Tableof Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 
| **x**                                                                                                                                                         | ** ** | **Quarterly report pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **for the quarterly period ended September 30,  2008**                                                                                                   |
| ** **                                                                                                                                                    |
| **or**                                                                                                                                                        |
| ** **                                                                                                                                                    |
| **o**                                                                                                                                                         | ** ** | **Transition report pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **for the transition period  from          to          ** |

 

**Commission File Number 000-24085**

 

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**AXT,INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

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

(Address of principal executive offices)****(Zip code)

 

**(510) 683-5900**

(Registrant’s telephone number,including area code)

 

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Indicate 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

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, a non-accelerated filer, ora smaller reporting company. See definitions of “large accelerated filer,”“accelerated filer,” and “smaller reporting company” in Rule 12b-2 of theExchange Act. (Check one):

 

| Large  accelerated filer o                     | Accelerated  filer x         |
|------------------------------------------------|-----------------------------------|
|                                           |                              |
| Non-accelerated  filer o                       | Smaller  reporting company o |
| (Do  not check if a smaller reporting company) |                              |

 

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 October 30, 2008** |
|--------------------------------|------------|---------------------------------------------------------|
| Common Stock, $0.001 par value |       | 30,450,007                                              |

 

 

 

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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 September 30, 2008 and  December 31, 2007                       | 3        |
| Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2008 and 2007 | 4        |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2008 and 2007           | 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                                                    | 29       |
| Item 4. Controls and Procedures                                                                                        | 31       |
| PART II. OTHER INFORMATION                                                                                        | 31       |
| Item 1. Legal Proceedings                                                                                              | 31       |
| Item 1A. Risk Factors                                                                                                  | 32       |
| Item 2. Unregistered Sales of Equity  Securities and Use of Proceeds                                                   | 33       |
| Item 3. Defaults Upon Senior Securities                                                                                | 33       |
| Item 4. Submission of Matters to a Vote of  Security Holders                                                           | 33       |
| Item 5. Other Information                                                                                              | 33       |
| Item 6. Exhibits                                                                                                       | 34       |
| Signatures                                                                                                             | 35       |

 

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**PART I.FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

AXT, INC.CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except per sharedata)

 
| ** **                                                                                                                                                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                         | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Assets:                                                                                                                                                                                            |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                    |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                          |       | $                      | 11,577     |                  | $          | 18,380 |   |
| Short-term investments                                                                                                                                                                             |       | 17,895                 |       | 20,825                |       |
| Accounts receivable, net of allowances of  $681 and $379 as of September 30, 2008 and December 31, 2007,  respectively                                                                   |       | 13,292                 |       | 12,149                |       |
| Inventories, net                                                                                                                                                                                   |       | 39,150                 |       | 24,781                |       |
| Prepaid expenses and other current assets                                                                                                                                                          |       | 2,964                  |       | 3,569                 |       |
| Assets held for sale                                                                                                                                                                               |       | —                 |       | 5,140                 |       |
| Total current assets                                                                                                                                                                               |       | 84,878                 |       | 84,844                |       |
| Property, plant and equipment, net                                                                                                                                                                 |       | 21,462                 |       | 15,986                |       |
| Restricted deposits                                                                                                                                                                                |       | 3,000                  |       | 6,700                 |       |
| Other assets                                                                                                                                                                                       |       | 5,246                  |       | 5,242                 |       |
| Total assets                                                                                                                                                                                       |       | $                      | 114,586    |                  | $          | 112,772 |   |
|                                                                                                                                                                                               |       |                   |       |                  |       |
| Liabilities and stockholders’ equity:                                                                                                                                                         |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                               |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                   |       | $                      | 8,674      |                  | $          | 4,328 |   |
| Accrued liabilities                                                                                                                                                                                |       | 3,415                  |       | 4,326                 |       |
| Line of credit                                                                                                                                                                                     |       | 3,000                  |       | —                |       |
| Current portion of long-term debt                                                                                                                                                                  |       | —                 |       | 450                   |       |
| Income taxes payable                                                                                                                                                                               |       | 298                    |       | 390                   |       |
| Total current liabilities                                                                                                                                                                          |       | 15,387                 |       | 9,494                 |       |
| Long-term debt, net of current portion                                                                                                                                                             |       | 18                     |       | 6,250                 |       |
| Other long-term liabilities                                                                                                                                                                        |       | 3,233                  |       | 3,778                 |       |
| Total liabilities                                                                                                                                                                                  |       | 18,638                 |       | 19,522                |       |
| Commitments and contingencies  (Note 10)                                                                                                                                                      |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                         |       |                   |       |                  |       |
| Preferred stock, $0.001 par value per  share; 2,000 shares authorized; 883 shares issued and outstanding as of  September 30, 2008 and December 31, 2007                                 |       | 3,532                  |       | 3,532                 |       |
| Common stock, $0.001 par value per share;  70,000 shares authorized; 30,450 and 30,358 shares issued and  outstanding as of September 30, 2008 and December 31, 2007,  respectively |       | 30                     |       | 30                    |       |
| Additional paid-in capital                                                                                                                                                                         |       | 186,588                |       | 185,949               |       |
| Accumulated deficit                                                                                                                                                                                |       | (96,861                | )          | (98,543               | )          |
| Accumulated other comprehensive income                                                                                                                                                             |       | 2,659                  |       | 2,282                 |       |
| Total stockholders’ equity                                                                                                                                                                    |       | 95,948                 |       | 93,250                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                    |       | $                      | 114,586    |                  | $          | 112,772 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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AXT, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per sharedata)

 
| ** **                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Revenue                                                |       | $                                                    | 17,863     |                                                | $          | 14,474 |   | $ | 57,429 |   | $ | 40,639 |   |
| Cost of revenue                                        |       | 13,326                                               |       | 9,944                                               |       | 40,227 |   | 25,672 |   |
| Gross profit                                           |       | 4,537                                                |       | 4,530                                               |       | 17,202 |   | 14,967 |   |
|                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Operating expenses:                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Selling, general and administrative                    |       | 4,901                                                |       | 3,083                                               |       | 12,146 |   | 10,529 |   |
| Research and development                               |       | 562                                                  |       | 382                                                 |       | 1,635 |   | 1,190 |   |
| Impairment (recovery) on assets held for  sale         |       | —                                               |       | —                                              |       | 83 |   | (481 | ) |
| Total operating expenses                               |       | 5,463                                                |       | 3,465                                               |       | 13,864 |   | 11,238 |   |
| Income (loss) from operations                          |       | (926                                                 | )          | 1,065                                               |       | 3,338 |   | 3,729 |   |
| Interest income, net                                   |       | 68                                                   |       | 102                                                 |       | 433 |   | 551 |   |
| Minority interests                                     |       | (277                                                 | )          | (537                                                | )          | (1,424 | ) | (1,290 | ) |
| Other income, net                                      |       | 298                                                  |       | 381                                                 |       | 707 |   | 851 |   |
|                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) before provision for income  taxes       |       | (837                                                 | )          | 1,011                                               |       | 3,054 |   | 3,841 |   |
| Provision for income taxes                             |       | 177                                                  |       | 153                                                 |       | 1,372 |   | 426 |   |
| Net income (loss)                                      |       | $                                                    | (1,014     | )                                                   | $          | 858 |   | $ | 1,682 |   | $ | 3,415 |   |
|                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss) per share:                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                  |       | $                                                    | (0.03      | )                                                   | $          | 0.03 |   | $ | 0.05 |   | $ | 0.11 |   |
| Diluted                                                |       | $                                                    | (0.03      | )                                                   | $          | 0.03 |   | $ | 0.05 |   | $ | 0.10 |   |
|                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Shares used in computing net income (loss)  per share: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                  |       | 30,455                                               |       | 30,150                                              |       | 30,410 |   | 29,940 |   |
| Diluted                                                |       | 30,455                                               |       | 31,464                                              |       | 31,502 |   | 31,287 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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AXT, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 
| ** **                                                           | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                           | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                                                 |       |                                                |       |   |   |
| Cash flows from operating activities:                                |       |                                                |       |   |   |
| Net income                                                           |       | $                                                   | 1,682      |   | $ | 3,415 |   |
|                                                                 |       |                                                |       |   |   |
| Adjustments to reconcile net income to net  cash used in operations: |       |                                                |       |   |   |
| Depreciation                                                         |       | 1,494                                               |       | 1,064 |   |
| Accretion of marketable securities  premium/discount                 |       | (5                                                  | )          | (51 | ) |
| Gain on disposal of property, plant and  equipment                   |       | (2                                                  | )          | — |   |
| Impairment (recovery) on assets held for  sale                       |       | 83                                                  |       | (481 | ) |
| Stock-based compensation                                             |       | 468                                                 |       | 341 |   |
| Realized loss (gain) on sale of investments                          |       | (326                                                | )          | 83 |   |
| Changes in assets and liabilities:                                   |       |                                                |       |   |   |
| Accounts receivable                                                  |       | (1,060                                              | )          | (2,193 | ) |
| Inventories                                                          |       | (13,904                                             | )          | (4,712 | ) |
| Prepaid expenses                                                     |       | 709                                                 |       | 512 |   |
| Other assets                                                         |       | 50                                                  |       | (696 | ) |
| Accounts payable                                                     |       | 4,106                                               |       | (1,050 | ) |
| Accrued liabilities                                                  |       | (934                                                | )          | 475 |   |
| Income taxes                                                         |       | (103                                                | )          | 251 |   |
| Other long-term liabilities                                          |       | (693                                                | )          | 467 |   |
| Net cash used in operating activities                                |       | (8,435                                              | )          | (2,575 | ) |
|                                                                 |       |                                                |       |   |   |
| Cash flows from investing activities:                                |       |                                                |       |   |   |
| Purchases of property, plant and equipment                           |       | (5,995                                              | )          | (2,786 | ) |
| Proceeds from sale of property, plant and  equipment                 |       | 4                                                   |       | 6 |   |
| Proceeds from sale of assets held for sale                           |       | 5,057                                               |       | — |   |
| Purchases of marketable securities                                   |       | (22,638                                             | )          | (22,704 | ) |
| Proceeds from sale of marketable securities                          |       | 24,495                                              |       | 24,508 |   |
| Decrease in restricted deposits                                      |       | 3,700                                               |       | 450 |   |
| Net cash provided by (used in) investing  activities                 |       | 4,623                                               |       | (526 | ) |
|                                                                 |       |                                                |       |   |   |
| Cash flows from financing activities:                                |       |                                                |       |   |   |
| Proceeds from issuance of common stock, net                          |       | 171                                                 |       | 4,390 |   |
| Proceeds from line of credit                                         |       | 3,000                                               |       | — |   |
| Long-term debt payments                                              |       | (6,682                                              | )          | (546 | ) |
| Net cash provided by (used in) financing  activities                 |       | (3511                                               | )          | 3,844 |   |
| Effect of exchange rate changes on cash and  cash equivalents        |       | 520                                                 |       | 208 |   |
| Net increase (decrease) in cash and cash  equivalents                |       | (6,803                                              | )          | 951 |   |
| Cash and cash equivalents at the beginning  of the period            |       | 18,380                                              |       | 16,116 |   |
| Cash and cash equivalents at the end of the  period                  |       | $                                                   | 11,577     |   | $ | 17,067 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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AXT, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

**Note 1.Basis of Presentation**

 

The accompanying condensedconsolidated financial statements of AXT, Inc.(“AXT”, the “Company”, “we,” “us,” and “our” refer to AXT, Inc. and all ofits consolidated 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 consolidated balance sheetdata was derived from our audited consolidated financial statements, but doesnot include all disclosures required by accounting principles generally accepted in the United States of America. In theopinion of our management, the unaudited condensed consolidated financialstatements reflect all adjustments, consisting only of normal recurringadjustments, considered necessary to present fairly the financial position,results of operations and cash flows of AXT and our subsidiaries for allperiods presented.

 

Our management has made anumber of estimates and assumptions relating to the reporting of assets andliabilities and the disclosure of contingent assets and liabilities to preparethese condensed consolidated financial statements in conformity with accountingprinciples generally accepted in the United States ofAmerica. Actual results could differ materially from those estimates.

 

The results of operationsare not necessarily indicative of the results to be expected in the future orfor the full fiscal year. It is recommended that these condensed consolidatedfinancial statements be read in conjunction with our consolidated financialstatements and the notes thereto included in our 2007 Annual Report on Form 10-Kfiled with the Securities and Exchange Commission (the “SEC”) on March 14,2008 and our Quarterly Reports on Form 10-Q for the quarterly periodsended March 31, 2008 and June 30, 2008 filed with the SEC on May 12,2008 and August 11, 2008, respectively.

 

**Note****2****.Accounting for Stock-Based Compensation**

 

Effective January 1,2006, we adopted the provisions of Statement of Financial Accounting Standards(“SFAS”) No. 123 (revised 2004), “*Share-BasedPayment*,” (“SFAS 123(R)”). SFAS 123(R) establishesaccounting for stock-based awards exchanged for employee services. Accordingly,stock-based compensation cost is measured at the grant date, based on the fairvalue of the award, and is recognized as an expense over the employee requisiteservice period. All of our stock compensation is accounted for as an equityinstrument. We previously applied Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations andprovided the required pro forma disclosures of SFAS No. 123, “*Accounting for Stock-Based Compensation*” (“SFAS 123”).

 

We elected the modified prospectivetransition method for adopting SFAS 123(R). Under this method, the provisionsof SFAS 123(R) apply to all awards granted or modified after the date ofadoption. The unrecognized expense of awards not yet vested at the date ofadoption will be recognized in net income in the periods after the date ofadoption using the same Black-Scholes valuation method and assumptionsdetermined under the original provisions of SFAS 123,**as disclosed in our previous quarterlyand annual reports.

 

Theeffect of recording stock compensation for the three and nine months ended September 30,2008 and 2007 was as follows (in thousands, except per share data):

 
| ** **                                                                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Stock-based compensation in the form of  employee stock options, included in: |       |                                                 |       |                                                |       |   |   |   |   |
|                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of revenue                                                                                                       |       | $                                                    | 13         |                                                | $          | 12 |   | $ | 44 |   | $ | 38 |   |
| Selling, general and administrative                                                                                   |       | 109                                                  |       | 96                                                  |       | 324 |   | 245 |   |
| Research and development                                                                                              |       | 25                                                   |       | 22                                                  |       | 100 |   | 58 |   |
|                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Total stock-based compensation                                                                                        |       | 147                                                  |       | 130                                                 |       | 468 |   | 341 |   |
| Tax effect on stock-based compensation                                                                                |       | —                                               |       | —                                              |       | — |   | — |   |
|                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Net effect on net income                                                                                              |       | $                                                    | 147        |                                                | $          | 130 |   | $ | 468 |   | $ | 341 |   |
|                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Effect on basic net income (loss) per share                                                                           |       | $                                                    | 0.00       |                                                | $          | 0.00 |   | $ | 0.02 |   | $ | 0.01 |   |
| Effect on diluted net income (loss) per share                                                                         |       | $                                                    | 0.00       |                                                | $          | 0.00 |   | $ | 0.01 |   | $ | 0.01 |   |

 

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As of September 30,2008 the total compensation costs related to unvested stock-based awardsgranted to employees under our stock option plan but not yet recognized wasapproximately $1,037,000, net of estimated forfeitures of $49,000. These costswill be amortized on a straight-line basis over a weighted-average period ofapproximately 2.2 years and will be adjusted for subsequent changes inestimated forfeitures. We elected not to capitalize any stock-basedcompensation to inventory as of September 30, 2008 due to the immaterialityof the amount.

 

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

 

Weestimate the fair value of stock options using a Black-Scholes valuation model,consistent with the provisions of SFAS 123(R), and the SEC Staff AccountingBulletin No. 107. There were no stock option grants made in the three andnine months ended September 30, 2007 and no options were granted in thethree months ended September 30, 2008. The fair value of our stock options granted to employees forthe nine months ended September 30, 2008 was estimated using the followingweighted-average assumptions:

 
| ** **                  | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **September 30, 2008** | ** ** |
| Expected term (in years)    |       | 4.0                              |       |
|                        |       |                             |       |
| Volatility                  |       | 60.79                            | %          |
|                        |       |                             |       |
| Expected dividend           |       | 0                                | %          |
|                        |       |                             |       |
| Risk-free interest rate     |       | 2.69                             | %          |
|                        |       |                             |       |
| Estimated forfeitures       |       | 4.3                              | %          |
|                        |       |                             |       |
| Weighted-average fair value |       | $                                | 2.47       |   |
|                             |            |                                  |            |  |

 

The following table summarizes the stockoption transactions during nine months ended September 30, 2008 (inthousands, except per share data):

 
| ** **                                                         | ** ** | **Shares** | ** ** | **Weighted-   average  Exercise  Price** | ** ** | **Weighted-   average**

**Remaining  Contractual  Life  (in years****)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** | ** **                                    | ** ** | ** **                                                                          | ** ** | ** **                      | ** ** |
| Options outstanding as of December 31, 2007                   |       | 2,477      |       | $                                             | 2.95       |                                                                                |       |                            |       |   |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Granted                                                            |       | 2          |       | 5.09                                          |       |                                                                                |       |                            |       |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Exercised                                                          |       | (92        | )          | 1.85                                          |       |                                                                                |       |                            |       |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Canceled                                                           |       | (34        | )          | 7                                             |       |                                                                                |       |                            |       |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Options outstanding as of September 30, 2008                  |       | 2,353      |       | $                                             | 2.94       |                                                                                | 6.29       |                            | $          | 721 |   |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Options vested and expected to vest as of  September 30, 2008 |       | 2,343      |       | $                                             | 2.93       |                                                                                | 6.28       |                            | $          | 720 |   |
|                                                               |       |       |       |                                          |       |                                                                                |       |                            |       |
| Options exercisable as of September 30, 2008                  |       | 1,758      |       | $                                             | 2.42       |                                                                                | 5.61       |                            | $          | 626 |   |

 

Asof December 31, 2007, options to purchase 1,638,139 shares at a weightedaverage exercise price of $2.56 per share were vested and exerciseable.

 

Theaggregate intrinsic value in the table above represents the total pretaxintrinsic value, based on our closing price of $1.88 on September 30,2008, which would have been received by the option holder had all optionholders exercised their options on of that date. The total number ofin-the-money options exerciseable as of September 30, 2008 was 1,079,000.

 

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Theoptions outstanding and exercisable as of September 30, 2008 were in thefollowing exercise price ranges:

 
| **Options Outstanding as of September 30, 2008** | ** ** | **Options Exercisable  as of September 30, 2008** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| **Range of Exercise Price**                                     | ** ** | **Shares**                                                                 | ** ** | **Weighted-average  Exercise Price** | ** ** | **Weighted-average  Remaining  Contractual Life** | ** ** | **Shares** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| $ 1.17 - $1.38                                                            |       | 1,198,583                                                                  |       | $ | 1.28 |   | 6.15 |   | 1,043,205 |   | $ | 1.28 |   |
| $ 1.39 - $1.44                                                            |       | 5,094                                                                      |       | $ | 1.43 |   | 6.89 |   | 3,074 |   | $ | 1.44 |   |
| $ 1.45 - $2.24                                                            |       | 412,363                                                                    |       | $ | 2.16 |   | 4.49 |   | 406,176 |   | $ | 2.17 |   |
| $ 2.25 - $6.31                                                            |       | 677,995                                                                    |       | $ | 4.95 |   | 7.93 |   | 247,310 |   | $ | 3.69 |   |
| $ 6.32 - $41.50                                                           |       | 58,500                                                                     |       | $ | 19.17 |   | 2.85 |   | 58,500 |   | $ | 19.17 |   |
|                                                                           |       | 2,352,535                                                                  |       | $ | 2.94 |   | 6.29 |   | 1,758,265 |   | $ | 2.42 |   |

 

The totalintrinsic value of options exercised for the three and nine months ended September 30,2008, was $30,000 and $275,000, respectively. The total intrinsic value ofoptions exercised for the three and nine months ended September 30, 2007,was $929,000 and $1,089,000, respectively. Cash received from option exercises for the three and nine months ended September 30,2008 was $22,000 and $171,000, respectively. Cash received from option exercises for the three and nine months ended September 30,2007 was $548,000 and $776,000, respectively.

 

A summary of activity related to restricted stock awards for the ninemonths ended September 30, 2008 is presented below:

 
| ** **                                                                    | ** ** | **Shares** | ** ** | **Weighted-Average  Grant Date Fair Value** | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
| Non-vested restricted stock shares outstanding as of  December 31, 2007  |       | 23,480     |       | $                                                          | 4.26       |   |
| Restricted stock shares granted                                               |       | —     |       | $                                                          | —     |   |
| Restricted stock shares vested                                                |       | (7,827     | )          | $                                                          | 4.26       |   |
| Non-vested restricted stock shares outstanding as of  September 30, 2008 |       | 15,653     |       | $                                                          | 4.26       |   |

 

As of September 30,2008, we had $59,000 of unrecognized compensation expense, net of forfeitures,related to restricted stock awards, which will be recognized over the weightedaverage period of 1.76 years. During the nine months ended September 30,2008, 7,827 shares of restricted stock vested.

 

**Note3. Investments and Fair Value Measurements**

 

Ourcash, cash equivalents and investments, and strategic investments inprivately-held companies are classified as follows (in thousands):

 
| ** **                                   | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | ** **                       | ** ** | **Gross**                       | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Amortized**                    | ** ** | **Unrealized**                  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                   | ** ** | **Cost**                         | ** ** | **Gain**                        | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gain** | ** ** | **(Loss)** | ** ** | **Value** | ** ** |
| **Classified as:**                           |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                         |       | $                                | 11,577     |                            | $          | — |   | $ | — |   | $ | 11,577 |   | $ | 10,818 |   | $ | — |   | $ | — |   | $ | 10,818 |   |
| Cash equivalents:                            |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market fund                            |       | —                           |       | —                          |       | — |   | — |   | 7,562 |   | — |   | — |   | 7,562 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cash equivalents                       |       | —                           |       | —                          |       | — |   | — |   | 7,562 |   | — |   | — |   | 7,562 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cash and cash equivalents              |       | 11,577                           |       | —                          |       | — |   | 11,577 |   | 18,380 |   | — |   | — |   | 18,380 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                 |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury, agency securities             |       | —                           |       | —                          |       | — |   | — |   | 1,400 |   | — |   | — |   | 1,400 |   |
| Asset-backed securities                      |       | —                           |       | —                          |       | — |   | — |   | 3,820 |   | — |   | (77 | ) | 3,743 |   |
| Commercial paper                             |       | —                           |       | —                          |       | — |   | — |   | 3,300 |   | — |   | (115 | ) | 3,185 |   |
| Corporate bonds                              |       | 22,345                           |       | —                          |       | (1,450 | ) | 20,895 |   | 19,051 |   | 260 |   | (114 | ) | 19,197 |   |
| Total investments                            |       | 22,345                           |       | —                          |       | (1,450 | ) | 20,895 |   | 27,571 |   | 260 |   | (306 | ) | 27,525 |   |
| Total cash, cash equivalents and investments |       | $                                | 33,922     |                            | —     |   | $ | (1,450 | ) | $ | 32,472 |   | $ | 45,951 |   | $ | 260 |   | $ | (306 | ) | $ | 45,905 |   |
| **Contractual maturities on investments:**   |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Due within 1 year                            |       | $                                | 448        |                            |       |   |   |   | $ | 430 |   | $ | 2,050 |   |   |   |   |   | $ | 2,050 |   |
| Due after 1 through 5 years                  |       | 21,897                           |       |                            |       |   |   | 20,465 |   | 25,521 |   |   |   |   |   | 25,475 |   |
|                                         |       | $                                | 22,345     |                            |       |   |   |   | $ | 20,895 |   | $ | 27,571 |   |   |   |   |   | $ | 27,525 |   |
|                                              |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Theinvestments include $3.0 million and $6.7 million recorded as restricteddeposits on the condensed consolidated balance sheets as of September 30,2008 and December 31, 2007, respectively. On July 1, 2008, we paiddown the entire principal amount of $6.4 million plus accrued interest andaccordingly the related restricted deposits were released. In September 2008,we obtained an express line of credit of $5.0 million from Citigroup SmithBarney and drew down $3.0 million for operating purposes and classified thesame amount as restricted deposits as of September 30, 2008. The $3.0million express line of credit carries an annual interest rate of 4.0%.

 

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 September 30, 2008, we had no gross realized gains orlosses and for the nine months ended September 30, 2008, we had $326,000in gross realized gains on sales of our available-for-sale securities,respectively. For the three and nine months ended September 30, 2007 wehad $54,000 and $83,000 in gross realized losses on sales of ouravailable-for-sale securities, respectively.

 

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debtsecurities. We have determined that the gross unrealized losses on ouravailable-for-sale securities as of September 30, 2008 are temporary innature. We reviewed our investment portfolio to identify and evaluateinvestments that have indications of possible impairment. Factors considered indetermining whether a loss is temporary include the magnitude of the decline inmarket value, the length of time the market value has been below cost (oradjusted cost), credit quality, and our ability and intent to hold thesecurities for a period of time sufficient to allow for any anticipatedrecovery in market value. The following table provides a breakdown of ouravailable-for-sale securities with unrealized losses as of September 30,2008 (in thousands):

 
| ** **             | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | ** **                                               | ** ** | **Gross**                                                | ** ** | ** **                            | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **             | ** ** | **Fair**                                                 | ** ** | **Unrealized**                                           | ** ** | **Fair**                              | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **             | ** ** | **Value**                                                | ** ** | **(Loss)**                                               | ** ** | **Value**                             | ** ** | **(Loss)** | ** ** | **Value** | ** ** | **(Loss)** | ** ** |
| Investments:           |       |                                                     |       |                                                     |       |                                  |       |   |   |   |   |   |   |
| Corporate bonds        |       | $                                                        | 20,895     |                                                     | $          | (1,450                                | )          | $ | — |   | $ | — |   | $ | 20,895 |   | $ | (1,450 | ) |
| Total in loss position |       | $                                                        | 20,895     |                                                     | $          | (1,450                                | )          | $ | — |   | $ | — |   | $ | 20,895 |   | $ | (1,450 | ) |

 

***Investmentsin Privately-held Companies***

 

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 our substratebusiness (see Note 9). As of September 30, 2008 and December 31,2007, our investments in unconsolidated privately-held companies had a carryingvalue of $4.1 million and $3.3 million, respectively, and are included in “otherassets” in the condensed consolidated balance sheets.

 

***Fair ValueMeasurements***

 

OnJanuary 1, 2008, we adopted SFAS No. 157, “*Fair Value Measurements*” (“SFAS No. 157”)which defines fair value, establishes a framework for using fair value tomeasure assets and liabilities, and expands disclosures about fair valuemeasurements.  SFAS No. 157 applies whenever other statements requireor permit assets or liabilities to be measured at fair value.  SFAS No. 157is effective for fiscal years beginning after November 15, 2007, exceptfor non-financial assets and liabilities that are recognized or disclosed atfair value in the financial statements on a nonrecurring basis, for whichapplication has been deferred for one year.

 

The following table summarizes our financial assets and liabilitiesmeasured at fair value on a recurring basis in accordance with SFAS No. 157as of September 30, 2008 (in thousands):

 
| ** **              | ** ** | **Balance as of  September 30, 2008** | ** ** | **Quoted Prices in  Active Markets of  Identical Assets**

**(Level 1)** | ** ** | **Significant Other  Observable Inputs**

**(Level 2)** | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Assets:                 | ** ** | ** **                                                | ** ** | ** **                                                                                             | ** ** | ** **                                                             | ** ** |
| Short-term investments: |       |                                                      |       |                                                                                                   |       |                                                                   |       |
| Corporate bonds         |       | $                                                         | 20,895     |                                                                                                   | $          | —                                                                 |       | $ | 20,895 |   |
| Total                   |       | $                                                         | 20,895     |                                                                                                   | $          | —                                                                 |       | $ | 20,895 |   |
|                    |       |                                                      |       |                                                                                                   |       |                                                                   |       |
| Liabilities             |       | $                                                         | —     |                                                                                                   | $          | —                                                                 |       | $ | — |   |

 

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Our financial assets and liabilities are valued using market prices onboth active markets (Level 1) and less active markets (Level 2).Level 1 instrument valuations are obtained from real-time quotes fortransactions in active exchange markets involving identical assets.Level 2 instrument valuations are obtained from readily-available pricingsources for comparable instruments. As of September 30, 2008, we did nothave any assets or liabilities without observable market values that wouldrequire a high level of judgment to determine fair value (Level 3 assets).

 

***ItemsMeasured at Fair Value on a Nonrecurring Basis***

 

Certain assets that are subject to nonrecurring fair value measurementsare not included in the table above. These assets include equity and costmethod investments in private companies. We did not record other-than-temporaryimpairment charges for either of these investments during the first nine monthsof 2008.

 

**Note 4.Inventories, Net**

 

The components ofinventories are summarized below (in thousands):

 
| ** **        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Inventories, net: |       |                   |       |                  |       |
| Raw materials     |       | $                      | 20,541     |                  | $          | 11,154 |   |
| Work in process   |       | 14,158                 |       | 12,254                |       |
| Finished goods    |       | 4,451                  |       | 1,373                 |       |
|              |       | $                      | 39,150     |                  | $          | 24,781 |   |

 

**Note 5.Recovery (Impairment) on Assets Held For Sale**

 

During the first ninemonths of 2008, we completed the sale of our property in Fremont, Californiafor $5.3 million in gross proceeds and $5.1 million in net proceeds afterdeducting commissions and selling expenses. We recorded an impairment chargeupon the sale of the property of $83,000.

 

During the first ninemonths of 2007, we benefited from a recovery of impairment on assets held forsale in connection with our adjustment of the fair value of the same propertyin Fremont, California, which had been decontaminated and was being preparedfor sale.  We recorded a $481,000 marketvalue adjustment after we entered into an agreement with an independent thirdparty purchaser in June 2007. However, the sale was not consummated with this purchaser under thisagreement, and the property was not sold until March 2008 to a differentindependent third-party purchaser.

 

**Note 6. Net Income (Loss) Per Share**

 

Basic net income (loss) per common share iscalculated by dividing net income (loss) available to common stockholders bythe weighted average number of common shares outstanding during the period.Diluted net income (loss) per common and common equivalent shares include thedilutive effect of common stock equivalents outstanding during the periodcalculated using the treasury stock method. Common stock equivalents consist ofthe shares issuable upon the exercise of stock options.

 

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

 
| ** **                                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                                                    | (1,014     | )                                                   | $          | 858 |   | $ | 1,682 |   | $ | 3,415 |   |
| Less: Preferred stock dividends                                                           |       | (44                                                  | )          | (44                                                 | )          | (132 | ) | (132 | ) |
|                                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss) available to common stockholders                                        |       | $                                                    | (1,058     | )                                                   | $          | 814 |   | $ | 1,550 |   | $ | 3,283 |   |
| Denominator:                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator for basic net income (loss) per share - weighted average  common shares       |       | 30,455                                               |       | 30,150                                              |       | 30,410 |   | 29,940 |   |
| Effect of dilutive securities:                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Common stock options                                                                      |       | —                                               |       | 1,314                                               |       | 1,092 |   | 1,347 |   |
| Denominator for dilutive net income (loss) per common share                               |       | 30,455                                               |       | 31,464                                              |       | 31,502 |   | 31,287 |   |
| Basic net income (loss) per share                                                         |       | $                                                    | (0.03      | )                                                   | $          | 0.03 |   | $ | 0.05 |   | $ | 0.11 |   |
| Diluted net income (loss) per share                                                       |       | $                                                    | (0.03      | )                                                   | $          | 0.03 |   | $ | 0.05 |   | $ | 0.10 |   |
| Options excluded from diluted net income (loss) per share as the  impact is anti-dilutive |       | 2,353                                                |       | 98                                                  |       | 679 |   | 822 |   |

 

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**Note 7.Comprehensive Income**

 

The components ofcomprehensive income are as follows (in thousands):

 
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                         | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss)                                                  |       | $                                                    | (1,014     | )                                                   | $          | 858 |   | $ | 1,682 |   | $ | 3,415 |   |
| Change in foreign currency translation gain                        |       | 28                                                   |       | 357                                                 |       | 1,781 |   | 956 |   |
| Change in unrealized gain (loss) on available-for-sale investments |       | (707                                                 | )          | 110                                                 |       | (1,404 | ) | 582 |   |
| Comprehensive income (loss)                                        |       | $                                                    | (1,693     | )                                                   | $          | 1,325 |   | $ | 2,059 |   | $ | 4,953 |   |

 

**Note 8.Segment Information and Foreign Operations**

 

***SegmentInformation***

*** ***

Weoperate in one segment for the design, development, manufacture anddistribution of high-performance compound semiconductor substrates and sale ofrelated materials. In accordance with SFAS No. 131, *“Disclosures About Segments of an Enterprise andRelated Information”* (“SFAS No. 131”), our chief operatingdecision-maker has been identified as the Chief Executive Officer, who reviewsoperating results to make decisions about allocating our resources andassessing our performance. We manage the Company on a consolidated basis with areview of revenue by product.  We discussrevenue and capacity for both AXT and our China joint ventures collectively,when determining capacity constraints and need for raw materials in our business,and consider their capacity when determining our strategic and productmarketing and advertising strategies. While we consolidate three of the joint ventures, we do not allocateresources to any of them, nor allocate any portion of overhead, interest andother income, interest expense or taxes to them.  Accordingly, we have determined that ourjoint venture operations do not constitute an operating segment in accordancewith SFAS No. 131. Since we operate in one segment, all financial segmentand product line information required by SFAS No. 131 can be found inthe condensed consolidated financial statements.

 

***Product Information***

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenue by product type: |       |                                                 |       |                                                |       |   |   |   |   |
| GaAs substrates          |       | $                                                    | 13,617     |                                                | $          | 9,909 |   | $ | 40,479 |   | $ | 27,997 |   |
| InP substrates           |       | 484                                                  |       | 408                                                 |       | 1,462 |   | 1,586 |   |
| Ge substrates            |       | 795                                                  |       | 536                                                 |       | 3,564 |   | 1,479 |   |
| Raw materials and other  |       | 2,967                                                |       | 3,621                                               |       | 11,924 |   | 9,577 |   |
| Consolidated             |       | $                                                    | 17,863     |                                                | $          | 14,474 |   | $ | 57,429 |   | $ | 40,639 |   |

 

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***GeographicalInformation***

 

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

 
| ** **     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net revenues:  |       |                                                 |       |                                                |       |   |   |   |   |
| North America* |       | $                                                    | 5,030      |                                                | $          | 2,820 |   | $ | 15,466 |   | $ | 8,918 |   |
| Europe         |       | 2,913                                                |       | 2,521                                               |       | 9,696 |   | 7,163 |   |
| Japan          |       | 3,557                                                |       | 3,301                                               |       | 12,292 |   | 8,699 |   |
| Taiwan         |       | 1,978                                                |       | 2,444                                               |       | 6,846 |   | 6,512 |   |
| Asia Pacific   |       | 4,385                                                |       | 3,388                                               |       | 13,129 |   | 9,347 |   |
| Consolidated   |       | $                                                    | 17,863     |                                                | $          | 14,474 |   | $ | 57,429 |   | $ | 40,639 |   |

 

----

*Primarily the UnitedStates

 

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**         | ** ** |
|--------------------|------------|------------------------|------------|
| ** **         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **         | ** ** | **2008**               | ** ** | **2007** | ** ** |
| Long-lived assets: |       |                   |       |   |   |
| North America      |       | $                      | 383        |   | $ | 149 |   |
| China              |       | 21,079                 |       | 15,837 |   |
|               |       | $                      | 21,462     |   | $ | 15,986 |   |

 

***SignificantCustomers***

 

Beginning2008, we have grouped sales to all IQE companies as sales to one customer.  Two customers represented 28.7% and 10.2% ofrevenue for the three month period ended September 30, 2008 while nocustomers represented more than 10% of revenue for the three month period endedSeptember 30, 2007. One customer represented 20.2% of revenue for the ninemonth period ended September 30, 2008 while no customer represented morethan 10% of revenue for the nine month period ended September 30,2007.  Our top five customers represented62.0% and 35.9% of revenue for the three month periods ended September 30,2008 and 2007, respectively.  Our topfive customers represented 47.5% and 38.5% of revenue for the nine monthperiods ended September 30, 2008 and 2007, respectively.

 

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** **

**Note9. Investments in Privately-held Companies**

 

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** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| **Company**                                                     | ** ** | **September 30,  2008**                | ** ** | **December 31,  2007** | ** ** | **Accounting  Method** | ** ** | **Ownership  Percentage** | ** ** |
| Beijing Ji Ya Semiconductor Material Co., Ltd                   |       | $                                           | 996        |                        | $          | 996                    |       | Consolidated |   | 46 | % |
| Nanjing Jin Mei Gallium Co., Ltd                                |       | 592                                         |       | 592                         |       | Consolidated           |       | 83 | % |
| Beijing BoYu Semiconductor Vessel Craftwork Technology Co., Ltd |       | 410                                         |       | 410                         |       | Consolidated           |       | 70 | % |
| Xilingol Tongli Germanium Co., Ltd                              |       | 2,861                                       |       | 2,138                       |       | Equity                 |       | 25 | % |
| Emeishan Jia Mei High Purity Metals Co., Ltd                    |       | 816                                         |       | 761                         |       | Equity                 |       | 25 | % |
|                                                                 |            |                                             |            |                             |            |                        |            |  |  |  |  |

 

Theinvestment balances for the two companies accounted for under the equity methodare included in “other assets” in the condensed consolidated balance sheets. Weown 25% of the ownership interests in each of these companies. These twocompanies are not considered variable interest entities because:

 
| · |   | both companies have  sustainable businesses of their own;                                                                                                                                                                                             |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                  |
| · |   | our voting power is  proportionate to our ownership interests;                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                  |
| · |   | we only recognize our  respective share of the losses and/or residual returns generated by the  companies if they occur; and                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                  |
| · |   | we do not have a  controlling financial interest in, do not maintain operational or management  control of, do not control the board of directors of, and are not required to  provide additional investment or financial support to, either company. |

 

Undistributedretained earnings relating to our investments were $10.9 million and $7.8million as of September 30, 2008 and December 31, 2007, respectively.Net income recorded from our investments was $879,000 and $729,000 for thethree months ended September 30, 2008 and 2007, respectively. Net income recordedfrom our investments was $3.1 million and $2.3 million for the nine monthsended September 30, 2008 and 2007, respectively.

 

The minority interest forthe three majority-owned joint ventures that are consolidated is includedwithin “Other long-term liabilities” in the condensed consolidated balancesheets and separately disclosed under “Minority interests” on the condensedconsolidated statements of operations. The equity earnings from the two minority-owned joint ventures that arenot consolidated are recorded as “Other income (expense), net” on the condensedconsolidated statements of operations.

 

We also have investmentsin two privately-held companies which are accounted for under the cost methodas we do not have the ability to exercise significant influence over theiroperations. As of September 30, 2008 and December 31, 2007, theseinvestments totaled approximately $0.4 million and are included in “Otherassets” on the condensed consolidated balance sheets.

 

**Note 10.Commitments and Contingencies**

 

***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 for losses suffered or incurred bythe indemnified party, generally their business partners or customers, inconnection with any U.S. patent, or any copyright or other intellectualproperty infringement claim by any third party with respect to our products.The term of these indemnification agreements is generally perpetual anytimeafter the execution of the agreement. The maximum potential amount of futurepayments we could be required to make under these agreements is unlimited. Wehave never incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value ofthese agreements is minimal.

 

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

 

***ProductWarranty***

*** ***

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represent the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts thatfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balances and update these based on the historical warranty cost trends.The following table reflects the change in our warranty accrual which isincluded in “accrued liabilities” on the condensed consolidated balance sheets,during the three and nine months ended September 30, 2008 and 2007 (inthousands):

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                   | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning accrued warranty and related costs |       | $                                                    | 1,309      |                                                | $          | 949 |   | $ | 1,030 |   | $ | 459 |   |
| Charged (credited) to cost of revenue        |       | (95                                                  | )          | (116                                                | )          | 313 |   | 580 |   |
| Actual warranty expenditures                 |       | (118                                                 | )          | (14                                                 | )          | (247 | ) | (220 | ) |
| Ending accrued warranty and related costs    |       | $                                                    | 1,096      |                                                | $          | 819 |   | $ | 1,096 |   | $ | 819 |   |

 

***Purchase Commitment***

 

On February 27,2007, we entered into an agreement with Recapture Metals Limited of Ontario, Canada(“Recapture”), pursuant to which Recapture will supply our subsidiary in thePeople’s Repiblic of China with one thousand kilograms per month of 99.99999%pure gallium, during the eighteen month period beginning July 1, 2007.Under the terms of the agreement, we are required to purchase a minimum ofeighteen thousand kilograms of gallium, unless the agreement is terminatedprior to the expiration of the eighteen month period on December 31, 2008.As of September 30, 2008, our total remaining commitment under thisagreement is approximately $1.2 million.

 

**Note 11.Foreign Exchange Transaction Gains/Losses**

 

Weincurred foreign currency transaction exchange losses of $69,000 and $162,000for the three month periods ended September 30, 2008, and 2007, respectively.We incurred foreign currency transaction exchange losses of $473,000 and$128,000 for the nine month periods ended September 30, 2008, and 2007,respectively. These amounts are included in “Other income (expense), net” onthe condensed consolidated statements of operations.

 

**Note 12. Income Taxes**

 

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 48(“FIN48”), *“Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109)”* (“SFAS 109”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS 109. This interpretationprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. FIN 48 also provides guidance on derecognition of taxbenefits, classification on the balance sheet, interest and penalties,accounting in interim periods, disclosure, and transition. We adopted FIN 48effective January 1, 2007. We recognize interest and penalties related touncertain tax positions in income tax expense. As of September 30, 2008,we do not have any gross unrecognized tax benefits, nor any accrued interestand penalties related to uncertain tax positions. As a result of theimplementation of FIN 48, we identified $16.4 million in unrecognized taxbenefits. This amount decreased the tax loss carryforwards in the U.S. whichare fully offset by a valuation allowance. We file income tax returns in theU.S. federal, various states and foreign jurisdictions. We have substantiallyconcluded all U.S. federal and state income tax matters through December 31,2007.

 

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**Note 13.Recent Accounting Pronouncements**

 

In May 2008,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard (“SFAS”) No. 162 “The Hierarchy of Generally AcceptedAccounting Principles” (“SFAS No. 162”). SFAS No. 162identifies the sources of accounting principles and the framework for selectingthe principles used in the preparation of financial statements of nongovernmentalentities that are presented in conformity with generally accepted accountingprinciples (GAAP) in the United States (the GAAP hierarchy). SFAS No. 162will be effective 60 days following the SEC’s approval of the PublicCompany Accounting Oversight Board’s amendments to AU Section 411, “TheMeaning of Present Fairly in Conformity With Generally Accepted AccountingPrinciples.” The FASB has stated that it does not expect that SFAS No. 162will result in a change in current practice.

 

In March 2008,the FASB issued SFAS No. 161, “*Disclosures aboutDerivative Instruments and Hedging Activities*” (“SFAS 161”). SFAS161 requires companies with derivative instruments to disclose information thatshould enable financial-statement users to understand how and why a companyuses derivative instruments, how derivative instruments and related hedgeditems affect a company’s financial position, financial performance and cashflows. SFAS 161 is effective for financial statements issued for fiscal yearsand interim periods beginning after November 15, 2008. Based on ourcurrent operations, we do not expect that the adoption of SFAS 161 willhave a material impact on our consolidated financial position or results ofoperations.

 

In December 2007, theFASB issued SFAS No. 141 (revised 2007), “*BusinessCombinations*”, (“SFAS 141R”). SFAS 141R establishes theprinciples and requirements for how an acquirer in a business combination (1) recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed and any non-controlling interest in the acquiree, (2) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase and (3) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS 141(R) will be applicable beginningwith our fiscal 2009. The impact of the adoption of SFAS 141(R) onour results of operations and financial position will depend on the nature andextent of business combinations that we complete, if any, in or after fiscal2009.

 

In December 2007, the FASB issued SFAS No. 160,*“Noncontrolling Interests in ConsolidatedFinancial Statements”*(“SFAS 160”). SFAS 160 requires thatminority interest be separately reported in the consolidated entity’s equitysection and that no gain or loss shall be reported when transactions occurbetween the controlling interest and the non-controlling interests.Furthermore, the acquisition of non-controlling interest by the controllinginterest is not treated as a business combination. SFAS 160 is effectivefor fiscal years beginning after December 15, 2008. We have not yetevaluated the impact that the adoption of SFAS 160 will have on our consolidatedfinancial position, results of operations or cash flows.

 

In February 2007, the FASB issued SFAS No. 159,“*The Fair Value Option for Financial Assetsand Financial Liabilities—Including an amendment of FASB Statement No. 115*”(“SFAS 159”). SFAS 159 expands the use of fair value accounting tomany financial instruments and certain other items. The fair value option isirrevocable and generally made on an instrument-by-instrument basis, even if acompany has similar instruments that it elects not to measure based on fairvalue. SFAS 159 is effective for fiscal years beginning after November 15,2007. We do not have any instruments eligible for election of the fair valueoption. Therefore, the adoption of SFAS 159 in the first quarter of fiscal 2008did not impact our consolidated financial position, results of operations orcash flows

 

In September 2006, the FASB issued SFAS No. 157,“*Fair Value Measurements*” (“SFAS 157”).SFAS 157 defines fair value, establishes a framework and gives guidance regardingthe methods used for measuring fair value, and expands disclosures about fairvalue measurements. SFAS 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods ofthose fiscal years. In February 2008, the FASB released a FASB StaffPosition (FSP FAS 157-2— *Effective Date ofFASB Statement No. 157*) which delays the effective date of SFAS157 for all nonfinancial assets and nonfinancial liabilities, except those thatare recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually) to fiscal years beginning after November 15,2008. These non-financial items include assets and liabilities such asreporting units measured at fair value in a goodwill impairment test andnon-financial assets acquired and liabilities assumed in a businesscombination. The partial adoption of SFAS 157 as of January 1, 2008 forfinancial assets and liabilities did not have a material impact on ourcondensed consolidated financial position, results of operations or cash flows.See Note 3 of the Notes to Condensed Consolidated Financial Statements.

 

On October 10,2008, the FASB issued FASB Staff Position (“FSP”) No. 157-3 (“FSP 157-3”),“*Determining the Fair Value of a FinancialAsset When the Market for That Asset is Not Active”* (“FSP 157-3”),to clarify the application of SFAS 157 in a market that is not active,providing an example to illustrate key considerations in determining the fairvalue of a financial asset when the market for that financial asset is notactive.  This FSP applies to financialassets within the scope of 

 

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accountingpronouncements that require or permit fair value measurement in accordance withSFAS 157 and is effective upon issuance. We have determined there is no impact from adopting the provisions ofFSP 157-3 on our consolidated financial position, results of operations or cashflows.

 

Invarious areas, including revenue recognition, stock option accounting,accounting standards and practices continue to evolve. Additionally, the SECand the FASB’s Emerging Issues Task Force continue to address revenues, stockoption accounting related accounting issues. We believe that we are incompliance with all of the rules and related guidance as they currentlyexist. However, any changes to accounting principles generally accepted in theUnited States of America in these areas could impact the future accounting ofour operations.

 

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

 

This quarterly report on Form 10-Q,including the following sections, contains forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, particularly statements relating to our expectations regarding resultsof operations, customer demand, improvements in our product quality, ourability to expand our markets and increase sales, customer qualifications ofour products, gross margins, favorable pricing, reliable supply and enhancedsourcing lead-times of raw materials, and our reserve balances. Theseforward-looking statements are based upon management’s current views withrespect to future events and financial performance, and are subject to certainrisks and uncertainties that could cause actual results to differ materiallyfrom historical results or those anticipated in such forward-lookingstatements. Such risks and uncertainties include those set forth under thesection entitled “Risk Factors” below, which identify important factors thatcould cause actual results to differ materially from those predicted in anysuch forward-looking statements. We caution investors that actual results maydiffer materially from those projected in the forward-looking statements as aresult of certain risk factors identified in this Form 10-Q and otherfilings we have made with the Securities and Exchange Commission.Forward-looking statements may be identified by the use of terms such as “anticipates,”“believes,” “estimates,” “expects,” “intends,” and similar expressions.Statements concerning our future or expected financial results and condition,business strategy and plans or objectives for future operations areforward-looking statements.

 

These forward-lookingstatements are not guarantees of future performance. Readers are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date hereof. This discussion should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations included in our Annual Report on Form 10-K for the year ended December 31,2007 and the condensed consolidated financial statements included elsewhere inthis report.

 

**Overview**

 

We are a leading worldwidedeveloper and producer of high-performance compound and single elementsemiconductor substrates comprising gallium arsenide (GaAs), indium phosphide(InP) and germanium (Ge). We currently sell the following substrate products inthe sizes and for the applications indicated:

 
| **Product**             | ** ** | ** **                |
|-------------------------|------------|---------------------------|
| **Substrates**          | ** ** | **Diameter**              | ** ** | **Applications** |
| GaAs  (semi-insulating) |       | 2” to 6”        |   | ·  Power amplifiers  and integrated circuits for wireless handsets |
|                    |       |                      |   | ·  Direct broadcast  television |
|                    |       |                      |   | ·  High-performance  transistors |
|                    |       |                      |   | ·  Satellite  communications |
|                    |       |                      |   |   |
| GaAs  (semi-conducting) |       | 2”, 3”, 4” |   | ·  High brightness  LEDs |
|                    |       |                      |   | ·  Lasers |
|                    |       |                      |   | ·  Optical couplers |
|                    |       |                      |   |   |
| InP                     |       | 2”, 3”, 4” |   | ·  Broadband and fiber  optic communications |
|                    |       |                      |   |   |
| Ge                      |       | 2”, 4”          |   | ·  Satellite and  terrestrial solar cells |
|                    |       |                      |   | ·  Optical  applications |

 

We manufacture compoundsemiconductor substrates using our proprietary vertical gradient freeze, orVGF, technology. Our in-house VGF technology and manufacturing capabilitiesenables us to add capacity quickly and cost efficiently. We manufacture all ofour products in China, which generally has lower costs for facilities, laborand materials than in the U.S. or Europe.

 

Wealso have three majority-owned and two minority-owned joint ventures in Chinawhich provide us favorable pricing,reliable supply and enhanced sourcing lead-times for key raw materials whichare central to our final manufactured products. These joint ventures produce products including 99.99% puregallium (4N Ga), high purity gallium, arsenic, germanium, germanium dioxide,paralytic boron nitride (pBN) crucibles and boron oxide. AXT’s ownershipinterest in these entities ranges from 25% to 83%. We consolidate the threeventures in which we own a majority or controlling financial interest andemploy equity accounting for the two joint ventures in which we have a 25%interest. We purchase portions of the materials produced by these ventures forour own use and the joint ventures sell the remainder of their production tothird parties.

 

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Revenue increased $16.8million, or 41.3%, to $57.4 million for the nine months ended September 30,2008 from $40.6 million for the same period of 2007 primarily due to highercustomer demand for six-inch diameter wafers, and an increase in germaniumsubstrates and raw material sales. While this is a large increase over theprior year, the demand for our GaAs products which are used in a number ofconsumer, industrial and automotive applications was softer than we expected.While the volatile business and financial markets are prompting us to continueto take a conservative approach to our business, we remain optimistic about ourbusiness in the quarters to come. Despite the continuing margin pressure, our galliumarsenide and raw materials businesses have been solid.  Positive industry trends, coupled with ourcompetitive manufacturing and cost advantages give us confidence in our abilityto continue to drive future businesses in 2009. On March 28, 2008, wecompleted the sale of our Fremont, California facility and received netproceeds of approximately $5.1 million after deducting commissions and sellingexpenses. As of September 30, 2008, we had available cash, cashequivalents and short-term investments of $29.5 million, excluding restricteddeposits.  On July 1, 2008, weexercised our right to redeem the taxable variable rate revenue bond and repaidall outstanding indebtedness and accrued interest under the terms of therevenue bond of approximately $6.4 million. Accordingly, all of our remaining obligations under the revenue bondhave terminated and the related restricted deposits have been released.  In September 2008, we obtained an expressline of credit from Citigroup Smith Barney and drew down $3.0 million andclassified the same amount as restricted deposits as of September 30,2008. The proceeds from the express line of credit was used in operations. The$3.0 million restricted cash carries an annual interest rate of 4.0%.

 

**Critical Accounting Policies and Estimates**

 

We have prepared ourcondensed consolidated financial statements in accordance with accountingprinciples generally accepted in the United States of America. As such, we havehad to make estimates, assumptions and judgments that affect the amountsreported on our financial statements. These estimates, assumptions andjudgments about future events and their effects on our results cannot bedetermined with certainty, and are made based upon our historical experienceand on other assumptions that are believed to be reasonable under thecircumstances. These estimates may change as new events occur oradditional information is obtained, and we may periodically be faced with uncertainties,the outcomes of which are not within our control and may not be known fora prolonged period of time. The discussion and analysis of our results ofoperations and financial condition are based upon these condensed consolidatedfinancial statements.

 

We have identified thepolicies below as critical to our business operations and understanding of ourfinancial condition and results of operations.

 

A critical accountingpolicy is one that is both material to the presentation of our financial statementsand requires us to make difficult, subjective or complex judgments that couldhave a material effect on our financial condition and results of operations.They may require us to make assumptions about matters that are highlyuncertain at the time of the estimate, and different estimates that we couldhave used, or changes in the estimate that are reasonably likely to occur,may have a material impact on our financial condition or results ofoperations.  We believe that thefollowing are our critical accounting policies:

 

***Revenue Recognition***

 

Wemanufacture and sell high-performance compound semiconductor substrates andsell certain raw materials including gallium, germanium dioxide, and pBNcrucibles. After we ship our products, there are no remaining obligations orcustomer acceptance requirements that would preclude revenue recognition. Ourproducts 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 either upon shipment from our dock, receiptat the customer’s dock, or removal from consignment inventory at the customer’slocation, provided that we have received a signed purchase order, the price isfixed or determinable, title and risk of ownership have transferred, collectionof resulting receivables is probable, and product returns are reasonablyestimable. We do not provide training, installation or commissioning services.Additionally, we may provide discounts or other incentives to customers inorder to secure business.

 

Weprovide for future returns based on historical experience, current economictrends and changes in customer demand at the time revenue is recognized.

 

***Allowance for Doubtful Accounts***

 

Weperiodically review the likelihood of collection on our accounts receivablebalances and provide an allowance for doubtful accounts receivable primarilybased upon the age of these accounts. We provide a 100% allowance forreceivables 

 

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fromU.S. customers in excess of 90 days and for receivables from customers locatedoutside the U.S. 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.

 

Asof September 30, 2008 and December 31, 2007, our accounts receivable,net, balance was $13.3 million and $12.1 million, respectively, which was netof an allowance for doubtful accounts of $681,000 and $379,000, respectively.If actual uncollectible accounts differ substantially from our estimates,revisions to the estimated allowance for doubtful accounts would be required,which could have a material impact on our financial results for the period.

 

***Warranty Reserve***

 

Wemaintain a warranty reserve based upon our claims experience during the priortwelve months. Warranty costs are accrued at the time revenue is recognized. Asof September 30, 2008 and December 31, 2007, accrued productwarranties totaled $1.1 million and $1.0 million, respectively. If actual warrantycosts differ substantially from our estimates, revisions to the estimatedwarranty liability would be required, which could have a material impact on ourfinancial condition and results of operations.

 

***Inventory Valuation***

 

Inventoriesare stated at the lower of cost or market. Cost is determined using theweighted average cost method. Our inventory consists of raw materials as wellas finished goods and work-in-process that include material, labor andmanufacturing overhead costs. Given the nature of our substrate products, andthe materials used in the manufacturing process, the wafers and ingotscomprising work-in-process may be held in inventory for up to two yearsand three years, respectively, as the risk of obsolescence for these materialsis low. We routinely evaluate the levels of our inventory in light of currentmarket conditions in order to identify excess and obsolete inventory, and weprovide a valuation allowance for certain inventories based upon the age andquality of the product and the projections for sale of the completed products.As of September 30, 2008 and December 31, 2007, we had an inventoryreserve of $12.3 million and $13.6 million for excess and obsolete inventory,respectively. The majority of this inventory has not been scrapped, andaccordingly, may be sold in future periods. If actual demand for our productswere to be substantially lower than estimated, additional inventory adjustmentsfor excess or obsolete inventory might be required, which could have a materialimpact on our business, financial condition and results of operations.

 

***Impairment of Investments***

 

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

 

Weinvest in equity instruments of privately-held companies for business andstrategic purposes. These investments are classified as other assets and areaccounted for either under the cost method or under the equity method as we donot have the ability to exercise significant influence over their operations.We monitor our investments for impairment and would 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***

 

Weevaluate the recoverability of property, equipment and intangible assets inaccordance with SFAS No. 144, *“Accountingfor the Impairment or Disposal of Long-Lived Assets.”* When eventsand circumstances indicate that long-lived assets may be impaired, wecompare the carrying value of the long-lived assets to the projection of futureundiscounted cash flows attributable to these assets. In the event that thecarrying value exceeds the future undiscounted cash flows, we record animpairment charge against income equal to the excess of the carrying value overthe assets’ fair value. Fair values are determined based on quoted marketvalues, discounted cash flows or internal and external appraisals, asapplicable. Assets held for sale are carried at the lower of carrying value orestimated net realizable value.

 

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***Employee Stock Options***

 

We grant options to substantially all managementemployees and believe that this program helps us to attract, motivate andretain high quality employees, to the ultimate benefit of our stockholders.Effective January 1, 2006, we adopted the fair value recognitionprovisions of SFAS No. 123 (revised 2004), “*Share-BasedPayment*” (“SFAS 123(R)”), using the modified prospectiveapplication transition method. Under this transition method, stock-basedcompensation cost was recognized in the condensed consolidated financialstatements for all share-based payments after January 1, 2006.Compensation cost recognized includes the estimated expense for the portion ofthe vesting period after January 1, 2006 for share-based payments priorto, but not vested as of January 1, 2006, based on the grant date fairvalue estimated in accordance with the original provisions of SFAS 123, “*Accounting for Stock-Based Compensation.”* We recognize thesecompensation costs net of an estimated forfeiture rate over the requisiteservice period of the award, which is generally the vesting term of four yearsfor stock options. Results for prior periods have not been restated, asprovided for under the modified prospective application transition method.

 

***Income Taxes***

 

We account for income taxes in accordance with SFAS No. 109,*“Accounting for Income 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 involvessignificant judgment in estimating the impact of uncertainties in theapplication of complex tax laws, particularly in foreign countries such asChina.  Effective January 1, 2007,we adopted FASB Interpretation No. 48 (“FIN 48”), “*Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109*.” See Note 12 — “IncomeTaxes” in the condensed consolidated financial statements for additionalinformation.

 

**Results ofOperations**

 

**Revenue**

 
| ** **    | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                                                    | 13,617     |         | $          | 9,909          |       | $ | 3,708 |   | 37.4 | % |
| InP           |       | 484                                                  |       | 408          |       | 76             |       | 18.6 | % |
| Ge            |       | 795                                                  |       | 536          |       | 259            |       | 48.3 | % |
| Raw materials |       | 2,967                                                |       | 3,621        |       | (654           | )          | (18.1 | )% |
| Total revenue |       | $                                                    | 17,863     |         | $          | 14,474         |       | $ | 3,389 |   | 23.4 | % |

 

Revenue increased $3.4million, or 23.4%, to $17.9 million for the three months ended September 30,2008 from $14.5 million for the three months ended September 30, 2007.Total GaAs substrate revenue increased $3.7 million, or 37.4%, to $13.6 millionfor the three months ended September 30, 2008 from $9.9 million for thethree months ended September 30, 2007. While this is a large increase overthe prior year, the demand for our GaAs products which are used in a number ofconsumer, industrial and automotive applications was softer than we expecteddue to an overall market slowdown and lower than expected demand from customerorders. We are also continuing our efforts to resolve specific productspecification issues with a few select customers from the prior quarter.

 

Sales of 5 inch and 6inch diameter GaAs substrates were $6.1 million for the three months ended September 30,2008 compared to $3.1 million for the three months ended September 30,2007. The increase in larger diameter semi-insulating substrates came from thegrowth in demand for both cellular and WLAN (Wide Local Area Network) markets.Our growth came particularly from production orders pursuant to a supplyagreement we signed in the fourth quarter of 2007 with IQE plc.

 

Sales of 2 inch, 3 inchand 4 inch diameter GaAs substrates were $7.5 million for the three monthsended September 30, 2008 compared with $6.8 million for the three monthsended September 30, 2007. The increase in revenue from smaller diametersubstrates was due to the continued market growth generally of LED laser diodesand commercial epitaxy primarily from 4 inch large semi-conducting customersoffset by lesser demand from 2 inch customers.

 

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InP substrate revenueincreased $76,000, or 18.6%, to $484,000 for the three months ended September 30,2008 from $408,000 for the three months ended September 30, 2007 primarilydue to a slight increase in demand from customers in the optical networkingindustry.

 

Ge substrate revenueincreased $259,000, or 48.3%, to $795,000 for the three months ended September 30,2008 from $536,000 for the three months ended September 30, 2007. Theincrease in Ge substrate revenue was due to an overall increased demand forspace applications.

 

Raw materials revenuedecreased $654,000, or 18.1%, to $3.0 million for the three months ended September 30,2008 from $3.6 million for the three months ended September 30, 2007. Thedecrease in raw materials revenue was primarily due to transportationrestrictions imposed in the Beijing area during the Olympics and Paralympicswhich ended on September 30, 2008.

 
| ** **    | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|---------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **    | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **    | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs          |       | $                                                   | 40,479     |         | $          | 27,997         |       | $ | 12,482 |   | 44.6 | % |
| InP           |       | 1,462                                               |       | 1,586        |       | (124           | )          | (7.8 | )% |
| Ge            |       | 3,564                                               |       | 1,479        |       | 2,085          |       | 141.0 | % |
| Raw materials |       | 11,912                                              |       | 9,532        |       | 2,380          |       | 25.0 | % |
| Other         |       | 12                                                  |       | 45           |       | (33            | )          | (73.3 | )% |
| Total revenue |       | $                                                   | 57,429     |         | $          | 40,639         |       | $ | 16,790 |   | 41.3 | % |

 

Revenue increased $16.8million, or 41.3%, to $57.4 million for the nine months ended September 30,2008 from $40.6 million for the nine months ended September 30, 2007.Total GaAs substrate revenue increased $12.5 million, or 44.6%, to $40.5million for the nine months ended September 30, 2008 from $28.0 millionfor the nine months ended September 30, 2007. While this is a largeincrease over the prior year, the demand for our GaAs products which are usedin a number of consumer, industrial and automotive applications was softer thanwe expected due to an overall market slowdown and lower than expected demandfrom customer orders. We are also continuing our efforts to resolve specific productspecification issues with a few select customers from the prior quarter.

 

Sales of 5 inch and 6inch diameter GaAs substrates were $19.0 million for the nine months ended September 30,2008 compared to $11.1 million for the nine months ended September 30,2007. The increase in larger diameter semi-insulating substrates came from thegrowth in demand for both cellular and WLAN (Wide Local Area Network) markets.Our growth came particularly from production orders pursuant to a supplyagreement we signed in the fourth quarter of 2007 with IQE plc.

 

Sales of 2 inch, 3 inchand 4 inch diameter GaAs substrates were $21.5 million for the nine monthsended September 30, 2008 compared with $16.9 million for the nine monthsended September 30, 2007. The increase in revenue from smaller diametersubstrates was due to the continued market growth generally of LED laser diodesand commercial epitaxy primarily from 4 inch large semi-conducting customersoffset by lesser demand from 2 inch customers.

 

InP substrate revenuedecreased $124,000, or 7.8%, to $1.5 million for the nine months ended September 30,2008 from $1.6 million for the nine months ended September 30, 2007. Inthe nine months ended June 30, 2007 we had a one-time sale of $251,000indium scrap metal that was fully reserved. Excluding the impact of theone-time sale, InP substrate revenue actually increased $127,000 for the ninemonths ended September 30, 2008 compared to the nine months ended September 30,2007 due to a slight increase in demand from customers in the opticalnetworking industry.

 

Ge substrate revenueincreased $2.1 million, or 141.0%, to $3.6 million for the nine months ended September 30,2008 from $1.5 million for the nine months ended September 30, 2007. Theincrease in Ge substrate revenue was due to an overall increased demand forspace applications.

 

Raw materials revenueincreased $2.4 million, or 25.0%, to $11.9 million for the nine months ended September 30,2008 from $9.5 million for the nine months ended September 30, 2007. Despitethe transportation restrictions imposed in the Beijing area during the Olympicsand Paralympics which ended on September 30, 2008, the increase in rawmaterials revenue was primarily due to a combination of increased sales tocustomers as demand increased and higher raw materials prices.

 

21

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***Tableof Contents***

*** ***

***Revenueby Geographic Region***

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                           |       | $                                                    | 5,030      |         | $          | 2,820          |       | $ | 2,210 |   | 78.4 | % |
| *% of total revenue*                      |       | 28                                                   | %          | 20           | %          |           |       |   |   |
| Europe                                    |       | 2,913                                                |       | 2,521        |       | 392            |       | 15.5 | % |
| *% of total revenue*                      |       | 16                                                   | %          | 17           | %          |           |       |   |   |
| Japan                                     |       | 3,557                                                |       | 3,301        |       | 256            |       | 7.8 | % |
| *% of total revenue*                      |       | 20                                                   | %          | 23           | %          |           |       |   |   |
| Taiwan                                    |       | 1,978                                                |       | 2,444        |       | (466           | )          | (19.1 | )% |
| *% of total revenue*                      |       | 11                                                   | %          | 17           | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 4,385                                                |       | 3,388        |       | 997            |       | 29.4 | % |
| *% of total revenue*                      |       | 25                                                   | %          | 23           | %          |           |       |   |   |
| Total revenue                             |       | $                                                    | 17,863     |         | $          | 14,474         |       | $ | 3,389 |   | 23.4 | % |

 

----

*Primarily the UnitedStates

 

Revenue fromcustomers in North America increased by $2.2 million, or 78.4%, to $5.0 millionfor the three months ended September 30, 2008 from $2.8 million for thethree months ended September 30, 2007. We expected our North Americarevenue to increase substantially in 2008 based upon a supply agreement wesigned in the fourth quarter of 2007 with IQE plc. Under the terms of the agreement, IQE plc shallpurchase from us a minimum of approximately $15.1 million of 4-inch and 6-inchsemi-insulating gallium arsenide (GaAs) substrates.  IQE plc has an optionto purchase an additional $3.5 million of 6-inch substrates from us under theagreement.  All substrates ordered pursuant to the agreement are to beshipped by the end of 2008.

 

Revenue from customers inEurope increased by $0.4 million, or 15.5%, to $2.9 million for the threemonths ended September 30, 2008 from $2.5 million for the three monthsended September 30, 2007. This increase came primarily from increasedsubstrate sales to customers in Germany and France, and to a lesser extent fromincreased sales to a customer in the United Kingdom that is part of the IQE plcgroup with whom we signed a supply agreement in the fourth quarter of 2007.

 

Revenue from customers inJapan increased by $0.3 million, or 7.8%, to $3.6 million for the three monthsended September 30, 2008 from $3.3 million for the three months ended September 30,2007. The increase came from increased substrate sales to two major existingcustomers, particularly in large diameter wafers, and from increased rawmaterial sales of 4N gallium.

 

Revenue from customers inTaiwan decreased by $0.5 million, or 19.1%, to $2.0 million for the threemonths ended September 30, 2008 from $2.4 million for the three monthsended September 30, 2007. The decrease came mainly from one major existingcustomer for large diameter wafers as we continue our effort to resolvingissues with product specifications.

 

Revenue from customers inAsia Pacific (excluding Japan and Taiwan) increased by $1.0 million, or 29.4%,to $4.4 million for the three months ended September 30, 2008 from $3.4million for the three months ended September 30, 2007. The increase camemainly from one major customer in Singapore that is part of the IQE plcgroup that signed the supply agreement with us in the fourth quarter of 2007.

*** ***
| ** **                                | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                           |       | $                                                   | 15,466     |         | $          | 8,918          |       | $ | 6,548 |   | 73.4 | % |
| *% of total revenue*                      |       | 27                                                  | %          | 22           | %          |           |       |   |   |
| Europe                                    |       | 9,696                                               |       | 7,163        |       | 2,533          |       | 35.4 | % |
| *% of total revenue*                      |       | 17                                                  | %          | 18           | %          |           |       |   |   |
| Japan                                     |       | 12,292                                              |       | 8,699        |       | 3,593          |       | 41.3 | % |
| *% of total revenue*                      |       | 21                                                  | %          | 21           | %          |           |       |   |   |
| Taiwan                                    |       | 6,846                                               |       | 6,512        |       | 334            |       | 5.1 | % |
| *% of total revenue*                      |       | 12                                                  | %          | 16           | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 13,129                                              |       | 9,347        |       | 3,782          |       | 40.5 | % |
| *% of total revenue*                      |       | 23                                                  | %          | 23           | %          |           |       |   |   |
| Total revenue                             |       | $                                                   | 57,429     |         | $          | 40,639         |       | $ | 16,790 |   | 41.3 | % |

 

----

*Primarily the UnitedStates

 

22

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Table of Contents

 

Revenue fromcustomers in North America increased by $6.5 million, or 73.4%, to $15.5million for the nine months ended September 30, 2008 from $8.9 million forthe nine months ended September 30, 2007. We expected our North Americarevenue to increase substantially in 2008 based upon a supply agreement wesigned in the fourth quarter of 2007 with IQE plc. Under the terms of the agreement, IQE plc shallpurchase from us a minimum of approximately $15.1 million of 4-inch and 6-inchsemi-insulating gallium arsenide (GaAs) substrates.  IQE plc has an optionto purchase an additional $3.5 million of 6-inch substrates from us under theagreement.  All substrates ordered pursuant to the agreement are to beshipped by the end of 2008.

 

Revenue from customers inEurope increased by $2.5 million, or 35.4%, to $9.7 million for the nine monthsended September 30, 2008 from $7.2 million for the nine months ended September 30,2007. This increase came primarily from increased substrate sales to customersin Germany and France, and to a lesser extent from increased sales to acustomer in the United Kingdom that is part of the IQE plc group with whom wesigned a supply agreement in the fourth quarter of 2007.

 

Revenue from customers inJapan increased by $3.6 million, or 41.3%, to $12.3 million for the nine monthsended September 30, 2008 from $8.7 million for the nine months ended September 30,2007. The increase came from increased substrate sales to two major existingcustomers, particularly in large diameter wafers, and from increased rawmaterial sales of 4N gallium.

 

Revenue from customers inTaiwan increased by $0.3 million, or 5.1%, to $6.8 million for the nine monthsended September 30, 2008 from $6.5 million for the nine months ended September 30,2007. The increase came mainly from one major existing customer for largediameter wafers as we continue our effort to resolving issues with product specifications.

 

Revenue from customers inAsia Pacific (excluding Japan and Taiwan) increased by $3.8 million, or 40.5%,to $13.1 million for the nine months ended September 30, 2008 from $9.3million for the nine months ended September 30, 2007. Sales to customersin the People’s Republic of China increased by $2.7 million, of which rawmaterials was $1.4 million, while $0.7 million was from increased sales ofsubstrates to existing customers, and $0.6 million was from sales of substratesto new customers. Sales to a major customer in Singapore that is part of theIQE plc group that signed the supply agreement with us in the fourthquarter of 2007 increased by $0.7 million. Sales to customers in Koreaincreased by $0.4 million as demand increased in smaller diameter wafers.

 

***Gross Margin***

 
| ** **       | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **       | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit     |       | $                                                    | 4,537      |         | $          | 4,530          |       | $ | 7 |   | 0.2 | % |
| *Gross Margin %* |       | 25.4                                                 | %          | 31.3         | %          |           |       |   |   |
|                  |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Grossmargin decreased to 25.4% of total revenue for the three months ended September 30,2008 from 31.3% of total revenue for the three months ended September 30,2007. Gross margins in the three months ended September 30, 2008 and 2007were positively impacted by sales of approximately $769,000 and $556,000,respectively, of GaAs wafers that were previously fully reserved. In the threemonths ended September 30, 2007 we had manufacturing equipment that hadbecome fully depreciated.  Since thebeginning of 2008, gross margins were negatively impacted by declining averageselling prices and rising raw material costs, as well as an increase indepreciation as a result of our purchase of equipment acquired for our capacityexpansion. The decline in sales in the third quarter of 2008 from the priorquarter also resulted in lower throughput of production with less recovery ofoverheads.

 
| ** **       | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **       | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit     |       | $                                                   | 17,202     |         | $          | 14,967         |       | $ | 2,235 |   | 14.9 | % |
| *Gross Margin %* |       | 30.0                                                | %          | 36.8         | %          |           |       |   |   |
|                  |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Grossmargin decreased to 30.0% of total revenue for the nine months ended September 30,2008 from 36.8% of total revenue for the nine months ended September 30,2007. Gross margins in the nine months ended September 30, 2008 and 2007were positively impacted by sales of approximately $2.1 million and $1.7million, respectively, of GaAs wafers that were previously fully reserved. Inthe nine months ended September 30, 2007 we had manufacturing equipmentthat had become fully depreciated. In addition, during the nine months ended September 30,2007, we had a one-time sale of $251,000 of indium scrap metal that was fullyreserved.  Since the beginning of 2008,gross margins were negatively impacted by declining average selling prices andrising raw material costs, as well as an increase in depreciation as a resultof our purchase of equipment acquired for our capacity expansion.

 

 

23

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

*** ***
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                   | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative expenses |       | $                                                    | 4,901      |         | $          | 3,083          |       | $ | 1,818 |   | 59.0 | % |
| *% of total revenue*                         |       | 27.4                                                 | %          | 21.3         | %          |           |       |   |   |
|                                              |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Selling, general andadministrative expenses increased $1.8 million to $4.9 million for the threemonths ended September 30, 2008 from $3.1 million for the three monthsended September 30, 2007. The increase was primarily due to $700,000 rentdeposit forfeited, $394,000 higher bad debt expenses for our slow-payingcustomers in Asia, $225,000 increased selling, general and administrativeexpenses in our China joint ventures, mainly labor related, $219,000 increasedcompensation related expenses from general annual adjustments and increasedheadcount, $141,000 higher bank fees in connection with our paydown of therevenue bond in July 2008, $127,000 higher insurance costs, and $12,000higher miscellaneous costs. The $700,000 rent deposit forfeited was a result ofa termination of our existing lease. We entered into a new lease with the samelandlord for smaller headquarters facilities at a saving of approximately $2.5million over the next seven years.

 
| ** **                                   | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                   | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative expenses |       | $                                                   | 12,146     |         | $          | 10,529         |       | $ | 1,617 |   | 15.4 | % |
| *% of total revenue*                         |       | 21.1                                                | %          | 25.9         | %          |           |       |   |   |
|                                              |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Selling, general andadministrative expenses increased $1.6 million, or 15.4% to $12.1 million forthe nine months ended September 30, 2008 from $10.5 million for the ninemonths ended September 30, 2007. The increase was primarily due to $702,000higher compensation related expenses from general annual adjustments andincreased headcount, $700,000 rent deposit forfeited, $585,000 increasedselling, general and administrative expenses in our China joint ventures,mainly labor related, $205,000 higher insurance costs, $126,000 higher bankfees in connection with our paydown of the revenue bond in July 2008, and$41,000 higher miscellaneous costs, partially offset by $420,000 lower bad debtexpense and $322,000 lower legal and professional fees. Legal fees in the ninemonths ended September 30, 2007 included $350,000 which was our portion ofthe settlement of the securities class action lawsuit reached on April 24,2007. The $700,000 rent deposit forfeited was a result of a termination of ourexisting lease. We entered into a new lease with the same landlord for smallerheadquarters facilities at a saving of approximately $2.5 million over the nextseven years.

 

***Researchand Development***

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                                    | 562        |         | $          | 382            |       | $ | 180 |   | 47.1 | % |
| *% of total revenue*     |       | 3.1                                                  | %          | 2.6          | %          |           |       |   |   |
|                          |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Research and developmentexpenses increased $180,000, or 47.1% to $562,000 for the three months ended September 30,2008 from $382,000 for the three months ended September 30, 2007. Theincrease was due to salary and related costs associated with the appointment ofa new chief technology officer effective December 31, 2007, higherconsulting fees and general annual salary and related cost increases.

 
| ** **               | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                                   | 1,635      |         | $          | 1,190          |       | $ | 445 |   | 37.4 | % |
| *% of total revenue*     |       | 2.8                                                 | %          | 2.9          | %          |           |       |   |   |
|                          |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Research and developmentexpenses increased $445,000, or 37.4% to $1.6 million for the nine months endedSeptember 30, 2008 from $1.2 million for the nine months ended September 30,2007. The increase was due to salary and related costs associated with theappointment of a new chief technology officer effective December 31, 2007,higher consulting fees and general annual salary and related cost increases.

 

24

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***Impairment (Recovery) onAssets Held For Sale***

*** ***
| ** **                                    | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Impairment (Recovery) on assets held for sale |       | $                                                   | 83         |         | $          | (481           | )          | $ | (564 | ) | 117.3 | % |
| *% of total revenue*                          |       | 0.1                                                 | %          | -1.2         | %          |           |       |   |   |
|                                               |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

During the ninemonths ended September 30, 2008, we completed the sale of our property inFremont, California. The final purchase price for the property was $5.3million. We received net proceeds of $5.1 million after deducting commissionsand selling expenses. We recorded an impairment charge upon the sale of theproperty of $83,000.  During the ninemonths ended September 30, 2007, we benefited from a recovery ofimpairment on assets held for sale in connection with our adjustment of thefair value of the same property in Fremont, California, which had beendecontaminated and was being prepared for sale. We recorded a $481,000 market value adjustment after we entered into anagreement with an independent third party purchaser in June 2007.  However, the sale was not consummated withthis purchaser under this agreement, and the property was not sold until March 2008to a different independent third-party purchaser.

.

***InterestIncome, net***

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net |       | $                                                    | 68         |         | $          | 102            |       | $ | (34 | ) | (33.3 | )% |
| *% of total revenue* |       | 0.4                                                  | %          | 0.7          | %          |           |       |   |   |
|                      |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Interest income, netdecreased $34,000 to $68,000 for the three months ended September 30, 2008from $102,000 for the three months ended September 30, 2007.  Interest income, net for the three monthsended September 30, 2008 was due to the overall lower balances of our cashand investments after we paid down on our taxable revenue bond and use of cashin operations, offset by lower interest expense related to the revenue bond,while interest income, net for the three months ended September 30, 2007was primarily generated from the net proceeds of our public offering of commonstock, completed in December 2006 and January 2007.

 
| ** **           | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net |       | $                                                   | 433        |         | $          | 551            |       | $ | (118 | ) | (21.4 | )% |
| *% of total revenue* |       | 0.8                                                 | %          | 1.4          | %          |           |       |   |   |
|                      |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Interest income, netdecreased $118,000 to $433,000 for the nine months ended September 30,2008 from $551,000 for the nine months ended September 30, 2007 as aresult of higher balances of our cash and investments in the nine months ended September 30,2007, which came from the net proceeds of our public offering of common stock,completed in December 2006 and January 2007.  The lower balances of our cash andinvestments as of September 30, 2008 also resulted from our paydown of thetaxable revenue bond.

 

***Minority interests***

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Minority interests   |       | $                                                    | (277       | )            | $          | (537           | )          | $ | (260 | ) | (48.4 | )% |
| *% of total revenue* |       | (1.6                                                 | )%         | (3.7         | )%         |           |       |   |   |
|                      |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Minority interestsdecreased $260,000 or 48.4% to $277,000 for the three months ended September 30,2008 from $537,000 for the three months ended September 30, 2007 due tothe transportation restrictions imposed in the Beijing area during the Olympicsand Paralympics which impacted the sales of raw materials from our threemajority-owned joint ventures, and accordingly the minority interestsdecreased.

 

25

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| ** **           | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Minority interests   |       | $                                                   | (1,424     | )            | $          | (1,290         | )          | $ | 134 |   | 10.4 | % |
| *% of total revenue* |       | (2.5                                                | )%         | (3.2         | )%         |           |       |   |   |
|                      |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Minority interestsincreased $134,000 or 10.4% to $1.4 million for the nine months ended September 30,2008 from $1.3 million for the nine months ended September 30, 2007 aseach of our three majority-owned joint ventures increased sales due to capacityexpansion, and were more profitable, and consequently the minority interestsincreased, offset by the temporary impact of decreased sales in the quarterended September 30, 2008 due to the transportation restrictions imposed inthe Beijing area during the Olympics and Paralympics.

 

***Other Income, net***

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income, net    |       | $                                                    | 298        |         | $          | 381            |       | $ | (83 | ) | (21.8 | )% |
| *% of total revenue* |       | 1.7                                                  | %          | 2.6          | %          |           |       |   |   |
|                      |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

Other income, net was $298,000for the three months ended September 30, 2008 primarily due to $367,000from our equity earnings of the two minority-owned joint ventures that are notconsolidated, partially offset by $69,000 in foreign exchanges losses. Otherincome, net was $381,000 for the three months ended September 30, 2007primarily due to $199,000 from our equity earnings from the two minority-ownedjoint ventures that are not consolidated, $162,000 in foreign exchange gainsand $20,000 of miscellaneous items.

 
| ** **           | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **           | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **           | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income, net    |       | $                                                   | 707        |         | $          | 851            |       | $ | (144 | ) | (16.9 | )% |
| *% of total revenue* |       | 1.2                                                 | %          | 2.1          | %          |           |       |   |   |
|                      |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

Other income, net was$707,000 for the nine months ended September 30, 2008 primarily due to$812,000 from our equity earnings from the two minority-owned joint venturesthat are not consolidated, $326,000 from our realized gain on sale ofinvestments, and $42,000 other income, partially offset by $473,000 in foreignexchange losses. Other income, net was $851,000 for the nine months ended September 30,2007 primarily $767,000 from our equity earnings from the two minority-ownedjoint ventures that are not consolidated and $212,000 other income, mainlyinsurance proceeds from a fire loss in China, partially offset by foreignexchange losses of $128,000.

 

***Provisionfor Income Taxes***

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2008**                                             | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**                       | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                                    | 177        |         | $          | 153            |       | $ | 24 |   | 15.7 | % |
| *% of total revenue*       |       | 1.0                                                  | %          | 1.1          | %          |           |       |   |   |
|                            |            |                                                      |            |              |            |                |            |  |  |  |  |  |

 

We provided for incometaxes of $177,000 for our China operations for the three months ended September 30,2008 compared to $153,000 for the three months ended September 30, 2007.Beginning in 2008, the tax provision was calculated based on the assumptionthat we will no longer receive refunds for profit reinvestments in China.

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2008**                                            | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**                      | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                                   | 1,372      |         | $          | 426            |       | $ | 946 |   | 222.1 | % |
| *% of total revenue*       |       | 2.4                                                 | %          | 1.0          | %          |           |       |   |   |
|                            |            |                                                     |            |              |            |                |            |  |  |  |  |  |

 

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We provided for incometaxes of $1.4 million for our China operations for the nine months ended September 30,2008 compared to $426,000 for the nine months ended September 30, 2007.Beginning in 2008, the tax provision was calculated based on the assumptionthat we will no longer receive refunds for profit reinvestments in China.

 

**Liquidityand Capital Resources**

 

As of September 30,2008, our principal sources of liquidity were $29.5 million in cash and cashequivalents and short-term investments, excluding restricted deposits. Weconsider cash and cash equivalents and short-term investments as liquid andavailable for use. Short-term investments are comprised of government bonds andhigh-grade commercial debt instruments.

 

Cashand cash equivalents and short-term investments of $29.5 million decreased by$7.5 million in the third quarter of 2008 compared to the second quarter of2008.  On July 1, 2008, we spentapproximately $6.4 million plus accrued interest to pay down our taxablerevenue bond and approximately $4.0 million was spent in operations.  In September 2008, we obtained anexpress line of credit of $5.0 million from Citigroup Smith Barney and drewdown $3.0 million for operating purposes and classified the same amount asrestricted deposits as of September 30, 2008. The $3.0 million restrictedcash carries an annual interest rate of 4.0%.

 

Net cash used inoperating activities of $8.4 million for the nine months ended September 30,2008 was primarily comprised of our net income of $1.7 million, adjusted fornon-cash items of depreciation of $1.5 million, stock-based compensation of$0.5 million, partially offset by a realized gain on sale of investments of$0.3 million, and offset by a net increase of $11.8 million in assets andliabilities. The $11.8 million net increase in assets and liabilities primarilyresulted from a $13.9 million increase in inventories, $1.1 million increase inaccounts receivable, $0.9 million decrease in accrued liabilities,$0.7 million decrease in other long-term liabilities, primarily minorityinterests, a $0.1 million decrease in income taxes payable, partiallyoffset by a $4.1 million increase in accounts payable, and a $0.8 milliondecrease in prepaid and other assets.

 

Inventories, net,increased by $13.9 million, as we increased inventory in raw materials andwork-in-process to increase production in anticipation of increased forecastsales, and finished goods for consignment orders. Inventory in raw materials inour joint ventures increased due to transportation restrictions during theBeijing Olympics and Paralympics.

 

Accounts receivable, netincreased by $1.1 million, as a result of increased sales partially offset byan increase in our allowance for doubtful accounts. Our days sales outstanding(DSO) is 68 days as of September 30, 2008, compared to 64 days as of December 31,2007.

 

Net cash provided byinvesting activities of $4.6 million for the nine months ended September 30,2008 was primarily from the proceeds from the sale of investments of $24.4million, proceeds from sale of assets held for sale of $5.1 million and thedecrease of restricted cash of $3.7 million, partially offset by the purchaseof investments totaling $22.6 million, and the purchase of property, plant andequipment of $6.0 million.

 

We expect to invest approximately$0.8 million in capital projects for the remainder of 2008. We believe that ourexisting and planned facilities and equipment are sufficient to fulfill currentand expected future orders.

 

Net cash used infinancing activities of $3.5 million for the nine months ended September 30,2008 consisted of payments of $6.7 million related to long-term borrowings,partially offset by $3.0 million proceeds from our express line of credit, and$0.2 million from the proceeds from the exercise of employee stock options.

 

We believe that we haveadequate cash and investments to meet our needs over the next 12 months. If ourperformance fails to improve, we will continue to use cash and may at some timebe forced to seek additional capital. There can be no assurance that suchadditional capital will be available or, if available it will be at termsacceptable to us. Cash from operations could be affected by various risks anduncertainties, including, but not limited to those set forth below under Item1A “Risks Factors.”

 

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Outstanding contractualobligations as of September 30, 2008 are summarized as follows (inthousands):

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More than  5 years** | ** ** |
| Line of credit                   |       | $                                         | 3,000      |   | $ | 3,000 |   | $ | — |   | $ | — |   | $ | — |   |
| Debt                             |       | 18                                        |       | — |   | 18 |   | — |   | — |   |
| Operating leases                 |       | 2,045                                     |       | 321 |   | 509 |   | 556 |   | 659 |   |
| Less: Sublease income            |       | (31                                       | )          | (31 | ) | — |   | — |   | — |   |
| Tenant improvement loan          |       | 660                                       |       | 79 |   | 189 |   | 189 |   | 203 |   |
| Purchase obligation              |       | 1,245                                     |       | 1,245 |   | — |   | — |   | — |   |
| Total                            |       | $                                         | 6,937      |   | $ | 4,614 |   | $ | 716 |   | $ | 745 |   | $ | 862 |   |

 

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 $0.2million and $0.5 million for the three month periods ended September 30,2008 and 2007, respectively.  On July 2,2008, we entered into a new lease agreement with T. Drive Partners, L.P., aCalifornia partnership of the facility located at 4281 Technology Drive,Fremont California with approximately 27,760 square feet.  The new lease shall commence on December 1,2008 for a term of seven years, with an option by us to cancel after fiveyears, upon forfeiture of the security deposit and payment of one-half of thefifth year’s rent.  The base rent for thenew lease shall be $0.72 per square foot per month triple net, with annualrental increases of 4.5% per annum, payment of $50,000 security deposit, andtenant improvements of $575,000 to be amortized over seven years at 4% perannum.

 

OnFebruary 27, 2007, we entered into an agreement with Recapture MetalsLimited of Ontario, Canada (“Recapture”), pursuant to which Recapture willsupply our subsidiary in the PRC with one thousand kilograms per month of99.99999% pure gallium, during the eighteen month period beginning July 1,2007. Under the terms of the agreement, we are required to purchase a minimumof eighteen thousand kilograms of gallium, unless the agreement is terminatedprior to the expiration of the eighteen month period on December 31, 2008.

 

**RecentAccounting Pronouncements**

 

In May 2008, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 162“The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”).SFAS No. 162 identifies the sources of accounting principles and theframework for selecting the principles used in the preparation of financialstatements of nongovernmental entities that are presented in conformity withgenerally accepted accounting principles (GAAP) in the United States (the GAAPhierarchy). SFAS No. 162 will be effective 60 days following theSEC’s approval of the Public Company Accounting Oversight Board’s amendments toAU Section 411, “The Meaning of Present Fairly in Conformity WithGenerally Accepted Accounting Principles.” The FASB has stated that it does notexpect that SFAS No. 162 will result in a change in current practice.

 

In March 2008, the FASB issued SFAS No. 161, “*Disclosures about Derivative Instruments and Hedging Activities*”(“SFAS 161”). SFAS 161 requires companies with derivative instruments todisclose information that should enable financial-statement users to understandhow and why a company uses derivative instruments, how derivative instrumentsand related hedged items affect a company’s financial position, financialperformance and cash flows. SFAS 161 is effective for financial statementsissued for fiscal years and interim periods beginning after November 15,2008. Based on our current operations, we do not expect that theadoption of SFAS 161 will have a material impact on our consolidatedfinancial position or results of operations.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), “*Business Combinations*”,(“SFAS 141R”). SFAS 141R establishes the principles and requirementsfor how an acquirer in a business combination (1) recognizes and measuresin its financial statements the identifiable assets acquired, the liabilitiesassumed and any non-controlling interest in the acquiree, (2) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase and (3) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS 141(R) will be applicable beginningwith our fiscal 2009. The impact of the adoption of SFAS 141(R) onour results of operations and financial position will depend on the nature andextent of business combinations that we complete, if any, in or after fiscal2009.

 

In December 2007, the FASB issued SFAS No. 160,*“Noncontrolling Interests in Consolidated FinancialStatements”* (“SFAS 160”). SFAS 160 requires that minorityinterest be separately reported in the consolidated entity’s equity section and

 

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that no gainor loss shall be reported when transactions occur between the controllinginterest and the non-controlling interests. Furthermore, the acquisition ofnon-controlling interest by the controlling interest is not treated as abusiness combination. SFAS 160 is effective for fiscal years beginningafter December 15, 2008. We have not yet evaluated the impact that theadoption of SFAS 160 will have on our consolidated financial position,results of operations or cash flows.

 

In February 2007, the FASB issued SFAS No. 159,“*The Fair Value Option for Financial Assetsand Financial Liabilities—Including an amendment of FASB Statement No. 115*”(“SFAS 159”). SFAS 159 expands the use of fair value accounting tomany financial instruments and certain other items. The fair value option isirrevocable and generally made on an instrument-by-instrument basis, even if acompany has similar instruments that it elects not to measure based on fairvalue. SFAS 159 is effective for fiscal years beginning after November 15,2007. We do not have any instruments eligible for election of the fair valueoption. Therefore, the adoption of SFAS 159 in the first quarter of fiscal 2008did not impact our consolidated financial position, results of operations orcash flows

 

In September 2006, the FASB issued SFAS No. 157,“*Fair Value Measurements*” (“SFAS 157”).SFAS 157 defines fair value, establishes a framework and gives guidanceregarding the methods used for measuring fair value, and expands disclosuresabout fair value measurements. SFAS 157 is effective for financial statementsissued for fiscal years beginning after November 15, 2007, and interimperiods of those fiscal years. In February 2008, the FASB released a FASBStaff Position (FSP FAS 157-2— *EffectiveDate of FASB Statement No. 157*) which delays the effective dateof SFAS 157 for all nonfinancial assets and nonfinancial liabilities, exceptthose that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually) to fiscal years beginningafter November 15, 2008. These non-financial items include assets andliabilities such as reporting units measured at fair value in a goodwillimpairment test and non-financial assets acquired and liabilities assumed in abusiness combination. The partial adoption of SFAS 157 as of January 1,2008 for financial assets and liabilities did not have a material impact on ourcondensed consolidated financial position, results of operations or cash flows.See Note 3 of the Notes to Condensed Consolidated Financial Statements.

 

On October 10, 2008, the FASB issued FASB StaffPosition (“FSP”) No. 157-3 (“FSP 157-3”), “*Determining the Fair Value of a Financial Asset When the Market forThat Asset is Not Active”* (“FSP 157-3”), to clarify the applicationof SFAS 157 in a market that is not active, providing an example to illustratekey considerations in determining the fair value of a financial asset when themarket for that financial asset is not active. This FSP applies to financial assets within the scope of accountingpronouncements that require or permit fair value measurement in accordance withSFAS 157 and is effective upon issuance. We have determined there is no impact from adopting the provisions of FSP157-3 on our consolidated financial position, results of operations orcash flows.

 

In various areas, including revenue recognition,stock option accounting, accounting standards and practices continue to evolve.Additionally, the SEC and the FASB’s Emerging Issues Task Force continue toaddress revenues, stock option accounting related accounting issues. We believethat we are in compliance with all of the rules and related guidance asthey currently exist. However, any changes to accounting principles generallyaccepted in the United States of America in these areas could impact the futureaccounting of our operations.

 

**ITEM 3*.*QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

***Foreign CurrencyRisk***

 

A significant portion of our business is conductedin currencies other than the U.S. dollar. The functional currency for ourforeign operations is the Renminbi, the local currency of China, where ouroperating expenses are predominantly in the local currency. Since most of ouroperations are conducted in China, most of our costs are incurred in Chinesecurrency, which subjects us to fluctuations in the exchange rates between theU.S. dollar and the Chinese Renminbi. We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for thesesubsidiaries, as well as in translation of the assets and liabilities of theseassets at each balance sheet date. These risks may be increased by thefluctuations and revaluations of the Chinese Renminbi. Our financial resultscould be adversely affected by factors such as changes in foreign currencyexchange rates or weak economic conditions in foreign markets, including therevaluation by China of the Renminbi, and any future adjustments that China maymake to its currency such as any move it might make to a managed float systemswith opportunistic interventions. We also have certain trade accountsreceivable denominated in Japanese Yen. In the future we may experience foreignexchange losses on our non-functional currency denominated receivables andpayables to the extent that we have not mitigated our exposure utilizingforeign currency forward exchange contracts. Foreign exchange losses could havea materially adverse effect on our operating results and cash flows.

 

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We do not currently use short-term forwardexchange contracts for hedging purposes to reduce the effects of adverse foreignexchange rate movements. We had previously purchased foreign exchange contractsto hedge against certain trade accounts receivable denominated in Japanese yen.The change in the fair value of the forward contracts was recognized as part ofthe related foreign currency transactions as they occur. As of September 30,2008, we had no outstanding commitments with respect to foreign exchangecontracts.

 

In the three months ended September 30,2008, we recorded net realized foreign exchange losses of $69,000, included aspart of other expense in our consolidated statements of operations. The foreignexchange losses were primarily due to fluctuation in the Japanese Yen versusthe U.S. dollar on our Yen-denominated accounts receivables. During the thirdquarter of 2008, we recorded unrealized foreign currency gains of $28,000 incumulative other comprehensive income on our condensed consolidated balancesheets.

 

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***Interest Rate Risk***

 

Cash and cash equivalents earning interestand certain variable rate debt instruments are subject to interest ratefluctuations. The following table sets forth the probable impact of a 10% changein interest rates (in thousands):

 
| **Instrument**                            | ** ** | **Balance as of  September 30,  2008** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash                                      |       | $                                                     | 11,577     |                        | 0.50       | %                                                     | $          | 58                                                                   |       | $                                                                     | 64         |   | $ | 52 |   |
| Investment in debt and equity instruments |       | 20,895                                                |       | 2.32                        | %          | 485                                                   |       | 534                                                                  |       | 437                                                                   |       |
| Long-term debt                            |       | (3,000                                                | )          | 4.06                        | %          | (138                                                  | )          | (152                                                                 | )          | (124                                                                  | )          |
|                                      |       |                                                  |       |                        |       | $                                                     | 405        |                                                                 | $          | 446                                                                   |       | $ | 365 |   |
|                                           |            |                                                       |            |                             |            |                                                       |            |                                                                      |            |                                                                       |            |  |  |  |  |

 

The primary objective of our investmentactivities is to preserve principal while maximizing income withoutsignificantly increasing risk. Financial instruments that potentially subjectus to concentration of credit risk consist primarily of cash equivalents,short-term investments, and trade accounts receivable. We invest primarily inmoney market accounts, commercial paper instruments, and investment gradesecurities. We are exposed to credit risks in the event of default by theissuers to the extent of the amount recorded on the consolidated balancesheets. These securities are generally classified as available-for-sale andconsequently are recorded on the balance sheet at fair value with unrealizedgains or losses reported as a separate component of accumulated othercomprehensive income, net of estimated tax. Our cash, cash equivalents andshort-term investments are in high-quality securities placed with major banksand financial institutions and commercial paper. We have no investments inauction rate securities.

 

***Equity Risk***

 

We maintain minority investments inprivately-held companies. These investments are reviewed for other thantemporary declines in value on a quarterly basis. These investments areclassified as other assets in the condensed consolidated balance sheets and areaccounted for either under the cost method or under the equity method as we donot have the ability to exercise significant influence over their operations.We monitor our investments for impairment and record reductions in carryingvalue when events or changes in circumstances indicate that the carrying valuemay not be recoverable. 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. As of September 30, 2008,the minority investments accounted for under the cost method totaled$0.4 million, while minority investments accounted for under the equitymethod totaled $3.7 million.

 

**ITEM 4*.*CONTROLSAND PROCEDURES**

 

***Disclosure Controls andProcedures***

 

Under thesupervision and with the participation of our management, our Chief ExecutiveOfficer and Chief Financial Officer have evaluated the effectiveness of thedesign and operation of our disclosure controls and procedures, as such termsare defined under Rule 13a-15(e) and 15d-15(e) promulgated underthe Securities Exchange Act of 1934, as amended. Based upon that evaluation,our Chief Executive Officer and our Chief Financial Officer concluded that theour disclosure controls and procedures were effective as of the end of theperiod covered by this quarterly report.

 

***Changes in InternalControl Over Financial Reporting***

 

No change inour internal control over financial reporting was made in the three monthsended September 30, 2008 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**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.

 

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On October 15, 2004, a purportedsecurities class action lawsuit was filed in the United States Court for theNorthern District of California, City of Harper Woods Employees RetirementSystem v. AXT, Inc. et al., No. C 04 4362 MJJ. The Court consolidatedthe case with a subsequent 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 named AXT, Inc.and our former chief technology officer as defendants, and was brought onbehalf of a class of all purchasers of our securities from February 6,2001 through April 27, 2004. The complaint alleged that we announcedfinancial results during this period that were false and misleading. Nospecific amount of damages was claimed. On September 23, 2005, the Courtgranted our motion to dismiss the complaint, with leave to amend. The leadplaintiff filed an amended complaint, which we had moved to dismiss. On April 24,2007, we reached a settlement of this litigation. On February 27, 2008,the district court approved the settlement, and subsequently entered a judgmentof dismissal.

 

**Item 1A. Risk Factors**

 

Inaddition to the risk factors set forth under Part I, Item 1A. “Risk Factors” inour Annual Report on Form 10K for the fiscal year ended December 31, 2007, webelieve the following risk factors also apply to AXT during 2008:

 

***The average selling prices ofour products may decline over relatively short periods, which may reduce ourgross margins.***

 

Themarket for our products is characterized by declining average selling pricesresulting from factors such as increased competition, overcapacity, theintroduction of new products and decreased sales of products incorporating ourproducts and average selling pricesfor our products may decline over relatively short time periods.  We have in the past experienced,and in the future may experience, substantial period-to-period fluctuations inoperating results due to declining average selling prices.  Onaverage, we have experienced average selling price declines over the course ofthe last twelve months of anywhere from approximately 5 to 20% per yeardepending on the product.  It is alsopossible for the pace of average selling price declines to accelerate beyondthese levels for certain products in a commoditizing market.  We anticipate that averageselling prices will decrease in the future in response to product introductionsby competitors or us, or by other factors, including pricing pressures fromsignificant customers.  When our average selling prices decline, ourgross profits decline unless we are able to sell more products or reduce thecost to manufacture our products. We generally attempt to combat averageselling price declines by improving yields, manufacturing efficiency andworking to reduce the costs of our raw materials and of manufacturing ourproducts. We have in the past and may in the future experience declining salesprices, which could negatively impact our revenues, gross profits and financialresults. We therefore need to sell our current products in increasing volumesto offset any decline in their average selling prices, and introduce newproducts, which we may not be able to do, or do on a timely basis. 

 

We may be unable to reducethe cost of our products sufficiently to enable us to compete with others. Ourcost reduction efforts may not allow us to keep pace with competitive pricingpressures and could adversely affect our margins. In order to remaincompetitive, we must continually reduce the cost of manufacturing our productsthrough design and engineering changes. We may not be successful in deliveringour products to market in a timely manner. We cannot assure you that anychanges effected by us will result in sufficient cost reductions to allow us toreduce the price of our products to remain competitive or improve our grossmargins. 

 

***Shifts in our product mix may result in declines in gross margins.***

 

Our gross profit marginsvary among our product families, and are generally higher on our largerdiameter wafers.  In addition, historicallyour gross margins have been higher on our raw materials sales.  Accordingly, our overall gross margins havefluctuated from period to period as a result of shifts in product mix, theintroduction of new products, decreases in average selling prices for productsand our ability to reduce product costs, and these fluctuations are expected tocontinue in the future. 

 

We do not control the pricesat which our joint venture companies sell their raw materials products to otherthird parties.  However, as weconsolidate the results of three of these companies with our own, any reductionin their gross margins could have a significant, adverse impact on our overallgross margins.  One or more of our jointventure companies has in the past and may in the future sell raw materials atsignificantly reduced prices in order to gain volume sales, or sales to newcustomers.  In such an event, our grossmargin may be adversely impacted.

 

***Ongoing financial market volatilityand adverse changes in the domestic and global economic environment could havea significant adverse impact on our business, financial condition and operatingresults***

 

Ourbusiness and operating results could be significantly impacted by generaleconomic conditions. In recent months, the U.S. and global economy hasexperienced a significant downturn due to the effects of the credit marketcrisis, slower economic activity and a generally negative economic outlook, adecrease in consumer and business confidence and liquidity concerns. Global market and economic conditions continue to be disruptive andvolatile.  The possible duration and severity of this adverse economiccycle is unknown. Although the Company remains well-capitalized and has notsuffered any liquidity issues as a result of these recent events, the cost andavailability of funds may be adversely affected by illiquid creditmarkets.  Continued turbulence in U.S. and international markets andeconomies may adversely affect the Company’s liquidity, financial condition andprofitability.  A severe or prolonged economic downturn could result in avariety of risks to our business, including:

 

·                  increased volatility in our stock price;

·                  increased volatility in foreign currencyexchange rates;

·                  delays in, or curtailment of, purchasingdecisions by our customers or potential customers either as a result of overalleconomic uncertainty or as a result of their inability to access the liquiditynecessary to engage in purchasing initiatives;

·                  increased credit risk associated with ourcustomers or potential customers, particularly those that may operate inindustries most affected by the economic downturn, such as financial services;and

·                  impairment of our intangible or other assets.

 

Wehave experienced and expect to continue to experience delays in customerpurchasing decisions or disruptions in normal volume of customer orders that webelieve are in part due to the uncertainties in the global economy and anadverse impact on consumer spending. To the extent that the current economicdownturn worsens or persists, or any of the above risks occur, our business andoperating results could be significantly and adversely affected.

 

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

 

None

 

**Item 3. Defaults uponSenior Securities**

 

None

 

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

 

None

 

**Item 5. Other Information**

 

None

 

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**Item 6. Exhibits**

 

**a.Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                           |
| 3.1(1)              |       | Restated  Certificate of Incorporation                                                                                                                         |
|                |       |                                                                                                                                                           |
| 3.2(2)              |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock.                                                                          |
|                |       |                                                                                                                                                           |
| 3.3(3)              |       | Second  Amended and Restated By Laws                                                                                                                           |
|                |       |                                                                                                                                                           |
| 4.2(4)              |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                          |
|                |       |                                                                                                                                                           |
| 10.28(5)            |       | Lease  Agreement executed July 2, 2008 by and between AXT, Inc. and T.  Drive Partners, L.P. a California partnership.                               |
|                |       |                                                                                                                                                           |
| 31.1                |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 31.2                |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 32.1                |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                           |
| 32.2                |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

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

 

(2) Incorporatedby reference to Exhibit 3.1 to our Form 8-K as filed with the SEC on June 14,1999.

 

(3)  Incorporatedby reference to Exhibit 3.4 to our Form 8-K as filed with the SEC on May 30,2001.

 

(4) Incorporatedby reference to the exhibit of the same number as filed with the SEC in our Form 8-Kon May 30, 2001.

 

(5) Incorporatedby reference to the exhibit of the same number as filed with the SEC in our Form 8-Kon July 8, 2008.

 

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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:  November 10, 2008 | By:       | /s/ Philip  C. S. Yin |
|                           |      | Philip C. S.  Yin |
|                           |      | Chairman of  the Board and   Chief Executive Officer |
|                           |      | (Principal  Executive Officer) |
|                           |      |   |
|                           |      | /s/ Wilson  W. Cheung |
|                           |      | Wilson W.  Cheung |
|                           |      | Chief  Financial Officer |
|                           |      | (Principal  Financial and Accounting Officer) |

 

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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  (which is incorporated herein by reference to Exhibit 2.1 to the registrant’s  form 8-K dated May 28, 1999). |
|        |       |                                                                                                                                                                                                                   |
| 3.3(3)      |       | Second  Amended and Restated By Laws                                                                                                                                                                                   |
|        |       |                                                                                                                                                                                                                   |
| 4.2(4)      |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                                                                                  |
|        |       |                                                                                                                                                                                                                   |
| 10.28(5)    |       | Lease  Agreement executed July 2, 2008 by and between AXT, Inc. and T.  Drive Partners, L.P. a California partnership.                                                                                       |
|        |       |                                                                                                                                                                                                                   |
| 31.1        |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                             |
|        |       |                                                                                                                                                                                                                   |
| 31.2        |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                             |
|        |       |                                                                                                                                                                                                                   |
| 32.1        |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                         |
|        |       |                                                                                                                                                                                                                   |
| 32.2        |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                         |

 

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

 

(2) Incorporatedby reference to Exhibit 3.1 to our Form 8-K as filed with the SEC on June 14,1999.

 

(3) Incorporatedby reference to Exhibit 3.4 to our Form 8-K as filed with the SEC on May 30,2001.

 

(4) Incorporatedby reference to the exhibit of the same number as filed with the SEC in our Form 8-Kon May 30, 2001

 

(5) Incorporatedby reference to the exhibit as of the same number as filed with the SEC in our Form 8-Kon July 8, 2008.

 

36

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