                   |       | (1,801               | )          | 85 |   |
| Other assets                                                                 |       | 89                   |       | 43 |   |
| Accounts  payable                                                            |       | 383                  |       | (79 | ) |
| Accrued  liabilities and restructuring                                       |       | (975                 | )          | (1,181 | ) |
| Income taxes  payable                                                        |       | 13                   |       | 90 |   |
| Other  long-term liabilities                                                 |       | 61                   |       | 26 |   |
| Net cash  used in operating activities                                       |       | (6,745               | )          | (5,469 | ) |
|                                                                         |       |                 |       |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                       |       |                 |       |   |   |
| Purchases of  property, plant and equipment                                  |       | (1,331               | )          | (827 | ) |
| Proceeds from  sales of property, plant and equipment                        |       | 161                  |       | 31 |   |
| Purchases of  marketable securities                                          |       | (4,697               | )          | (5,380 | ) |
| Proceeds  from sale of marketable securities                                 |       | 5,985                |       | 13,988 |   |
| Decrease in  restricted cash                                                 |       | 150                  |       | — |   |
| Proceeds  from assets held for sale, net                                     |       | —               |       | 1,303 |   |
| Net cash  provided by investing activities                                   |       | 268                  |       | 9,115 |   |
|                                                                         |       |                 |       |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                       |       |                 |       |   |   |
| Proceeds  from (payments of):                                                |       |                 |       |   |   |
| Issuance of  common stock                                                    |       | 298                  |       | 60 |   |
| Repurchase  of common stock                                                  |       | —               |       | (193 | ) |
| Long-term  debt payments                                                     |       | (318                 | )          | (300 | ) |
| Net cash  used in financing activities                                       |       | (20                  | )          | (433 | ) |
| Effect of  exchange rate changes                                             |       | 78                   |       | (218 | ) |
| Net increase  (decrease) in cash and cash equivalents                        |       | (6,419               | )          | 2,995 |   |
| Cash and  cash equivalents at the beginning of the period                    |       | 17,472               |       | 12,117 |   |
| Cash and  cash equivalents at the end of the period                          |       | $                    | 11,053     |   | $ | 15,112 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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AXT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS

(Unaudited)

 

**Note1. Basis of Presentation**

 

The accompanying condensed consolidated financial statements of AXT, Inc.(“AXT”, “Company”, “we”, “us” and “our” refer to AXT, Inc. and all of itsconsolidated subsidiaries) are unaudited,and have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, the year-end condensed balance sheet data werederived from audited financial statements, but do not include all disclosuresrequired by accounting principles generallyaccepted in the United States of America. In the opinion of management,the unaudited condensed consolidated financial statements reflect alladjustments, consisting only of normal recurring adjustments, considerednecessary to present fairly the financial position, results of operations andcash flows of AXT and its subsidiaries for all periods presented.

 

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

 

The results of operations are not necessarily indicative of the resultsto be expected in the future or for the full fiscal year. It is recommendedthat these condensed consolidated financial statements be read in conjunctionwith our consolidated financial statements and the notes thereto included inour 2005 Annual Report on Form 10-K filed with the Securities and ExchangeCommission on March 30, 2006 and our Quarterly Report on Form 10-Q forthe quarterly period ended March 31, 2006 filed with the Securities andExchange Commission on May 12, 2006.

 

Certain reclassifications have been made tothe prior year’s condensed consolidated financial statements to conform tocurrent period presentation.

 

**Note2. Discontinued Operations and Related Assets Held for Sale**

** **

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our acquisition of LyteOptronics, Inc. in May 1999. The discontinued opto-electronicsdivision manufactured blue, cyan and green high-brightness light emittingdiodes (HBLEDs) for the illumination markets, including full-color displays,wireless handset backlighting and traffic signals, and also manufacturedvertical cavity surface emitting lasers (VCSELs) and laser diodes for fiberoptic communications and storage area networks. Because of this discontinuation,the results of operations of the opto-electronics division have been segregatedfrom continuing operations and are reported separately as discontinuedoperations in our condensed consolidated statements of operations for allperiods presented.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million.

 

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

 

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

 

6

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| ** **                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                     | ** ** | **2006**                              | ** ** | **2005**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | ** **                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                        |       | $                                     | —     |                                | $          | — |   | $ | — |   | $ | — |   |
| Cost of  revenue                               |       | —                                |       | —                              |       | — |   | — |   |
|                                           |       |                                  |       |                                |       |   |   |   |   |
| Gross profit                                   |       | —                                |       | —                              |       | — |   | — |   |
| Operating  expenses:                           |       |                                  |       |                                |       |   |   |   |   |
| Selling,  general and administrative           |       | (2                                    | )          | —                              |       | (3 | ) | (58 | ) |
| Research and  development                      |       | —                                |       | —                              |       | — |   | — |   |
| Impairment  costs                              |       | —                                |       | —                              |       | — |   | — |   |
| Total operating  expenses                      |       | (2                                    | )     | —                              |       | (3 | )  | (58 | ) |
| Gain from  discontinued operations, net of tax |       | 2                                     |       | —                              |       | 3 |   | 58 |   |
| Gain from  disposal, net of tax                |       | —                                |       | 53                                  |       | — |   | 353 |   |
| Net income                                     |       | $                                     | 2          |                                | $          | 53 |   | $ | 3 |   | $ | 411 |   |

 

The carrying value of the assets and liabilities of the discontinuedopto-electronics business included in the condensed consolidated balance sheetsare as follows (in thousands):

 
| ** **                       | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Current assets:                  |       |                    |       |                        |       |
| Cash                             |       | $                       | 428        |                        | $          | 472 |   |
| Total  current assets            |       | 428                     |       | 472                         |       |
| Total assets                     |       | $                       | 428        |                        | $          | 472 |   |
| Current liabilities:             |       |                    |       |                        |       |
| Accrued  liabilities             |       | $                       | 47         |                        | $          | 95 |   |
| Total  liabilities               |       | 47                      |       | 95                          |       |
| Net assets                       |       | 381                     |       | 377                         |       |
| Total liabilities and net assets |       | $                       | 428        |                        | $          | 472 |   |

 

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

 

Effective January 1, 2006, we adopted theprovisions of Statement of Financial Accounting Standards(“SFAS”) No. 123 (revised 2004), “*Share-BasedPayment*,” (“SFAS123(R)”). SFAS 123(R) establishes accounting for stock-based awardsexchanged for employee services. Accordingly, stock-based compensation cost ismeasured at each grant date, based on the fair value of the award, and isrecognized as expense over the employee’s requisite service period. All of theCompany’s stock compensation is accounted for as an equity instrument. TheCompany previously applied Accounting Principles Board (“APB”) Opinion No. 25,“*Accounting for Stock Issued to Employees*,”and related interpretations and provided the required pro forma disclosures ofSFAS No. 123, “*Accounting for Stock-BasedCompensation*”**(“SFAS 123(R)”).

 

We have elected the modified prospective application transition methodfor adopting SFAS 123(R). Under this method, the provisions of SFAS 123(R)apply to all awards granted or modified after the date of adoption. Theunrecognized expense of awards not yet vested at the date of adoption will berecognized in net income (loss) in the periods after the date of adoption usingthe same Black-Scholes valuation method and assumptions determined under theoriginal provisions of SFAS 123, “ *Accountingfor Stock-Based Compensation,”*as disclosed in our previousquarterly and annual reports.

 

***Prior to the Adoption of SFAS 123(R)***

 

Prior to the adoption of SFAS 123 (R), we providedthe disclosures required under SFAS 123, as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation – Transition and Disclosures*.”SFAS 123(R) requires us to present pro formainformation for the comparative period prior to adoption as if we had accountedfor all our employee stock options under the fair value method of the originalSFAS 123. The following table illustrates the effect on net loss and net lossper share if we had applied the fair value recognition provisions of SFAS 123to stock-based employee compensation to the prior-year periods (in thousands,except per share data):

 

7

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| ** **                                                                                      | ** ** | **Three  Months** | ** **   | **Six  Months**   | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------|--------------|-------------------|------------|
| ** **                                                                                      | ** ** | **Ended**         | ** **   | **Ended**         | ** ** |
| ** **                                                                                      | ** ** | **June 30,** | ** **   | **June 30,** | ** ** |
| ** **                                                                                      | ** ** | **2005**          | ** **   | **2005**          | ** ** |
| Net loss:                                                                                       | ** ** | ** **        | ** **   | ** **        | ** ** |
| As reported                                                                                     |       | $                 |  (3,279 | )                 | $          |  (7,402 | ) |
| Add: Stock-based employee  compensation expense (income)  included in net loss as reported      |       | 2                 |         | (3                | )          |
| Less: Stock-based compensation  expense  using the fair value based method, net  of related tax |       | (232              | )            | (467              | )          |
| Pro forma net loss                                                                              |       | $                 | (3,509       | )                 | $          | (7,872 | ) |
| Basic and diluted net loss per common share                                                     |       |              |         |              |       |
| As reported                                                                                     |       | $                 | (0.14        | )                 | $          | (0.32 | ) |
| Proforma                                                                                        |       | $                 | (0.15        | )                 | $          | (0.34 | ) |
| Shares used in computing basic and diluted  net loss per share                                  |       | 23,079            |         | 23,113            |       |

 

***Impact of the Adoption of SFAS No. 123 (R)***

 

We elected to adopt the modified prospectiveapplication transition method as provided by SFAS 123(R), and we recorded $186,000 and $443,000 ofstock compensation expense in our unaudited condensed consolidated statementsof operations for the three and six months ended June 30, 2006. We elected not to capitalizeany stock-based compensation to inventory as of January 1, 2006 when theprovisions of SFAS 123(R) were initially adopted. We utilized the Black-Scholes valuationmodel for estimating the fair value of the stock compensation granted bothbefore and after the adoption of SFAS 123(R). In accordance with themodified prospective application transition method, our condensed consolidatedfinancial statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS 123(R). The following table summarizescompensation costs related to our stock-based compensation plan (in thousands, except per share data):

 
| ** **                                                                         | ** ** | **Three Months**  | ** ** | **Six Months**    | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                                         | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                         | ** ** | **2006**          | ** ** | **2006**          | ** ** |
| Stock-based  compensation in the form of employee stock options, included in: |       |              |       |              |       |
|                                                                               |       |              |       |              |       |
| Cost of  revenue                                                                   |       | $                 | 32         |              | $          | 60 |   |
| Selling,  general and administrative                                               |       | 91                |       | 264               |       |
| Research and  development                                                          |       | 63                |       | 119               |       |
|                                                                               |       |              |       |              |       |
| Total  stock-based compensation                                                    |       | $                 | 186        |              | $          | 443 |   |
| Tax effect  on stock-based compensation                                            |       | —            |       | —            |       |
|                                                                               |       |              |       |              |       |
| Net effect  on net loss                                                            |       | $                 | 186        |              | $          | 443 |   |
|                                                                               |       |              |       |              |       |
| Effect on  basic and diluted net loss per share                                    |       | $                 | (0.01      | )                 | $          | (0.02 | ) |

 

As of June 30, 2006, the total compensation cost related tounvested stock-based awards granted to employees under our stock option planbut not yet recognized was approximately $1.0 million, net of estimatedforfeitures of $44,000. This cost will be amortized on a straight-line basisover a weighted-average period of approximately 1.23 years and will be adjustedfor subsequent changes in estimated forfeitures. We elected not to capitalize any stock-basedcompensation to inventory as of June 30, 2006, due to the immateriality ofthe amount.

 

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

 

8

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We estimate the fair value of stock options using aBlack-Scholes valuation model, consistent with the provisions of SFAS 123(R), Securitiesand Exchange Commission Staff Accounting Bulletin No. 107 and our prior periodpro forma disclosures of net loss, including stock-based compensation(determined under a fair value method as prescribed by SFAS No. 123). Thefair value of our stock options granted to employees forthe three months and six months ended June 30, 2006 was estimated usingthe following weighted-average assumptions:

 
| ** **                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2006**                              | ** ** | **2005**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term (in years)    |       | 5.0                                   |       | 5.0                                 |       | 5.0 |   | 5.0 |   |
|                        |       |                                  |       |                                |       |   |   |   |   |
| Volatility                  |       | 83.95                                 | %          | NA                                  |       | 85.91 | % | 93.2 | % |
|                        |       |                                  |       |                                |       |   |   |   |   |
| Expected dividend           |       | 0                                     | %          | 0                                   | %          | 0 | % | 0 | % |
|                        |       |                                  |       |                                |       |   |   |   |   |
| Risk-free interest rate     |       | 5.10                                  | %          | NA                                  |       | 4.86 | % | 3.72 | % |
|                        |       |                                  |       |                                |       |   |   |   |   |
| Estimated forfeitures       |       | 2.90                                  | %          | 0                                   | %          | 9.59 | % | 0 | % |
|                        |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average fair value |       | $                                     | 2.67       |                                | $          | NA |   | $ | 1.68 |   | $ | 0.86 |   |
|                             |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |

 

The following tablesummarizes the stock option transactions during the six months ended June 30,2006 (in thousands, except per share data):

 
| ** **                                                 | ** ** | **Shares** | ** ** | **Weighted-  average  Exercise  Price** | ** ** | **Weighted-  average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | ** ** | ** ** | ** **                              | ** ** | **(in years****)**                                   | ** ** | ** **                      | ** ** |
| Options  outstanding at December 31, 2005                  |       | 2,917      |       | $                                       | 2.30       |                                                 |       |                            |       |   |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |   |
| Granted                                                    |       | 19         |       | 2.54                                    |       |                                                 |       |                            |       |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |
| Exercised                                                  |       | (144       | )          | 2.08                                    |       |                                                 |       |                            |       |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |
| Canceled                                                   |       | (70        | )          | 1.53                                    |       |                                                 |       |                            |       |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |
| Options  outstanding at June 30, 2006                 |       | 2,722      |       | $                                       | 2.34       |                                                 | 6.89       |                            | $          | 3,826 |   |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |   |   |
| Options  vested and expected to vest at June 30, 2006 |       | 2,685      |       | $                                       | 2.34       |                                                 | 6.87       |                            | $          | 3,757 |   |
|                                                       |       |       |       |                                    |       |                                                 |       |                            |       |   |   |
| Options  exercisable at June 30, 2006                 |       | 1,673      |       | $                                       | 2.89       |                                                 | 5.78       |                            | $          | 1,920 |   |

 

Theoptions outstanding and exercisable at June 30, 2006 were in the followingexercise price ranges:

 
| **Options Outstanding at June 30, 2006** | ** ** | **Options Vested and Exercisable  at June 30, 2006** | ** ** |
|------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                           | ** ** | **Weighted-Average** | ** ** | **Remaining** | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** |
| **Range of Exercise Price**              | ** ** | **Shares**                                           | ** ** | **Exercise Price** | ** ** | **Contractual Life** | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** |
| $                                        | 1.17       |                                                 | —     | $ | 1.38 |   |   | 1,584,545 |   | $ | 1.29 |   | 7.62 |   | 701,304 |   | $ | 1.32 |   |
| $                                        | 1.39       |                                                 | —     | $ | 1.41 |   |   | 11,500 |   | $ | 1.41 |   | 8.89 |   | 2,344 |   | $ | 1.40 |   |
| $                                        | 1.45       |                                                 | —     | $ | 2.21 |   |   | 634,894 |   | $ | 2.17 |   | 6.24 |   | 505,524 |   | $ | 2.18 |   |
| $                                        | 2.25       |                                                 | —     | $ | 5.00 |   |   | 373,370 |   | $ | 3.59 |   | 6.01 |   | 349,326 |   | $ | 3.61 |   |
| $                                        | 5.01       |                                                 | —     | $ | 41.50 |   |   | 117,500 |   | $ | 13.41 |   | 3.27 |   | 115,000 |   | $ | 13.49 |   |
|                                     |       |                                                 |       |   |   | 2,721,809 |   | $ | 2.34 |   | 6.89 |   | 1,673,498 |   | $ | 2.89 |   |

 

Thetotal intrinsic value of options exercised for the three and six months ended June 30,2006 was $167,000 and $233,000. Cash received from option exercises for the threeand six months ended June 30, 2006 was $232,000 and $298,000. The totalfair value of options vested for the three months and six months ended June 30,2006 was $291,000, and $800,000, respectively. 

 

9

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**Note 4. Cash, Cash Equivalentsand Investments**

 

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

 
| ** **                                   | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | ** **                  | ** ** | **Gross**                       | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Amortized**               | ** ** | **Unrealized**                  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                   | ** ** | **Cost**                    | ** ** | **Gain**                        | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gain** | ** ** | **(Loss)** | ** ** | **Value** | ** ** |
| **Classified as:**                           | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash                                         |       | $                           | 7,584      |                            | $          | — |   | $ | — |   | $ | 7,584 |   | $ | 12,803 |   | $ | — |   | $ | — |   | $ | 12,803 |   |
| Cash equivalents:                            |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market funds                           |       | 2,771                       |       | —                          |       | — |   | 2,771 |   | 1,729 |   | — |   | — |   | 1,729 |   |
| Commercial paper                             |       | 698                         |       | —                          |       | — |   | 698 |   | 2,940 |   | — |   | — |   | 2,940 |   |
| Total cash equivalents                       |       | 3,469                       |       | —                          |       | — |   | 3,469 |   | 4,669 |   | — |   | — |   | 4,669 |   |
| Total cash and cash equivalents              |       | 11,053                      |       | —                          |       | — |   | 11,053 |   | 17,472 |   | — |   | — |   | 17,472 |   |
|                                         |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                 |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agency securities          |       | 4,488                       |       | —                          |       | (21 | ) | 4,467 |   | 4,460 |   | — |   | (12 | ) | 4,448 |   |
| Asset-backed securities                      |       | 1,649                       |       | —                          |       | (6 | ) | 1,643 |   | 3,285 |   | — |   | (11 | ) | 3,274 |   |
| Commercial paper                             |       | 888                         |       | —                          |       | (1 | ) | 887 |   | — |   | — |   | — |   | — |   |
| Corporate bonds                              |       | 3,635                       |       | —                          |       | (14 | ) | 3,621 |   | 2,504 |   | — |   | (13 | ) | 2,491 |   |
| Corporate equity securities                  |       | 1,087                       |       | 1,794                           |       | — |   | 2,881 |   | 1,468 |   | 1,324 |   | — |   | 2,792 |   |
| Total investments                            |       | 11,747                      |       | 1,794                           |       | (42 | ) | 13,499 |   | 11,717 |   | 1,324 |   | (36 | ) | 13,005 |   |
| Total cash, cash equivalents and investments |       | $                           | 22,800     |                            | $          | 1,794 |   | $ | (42 | ) | $ | 24,552 |   | $ | 29,189 |   | $ | 1,324 |   | $ | (36 | ) | $ | 30,477 |   |
|                                         |       |                        |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Contractual maturities on investments:**   | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Due within 1 year                            |       | $                           | 8,410      |                            |       |   |   |   | $ | 10,182 |   | $ | 8,384 |   |   |   |   |   | $ | 9,682 |   |
| Due after 1 through 5 years                  |       | 3,337                       |       |                            |       |   |   | 3,317 |   | 3,333 |   |   |   |   |   | 3,323 |   |
|                                         |       | $                           | 11,747     |                            |       |   |   |   | $ | 13,499 |   | $ | 11,717 |   |   |   |   |   | $ | 13,005 |   |

 

Theinvestments include $7.3 million and $7.5 million, respectively, recorded asrestricted deposits on the condensed consolidated balance sheets as of June 30,2006 and December 31, 2005.

 

Wemanage our investments as a single portfolio of highly marketable securitiesthat is intended to be available to meet our current cash requirements. For thethree months ended June 30, 2006, we had $1.1 million of gross realizedgains on sales of our available-for-sale securities. For the three months endedJune 30, 2005, we had no gross realized gains or losses on sales of ouravailable-for-sale securities. For the six months ended June 30, 2006, wehad $1.4 million of gross realized gains on sales of our available-for-salesecurities. For the six months ended June 30, 2005, we had no grossrealized gains or losses on sales of our available-for-sale securities.

 

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debt andequity securities as a result of an increase in interest rates during 2005 andthe first six months of 2006. We have determined that the gross unrealizedlosses on our available-for-sale securities as of June 30, 2006 aretemporary in nature. We reviewed our investment portfolio to identify andevaluate investments that have indications of possible impairment. Factorsconsidered in determining whether a loss is temporary include the magnitude ofthe decline in market value, the length of time the market value has been belowcost (or adjusted cost), credit quality, and our ability

 

10

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andintent to hold the securities for a period of time sufficient to allow for anyanticipated recovery in market value. The following table provides a breakdownof our available-for-sale securities with unrealized losses as of June 30,2006 (in thousands):

 
| ** **                           | ** ** | **In Loss Position** | ** ** | **In Loss Position** | ** ** | **Total In**           | ** ** |
|--------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **< 12 months**   | ** ** | **> 12 months**   | ** ** | **Loss Position** | ** ** |
| ** **                           | ** ** | ** **                     | ** ** | **Gross**                      | ** ** | ** **             | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                           | ** ** | **Fair**                       | ** ** | **Unrealized**                 | ** ** | **Fair**               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                           | ** ** | **Value**                      | ** ** | **(Loss)**                     | ** ** | **Value**              | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **(Loss)** | ** ** |
| Short-term  investments:             |       |                           |       |                           |       |                   |       |   |   |   |   |   |   |
| U.S.  Treasury and agency securities |       | $                              | 3,078      |                           | $          | (13                    | )          | $ | 1,389 |   | $ | (8 | ) | $ | 4,467 |   | $ | (21 | ) |
| Asset-backed  securities             |       | 203                            |       | —                         |       | 1,440                  |       | (6 | ) | 1,643 |   | (6 | ) |
| Commercial  paper                    |       | 887                            |       | (1                             | )          | —                 |       | — |   | 887 |   | (1 | ) |
| Corporate bonds                      |       | 2,633                          |       | (10                            | )          | 488                    |       | (4 | ) | 3,121 |   | (14 | ) |
| Total in  loss position              |       | $                              | 6,801      |                           | $          | (24                    | )          | $ | 3,317 |   | $ | (18 | ) | $ | 10,118 |   | $ | (42 | ) |

 

**Note5. Inventories, Net**

 

The components of inventories are summarized below (in thousands):

 
| ** **        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------|------------|-------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Inventories, net: |       |              |       |                  |       |
| Raw  materials    |       | $                 | 6,815      |                  | $          | 6,667 |   |
| Work in  process  |       | 8,878             |       | 9,141                 |       |
| Finished  goods   |       | 499               |       | 348                   |       |
|              |       | $                 | 16,192     |                  | $          | 16,156 |   |

 

**Note6. Restructuring Charges**

 

Our restructuring accrual is as follows (inthousands):

 
| **For the three months ended June 30,  2006**     | ** ** | **Restructuring Accrual  as of March 31, 2006** | ** ** | **Additions/  Reversals** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of June  30, 2006** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------|------------|--------------|------------|-------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities |       | $                                                    | 128        |                      | $          | —       |       | $                                               | (128       | ) | $ | — |   |
| Workforce  reduction                                   |       | —                                               |       | —                    |       | —       |       | —                                          |       |
| Total                                                  |       | $                                                    | 128        |                      | $          | —       |       | $                                               | (128       | ) | $ | — |   |

 
| **For the six months ended June 30,  2006**       | ** ** | **Restructuring Accrual  as of December 31,  2005** | ** ** | **Additions/  Reversals** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of June  30, 2006** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------|------------|--------------|------------|-------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities |       | $                                                        | 250        |                      | $          | —       |       | $                                               | (250       | ) | $ | — |   |
| Workforce  reduction                                   |       | 215                                                      |       | (2                        | )          | (213         | )          | —                                          |       |
| Total                                                  |       | $                                                        | 465        |                      | $          | (2           | )          | $                                               | (463       | ) | $ | — |   |

 

In December 2005, we reduced theworkforce at our Fremont, California facility by approximately 15positions that we no longer required to support production and operations, orapproximately 29%. This measure was taken as part of our ongoingeffort to reduce our Fremont, California facility headcount. Accordingly,we recorded a restructuring charge of approximately $273,000 related to thereduction in force for severance-related expenses, of which $215,000 remainedon the consolidated balance sheet as of December 31, 2005. We completedthe reduction in force by the end of the first quarter of 2006.

 

11

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As of June 30, 2006, we have a zero balancefor the restructuring accrual for future lease payments related to abandonedU.S. facilities located in California that are no longer required to supportproduction, as these have all been paid out. This was included on theaccompanying condensed consolidated balance sheet as accrued restructuring.

 

**Note 7. Net Loss Per Share**

 

Basic net loss per share is calculated bydividing net loss available to common stockholders by the weighted averagenumber of common shares outstanding during the period. Diluted net loss pershare includes the dilutive effect of common stock equivalents outstandingduring the period calculated using the treasury stock method. Common stockequivalents consist of the shares issuable upon the exercise of stock options.

 

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

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                       | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                       | ** ** | **2006**               | ** ** | **2005**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                       |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                                         |       | $                      | (876       | )                    | $          | (3,279 | ) | $ | (3,079 | ) | $ | (7,402 | ) |
| Less:  Preferred stock dividends                                                 |       | (44                    | )          | (44                  | )          | (88 | ) | (88 | ) |
| Net loss  available to common stockholders                                       |       | $                      | (920       | )                    | $          | (3,323 | ) | $ | (3,167 | ) | $ | (7,490 | ) |
| Denominator:                                                                     |       |                   |       |                 |       |   |   |   |   |
| Denominator  for basic net loss per share - weighted average common shares       |       | 23,052                 |       | 23,079               |       | 23,019 |   | 23,113 |   |
| Effect of  dilutive securities:                                                  |       |                   |       |                 |       |   |   |   |   |
| Common stock  options                                                            |       | —                 |       | —               |       | — |   | — |   |
| Denominator  for dilutive net loss per common share                              |       | 23,052                 |       | 23,079               |       | 23,019 |   | 23,113 |   |
| Basic and  diluted net loss per share                                            |       | $                      | (0.04      | )                    | $          | (0.14 | ) | $ | (0.14 | ) | $ | (0.32 | ) |
| Options  excluded from diluted net loss per share as the impact is anti-dilutive |       | 2,722                  |       | 2,492                |       | 2,722 |   | 2,492 |   |

 

**Note8. Comprehensive Loss**

 

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

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                | ** ** | **2006**               | ** ** | **2005**             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                                  |       | $                      | (876       | )                    | $          | (3,279 | ) | $ | (3,079 | ) | $ | (7,402 | ) |
| Foreign  currency translation loss                                        |       | 207                    |       | (74                  | )          | 78 |   | (218 | ) |
| Unrealized  gain (loss) on available-for-sale investments                 |       | (1,409                 | )          | (200                 | )          | 1,902 |   | (1,421 | ) |
| Less:  reclassification adjustment for realized gain included in net loss |       | (1,062                 | )          | —               |       | (1,438 | ) | — |   |
| Comprehensive  loss                                                       |       | $                      | (3,140     | )                    | $          | (3,553 | ) | $ | (2,537 | ) | $ | (9,041 | ) |

 

**Note9. Segment Information and Foreign Operations**

 

***Segment Information***

*** ***

Weoperate in one segment for the design, development, manufacture anddistribution of high-performance compound semiconductor substrates and sale of rawmaterials. In accordance with SFAS No. 131, *“Disclosures about Segments of an Enterprise andRelated Information”* (“SFAS No. 131”), our chief operatingdecision-maker has been identified as the Chief Executive Officer, who reviewsoperating results to make decisions about allocating resources and

 

12

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assessingperformance for the Company. All material operating units qualify foraggregation under SFAS No. 131 due to their identical customer baseand similarities in economic characteristics, nature of products and services,and procurement, manufacturing and distribution processes. Since we operate inone segment, all financial segment and product line information required bySFAS No. 131 can be found in the condensed consolidated financialstatements.

 

***GeographicalInformation***

*** ***

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

 
| ** **      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------|------------|------------------------|------------|----------------------|------------|
| ** **      | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **      | ** ** | **2006**               | ** ** | **2005**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:       |       |                   |       |                 |       |   |   |   |   |
| North  America* |       | $                      | 2,703      |                 | $          | 1,310 |   | $ | 4,662 |   | $ | 2,282 |   |
| Europe          |       | 2,258                  |       | 1,802                |       | 3,664 |   | 3,584 |   |
| Japan           |       | 1,130                  |       | 559                  |       | 1,796 |   | 799 |   |
| Taiwan          |       | 1,415                  |       | 402                  |       | 2,929 |   | 2,058 |   |
| Asia Pacific    |       | 2,849                  |       | 1,959                |       | 5,775 |   | 3,943 |   |
| Consolidated    |       | $                      | 10,355     |                 | $          | 6,032 |   | $ | 18,826 |   | $ | 12,666 |   |

 

----

*                    Primarilythe United States

 

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

 
| ** **         | ** ** | **As of**    | ** ** |
|--------------------|------------|-------------------|------------|
| ** **         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **         | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Long-lived assets: |       |              |       |   |   |
| North  America     |       | $                 | 6,388      |   | $ | 6,547 |   |
| Asia Pacific       |       | 10,260            |       | 10,759 |   |
|               |       | $                 | 16,648     |   | $ | 17,306 |   |

 

***Significant Customers***

*** ***

Onecustomer represented 11.4% and 14.6% of revenue for the three months ended June 30,2006 and 2005, respectively. One customer represented 12.7% and 12.2% ofrevenue for the six months ended June 30, 2006 and 2005, respectively. Ourtop five customers represented 40.6% and 38.7% of revenue for the three monthsended June 30, 2006, and 2005, respectively. Our top five customersrepresented 38.5% and 39.8% of revenue for the six months ended June 30,2006, and 2005, respectively.

 

**Note 10. Corporate Affiliates**

 

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

 
| ** **                                     | ** ** | **Investment Balance as of** | ** ** | ** **            | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                                     | ** ** | **June 30,**                 | ** ** | **December 31,** | ** ** | **Accounting** | ** ** | **Ownership** | ** ** |
| **Affiliate**                                  | ** ** | **2006**                          | ** ** | **2005**              | ** ** | **Method**     | ** ** | **Percentage** | ** ** |
| Beijing Ji Ya Semiconductor Material Co.,  Ltd |       | $                                 | 996        |                  | $          | 1,071          |       | Consolidated |   | 46 | % |
| Nanjing Jin Mei Gallium Co., Ltd               |       | 592                               |       | 616                   |       | Consolidated   |       | 83 |   |
| Beijing BoYu Manufacturing Co., Ltd            |       | 410                               |       | 409                   |       | Consolidated   |       | 70 |   |
| Xilingol Tongli Ge Co. Ltd                     |       | 878                               |       | 847                   |       | Equity         |       | 25 |   |
| Emeishan Jia Mei High Pure Metals Co., Ltd     |       | 639                               |       | 584                   |       | Equity         |       | 25 |   |
|                                                |            |                                   |            |                       |            |                |            |  |  |  |  |

 

13

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

 

•                       bothaffiliates have sustainable businesses of their own;

 

•                       our votingpower is proportionate to our ownership interests;

 

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

 

•                       we do nothave a controlling financial interest, do not maintain operational or managementcontrol of, do not control the board of directors of, and are not required toprovide additional investment or financial support to either affiliate.

 

Undistributedretained earnings relating to our corporate affiliates were $3.3 million and$1.8 million as of June 30, 2006 and 2005, respectively. Net incomerecorded from our corporate affiliates was $455,000 and $243,000 for the threemonths ended June 30, 2006 and 2005, respectively. Net income recordedfrom our corporate affiliates was $724,000 and $332,000 for the six monthsended June 30, 2006 and 2005, respectively.

 

The minority interest for those affiliates that are consolidated isincluded within “Other long-term liabilities” in the condensed consolidatedbalance sheets and within “Other income (expense), net” on the condensedconsolidated statements of operations.

 

**Note11. Commitments and Contingencies**

 

***LegalMatters***

*** ***

On October 15, 2004, a purported securitiesclass action lawsuit was filed in the United States Court for the NorthernDistrict of California, City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ. The Court consolidated the case with asubsequent related case and appointed a lead plaintiff. On April 5, 2005,the lead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour chief technology officer as defendants, and is brought on behalf of a class ofall purchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages is claimed.We believe that there are meritorious defenses against this litigation andintend to vigorously defend it. On September 23, 2005, the Court grantedour motion to dismiss the complaint, with leave to amend. The lead plaintifffiled an amended complaint, which we have moved to dismiss. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation. Any unfavorable outcome of the litigation could have anadverse impact on our business, financial condition and results of operations.

 

On June 1, 2005, a lawsuit was filed inthe Superior Court of California, County of Alameda, Zhao et al. v. AmericanXtal Technology, et al., No. R 605215713. The lawsuit complaint names asdefendants AXT, its chief technology officer, its former interim chiefexecutive officer, a former safety department employee and a supplier to AXT.The lawsuit is brought on behalf of two former employees and their minor child.The complaint alleges personal injury, general negligence, intentional tort,wage loss and other damages, including punitive damages, as a result of exposureto the child while in utero to high levels of gallium arsenide and methanolused in the production of gallium arsenide wafers. We believe that there aremeritorious defenses against this litigation and intend to vigorously defendit. AXT’s commercial general liability insurance carrier has agreed to fund AXT’sdefense of the case, but has reserved the right to deny coverage, in whole orin part, in the future under selected policy provisions and applicable law.There is $21 million in available limits under the policies in question. Theplaintiffs have made an initial settlement demand within our insurance limits.Due to the inherent uncertainties of litigation, we cannot accurately predictthe ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

 

***Indemnification Agreements***

 

Weenter into standard indemnification arrangements in the ordinary course ofbusiness. Pursuant to these arrangements, we indemnify, hold harmless, andagree to reimburse the indemnified parties, generally their business partnersor customers, for losses suffered or incurred by the indemnified party inconnection with any U.S. patent, or any

 

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copyrightor other intellectual property infringement claim by any third party withrespect to our products. The term of these indemnification agreements isgenerally perpetual after the execution of the agreement. The maximum potentialamount of future payments we could be required to make under these agreementsis unlimited. We have never incurred costs to defend lawsuits or settle claimsrelated to these indemnification agreements. As a result, we believe theestimated fair value of these agreements is minimal.

 

Wehave entered into indemnification agreements with our directors and officersthat may require us to indemnify our directors and officers againstliabilities that may arise by reason of their status or service as directorsor officers, other than liabilities arising from willful misconduct of aculpable nature; to advance their expenses incurred as a result of anyproceeding against them as to which they could be indemnified; and to obtaindirectors’ and officers’ insurance if available on reasonable terms, which wecurrently have in place.

 

***ProductWarranty***

*** ***

Wewarrant our products against material defects for a specific period of time,generally twelve months. We provide for the estimated future costs of warrantyobligations in cost of revenue when the related revenue is recognized. Theaccrued warranty costs represent the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace products that failwhile still under warranty. The amount of accrued estimated warranty costs isprimarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balance and update this based on historical warranty cost trends. Thefollowing table reflects the change in our warranty accrual during the threemonths and six months ended June 30, 2006 and 2005 (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **2006**                             | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Beginning accrued warranty and related  costs |       | $                                    | 184        |                               | $          | 135 |   | $ | 120 |   | $ | 135 |   |
| Charged to cost of revenue                    |       | 41                                   |       | (53                                | )          | 146 |   | (53 | ) |
| Actual warranty expenditures                  |       | (21                                  | )          | —                             |       | (62 | ) | — |   |
| Ending accrued warranty and related costs     |       | $                                    | 204        |                               | $          | 82 |   | $ | 204 |   | $ | 82 |   |

 

***Sales Returns***

** **

InMarch 2004, we increased our reserve for repair and replacement costs by$745,000. As of June 30, 2006, this reserve was zero since approximately$487,000 had been utilized and approximately $258,000 had been reversed torevenue as we favorably resolved an outstanding matter with a customer.

 

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

 

Weincurred foreign currency transaction exchange gains of $47,000 and losses of $29,000for the three months ended June 30, 2006, and 2005, respectively. Weincurred foreign currency transaction exchange gains of $11,000 and losses of $49,000for the six months ended June 30, 2006, and 2005, respectively. Theseamounts are included in other income (expense), net on the condensedconsolidated statements of operations.

 

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**Note 13.Recent Accounting Pronouncements**

** **

In February 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155 (“SFAS155”), “*Accounting for Certain Hybrid Instruments – anamendment of FASB Statements No. 133 and 140”.* SFAS 155 amendsSFAS No. 133, “Accounting for derivative Instruments and HedgingActivities” (“SFAS 133”) and SFAS No. 140, “*Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*” (“SFAS 140”). SFAS 155 gives entities the option ofapplying fair value accounting to certain hybrid financial instruments in theirentirety if they contain embedded derivatives that would otherwise requirebifurcation under SFAS 133. SFAS 155 will be effective for us as of January 1,2007. We are currently assessing the impact that SFAS 155 may have on our consolidatedfinancial position, results of operations or cash flows.

 

In June 2006, theFASB issued FASB Interpretation No. 48 “*Accounting For UncertainTax Positions – An Interpretation of FASB Statement No. 109”*(“FIN48”), FIN 48 clarifies the accounting for uncertainly in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109 “Accounting for Income Taxes”. It prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. FIN 48 iseffective for fiscal years beginning after Decemeber 15, 2006. We are currentlyassessing the impact of the adoption that FIN 48 may have on our consolidatedfinancial position, results of operations or cash flows.

 

**Note 14. Subsequent Event**

 

In June 2006, the Company filed a Form S-3shelf registration with the Securities and Exchange Commission, which wasdeclared effective by the SEC on August 2006. Under the shelf registrationprocess, we may offer shares of our common stock with a total value of up to$25.0 million.

 

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

 

This Management’s Discussion and Analysis of Financial Condition andResults of Operations includes a number of forward-looking statements madepursuant to the provisions of Section 21E of the Securities Exchange Actof 1934. These forward-looking statements are based upon management’s currentviews with respect to future events and financial performance, and are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or those anticipated. These risks anduncertainties include those set forth under “Risks Related to our Business”below. Forward-looking statements may be identified by the use of termssuch as “anticipates”, “believes”, “estimates”, “expects” and “intends” andsimilar expressions. Statements concerning our future or expected financialresults and condition, business strategy and plans or objectives for futureoperations are forward-looking statements.

 

These forward-looking statements are not guarantees of futureperformance. Readers are cautioned not to place undue reliance on theseforward-looking statements, which speak only as of the date hereof. Thisdiscussion should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations included in ourAnnual Report on Form 10-K for the year ended December 31, 2005 and the condensed consolidatedfinancial statements included elsewhere in this report.

 

**Overview**

 

We design, develop,manufacture and distribute high-performance compound and single elementsemiconductor substrates comprising gallium arsenide (GaAs), indium phosphide(InP) and germanium (Ge). Our substrate products are used primarily in lightingdisplay applications, wireless communications and fiber optic communications.We believe our vertical gradient freeze, or VGF, technique for manufacturingsemiconductor substrates provides significant benefits over other methods andhas enabled us to become a leading manufacturer of such substrates. We pioneeredthe commercial use of VGF technology to manufacture GaAs substrates andsubsequently used VGF technology to manufacture substrates from InP and Ge.

 

We also manufacture and sell rawmaterials related to our substrate business through five joint ventures locatedin China. These joint ventures produce products including 99.99% pure gallium(4N Ga), high purity gallium, arsenic, germanium, germanium dioxide, paralyticboron nitride (pBN) crucibles and boron oxide. AXT’s ownership interest inthese entities ranges from 25% to 83%. We consolidate the three ventures inwhich we own a majority or controlling financial interest and employ equityaccounting for the two joint ventures in which we have a 25% interest. Wepurchase portions of the materials produced by these ventures for our own useand the joint ventures sell the remainder of their production to third parties.

 

Revenue from continuing operations increased $6.2million, or 48.6%, to $18.8 million for the six months ended June 30, 2006from $12.7 million for the same period of 2005 primarily due to our improved productquality and higher customer demands for six-inch diameter wafers. As of June 30,2006, we had available cash, cash equivalents and short-term investments of $17.3million, excluding restricted deposits.

 

***DiscontinuedOpto-Electronics Business***

*** ***

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our acquisition of LyteOptronics, Inc. in May 1999. The discontinued opto-electronicsdivision manufactured blue, cyan and green high-brightness light emittingdiodes (HBLEDs) for the illumination markets, including full-color displays,wireless handset backlighting and traffic signals, and also manufacturedvertical cavity surface emitting lasers (VCSELs) and laser diodes for fiberoptic communications and storage area networks. Because of this discontinuation,the results of operations of the opto-electronics division have been segregatedfrom continuing operations and are reported separately as discontinuedoperations in our condensed consolidated statements of operations for allperiods presented. See Note 2 to our condensed consolidated financialstatements for details regarding the accounting for discontinued operations.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million.

 

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

 

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***Restructuring Charges***

 

In December 2005, we further reduced thework force at our Fremont, California facility by approximately 15positions that we no longer required to support production and operations, orapproximately 29%. This measure was taken as part of our ongoingeffort to reduce our Fremont, California facility headcount, and weexpect to save $0.9 million annually in payroll and related expenses.Accordingly, we recorded a restructuring charge of approximately $273,000related to the reduction in force for severance-related expenses, of which$215,000 was the balance as of December 31, 2005. We completed thereduction in force in the first quarter of 2006.

 

As of June 30, 2006, the remainingrestructuring accrual for future lease payments related to abandoned U.S.facilities located in California that are no longer required to supportproduction was zero, as these have all been paid out. This was included on theaccompanying condensed consolidated balance sheet as accrued restructuring.

 

**Critical Accounting Policies and Estimates**

 

We have prepared our condensed consolidatedfinancial statements in accordance with accounting principles generallyaccepted in the United States of America. As such, we have had to makeestimates, assumptions and judgments that affect the amounts reported on ourfinancial statements. These estimates, assumptions and judgments about futureevents and their effects on our results cannot be determined with certainty,and are made based upon our historical experience and on other assumptions thatare believed to be reasonable under the circumstances. These estimates may changeas new events occur or additional information is obtained, and we may periodicallybe faced with uncertainties, the outcomes of which are not within our controland may not be known for a prolonged period of time. The discussion andanalysis of our results of operations and financial condition are based uponthese condensed 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. They may requireus to make assumptions about matters that are highly uncertain at the time ofthe estimate, and different estimates that we could have used, or changes inthe estimate that are reasonably likely to occur, may have a materialimpact on our financial condition or results of operations.

 

We believe that the following are our critical accounting policies:

 

***Revenue Recognition***

 

We manufacture and sell high-performancecompound and single element semiconductor substrates and sell certain rawmaterials including gallium, germanium dioxide and pBN crucibles. After we shipour products, there are no remaining obligations or customer acceptancerequirements that would preclude recognition of the revenue earned on the sale.Our products are typically sold pursuant to a purchase order placed by ourcustomers, and our terms and conditions of sale do not require customeracceptance. We recognize revenue upon shipment and transfer of title ofproducts to our customers, which is ordinarily upon shipment from our dock,receipt at the customer’s dock, or removal from consignment inventory at thecustomer’s location, provided that we have received a signed purchase order,the price is fixed or determinable, title and risk of ownership havetransferred, collection of resulting receivables is probable, and productreturns are reasonably estimable. We do not provide training, installation orcommissioning services. Additionally, we do not provide discounts or otherincentives to customers except for one customer with which we agreed in thefourth quarter of 2004 to provide a certain amount of cumulative discountson future product purchases from us. We will recognize these discounts infuture periods as a reduction in revenue as products are sold to this customer.

 

Weprovide for future returns based on historical experience, current economictrends and changes in customer demand at the time revenue is recognized. In thefirst quarter of 2004, we recorded a specific reserve for sales returns of $745,000related to our failure to follow certain testing requirements and providetesting data and information to certain customers. This reserve was based ondiscussions with some of the affected customers and review of specificshipments. As of June 30, 2006, this reserve balance was zero sinceapproximately $487,000 had been utilized and approximately $258,000 had beenreversed to revenue as we favorably resolved an outstanding matter with acustomer.

 

***Allowance for Doubtful Accounts***

 

We periodically review the likelihood ofcollection on our accounts receivable balances and provide an allowance fordoubtful accounts receivable primarily based upon the age of these accounts. Weprovide a 100% allowance for U.S. receivables in excess of 90 days and for foreignreceivables in excess of 120 days. We assess the probability of collectionbased on a number of factors, including the length of time a receivable balancehas been outstanding, our past history with the customer and theircreditworthiness.

 

As of June 30, 2006 and December 31,2005, our accounts receivable balance was $7.4 million and $5.2 million,

 

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respectively, which was net of an allowance for doubtful accounts of$0.6 million and $0.6 million, respectively. If actual uncollectible accountsdiffer substantially from our estimates, revisions to the estimated allowancefor doubtful accounts would be required, which could have a material impact onour financial results for the period.

 

***Warranty Reserve***

 

We maintain a warranty reserve based upon ourclaims experience during the prior twelve months. Warranty costs are accrued atthe time revenue is recognized. As of June 30, 2006 and December 31,2005, accrued product warranties totaled $204,000 and $120,000, respectively.If actual warranty costs differ substantially from our estimates, revisions tothe estimated warranty liability would be required, which could have a materialimpact on our financial condition and results of operations.

 

***Inventory Valuation***

 

Inventories are stated at the lower of costor market. Cost is determined using the weighted average cost method. Ourinventory consists of raw materials as well as finished goods andwork-in-process that include material, labor and manufacturing overhead costs.Given the nature of our substrate products, and the materials used in themanufacturing process, the wafers and ingots comprising work-in-process may beheld in inventory for up to two years and three years, respectively, as therisk of obsolescence for these materials is low. 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 allowancefor certain inventories based upon the age and quality of the product and theprojections for sale of the completed products. As of June 30, 2006 and December 31,2005, we had an inventory reserve of $17.7 million and $16.9 million for excessand obsolete inventory, respectively. The majority of this inventory has notbeen scrapped. If actual demand for our products were to be substantially lowerthan estimated, additional inventory adjustments for excess or obsoleteinventory might be required, which could have a material impact on ourbusiness, financial condition and results of operations.

 

***Impairment of Investments***

 

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

 

We invest in equity instruments ofprivately-held companies for business and strategic purposes. These investmentsare classified as other assets and are accounted for under the cost method aswe do not have the ability to exercise significant influence over theiroperations. We monitor our investments for impairment and record reductions incarrying value when events or changes in circumstances indicate that thecarrying value may not be recoverable. Determination of impairment ishighly subjective and is based on a number of factors, including an assessmentof the strength of the investee’s management, the length of time and extent towhich the fair value has been less than our cost basis, the financial conditionand near-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value.

 

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

 

We evaluate the recoverability of property,equipment and intangible assets in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets.”* When events and circumstances indicate thatlong-lived assets may be impaired, we compare the carrying value of thelong-lived assets to the projection of future undiscounted cash flowsattributable to these assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against incomeequal to the excess of the carrying value over the assets’ fair value.

 

***Employee Stock Options***

 

We grant options to substantially allmanagement employees and believe that this program helps us to attract,motivate and retain high quality employees, to the ultimate benefit of ourstockholders. Effective January 1, 2006, we adopted the fair valuerecognition provisions of SFAS No. 123(revised 2004), “*Share-Based Payment*,”(“SFAS 123(R)”), using themodified prospective application transition method. Under this transitionmethod, stock-based compensation cost was recognized in the condensed consolidatedfinancial statements for all share-based payments after January 1, 2006. Compensationcost recognized includes the estimated expense for the portion of the vestingperiod after January 1, 2006 for share-based payments prior to, but notvested as of January 1, 2006, based on the grant date fair

 

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valueestimated in accordance with the original provisions of SFAS 123 “*Accounting for Stock-Based Compensation”*. Results for priorperiods have not been restated, as provided for under the modified prospective applicationtransition method. See Note 3 to our condensed consolidated financialstatements.

 

***Income Taxes***

 

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

 

We provide for income taxes based upon thegeographic composition of worldwide earnings and tax regulations governing eachregion, particularly China. The calculation of tax liabilities involves significantjudgment in estimating the impact of uncertainties in the application ofcomplex tax laws, particularly in foreign countries such as China.

 

**Resultsof Operations**

 

**Revenue**

 
| ** **     | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **     | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **     | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs           |       | $                              | 8,125      |         | $          | 4,487          |       | $ | 3,638 |   | 81.1 | % |
| InP            |       | 613                            |       | 280          |       | 333            |       | 118.9 | % |
| Ge             |       | 169                            |       | 25           |       | 144            |       | 576.0 | % |
| Raw materials  |       | 1,448                          |       | 1,231        |       | 217            |       | 17.6 | % |
| Other          |       | —                         |       | 9            |       | (9             | )          | (100 | )% |
| Total  revenue |       | $                              | 10,355     |         | $          | 6,032          |       | $ | 4,323 |   | 71.7 | % |

 

Revenue increased $4.3 million, or 71.7%, to $10.4 million for the threemonths ended June 30, 2006 from $6.0 million for the three months ended June 30,2005. Total GaAs substrate revenue increased $3.6 million, or 81.1%, to $8.1million for the three months ended June 30, 2006 from $4.5 million for thethree months ended June 30, 2005.

 

Sales of 5 inch and 6 inch diameter GaAs substrates were $3.3 millionfor the three months ended June 30, 2006 compared with $0.5 million forthe three months ended June 30, 2005. The increase in larger diametersubstrate revenue was due to the fact that, while the GaAs device market grewin strength for both cellular and the WLAN (Wide Local Area Network) markets,the compound semiconductor industry has been experiencing capacity constraints;with our excess capacity we were able to benefit from the overflow businessfrom our competition.

 

 Sales of 2 inch, 3 inch and 4inch diameter GaAs substrates were $4.9 million for the three months ended June 30,2006 compared with $4.0 million for the three months ended June 30, 2005.The increase in smaller diameter substrate revenue was due to the continuedgrowth of LED laser diodes and commercial epitaxy.

 

InP substrate revenue increased $333,000, or 118.9%, to $613,000 forthe three months ended June 30, 2006 from $280,000 for the three monthsended June 30, 2005. The increase in InP substrate revenue was due to oneparticular large customer order as a result of a government contract which isnot expected to repeat for the remainder of 2006.

 

Ge substrate revenue increased $144,000, or 576.0%, to $169,000 for thethree months ended June 30, 2006 from $25,000 for the three months ended June 30,2005. The increase in Ge substrate revenue was due to more customer qualificationsin China where demand for photovoltaic applications is high.

 

Raw materials revenue increased $217,000, or 17.6%, to $1.4 million forthe three months ended June 30, 2006 from $1.2 million for the threemonths ended June 30, 2005. The increase in raw materials revenue was dueto sales of germanium dioxide to a new customer.

 

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**Revenue**

 
| ** **     | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **     | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **     | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs           |       | $                              | 14,880     |         | $          | 9,680          |       | $ | 5,200 |   | 53.7 | % |
| InP            |       | 909                            |       | 417          |       | 492            |       | 118.0 | % |
| Ge             |       | 205                            |       | 30           |       | 175            |       | 583.3 | % |
| Raw materials  |       | 2,832                          |       | 2,522        |       | 310            |       | 12.3 | % |
| Other          |       | —                         |       | 17           |       | (17            | )          | (100 | )% |
| Total  revenue |       | $                              | 18,826     |         | $          | 12,666         |       | $ | 6,160 |   | 48.6 | % |

 

Revenue increased $6.1 million, or 48.6%, to $18.8 million for the sixmonths ended June 30, 2006 from $12.7 million for the six months ended June 30,2005. Total GaAs substrate revenue increased $5.2 million, or 53.7%, to $14.9million for the six months ended June 30, 2006 from $9.7 million for the sixmonths ended June 30, 2005.

 

Sales of 5 inch and 6 inch diameter GaAs substrates were $6.0 millionfor the six months ended June 30, 2006 compared with $1.0 million for the sixmonths ended June 30, 2005. The increase in larger diameter substraterevenue was due to the fact that, while the GaAs device market grew in strengthfor both cellular and the WLAN (Wide Local Area Network) markets, the compoundsemiconductor industry has been experiencing capacity constraints; with our excesscapacity we were able to benefit from the overflow business from ourcompetition.

 

Sales of 2 inch, 3 inch and 4 inch diameter GaAs substrates were $8.7million for the six months ended June 30, 2006 compared with $8.7 millionfor the six months ended June 30, 2005. We have sold a larger quantity ofsmaller diameter wafers in 2006 compared to 2005, but generated the same dollarrevenue due to the continuing pricing pressures causing average sales prices todecline. The reason for the increase in sales volume was due to the continuedgrowth of LED laser diodes and commercial epitaxy.

 

InP substrate revenue increased $0.5 million, or 118.0%, to $0.9million for the six months ended June 30, 2006 from $417,000 for the sixmonths ended June 30, 2005. The increase in InP substrate revenue was due tothe receipt of one large customer order for a government contract that is notexpected to repeat for the remainder of 2006.

 

Ge substrate revenue increased $0.2 million, or 583.3%, to $0.2 millionfor the six months ended June 30, 2006 from $30,000 for the six monthsended June 30, 2005. The increase in Ge substrate revenue was due to morecustomer qualifications in China where demand for photovoltaic applications ishigh.

 

Raw materials revenue increased $310,000, or 12.3%, to $2.8 million forthe six months ended June 30, 2006 from $2.5 million for the six monthsended June 30, 2005. The increase in raw materials revenue was mainly dueto sales of germanium dioxide to a new customer.

 

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***Revenueby Geographic Region***

*** ***
| ** **                                | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                           |       | $                              | 2,703      |         | $          | 1,310          |       | $ | 1,393 |   | 106.3 | % |
| *% of  total revenue*                     |       | 26                             | %          | 22           | %          |           |       |   |   |
| Europe                                    |       | 2,258                          |       | 1,802        |       | 456            |       | 25.3 | % |
| *% of  total revenue*                     |       | 22                             | %          | 30           | %          |           |       |   |   |
| Japan                                     |       | 1,130                          |       | 559          |       | 571            |       | 102.1 | % |
| *% of  total revenue*                     |       | 11                             | %          | 9            | %          |           |       |   |   |
| Taiwan                                    |       | 1,415                          |       | 402          |       | 1,013          |       | 252.0 | % |
| *% of  total revenue*                     |       | 14                             | %          | 7            | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 2,849                          |       | 1,959        |       | 890            |       | 45.4 | % |
| *% of  total revenue*                     |       | 27                             | %          | 32           | %          |           |       |   |   |
| Total  revenue                            |       | $                              | 10,355     |         | $          | 6,032          |       | $ | 4,323 |   | 71.7 | % |

 

----

*                 Primarilythe United States

 

The North America revenue increased by $1.4 million, or 106.3%, to $2.7million for the three months ended June 30, 2006 from $1.3 million for thethree months ended June 30, 2005. We believe our quality has improved asshown by customers that have qualified our China-grown products as sales toexisting customers increased by $1.1 million, while we gained $0.3 million insales to new customers.

 

The Europe revenue increased by $0.5 million, or 25.3%, to $2.3 millionfor the three months ended June 30, 2006 from $1.8 million for the threemonths ended June 30, 2005. This increase came from increased substratesales to customers in France, partially offset by decreases in sales tocustomers in Germany and the United Kingdom.

 

The Japan revenue increased by $0.6 million, or 102.1%, to $1.1 millionfor the three months ended June 30, 2006 from $0.6 million for the threemonths ended June 30, 2005. The increase came from substrate sales toexisting customers mainly in larger diameter wafers.

 

The Taiwan revenue increased by $1.0 million, or 252.0%, to $1.4million for the three months ended June 30, 2006 from $0.4 million for thethree months ended June 30, 2005. The increase was due to sales toexisting customers of $0.9 million mainly in larger diameter wafers, while wegained $0.1 million in sales to new customers mainly in smaller diameter wafers.

 

The Asia Pacific (excluding Japan and Taiwan) revenue increased by $0.9million, or 45.4% to $2.8 million for the three months ended June 30, 2006from $2.0 million for the three months ended June 30, 2005. Of thisincrease, sales to customers in China accounted for $0.5 million of the increasein substrate sales and $0.1 million of the increase in raw material sales.Revenue from sales to customers in Malaysia and Singapore accounted for $0.2million of the increase in substrate sales.

 

22

----

 
| ** **                                | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                           |       | $                              | 4,662      |         | $          | 2,282          |       | $ | 2,380 |   | 104.3 | % |
| *% of  total revenue*                     |       | 25                             | %          | 18           | %          |           |       |   |   |
| Europe                                    |       | 3,664                          |       | 3,584        |       | 80             |       | 2.2 | % |
| *% of  total revenue*                     |       | 19                             | %          | 28           | %          |           |       |   |   |
| Japan                                     |       | 1,796                          |       | 799          |       | 997            |       | 124.8 | % |
| *% of  total revenue*                     |       | 10                             | %          | 7            | %          |           |       |   |   |
| Taiwan                                    |       | 2,929                          |       | 2,058        |       | 871            |       | 42.3 | % |
| *% of  total revenue*                     |       | 16                             | %          | 16           | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 5,775                          |       | 3,943        |       | 1,832          |       | 46.5 | % |
| *% of  total revenue*                     |       | 30                             | %          | 31           | %          |           |       |   |   |
| Total  revenue                            |       | $                              | 18,826     |         | $          | 12,666         |       | $ | 6,160 |   | 48.6 | % |

 

----

*                 Primarilythe United States

 

The North America revenue increased by $2.4 million, or 104.3%, to $4.7million for the six months ended June 30, 2006 from $2.3 million for the sixmonths ended June 30, 2005. We believe our quality has improved as shownby customers that have qualified our China-grown products as sales to existingcustomers increased by $1.8 million, while we gained $0.6 million in sales tonew customers.

 

The Europe revenue increased by $80,000, or 2.2%, to $3.7 million forthe six months ended June 30, 2006 from $3.6 million for the six monthsended June 30, 2005. This increase came from increased substrate sales tocustomers in France, partially offset by decreases in sales to customers in theUnited Kingdom. In the United Kingdom we lost one customer in the second halfof 2005 due to quality problems with our product. We are beginning to regainsales to this customer as it began placing orders with us again in the firsthalf of 2006.

 

The Japan revenue increased by $997,000, or 124.8%, to $1.8 million forthe six months ended June 30, 2006 from $799,000 for the six months ended June 30,2005. Raw material sales to a new customer accounted for $0.3 million of thisincrease, while $0.3 million was from substrate sales to new customers that havequalified our China-grown products, and by $0.4 million of increased sales toexisting customers, mainly for larger diameter wafers.

 

The Taiwan revenue increased by $871,000, or 42.3%, to $2.9 million forthe six months ended June 30, 2006 from $2.1 million for the six monthsended June 30, 2005. The increase was due to sales to existing customersof $0.7 million mainly in large diameter wafers, while we gained $0.2 millionin sales to new customers mainly in smaller diameter wafers.

 

The Asia Pacific (excluding Japan and Taiwan) revenue increased by $1.8million, or 46.5% to $5.8 million for the six months ended June 30, 2006 from$3.9 million for the six months ended June 30, 2005. Of this increase, salesto customers in Malaysia and Singapore accounted for $1.3 million of the increase,mainly in larger diameter wafers, while sales to customers in China increasedby $0.3 million, and Korea increased by $0.2 million. 

 

23

----

 

***Gross Margin***

 
| ** **        | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **        | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                              | 2,759      |         | $          | 127            |       | $ | 2,632 |   | 2,072.4 | % |
| *Gross  Margin %* |       | 26.6                           | %          | 2.1          | %          |           |       |   |   |
|                   |            |                                |            |              |            |                |            |  |  |  |  |  |

 

*Gross margin.*Grossmargin increased to 26.6% of total revenue for the three months ended June 30,2006 compared with 2.1% of total revenue for the three months ended June 30,2005. Gross margin in the three months ended June 30, 2006 was positivelyimpacted by sales of approximately $802,000 of gallium arsenide (GaAs) waferswhich were previously fully reserved. Product mix also contributed to highergross margins as we sold a greater amount of InP substrates, as well as largerdiameter GaAs wafers, both of which contributed larger gross profits. In December 2005,we reduced the workforce at our Fremont, California facility that we no longerrequired to support production. This workforce reduction accounted forapproximately 2% of the increase in gross margin in the three months ended June 30,2006. Gross margin in the three months ended June 30, 2005 was negativelyimpacted by a $765,000 charge to cost of revenues as a result of an inventoryvaluation adjustment. This charge negatively impacted gross margin by 12.7%.Gross margin in the three months ended June 30, 2005 was positivelyimpacted by sales of approximately $651,000 of GaAs wafers which werepreviously fully reserved.

 
| ** **        | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **        | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                              | 4,269      |         | $          | 406            |       | $ | 3,863 |   | 951.5 | % |
| *Gross  Margin %* |       | 22.7                           | %          | 3.2          | %          |           |       |   |   |
|                   |            |                                |            |              |            |                |            |  |  |  |  |  |

 

*Gross margin.*Grossmargin increased to 22.7% of total revenue for the six months ended June 30,2006 compared with 3.2% of total revenue for the six months ended June 30,2005. Gross margin in the six months ended June 30, 2006 was positivelyimpacted by sales of approximately $1.4 million of GaAs wafers, which werepreviously fully reserved, and by approximately $53,000 as a result of areversal of a sales return reserve established in 2004 as we favorably resolvedan outstanding matter with a customer. In addition, we sold a greater amount ofInP substrates and larger diameter GaAs wafers in the six months ended June 30,2006 which contributed higher gross profits. In December 2005, we reducedthe workforce at our Fremont, California facility that we no longer required tosupport production. This workforce reduction accounted for approximately 3% ofthe increase in gross margin in the six months ended June 30, 2006. We hadmanufacturing equipment that became fully depreciated in 2006 and this savingscontributed to approximately 3% of gross margin in the six months ended June 30,2006. Gross margin was only 3.2% of total revenue for the six months ended June 30,2005, which was primarily due to product mix, as we sold a greater amount ofsmaller diameter wafers where there has been continuing pricing pressurescausing average sales prices to decline. Gross margin for the six months ended June 30,2005 was negatively impacted by a $765,000 charge to cost of revenues as aresult of an inventory valuation adjustment. This charge negatively impactedgross margin by 6.0%. Gross margin in the six months ended June 30, 2005was positively impacted by sales of approximately $803,000 of GaAs wafers whichwere previously fully reserved.

 

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

*** ***
| ** **                                   | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                   | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                   | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative expenses |       | $                              | 3,853      |         | $          | 2,716          |       | $ | 1,137 |   | 41.9 | % |
| *% of  total revenue*                        |       | 37.2                           | %          | 45.0         | %          |           |       |   |   |
|                                              |            |                                |            |              |            |                |            |  |  |  |  |  |

 

24

----

 

Selling, general and administrative expenses increased $1.1 million to$3.9 million for the three months ended June 30, 2006 from $2.7 millionfor the three months ended June 30, 2005. The increase was primarily dueto $0.7 million in salaries and related costs for our new hires in salesmanagement and our new Taiwan office, as well as general salary increases, $0.3million in professional fees, $0.2 million for stock-based compensation costsand bonuses, partially offset by $0.3 million lower expenses fordecommissioning our Fremont, California facilities.

 
| ** **                                    | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                                    | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative  expenses |       | $                              | 7,083      |         | $          | 6,968          |       | $ | 115 |   | 1.7 | % |
| *% of  total revenue*                         |       | 37.6                           | %          | 55.0         | %          |           |       |   |   |
|                                               |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Selling, general and administrative expenses increased $0.1 million to$7.1 million for the six months ended June 30, 2006 from $7.0 million forthe six months ended June 30, 2005. The increase was primarily due to $0.9million in salaries and related costs for our new hires in sales management andour new Taiwan office, as well as general salary increases, $0.4 million inprofessional fees, $0.6 million for stock-based compensation costs and bonuses,partially offset by $1.6 million lower expenses for decommissioning ourFremont, California facilities, $0.1 million lower recruiting fees, and $0.1million lower property taxes.

 

***Researchand Development***

*** ***
| ** **               | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|--------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **               | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                              | 571        |         | $          | 423            |       | $ | 148 |   | 35.0 | % |
| *% of  total revenue*    |       | 5.5                            | %          | 7.0          | %          |           |       |   |   |
|                          |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Research and development expenses increased $0.1 million, or 35.0%, to$0.6 million for the three months ended June 30, 2006 from $0.4 millionfor the three months ended June 30, 2005, as a result of our appointing Dr. MorrisYoung as our Chief Technology Officer to enhance our technology leadership. Newproducts testing expenses increased by $0.1 million.

 
| ** **               | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|--------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **               | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                              | 1,105      |         | $          | 785            |       | $ | 320 |   | 40.8 | % |
| *% of  total revenue*    |       | 5.9                            | %          | 6.2          | %          |           |       |   |   |
|                          |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Research and development expenses increased $0.3 million, or 40.8%, to$1.1 million for the three months ended June 30, 2006 from $0.8 million forthe three months ended June 30, 2005, as a result of our appointing Dr. MorrisYoung as our Chief Technology Officer to enhance our technology leadership. Hissalary and personnel costs were previously included in general andadministrative costs. New products testing expenses increased $0.1 million,while stock-based compensation and bonuses increased by $0.2 million.

 

25

----

 

***Restructuring***

 
| ** **            | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring         |       | $                              | —     |         | $          | 237            |       | $ | (237 | ) | (100.0 | )% |
| *% of  total revenue* |       | 0.0                            | %          | 3.9          | %          |           |       |   |   |
|                       |            |                                |            |              |            |                |            |  |  |  |  |  |

 

During the three months ended June 30,2006, there were no restructuring charges. During the three months ended June 30,2005, we recorded restructuring charges of $237,000, of which $169,000 relatedto leasecosts associated with facilities located in California that are no longerrequired to support production, and $98,000 related to the closure of our Japan office. Partially offsetting thesecharges, we had a credit adjustment of $30,000 related to the reductionin our China work force we effected in March 2005.

 
| ** **            | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring         |       | $                              | (2         | )            | $          | 362            |       | $ | (364 | ) | (100.6 | )% |
| *% of  total revenue* |       | (0.0                           | )%         | 2.9          | %          |           |       |   |   |
|                       |            |                                |            |              |            |                |            |  |  |  |  |  |  |

 

During the six months ended June 30,2006, we recognized a $2,000 gain related to a miscellaneous adjustment to aprior accrual. During the six months ended June 30, 2005, we recordedrestructuring charges of $362,000, of which $208,000 related to lease costs associated with facilitieslocated in California that are no longer required to support production,$98,000 related to the closure of ourJapan office, and $56,000 related to the reduction in our China workforce we effected in March 2005.

 

***InterestIncome, net***

*** ***
| ** **            | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                              | 111        |         | $          | 131            |       | $ | (20 | ) | (15.3 | )% |
| *% of  total revenue* |       | 1.1                            | %          | 2.2          | %          |           |       |   |   |
|                       |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Interest income, net decreased $20,000 to $111,000for the three months ended June 30, 2006 from $131,000 for the threemonths ended June 30, 2005 as a result of higher interest rates earned onour investments, partially offset by higher interest rates on our debt, whichwe have continued to pay down. We also had lower cash balances.

*** ***
| ** **            | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **            | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                              | 239        |         | $          | 250            |       | $ | (11 | ) | (4.4 | )% |
| *% of  total revenue* |       | 1.3                            | %          | 2.0          | %          |           |       |   |   |
|                       |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Interest income, net decreased $11,000 to $239,000for the six months ended June 30, 2006 from $250,000 for the six monthsended June 30, 2005 as a result of higher interest rates earned on our investments,partially offset by higher interest rates on our debt, which we have continuedto pay down. We also had lower cash balances.

 

26

----

 

***Other Income andExpense, net***

*** ***
| ** **                 | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                 | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense) net |       | $                              | 814        |         | $          | (196           | )          | $ | 1,010 |   | 515.3 | % |
| *% of  total revenue*      |       | 7.9                            | %          | (3.2         | )%         |           |       |   |   |
|                            |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Other income was $814,000 for the three months ended June 30, 2006due to a realized gain of $1.1 million on the sale of investments, partiallyoffset by minority interests in our joint ventures. Other expense was $196,000for the three months ended June 30, 2005 primarily due to foreign exchangelosses related to the Japanese yen and minority interests in our jointventures.

*** ***
| ** **                 | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                 | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense) net |       | $                              | 1,052      |         | $          | (301           | )          | $ | 1,353 |   | 449.5 | % |
| *% of  total revenue*      |       | 5.6                            | %          | (2.4         | )%         |           |       |   |   |
|                            |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

Other income was $1.1 million for the six months ended June 30,2006 due to a realized gain of $1.4 million on the sale of investments,partially offset by minority interests in our joint ventures. Other expense was$301,000 for the six months ended June 30, 2005 primarily due to foreignexchange losses related to the Japanese yen and minority interests in our jointventures.

 

***Provisionfor Income Taxes***

*** ***
| ** **                 | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                 | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                              | 138        |         | $          | 18             |       | $ | 120 |   | 666.7 | % |
| *% of  total revenue*      |       | 1.3                            | %          | 0.3          | %          |           |       |   |   |
|                            |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

We provided for income taxes of $138,000 for our overseas businessesfor the three months ended June 30, 2006 compared to $18,000 for the threemonths ended June 30, 2005. The reason for the increase was a combinationof higher income from processing fees in our overseas subsidiary at higher taxrates.

 
| ** **                 | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                 | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                              | 456        |         | $          | 53             |       | $ | 403 |   | 760.4 | % |
| *% of  total revenue*      |       | 2.4                            | %          | 0.4          | %          |           |       |   |   |
|                            |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

We provided for income taxes of $456,000 for our overseas businessesfor the six months ended June 30, 2006 compared to $53,000 for the sixmonths ended June 30, 2005. The reason for the increase was a combinationof higher income from processing fees in our overseas subsidiary at higher taxrates.

 

27

----

 

***Gain from DiscontinuedOperations***

*** ***
| ** **                        | ** ** | **Three Months Ended**         | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                        | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                              | 2          |         | $          | 53             |       | $ | (51 | ) | (96.2 | )% |
| *% of  total revenue*             |       | 0.0                            | %          | 0.9          | %          |           |       |   |   |
|                                   |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

For the three months ended June 30, 2006, the $2,000 was interestincome on cash balances held in the discontinued operations. For the threemonths ended June 30, 2005, we received net proceeds of approximately $1.3million from the sale of a building located in Monterey Park, California onwhich we recorded a gain of $53,000.

 

***Gain from DiscontinuedOperations***

*** ***
| ** **                        | ** ** | **Six Months Ended**           | ** ** | ** **   | ** ** | ** **     | ** ** |
|-----------------------------------|------------|--------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | ** **     | ** ** |
| ** **                        | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **($ in thousands)** | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                              | 3          |         | $          | 411            |       | $ | (408 | ) | (99.3 | )% |
| *% of  total revenue*             |       | 0.0                            | %          | 3.2          | %          |           |       |   |   |
|                                   |            |                                |            |              |            |                |            |  |  |  |  |  |

*** ***

For the six months ended June 30, 2006, the $3,000 was interestincome on cash balances held in the discontinued operations. For the six monthsended June 30, 2005, the $411,000 gain from discontinued operations ismade up of a gain of $300,000, which was the remaining portion of the first$750,000 held in escrow due to us from the sale of our discontinued operations,$58,000 relating to property tax refunds, and a gain of $53,000 from the saleof a building located in Monterey Park, California.

 

**Liquidity and Capital Resources**

 

As of June 30, 2006, our principal sources of liquidity were $17.3million in cash and cash equivalents and short-term investments, excludingrestricted deposits. We consider cash and cash equivalents and short-terminvestments as liquid and available for use. Short-term investments arecomprised of government bonds and high-grade commercial debt instruments. Alsoincluded in short-term investments is our investment in common stock of FinisarCorporation.

 

Cash and cash equivalents and short-term investments decreased $5.8million to $17.3 millionas of June 30, 2006 from $23.0 million as of December 31, 2005. Reducingthe amount of this decrease was the additional cash of $1.8 million from oursale of 400,000 shares of Finisar common stock in the six months ended June 30,2006. We plan to sell additional Finisar stock during the remainder of 2006.

 

Net cash used in operating activities of $6.7 million for the sixmonths ended June 30, 2006 was comprised primarily of our net loss of $3.1million, adjusted for non-cash items of depreciation of $1.8 million, and stock-basedcompensation of $0.4 million, a realized gain on sale of investments of $1.4million, and by a net increase of $4.5 million in assets and liabilities. Thenet increase in assets and liabilities resulted from a $2.2 million increase inaccounts receivable, net, a $1.8 million increase in prepaid expenses, mainlyforeign taxes, a $1.0 million decrease in accrued liabilities, primarily forrestructuring costs and decommissioning expenses, and partially offset by a $0.4 milliondecrease in accounts payable and decreases in other long term liabilities and incometaxes.

 

Net accounts receivable increased by $2.2 million, or 42.2%, to $7.4million as of June 30, 2006 from $5.2 million as of December 31, 2005.The increase was primarily a result of our increased sales. Our days salesoutstanding was 65 days as of June 30, 2006 compared to 62 days as of December 31,2005.

 

Net cash provided by investing activities of $0.3 million for the sixmonths ended June 30, 2006 was primarily from the net proceeds from sale ofinvestments of $1.3 million and the decrease of restricted cash of $0.2 million,partially offset by the purchase of property, plant and equipment, net, of $1.2million.

 

We expect to invest approximately $2.0 million in capital projects duringthe remainder of 2006. We believe that our existing and planned facilities andequipment are sufficient to fulfill current and expected future orders.

 

Net cash used in financing activities for the six months ended June 30,2006 consisted of payments of $0.3

 

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million relatedto long-term borrowings, partially offset by proceeds of $0.3 million receivedon exercise of stock options through our stock option program.

 

Our main Fremont, California manufacturing facility is financed bylong-term borrowings, which were refinanced by taxable variable rate revenuebonds in 1998. These bonds mature in 2023 and bear interest at a variable ratethat was 5.11% as of June 30, 2006. The bonds are traded in the publicmarket. Repayment of principal and interest under the bonds is supported by aletter of credit from our bank and is paid on a quarterly basis. We have theoption to redeem the bonds in whole or in part during their term. As of June 30,2006, $7.3 million was outstanding under these bonds.

 

As of June 30, 2006, the credit facility maintained by us with a bank included aletter of credit supporting repayment of our revenue bonds with an outstandingamount of $7.3 million. We have pledged and placed a like amount of investmentsecurities with an affiliate of the bank as additional collateral for thisfacility.

 

We believe that we have adequate cash and investments to meet our needsover the next twelve months. In June 2006, we filed a Form S-3 shelfregistration with the Securities and Exchange Commission, which was declaredeffective by the SEC in August 2006. Under the shelf registration process,we may offer shares of our common stock with a total value of up to $25.0million. Given our anticipated revenue increase and overall business outlook, theshelf registration statement provides us with flexibility to fund workingcapital, including future capital expenditures, research and development, andpotential investments or acquisitions in complementary businesses, products andtechnologies. However, we have no specific agreements, commitments orunderstandings with respect to any transactions at this time. There can be noassurance that such additional capital will be available or, if available itwill be at terms acceptable to us.

 

Cash from operations could be affected by various risks anduncertainties, including, but not limited to those set forth below under Item1A “Risk Factors.”

 

Outstanding contractual obligations as of June 30, 2006 aresummarized as follows (in thousands):

 
| ** **                  | ** ** | **Payments Due by Period** | ** ** |
|-----------------------------|------------|----------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                  | ** ** | **Less Than  1 year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More Than  5 years** | ** ** |
| Long-term  debt             |       | $                          | 7,402      |   | $ | 450 |   | $ | 1,002 |   | $ | 900 |   | $ | 5,050 |   |
| Operating  leases           |       | 4,914                      |       | 682 |   | 1,378 |   | 1,508 |   | 1,346 |   |
| Total                       |       | $                          | 12,316     |   | $ | 1,132 |   | $ | 2,380 |   | $ | 2,408 |   | $ | 6,396 |   |

 

We lease certain office space, manufacturing facilities and propertyunder long-term operating leases expiring at various dates through March 2013.Total rent payments under these operating leases were approximately $0.6million and $0.4 million for the six months ended June 30, 2006 and 2005,respectively.

 

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**RecentAccounting Pronouncements**

 

In February 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155 (“SFAS155”), “*Accounting for Certain Hybrid Instruments – anamendment of FASB Statements No. 133 and 140”.* SFAS 155 amendsSFAS No. 133, “Accounting for derivative Instruments and HedgingActivities” (“SFAS 133”) and SFAS No. 140, “*Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*” (“SFAS 140”). SFAS 155 gives entities the option ofapplying fair value accounting to certain hybrid financial instruments in theirentirety if they contain embedded derivatives that would otherwise requirebifurcation under SFAS 133. SFAS 155 will be effective for us as of January 1,2007. We are currently assessing the impact that SFAS 155 may have on ourconsolidated financial position, results of operations and cash flows.

 

In June 2006, theFASB issued FASB Interpretation No. 48 *“Accounting For UncertainTax Positions – An Interpretation of FASB Statement No. 109”* (“FIN48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109 “Accounting for Income Taxes”. It prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. FIN 48 iseffective for fiscal years beginning after December 15, 2006. We are currentlyassessing the impact of the adoption that FIN 48 may have on our consolidatedfinancial position, results of operations or cash flows.

 

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

 

**Foreign Currency Exchange Rate Exposure**

 

We operate in the United States, manufacture inChina, and the substantial majority of our sales to date have been made andcontinue to be made in U.S. dollars. Substantially all of our expenses from ourChina operations are incurred in the Chinese Renminbi. As a result, currencyfluctuations between the U.S. dollar and the Chinese Renminbi could causeforeign currency transaction gains or losses that we would recognize in theperiod incurred.

 

In July 2005, China uncoupled the Renminbi from the U.S. dollar andbegan to let it float in a narrow band against a basket of foreign currencies.The move revalued the Renminbi by 2.1% against the U.S. dollar; however, it isuncertain what further adjustments will follow. Since the Renminbi-U.S. dollarexchange rate floats, the Renminbi could appreciate relative to the U.S. dollar.

 

We expect our international revenue and expenses to continue to bedenominated largely in U.S. dollars. We also believe that our China operationswill likely expand in the future as our business continues to grow. As aresult, we anticipate that we may experience increased exposure to therisks of fluctuating currencies and may choose to engage in currencyhedging activities to reduce these risks. However, we cannot be certain thatany such hedging activities will be effective, or available to us at commerciallyreasonable rates.

 

**InterestRate Risk**

 

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

 
| **Instrument**                  | ** ** | **Balance as of  June 30, 2006** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Pro Forma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Pro Forma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| Cash                            |       | $                                               | 7,584      |                        | 0.50       | %                                                | $          | 38                                                               |       | $                                                                 | 34         |   | $ | 42 |   |
| Cash  equivalents               |       | 3,469                                           |       | 4.83                        |       | 168                                              |       | 151                                                              |       | 184                                                               |       |
| Investment  in debt instruments |       | 11,745                                          |       | 4.64                        |       | 545                                              |       | 490                                                              |       | 599                                                               |       |
| Long-term  debt                 |       | (7,300                                          | )          | 5.44                        |       | (397                                             | )          | (357                                                             | )          | (437                                                              | )          |
|                            |       |                                            |       |                        |       | $                                                | 354        |                                                             | $          | 318                                                               |       | $ | 388 |   |
|                                 |            |                                                 |            |                             |            |                                                  |            |                                                                  |            |                                                                   |            |  |  |  |  |

 

**EquityRisk**

 

We maintain minority investments in private and publicly tradedcompanies. These investments are reviewed for other than temporary declines invalue on a quarterly basis. Reasons for other than temporary declines in valueinclude whether the related company would have insufficient cash flow tooperate for the next twelve months, significant changes in the operatingperformance and changes in market conditions. For the six months ended June 30,2006, we recorded a $0.9 million unrealized gain in other comprehensive income towrite up our investment in one public U.S. company. As of June 30, 2006,the minority investments we continue to hold amounted to $4.4 million.

 

**ITEM 4*.*CONTROLSAND PROCEDURES**

 

(a) Underthe supervision and with the participation of our management, our ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended. Based upon thatevaluation, our Chief Executive Officer and our Chief Financial Officerconcluded that the our disclosure controls and procedures were effective as ofthe end of the period covered by this quarterly report.

 

(b) Nochange in our internal control over financial reporting was made during thequarter ended June 30, 2006, that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II OTHERINFORMATION**

 

**Item 1. Legal Proceedings**

 

From time to time we may be involved in judicial or administrativeproceedings concerning matters arising in the ordinary course of business. Wedo not expect that any of these matters, individually or in the aggregate, willhave a material adverse effect on our business, financial condition, cash flowsor results of operation.

 

On October 15, 2004, a purported securities class action lawsuit wasfiled in the United States Court for the Northern District of California, Cityof Harper Woods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362MJJ. The Court consolidated the case with a subsequent related case andappointed a lead plaintiff. On April 5, 2005, the lead plaintiff filed aconsolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362MJJ. The lawsuit complaint names AXT, Inc. and our chief technology officer asdefendants, and is brought on behalf of a class of all purchasers of oursecurities from February 6, 2001 through April 27, 2004. The complaint allegesthat we announced financial results during this period that were false andmisleading. No specific amount of damages is claimed. On September 23, 2005,the Court granted our motion to dismiss the complaint, with leave to amend. Thelead plaintiff filed an amended complaint, which we have moved to dismiss. Webelieve that there are meritorious defenses against this litigation and intendto vigorously defend it. Due to the inherent uncertainties of litigation, wecannot accurately predict the ultimate outcome of the litigation. Anyunfavorable outcome of the litigation could have an adverse impact on ourbusiness, financial condition and results of operations.

 

On June 1, 2005, a lawsuit was filed in the Superior Court of California,County of Alameda, Zhao et al. v. American Xtal Technology, et al., No. R605215713. The lawsuit complaint names as defendants AXT, its chief technologyofficer, its former interim chief executive officer, a former safety departmentemployee and a supplier to AXT. The lawsuit is brought on behalf of two formeremployees and their minor child. The complaint alleges personal injury, generalnegligence, intentional tort, wage loss and other damages, including punitivedamages, as a result of exposure of the child while in utero to high levels ofgallium arsenide and methanol used in the production of gallium arsenidewafers. We believe that there are meritorious defenses against this litigationand intend to vigorously defend it. AXT’s commercial general liabilityinsurance carrier has agreed to fund AXT’s defense of the case, but hasreserved the right to deny coverage, in whole or in part, in the future underselected policy provisions and applicable law. There is $21 million inavailable limits under the policies in question. The plaintiffs have made aninitial settlement demand within our insurance limits. Due to the inherentuncertainties of litigation, we cannot accurately predict the ultimate outcomeof the litigation. Any unfavorable outcome of the litigation could have anadverse impact on our business, financial condition and results of operations.

 

**Item 1A. Risk Factors**

 

We operate in a rapidlychanging environment that involves many risks, some of which are beyond ourcontrol. The following is a discussion that highlights some of these risks,which are substantially the same as included in our Annual Report on Form 10-Kfor the year ended December 31, 2005. Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also impair ourbusiness, operations or financial results.

 

**RisksRelated to Our Business**

** **

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

*** ***

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

 

Furthermore,some customers reduced their orders from us until our surface quality is asgood and consistent as that offered by competitors. As a result, some customersallocated their requirements for compound semiconductor substrates across morecompetitors and although our quality is improving, resulting in increasedsales, we believe that as a result of

 

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thesecustomer decisions, we have lost revenue and market share, that we may beunable to recover. If we are unable to recover and retain our market share, we may beunable to grow our business.

 

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

*** ***

Ourproducts are complex and may contain defects. We have experienced qualitycontrol problems with many of our products, which caused customers to returnproducts to us, reduce orders for our products, or both. Although our qualityhas improved, resulting in some increases in product sales, we believe that wecontinue to experience some reduction in orders as a result of our priorproduct quality problems. If we continue to experience quality controlproblems, or experience these or other problems in new products, customers may cancelor reduce orders or purchase products from our competitors, we may beunable to maintain or increase sales to our customers and sales of our productscould decline. Defects in our products could cause us to incur highermanufacturing costs and suffer product returns and additional service expenses,all of which could adversely impact our operating results.

 

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

 

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

*** ***

Therequirements adopted by the Securities and Exchange Commission, or SEC, inresponse to the passage of the Sarbanes-Oxley Act of 2002, will require annualreview and evaluation of our internal control systems, and an attestation ofthese systems by our independent registered public accounting firm beginningwith our fiscal year ending December 31, 2007. We are currently reviewingour internal control procedures and considering further documentation of theseprocedures that may be necessary. We are currently evaluating the extentto which any of our joint ventures may also be required to comply, if atall. We can give no assurances that our systems will satisfy these requirementsof the SEC or, if required, that any of the systems of our joint ventures willmeet these requirements, or that we will receive a favorable review andattestation by our independent registered public accounting firm.

 

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

 

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

 

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

*** ***

We are subjectto federal, state and local environmental and safety laws and regulations inall of our operating locations, including laws and regulations of China, suchas laws and regulations related to the development, manufacture and use of ourproducts, the operation of our facilities, and the use of our real property.These laws and regulations govern the use, storage, discharge and disposalof hazardous chemicals during manufacturing, research and development, andsales demonstrations. If we fail to comply with applicable regulations, wecould be subject to substantial liability for clean-up efforts, personal injuryand fines or suspension or be forced to cease our operations, and/or suspend orterminate the development, manufacture or use of certain of our products, the useof our facilities, or the use of our real property, each of which could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

InMarch 2001, we settled a claim made by the California Occupational Safetyand Health Administration, or Cal-OSHA, in an investigation primarily regardingimpermissible levels of potentially hazardous materials in certain areas of ourmanufacturing facility in Fremont, California for $200,415, and during 2004 wewere the target of press allegations and correspondence purportedly on behalfof current and/or former employees concerning our environmental complianceprograms and exposure of our employees to hazardous materials. In June 2005,a complaint was filed against us and a current and former officer, allegingpersonal injury, general negligence, intentional tort, wage loss and otherdamages,

 

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includingpunitive damages, as a result of exposure of plaintiffs, who are formeremployees of AXT, including a minor child in utero, to high levels of galliumarsenide in gallium arsenide wafers, and methanol. There is a possibility thatother current and/or former employees may bring additional litigationagainst us. Although we have put in place engineering, administrative andpersonnel protective equipment programs to address these issues, our ability toexpand or continue to operate our present locations could be restricted or wecould be required to acquire costly remediation equipment or incur othersignificant expenses. Existing or future changes in laws or regulations in theUnited States and China may require us to incur significant expendituresor liabilities, or may restrict our operations. In addition, our employeescould be exposed to chemicals or other hazardous materials at our facilitiesand we may be subject to lawsuits seeking damages for wrongful death orpersonal injuries allegedly caused by exposure to chemicals or hazardousmaterials at our facilities.

 

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

 

***Existingor future litigation could result in significant judgments against us, or causeus to incur costly settlements.***

*** ***

***In June 2005, a complaint was filedagainst us and a current and former officer, alleging personal injury, generalnegligence, intentional tort, wage loss and other damages, including punitivedamages, as a result of exposure of plaintiffs, who are former employees ofAXT, including a minor child in utero, to high levels of gallium arsenide ingallium arsenide wafers, and methanol. In addition, we are defendants in anongoing securities litigation matter. Litigation is inherently uncertain andwhile we would expect to defend ourselves vigorously, it is possible that ourbusiness, financial condition, results of operations or cash flows could beaffected in any particular period by litigation now pending and any additionallitigation brought against us. In addition, response to this litigation coulddivert management’s attention from our business and operations, causing ourbusiness and financial results to suffer. We could incur defense or settlementcosts in excess of the insurance covering these litigation matters, or thatcould result in significant judgments against us or cause us to incur costlysettlements, in excess of our insurance limits.***

*** ***

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

*** ***

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

 

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

*** ***

Asmall number of substrate customers have historically accounted for asubstantial portion of our total revenue. Our top five customers represented 38.5%,and 39.8% of revenue for the six months ended June 30, 2006 and 2005,respectively. We expect that a significant portion of our future revenue willcontinue to be derived from a limited number of substrate customers. Ourcustomers are not obligated to purchase a specified quantity of our products orto provide us with binding forecasts of product purchases. In addition, ourcustomers may reduce, delay or cancel orders at any time without anysignificant penalty. During the past year, we have experienced slower bookings,significant push-outs and cancellation of orders from some customers. If welose a major customer or if a customer cancels, reduces or delays orders, ourrevenue would decline. In addition, customers that have accounted forsignificant revenue in the past may not continue to generate revenue forus in any future period. Any delay in scheduled shipments of our products couldcause revenue to fall below our expectations and the expectations of marketanalysts or investors, causing our stock price to decline.

 

***Wemay incur claims or other liabilities or obligations related to ourfailure to follow requirements for testing of products and provision of testingdata and information relating to customer requirements. Additionally, customersmay cancel or reduce future shipments in response to these failures, orrequire re-qualifications.***

*** ***

Duringthe first quarter of 2004, we determined that we had not followed requirementsfor testing of products and provision of testing data and information relatingto customer requirements. We notified affected customers concerning ourfindings; however, there can be no assurance that we will not incur customerclaims or other liabilities or obligations in connection with this matter. Inaddition, revenue in future periods may be adversely impacted if customersdecide not to order from us as a

 

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resultof this disclosure. We experienced several cancellations of future orders bycustomers pending further information regarding enhancements to our producttesting and quality control systems. In addition, some customers are requiringadditional qualification of our China operations before placing future orderswith us. We cannot be sure that we will not receive additional cancellations oforders by other customers, or fail to win expected future orders fromcustomers, as a result of our disclosure of our investigation conclusions, or thatour customers will qualify our China operations and place future orders withus.

 

***Problemsincurred by our joint ventures or venture partners could result in a materialadverse impact on our financial condition or results of operations***

*** ***

Wehave invested in five joint venture operations in China that produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium,germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. Wepurchase a portion of the materials produced by these ventures for our use andsell the remainder of their production to third parties. Our ownership interestin these entities ranges from 25% to 83%. We consolidate the three ventures inwhich we own a majority or controlling financial interest and employ equityaccounting for the two joint ventures in which we have a 25% interest. Severalof these ventures occupy space within larger facilities owned and/or operatedby one of the other venture partners. Several of these venture partners areengaged in other manufacturing activities at or near the same facility. In somefacilities, we share access to certain functions, including water, hazardouswaste treatment or air quality treatment. If any of our joint venture partnersin any of these five ventures experiences problems with its operations,disruptions of our joint venture operations could result, having a materialadverse effect on the financial condition and results of operation of our jointventures, and correspondingly on our financial condition or results ofoperations.

 

Inaddition, if any of our joint ventures or venture partners with which our jointventures share facilities is deemed to have violated applicable laws, rules orregulations governing the use, storage, discharge or disposal of hazardouschemicals during manufacturing, research and development, or salesdemonstrations, the operations of our joint ventures could be adverselyaffected and we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our joint ventureoperations as a result of the actions of the joint ventures or other venturepartners. Employees working for our joint ventures or any of the other venturepartners could bring litigation against us as a result of actions taken at thejoint venture or venture partner facilities, even though we are not directlycontrolling the operations, including actions for exposure to chemicals orother hazardous materials at the facilities of our joint ventures or thefacilities of any venture partner that are shared by our joint ventures. Iflitigation is brought against us, litigation is inherently uncertain and, whilewe would expect to defend ourselves vigorously, it is possible that ourbusiness, financial condition, results of operations or cash flows could beaffected in any particular period by any litigation if brought against us,particularly if litigation with us, as a non-Chinese company, is deemedadvantageous. Even if we are not deemed responsible for the actions of thejoint ventures or venture partners, litigation could be costly, time consumingto defend and divert management attention; in addition, pursuit of us couldoccur if we are deemed to be the most financially viable of the partners.

 

Goingforward, we believe that investing in additional joint ventures will beimportant to remaining competitive in our marketplace and ensuring a supply ofcritical raw materials. However, we may not be able to identifycomplementary joint venture opportunities or, even once opportunities areidentified, we may not be able to reach agreement on the terms of theventure with the other venture partners. Additional joint ventures could causeus to incur contingent liabilities or other expenses, any of which could adverselyaffect our financial condition and operating results.

 

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

 

•        difficultiesin managing geographically disparate operations;

 

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

 

•        unexpectedchanges in regulatory requirements that may limit our ability to exportthe venture products or sell into particular jurisdictions or impose multipleconflicting tax laws and regulations;

 

•        politicaland economic instability, civil unrest or war;

 

•        terroristactivities that impact international commerce;

 

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

 

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

 

•        nationalizationof foreign-owned assets, including intellectual property.

 

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

*** ***

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

 

***Thecompound semiconductor industry is cyclical and has experienced a downturnwhich has adversely impacted our operating results.***

*** ***

Ourcontinuing business depends in significant part upon manufacturers ofelectronic and opto-electronic compound semiconductor devices, as well as thecurrent and anticipated market demand for these devices and products using thesedevices. As a supplier to the compound semiconductor industry, we are subjectto the business cycles that characterize the industry. The timing, length andvolatility of these cycles are difficult to predict. The compound semiconductorindustry has historically been cyclical because of sudden changes in demand,the amount of manufacturing capacity and changes in the technology employed in compoundsemiconductors. The rate of changes in demand, including end demand, is high,and the effect of these changes upon us occurs quickly, exacerbating thevolatility of these cycles. These changes have affected the timing and amountsof customers’ purchases and investments in new technology. These industrycycles create pressure on our revenue, gross margin and net income (loss).

 

Theindustry has in the past experienced periods of oversupply that result insignificantly reduced demand and prices for compound semiconductor devices andcomponents, including our products, both as a result of general economicchanges and overcapacity. When these periods occur and our operating resultsand financial condition are adversely affected, oversupply creates pressure onour revenue, gross margins and net income (loss). Inventory buildups intelecommunications products and slower than expected sales of computerequipment resulted in overcapacity and led to reduced sales by our customers,and therefore reduced purchases of our products. During periods of weak demandsuch as those experienced historically, customers typically reduce purchases,delay delivery of products and/or cancel orders of component parts such as ourproducts.

 

Increasedprice competition has resulted, causing pressure on our net sales, gross marginand net income (loss). We experienced cancellations, price reductions, delaysand push-outs of orders, which have resulted in reduced revenues. If theeconomic downturn occurred again, further order cancellations, reductions inorder size or delays in orders could occur and would materially adverselyaffect our business and results of operations. Actions to reduce our costs,such as those we have recently taken, may be insufficient to align ourstructure with prevailing business conditions. We may be required toundertake additional cost-cutting measures, and may be unable to invest inmarketing, research and development and engineering at the levels we believeare necessary to maintain our competitive position. Our failure to make theseinvestments could seriously harm our business.

 

Duringperiods of increasing demand for compound semiconductor devices, we must havesufficient manufacturing capacity and inventory to meet customer demand, andmust be able to attract, hire, train and retain qualified employees to meetdemand. If we are unable to effectively manage our resources and productioncapacity during an industry upturn, there could be a material adverse effect onour business, financial condition and results of operations.

 

***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 goodseffectively to meet changing customer requirements, while keeping inventorycosts down and improving gross margins. Some of our

 

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products and supplies have in the past and may inthe 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 acharge for a reduction in inventory values. We have in the past, includingduring 2004, had to take inventory valuation and impairment charges. Anyfuture unexpected changes in demand or increases in costs ofproduction that cause us to take additional charges for un-saleable,obsolete or excess inventory, or to reduce inventory values, could adverselyaffect our results of operations.

 

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

*** ***

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

 

***Ifwe have low product yields, or if there is a deliberate sabotage of ourproducts, the shipment of our products may be delayed and our operatingresults may be adversely impacted.***

*** ***

Ourproducts are manufactured using complex technologies, and the number of usablesubstrates we 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.

 

Ifour yields decrease, our revenue could decline if we are unable to produceneeded product on time. At the same time, our manufacturing costs could remainfixed, or could 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 may experiencesimilar problems in the future and we cannot predict when they may occuror their severity. In particular, many of our manufacturing processes are newand are still being refined, which can result in lower yields.

 

Ifthere is deliberate sabotage of our products making it unfit for use by ourcustomers, our products would be rejected, resulting in compensation costs paidto our customers, and possible disqualification. This could lead to revenueloss and market share loss.

 

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

*** ***

Oursuccess depends on our ability to offer new products and product features thatincorporate leading technology and respond to technological advances. Inaddition, our new products must meet customer needs and compete effectively onquality, price and performance. The life cycles of our products are difficultto predict because the markets for our products are characterized by rapidtechnological change, changing customer needs and evolving industry standards.If our competitors introduce products employing new technologies or performancecharacteristics, our existing products could become obsolete and unmarketable.During the past three years, we have seen our competitors selling moresubstrates manufactured using a crystal growth technology similar to ours,which has eroded our technological differentiation. Other companies, includingTriquent, are actively developing substrate materials that could be used tomanufacture devices that could provide the same high-performance, low-powercapabilities as GaAs- and InP-based

 

37

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devicesat competitive prices. If these substrate materials or VGF-derived products aresuccessfully developed and semiconductor device manufacturers adopt them,demand for our GaAs substrates could decline and our revenue could suffer.

 

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

 

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

*** ***

Themarkets for our products are intensely competitive. We face competition for oursubstrate products from other manufacturers of substrates, such as FreibergerCompound Materials, Hitachi Cable, and Sumitomo Electric, from semiconductordevice manufacturers that produce substrates for their own use, and fromcompanies, such as Triquent, that are actively developing alternative materialsto GaAs and marketing semiconductor devices using these alternative materials.We believe that at least two of our major competitors are shipping high volumesof GaAs substrates manufactured using a technique similar to our VGF technique.Other competitors may develop and begin using similar technology. If weare unable to compete effectively, our revenue may not increase and we may beunable to become profitable. We face many competitors that have a number of significantadvantages over us, including:

 

•              greaterexperience in the business;

 

•              moremanufacturing experience;

 

•              extensiveintellectual property;

 

•              broader namerecognition; and

 

•              significantlygreater financial, technical and marketing resources.

 

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

 

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

 

Inaddition, new competitors have and may continue to emerge, such as a smallcrystal growing company in China, supplying ingots to the market established bya former employee of ours. While new competitors such as this company currentlydo not appear to be fully competitive, competition from sources such as thiscould increase, particularly if such competitors are able to obtain largecapital investments.

 

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

*** ***

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

 

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

 

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

 

***Thefinancial condition of our customers may affect their ability to payamounts owed to us.***

*** ***

Manyof our customers are facing business downturns that have reduced their cashbalances and their prospects. We frequently allow our customers to pay forproducts we ship to them within 30 to 120 days after delivery. Subsequent toour shipping a product, some customers have been unable to make payments asdue, reducing our cash balances and causing us to incur charges to allow for apossibility that some accounts might not be paid. During 2004, one customerfiled for bankruptcy protection. We incurred a charge equal to the amount owedus and believe that there is a substantial likelihood that we will not be ableto recoup any of this amount. Other customers may also be forced to filefor bankruptcy. If our customers do not pay their accounts when due, we will berequired to incur charges that would reduce our earnings.

 

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

*** ***

Wedepend on a limited number of suppliers for certain raw materials, componentsand equipment used in manufacturing our products, including key materials suchas quartz tubing, polishing solutions and paralytic boron nitride. Althoughseveral of these raw materials are purchased from suppliers in which we hold anownership interest, we generally purchase these materials through standardpurchase orders and not pursuant to long-term supply contracts and no supplierguarantees supply of raw materials or equipment to us. Although the risk issignificantly diminished as a result of our investment in our new materialjoint ventures, if we lose any of our key suppliers, our manufacturing effortscould be significantly hampered and we could be prevented from timely producingand delivering products to our customers. Prior to investing in our rawmaterial joint ventures, we sometimes experienced delays obtaining critical rawmaterials and spare parts, including gallium, due to shortages of thesematerials and could experience such delays again in the future due toshortages of materials and may be unable to obtain an adequate supply ofmaterials. These shortages and delays could result in higher materials costsand cause us to delay or reduce production of our products. If we have to delayor reduce production, we could fail to meet customer delivery schedules and ourrevenue and operating results could suffer.

 

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

*** ***

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

 

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

*** ***

Customerstypically place orders with us for our substrate products three months to ayear or more after our initial contact with them. The sale of our products may besubject to delays due to our customers’ lengthy internal budgeting, approvaland evaluation processes. During this time, we may incur substantialexpenses and expend sales, marketing and management efforts while the customersevaluate our products. These expenditures may not result in sales of ourproducts. If we do not achieve anticipated sales in a period as expected, we may experiencean unplanned shortfall in our revenue. As a result, we may not be able tocover expenses, causing our operating results to vary. In addition, if acustomer decides 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 forecast our future sales accurately. 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 cycles of our current substrate products.

 

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

 

39

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

 

Despiteour efforts to protect our intellectual property, third parties can developproducts or processes similar to ours. Our means of protecting our proprietaryrights may not be adequate, and our competitors may independentlydevelop similar technology, duplicate our products or design around ourpatents. We believe that at least two of our competitors have begun to shipGaAs substrates produced using a process similar to our VGF technique. Ourcompetitors may also develop and patent improvements to the VGF technologyupon which we rely, and thus may limit any exclusivity we enjoy by virtueof our patents or trade secrets.

 

Itis possible that pending or future United States or foreign patent applicationsmade by us will not be approved, that our issued patents will not protect ourintellectual property, or that third parties will challenge the ownershiprights or the validity of our patents. In addition, the laws of some foreigncountries may not protect our proprietary rights to as great an extent asdo the laws of the United States and it may be more difficult to monitorthe use of our intellectual property. Our competitors may be able tolegitimately ascertain non-patented proprietary technology embedded in oursystems. If this occurs, we may not be able to prevent the development oftechnology substantially similar to ours.

 

Wemay have to resort to costly litigation to enforce our intellectualproperty rights, to protect our trade secrets or know-how or to determine theirscope, validity or enforceability. Enforcing or defending our proprietarytechnology is expensive, could cause us to divert resources and may notprove successful. Our protective measures may prove inadequate to protectour proprietary rights, and if we fail to enforce or protect our rights, wecould lose valuable assets.

 

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

 

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

*** ***

Ourrevenue growth depends in part on the expansion of our international salesand operations. International sales represented 81% and 79% of our totalrevenue for the years ended December 31, 2005 and 2004, respectively, and75% of our total revenue for the six months ended June 30, 2006. We expectthat sales to customers outside the U.S., particularly sales to customers inAsia, will continue to represent a significant portion of our revenue.

 

Currently,an increasing percentage of our sales is to customers headquartered in Asia. Allof our manufacturing facilities and some of our suppliers are also locatedoutside the U.S. Managing our overseas operations presents challenges,including periodic regional economic downturns, trade balance issues, varyingbusiness conditions and demands, political instability, variations inenforcement of intellectual property and contract rights in differentjurisdictions, differences in the ability to develop relationships withsuppliers and other local businesses, changes in U.S. and international lawsand regulations including U.S. export restrictions, fluctuations ininterest and currency exchange rates, the ability to provide sufficient levelsof technical support in different locations, cultural differences, shippingdelays and terrorist acts or acts of war, among other risks. Many of thesechallenges are present in China, which represents a large potential market forsemiconductor devices and where we anticipate significant opportunity forgrowth. Global uncertainties with respect to: (i) economic growth rates invarious countries; (ii) sustainability of demand for electronics products;(iii) capital spending by semiconductor manufacturers; (iv) priceweakness for certain semiconductor devices; and (v) political instabilityin regions where we have operations may also affect our business,financial condition and results of operations.

 

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

 

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

 

•              unexpectedchanges in regulatory requirements;

 

40

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•              longerperiods to collect accounts receivable;

 

•              changes inexport license requirements;

 

•              politicaland economic instability;

 

•              unexpectedchanges in diplomatic and trade relationships; and

 

•              foreignexchange rate fluctuations.

 

Oursales are denominated in U.S. dollars, except for sales to our Japanese andsome Taiwanese customers, which are denominated in Japanese yen. Thus,increases in the value of the U.S. dollar could increase the price of ourproducts in non-U.S. markets and make our products more expensive thancompetitors’ products in these markets.

 

Also, denominating some sales in Japanese yensubjects us to fluctuations in the exchange rates between the U.S. dollar andthe Japanese yen. The functional currency of our Chinese subsidiary and jointventures is the local currency. We incur transaction gains or losses resultingfrom consolidation of expenses incurred in local currencies for these entities,as well as in translation of the assets and liabilities of their 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.

 

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

*** ***

TheChinese government faced a power shortage over the summer of 2004 and reportedthat power demand in 24 provinces outstripped supply in peak periods during January toApril of 2004. Instability in electrical supply caused sporadic outagesamong residential and commercial consumers. As a result, the Chinese governmentimplemented tough measures in 2004 to ease the energy shortage. Provincesimposed power brownouts during 2004 to reduce electricity demand, and some companiesin Beijing were ordered to give their employees a week off to ease the pressureon power supply. Plants, most of which are state-owned, were closed andreopened on a staggered schedule to reduce power consumption during thecapital’s hottest months during 2004. As a result, we closed most of ouroperations for a week in late July 2004 in conformance with thispolicy. If we are required to make temporary closures of our subsidiaryand joint venture operations at any time during 2006, we may be unable tomanufacture our products, and would then be unable to meet customer ordersexcept from inventory on hand. As a result, our revenues could be adverselyimpacted, and our relationships with our customers could suffer, impacting ourability to generate future sales. In addition, if power is shut off at ourBeijing subsidiary at any time, either voluntarily or as a result of unplannedbrownouts, during certain phases of our manufacturing process including ourcrystal growth phase, the work in process may be ruined and renderedunusable, causing us to incur expense that will not be covered by revenue, andnegatively impacting our cost of revenue and gross margins. We are attemptingto partially mitigate the potential effects of power outages by building inventoryin anticipation of power outages during the summer. This inventory buildup isprepared to accommodate forecasted demand rather than specific customer orders.If the inventory we build is not ordered by customers, we may have toscrap these products and incur a cost which will reduce our gross margins.

 

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

*** ***

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

 

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

*** ***

***41***

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*** ***

Weanticipate that our existing cash resources will fund any anticipated operatinglosses and purchases of capital equipment, as well as provide adequate workingcapital for the next twelve months. However, our liquidity is affected by manyfactors including, among others, the extent to which we pursue additionalcapital expenditures, the level of our production, and other factors related tothe uncertainties of the industry and global economies. If we fail to manageour contractions successfully we may draw down our cash reserves, whichwould adversely affect our operating results and financial condition, reduceour value and possibly impinge our ability to raise debt and equity funding inthe future, at a time when we might be required to raise additional cash.Accordingly, there can be no assurance that events in the future will notrequire us to seek additional capital or, if required, that such capital wouldbe available on terms acceptable to us, if at all. As part of our effortto reduce costs, we may lose key staff, production resources andtechnology that we will need to grow when end markets recover. These eventscould reduce our ability to grow profitably as markets recover.

 

***Changesin China’s political, social and economic environment may affect ourfinancial performance.***

*** ***

Ourfinancial performance may be affected by changes in China’s political,social and economic environment. The role of the Chinese central and localgovernments in the Chinese economy is significant. Chinese policies towardeconomic liberalization, and laws and policies affecting technology companies,foreign investment, currency exchange rates and other matters could change,resulting in greater restrictions on our ability to do business and operate 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 governmentalregulations could result in the loss of our ability to manufacture our productsin China.

 

Chinafrom time to time has 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 negatively affect our ability tooperate our facilities in China.

 

***We may face additional risks as a resultof the revaluation of the Chinese currency.***

 

In July 2005, China agreed to a shift inChinese currency policy. It established a 2% revaluation of the renminbi and referenced the renminbi to a basketof currencies, with a daily trading band of +/-0.3%. Depending on market conditions and the state ofthe Chinese economy, it is possible that China will make more adjustments inthe future. Over the next five to ten years, China may move to a managedfloat system, with opportunistic interventions. This reserve diversification may negativelyimpact the United States dollar and U.S. interest rates, which, in turn, could negativelyimpact our operating results and financial condition. The functionalcurrency of our Chinese subsidiary, including our joint ventures, is the localcurrency; since most of our operations are conducted in China, most of ourcosts are incurred in Chinese currency, which subjects us to fluctuations inthe exchange rates between the U.S. dollar and the Chinese renminbi. We incurtransaction gains or losses resulting from consolidation of expenses incurred inlocal currencies for these subsidiaries, as well as in translation of theassets and liabilities of these assets at each balance sheet date. These risks may beincreased by the fluctuation and revaluation of the Chinese renminbi. If we donot effectively manage the risks associated with this currency risk, ourrevenue, cash flows and financial condition could be adversely affected.

 

***Areoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of adifferent contagious disease such as the Avian Flu may adversely impactour manufacturing operations and some of our key suppliers and customers.***

*** ***

Allof our substrate manufacturing activities are conducted in China. In addition,we acquire 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 were reported in 2004. One employee at our LEDproduction 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, such as Avian Flu, and if our employeescontracted the disease, we might be required to temporarily close ourmanufacturing operations. Similarly, if one of our key suppliers is required toclose for an extended period, we might not have enough raw material inventoryto continue manufacturing operations. In addition, while we possess managementskills among our China staff that enable us to maintain our manufacturingoperations with minimal on-site supervision from our US-based staff, ourbusiness could also be harmed if travel to or from Asia and the United Statesis restricted or inadvisable, as it was during parts of 2003. None of oursubstrate competitors is as dependent on manufacturing facilities in China aswe are. If our manufacturing operations were closed for a significant period,we could lose revenue and market share during that period, which would depressour financial performance and could be difficult to recapture. Finally, if oneof our key customers is required to close for an extended period, we might notbe able to ship product to them, our revenue

 

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woulddecline and our financial performance would suffer.

 

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

*** ***

TheUnited States continues to be on alert for terrorist activity. The potentialnear- and long-term impact terrorist activities may have in regards to oursuppliers, customers and markets for our products and the U.S. economy is uncertain.There may be embargos of ports or products, or destruction of shipments orour facilities, or attacks that affect our personnel. There may be otherpotentially adverse effects on our operating results due to a significant eventthat we cannot foresee. Since we perform 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.

 

***Ifany of our facilities is damaged by occurrences such as fire, explosion, ornatural disaster, we might not be able to manufacture our products.***

*** ***

Theongoing operation of our manufacturing and production facilities in China iscritical to our ability to meet demand for our products. If we are not able touse all or a significant portion of our facilities for prolonged periods forany reason, we would not be able to manufacture products for our customers. Forexample, a fire or explosion caused by our use of combustible chemicals andhigh temperatures during our manufacturing processes could render some or allof our facilities inoperable for an indefinite period of time. Actions outsideof our control, such as earthquakes or other natural disasters, could alsodamage our facilities, rendering them inoperable. If we are unable to operateour facilities and manufacture our products, we would lose customers andrevenue and our business would be harmed.

 

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

*** ***

Wehave not been able to sustain growth for any significant period in the lastfive years, and may not be able to return to historic growth levels in thecurrent economic environment. Our net loss in 2002 was the largest in ourhistory and our losses continued during 2003, 2004, 2005, and for each of thequarterly periods in the first half of 2006.

 

Wehave experienced and may continue to experience significant fluctuationsin our revenue and earnings. Our quarterly and annual revenue and operatingresults have varied significantly in the past and may vary significantlyin the future due to a number of factors, including:

 

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

 

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

 

•              fluctuationsin demand for our products;

 

•              expansion ofour manufacturing capacity;

 

•              expansion ofour operations in China;

 

•              limitedavailability and increased cost of raw materials;

 

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

 

•              fluctuationof our manufacturing yields;

 

•              decreases inthe prices of our or our competitors’ products;

 

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

 

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

 

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

 

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

 

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

*** ***

Ourstock price has fluctuated significantly since we began trading on The NASDAQNational Market. For the year ended December 31, 2005, the high and lowclosing sales prices of our common stock were $2.47 and $1.08, respectively,and for the six months ended June 30, 2006, the high and low closing salesprices of our common stock were $4.47 and $1.98, respectively. A number offactors could cause the price of our common stock to continue to fluctuatesubstantially, including:

 

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

 

•              changes inexpectations about our future financial performance or changes in financialestimates of any securities analysts who follow our stock;

 

•              litigation,regulatory developments, or sales of large blocks of stock;

 

•              announcementsof technological innovations by us or our competitors;

 

•              new productintroductions by us or our competitors;

 

•              largecustomer orders or order cancellations, delays or push-outs; and

 

•              theoperating and stock price performance of comparable companies.

 

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

 

***Wehave adopted certain anti-takeover measures that may make it moredifficult for a third party to acquire us.***

*** ***

Ourboard of directors has the authority to issue up to 2,000,000 shares ofpreferred stock and to determine the price, rights, preferences and privilegesof those shares without any further vote or action by the stockholders. Therights of the holders of common stock will be subject to, and may beadversely affected by, the rights of the holders of any preferred stock that may beissued in the future. The issuance of shares of preferred stock could have theeffect of making it more difficult for a third party to acquire a majority ofour outstanding voting stock. We have no present intention to issue additional sharesof preferred stock.

 

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

 

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

 

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

 

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

 

•              the abilityof our board to alter our amended and restated bylaws;

 

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

 

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

 

Furthermore,because we are incorporated in Delaware, we are subject to the provisions of Section 203of the Delaware General Corporation Law. These provisions prohibit largestockholders, in particular those owning 15% or more of the outstanding votingstock, from consummating a merger or combination with a corporation unless:

 

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

 

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

 

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

 

None

 

**Item 3. Defaults uponSenior Securities**

 

None

 

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

 

AXT held its annual meeting of stockholders at its headquarters inFremont, California on May 23, 2006. Of the 23,053,521 shares outstandingas of the record date, 21,481,946 shares were represented in person or by proxyat the meeting. Proxies were solicited by the Company pursuant to Regulation14A under the Securities Exchange Act of 1934, as amended. At the meeting, AXT’sstockholders voted on the following matters:

 

(1)               Proposal to elect two class IIdirectors to hold office for a three-year term, and until their respectivesuccessors are elected and qualified.

 
| **Class II directors** | ** ** | **For**    | ** ** | **Against** | ** ** |
|-----------------------------|------------|------------|------------|-------------|------------|
| Jesse Chen                  |       | 15,793,403 |       | 5,688,543   |       |
| Philip C.S. Yin             |       | 19,218,304 |       | 2,263,642   |       |

 

In addition, the term of office as directors of Dr. Morris Young, Mr.Leonard Le Blanc and Dr. David Chang continued after the meeting.

 

(2)               Proposal to ratify the appointment ofBurr, Pilger & Mayer LLP as our independent registered publicaccounting firm for the fiscal year ending December 31, 2006.

 
| ** **                        | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-----------------------------------|------------|------------|------------|-------------|------------|-------------|------------|
| Burr, Pilger & Mayer LLP |       | 20,769,270 |       | 28,774      |       | 683,901     |       |

 

(3)               Proposal to restate the AXT, Inc.1997 Stock Option Plan as the AXT, Inc. 2006 Equity Incentive Plan.

 
| ** **                                | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-------------------------------------------|------------|-----------|------------|-------------|------------|-------------|------------|
| AXT, Inc. 2006 Equity Incentive Plan |       | 4,460,637 |       | 5,500,658   |       | 77,350      |       |

 

Accordingly, proposal three was not approved by the stockholders.

 

**Item 5. Other Information**

 

None

 

45

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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 Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 31.2                |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 32.1                |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                           |
| 32.2                |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

| (1)    | Incorporated by reference to the  exhibit of the same number filed with the SEC with our Annual Report on  Form 10-K for the year ended December 31, 1998. |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                      |
| (2)    | Incorporated  by reference to Exhibit 2.1 to registrant’s Form 8-K filed with the  SEC on June 14, 1999.                                              |
|   |                                                                                                                                                                      |
| (3)    | Incorporated  by reference to Exhibit 3.4 to registrant’s Form 8-K filed with the  SEC on May 30, 2001.                                               |
|   |                                                                                                                                                                      |
| (4)    | Incorporated  by reference to Exhibit 3.4 to registrant’s Form 10-Q filed with  SEC on August 5, 2004.                                                |
|   |                                                                                                                                                                      |
| (5)    | Incorporated  by reference to the exhibit as of the same number as filed with the SEC  in our Form 8-K on May 30, 2001.                                    |

 

46

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**SIGNATURES**

 

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

 
|                         | AXT, INC. |
|------------------------------|----------------|
|                         |           |
| Dated: August 11,  2006 | By:            | /s/ Philip C.  S. Yin |   |
|                         |           | Philip C. S.  Yin |
|                         |           | Chief  Executive Officer |
|                         |           | (Principal  Executive Officer) |
|                         |           |   |
|                         |           | /s/ Wilson  W. Cheung |   |
|                         |           | Wilson W.  Cheung |
|                         |           | Chief  Financial Officer |
|                         |           | (Principal  Financial and Accounting Officer) |

 

47

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |       | Restated  Certificate of Incorporation                                                                                                                         |
|                |       |                                                                                                                                                           |
| 3.2(2)              |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock                                                                           |
|                |       |                                                                                                                                                           |
| 3.3(3)              |       | Second  Amended and Restated Bylaws                                                                                                                            |
|                |       |                                                                                                                                                           |
| 3.4(4)              |       | Certificate  of Amendment to the Restated Certificate of Incorporation                                                                                         |
|                |       |                                                                                                                                                           |
| 4.2(5)              |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                          |
|                |       |                                                                                                                                                           |
| 31.1                |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 31.2                |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 32.1                |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                           |
| 32.2                |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

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

 

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

 

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

 

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

 

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

 

48

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