**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

| **ý**                                                                                                                                                    | ** ** | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **for the quarterly period ended March 31,  2006**                                                                                                            |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                    |
| **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.) |

 

**4281 Technology Drive, Fremont, California94538**

(Address of principal executiveoffices) (Zip code)

 

**(510) 683-5900**

(Registrant’s telephone number,including area code)

 

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

 

Indicate by checkmarkwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Act. (Check one):

 

Large accelerated filer o                                           Acceleratedfiler  o                                             Non-accelerated filer ý

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).YES  o NO  ý

 

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

 
| **Class**                      | ** ** | **Outstanding  at April 28, 2006** |
|--------------------------------|------------|------------------------------------|
| Common Stock, $0.001 par value |       | 23,053,521                         |

 

 

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AXT, INC.FORM 10-QTABLE OF CONTENTS

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

 

2

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**PARTI. FINANCIAL INFORMATION**

 

**Item1. Financial Statements**

 

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

 
| ** **                                                                                                                                                                     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| Assets:                                                                                                                                                                        |       |                |       |                   |       |
| Current assets                                                                                                                                                                 |       |                |       |                   |       |
| Cash and cash equivalents                                                                                                                                                      |       | $                   | 12,853     |                   | $          | 17,472 |   |
| Investments                                                                                                                                                                    |       | 9,163               |       | 5,555                  |       |
| Accounts receivable, net of allowance of  $628 and $619 as of March 31, 2006 and December 31, 2005, respectively                                                               |       | 5,917               |       | 5,226                  |       |
| Inventories, net                                                                                                                                                               |       | 15,802              |       | 16,156                 |       |
| Prepaid expenses and other current assets                                                                                                                                      |       | 2,859               |       | 1,801                  |       |
| Total current assets                                                                                                                                                           |       | 46,594              |       | 46,210                 |       |
| Property, plant and equipment, net                                                                                                                                             |       | 16,359              |       | 17,306                 |       |
| Restricted deposits                                                                                                                                                            |       | 7,450               |       | 7,450                  |       |
| Other assets                                                                                                                                                                   |       | 3,685               |       | 3,832                  |       |
| Total assets                                                                                                                                                                   |       | $                   | 74,088     |                   | $          | 74,798 |   |
|                                                                                                                                                                           |       |                |       |                   |       |
| Liabilities and stockholders’ equity:                                                                                                                                     |       |                |       |                   |       |
| Current liabilities                                                                                                                                                            |       |                |       |                   |       |
| Accounts payable                                                                                                                                                               |       | $                   | 2,463      |                   | $          | 3,070 |   |
| Accrued liabilities                                                                                                                                                            |       | 2,792               |       | 3,533                  |       |
| Accrued restructuring                                                                                                                                                          |       | 128                 |       | 465                    |       |
| Current portion of long-term debt                                                                                                                                              |       | 450                 |       | 300                    |       |
| Income taxes payable                                                                                                                                                           |       | 2,966               |       | 2,495                  |       |
| Total current liabilities                                                                                                                                                      |       | 8,799               |       | 9,863                  |       |
| Long-term debt, net of current portion                                                                                                                                         |       | 7,102               |       | 7,420                  |       |
| Other long-term liabilities                                                                                                                                                    |       | 1,643               |       | 1,897                  |       |
| Total liabilities                                                                                                                                                              |       | 17,544              |       | 19,180                 |       |
| Commitments and contingencies  (Note 11)                                                                                                                                  |       |                |       |                   |       |
| Stockholders’ equity:                                                                                                                                                     |       |                |       |                   |       |
| Preferred stock, $0.001 par value per share;  2,000 shares authorized; 883 shares issued and outstanding                                                                       |       | 3,532               |       | 3,532                  |       |
| Common stock, $0.001 par value per share;  70,000 shares authorized; 23,007 and 22,977 shares issued and outstanding as  of March 31, 2006 and December 31, 2005, respectively |       | 23                  |       | 23                     |       |
| Additional paid-in capital                                                                                                                                                     |       | 155,764             |       | 155,441                |       |
| Accumulated deficit                                                                                                                                                            |       | (106,979            | )          | (104,776               | )          |
| Accumulated other comprehensive income                                                                                                                                         |       | 4,204               |       | 1,398                  |       |
| Total stockholders’ equity                                                                                                                                                |       | 56,544              |       | 55,618                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                |       | $                   | 74,088     |                   | $          | 74,798 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

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

 
| ** **                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                     | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                           |       |                              |       |   |   |
| Revenue                                                        |       | $                                 | 8,471      |   | $ | 6,634 |   |
| Cost of revenue                                                |       | 6,961                             |       | 6,355 |   |
| Gross profit                                                   |       | 1,510                             |       | 279 |   |
| Operating expenses:                                            |       |                              |       |   |   |
| Selling, general and administrative                            |       | 3,230                             |       | 4,252 |   |
| Research and development                                       |       | 534                               |       | 362 |   |
| Restructuring charges                                          |       | (2                                | )          | 125 |   |
| Total operating expenses                                       |       | 3,762                             |       | 4,739 |   |
| Loss from operations                                           |       | (2,252                            | )          | (4,460 | ) |
| Interest income, net                                           |       | 128                               |       | 119 |   |
| Other income (expense), net                                    |       | 238                               |       | (105 | ) |
| Loss before provision for income taxes                         |       | (1,886                            | )          | (4,446 | ) |
| Provision for incomes taxes                                    |       | 318                               |       | 35 |   |
| Loss from continuing operations                                |       | (2,204                            | )          | (4,481 | ) |
| Discontinued operations:                                       |       |                              |       |   |   |
| Gain from discontinued operations, net of  tax                 |       | 1                                 |       | 58 |   |
| Gain on disposal, net of tax                                   |       | —                            |       | 300 |   |
| Net loss                                                       |       | $                                 | (2,203     | ) | $ | (4,123 | ) |
|                                                           |       |                              |       |   |   |
| Basic and diluted loss per share:                              |       |                              |       |   |   |
| Loss from continuing operations                                |       | $                                 | (0.10      | ) | $ | (0.20 | ) |
| Gain from discontinued operations                              |       | —                            |       | 0.01 |   |
| Net loss                                                       |       | $                                 | (0.10      | ) | $ | (0.18 | ) |
|                                                           |       |                              |       |   |   |
| Shares used in computing basic and diluted  net loss per share |       | 22,986                            |       | 23,147 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

4

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

 
| ** **                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                         | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                               |       |                              |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                              |       |                              |       |   |   |
| Net loss                                                           |       | $                                 | (2,203     | ) | $ | (4,123 | ) |
| Adjustments to reconcile net loss to net  cash used in operations: |       |                              |       |   |   |
| Depreciation                                                       |       | 838                               |       | 1,312 |   |
| Amortization of marketable securities  premium/discount            |       | (9                                | )          | 87 |   |
| Non-cash restructuring charge                                      |       | —                            |       | 125 |   |
| Loss on disposal of property, plant and  equipment                 |       | 48                                |       | 175 |   |
| Stock based compensation                                           |       | 257                               |       | (5 | ) |
| Realized gain on sale of investments                               |       | (376                              | )          | — |   |
| Changes in assets and liabilities:                                 |       |                              |       |   |   |
| Accounts receivable, net                                           |       | (691                              | )          | (428 | ) |
| Inventories, net                                                   |       | 354                               |       | 478 |   |
| Prepaid expenses                                                   |       | (1,058                            | )          | (828 | ) |
| Other assets                                                       |       | 147                               |       | 30 |   |
| Accounts payable                                                   |       | (607                              | )          | (116 | ) |
| Accrued liabilities                                                |       | (1,078                            | )          | 96 |   |
| Income taxes                                                       |       | 471                               |       | 104 |   |
| Other long-term liabilities                                        |       | (254                              | )          | (117 | ) |
| Net cash used in operating activities                              |       | (4,161                            | )          | (3,210 | ) |
|                                                               |       |                              |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                              |       |                              |       |   |   |
| Purchases of property, plant and equipment                         |       | (98                               | )          | (217 | ) |
| Proceeds from sales of property, plant and  equipment              |       | 159                               |       | — |   |
| Purchases of investments                                           |       | (3,670                            | )          | (2,200 | ) |
| Proceeds from sale of investments                                  |       | 3,382                             |       | 8,354 |   |
| Net cash provided by (used in) investing  activities               |       | (227                              | )          | 5,937 |   |
|                                                               |       |                              |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                              |       |                              |       |   |   |
| Proceeds from (payments of):                                       |       |                              |       |   |   |
| Issuance of common stock                                           |       | 66                                |       | 60 |   |
| Repurchase of common stock                                         |       | —                            |       | (29 | ) |
| Long-term debt payments                                            |       | (168                              | )          | (150 | ) |
| Net cash used in financing activities                              |       | (102                              | )          | (119 | ) |
| Effect of exchange rate changes                                    |       | (129                              | )          | (144 | ) |
| Net increase (decrease) in cash and cash  equivalents              |       | (4,619                            | )          | 2,464 |   |
| Cash and cash equivalents at the beginning  of the period          |       | 17,472                            |       | 12,117 |   |
| Cash and cash equivalents at the end of the  period                |       | $                                 | 12,853     |   | $ | 14,581 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

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

**Note 1. Basis of Presentation**

 

The accompanying condensedconsolidated financial statements of AXT, Inc. (“AXT”, “Company”, “we,” “us,”and “our” refer to AXT, Inc. and all of its consolidated subsidiaries) areunaudited, and have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, the year-end condensed balance sheet data was derived fromaudited financial statements, but does not include all disclosures required by accountingprinciples generally accepted in the United States of America. In the opinionof management, the unaudited condensed consolidated financial statementsreflect all adjustments, consisting only of normal recurring adjustments,considered necessary to present fairly the financial position, results ofoperations and cash flows of AXT and its subsidiaries for all periodspresented.

 

Management of the Company hasmade a number of estimates and assumptions relating to the reporting of assetsand liabilities and the disclosure of contingent assets and liabilities toprepare these condensed consolidated financial statements in conformity withaccounting principles generally accepted in the United States of America.Actual results could differ materially from those estimates.

 

The results of operations arenot necessarily indicative of the results to be expected in the future or forthe 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 2005 Annual Report on Form10-K filed with the Securities and Exchange Commission on March 30, 2006.

 

Certain reclassifications havebeen made to the prior years’ condensed consolidated financial statements toconform to current period presentation.

 

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

 

In June 2003, we announcedthe discontinuation of our opto-electronics division, which we had establishedas part of our acquisition of Lyte Optronics, Inc. in May 1999. Thediscontinued opto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and traffic signals,and also manufactured vertical cavity surface emitting lasers (VCSELs) andlaser diodes for fiber optic communications and storage area networks.Accordingly, the results of operations of the opto-electronics division havebeen segregated from continuing operations and are reported separately asdiscontinued operations in our consolidated statements of operations for allperiods presented.

 

In September 2003, wecompleted the sale of substantially all of the assets of our opto-electronicsbusiness to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science andTechnology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6million.

 

In June 2005, we completedthe sale of a building located in Monterey Park, California. This asset hadbeen classified as “assets held for sale” in the amount of $1.25 million on theconsolidated balance sheet as of December 31, 2004. We received netproceeds on the sale of the property of approximately $1.3 million andaccordingly recorded a gain on disposal of $53,000.

 

Our condensed consolidatedfinancial statements have been presented to reflect the opto-electronicsbusiness as a discontinued operation for all periods presented. Operatingresults of the discontinued operation are as follows (in thousands):

 
| ** **                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                             |       | $                                | —     |   | $ | — |   |
| Cost of revenue                     |       | —                           |       | — |   |
|                                |       |                             |       |   |   |
| Gross loss                          |       | —                           |       | — |   |
| Operating expenses:                 |       |                             |       |   |   |
| Selling, general and administrative |       | (1                               | )     | (58 | ) |
| Research and development            |       | —                           |       | — |   |
| Impairment costs                    |       | —                           |       | — |   |
| Total operating expenses            |       | (1                               | )     | (58 | ) |
| Gain from operations, net of tax    |       | 1                                |       | 58 |   |
| Gain on disposal, net of tax        |       | —                           |       | 300 |   |
| Net income                          |       | $                                | 1          |   | $ | 358 |   |

 

6

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The carrying value of theassets and liabilities of the discontinued opto-electronics business includedin the condensed consolidated balance sheets are as follows (in thousands):

 
| ** **                        | ** ** | **March 31, 2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|--------------------|------------|------------------------|------------|
| Current  assets:                  |       |               |       |                   |       |
| Cash                              |       | $                  | 449        |                   | $          | 472 |   |
| Accounts receivable, net          |       | —             |       | —                 |       |
| Assets held for sale              |       | —             |       | —                 |       |
| Total current assets              |       | 449                |       | 472                    |       |
| Other assets                      |       | —             |       | —                 |       |
| Total assets                      |       | $                  | 449        |                   | $          | 472 |   |
| Current  liabilities:             |       |               |       |                   |       |
| Accrued liabilities               |       | $                  | 71         |                   | $          | 95 |   |
| Total liabilities                 |       | 71                 |       | 95                     |       |
| Net assets                        |       | 378                |       | 377                    |       |
| Total liabilities  and net assets |       | $                  | 449        |                   | $          | 472 |   |

 

**Note****3. Accounting forStock-Based Compensation**

 

Effective January 1, 2006,we adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(revised 2004), “*Share-Based Payment*,”(“SFAS 123(R)”). SFAS 123(R) establishes accounting for stock-basedawards exchanged for employee services. Accordingly, stock-based compensationcost is measured at grant date, based on the fair value of the award, and isrecognized as expense over the employee requisite service period. All of theCompany’s stock compensation is accounted for as an equity instrument. TheCompany previously applied Accounting Principles Board (“APB”) OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations and provided the required pro forma disclosures of SFASNo. 123, “Accounting for Stock-Based Compensation”.

 

Wehave elected the modified prospective transition method for adopting SFAS123(R). Under this method, the provisions of SFAS 123(R) apply to all awardsgranted or modified after the date of adoption. The unrecognized expense ofawards not yet vested at the date of adoption will be recognized in net income(loss) in the periods after the date of adoption using the same Black-Scholesvaluation method and assumptions determined under the original provisions ofSFAS 123, “ *Accounting for Stock-BasedCompensation,”*as disclosed in our previous quarterly and annualreports.

 

*Prior tothe Adoption of SFAS  123(R)*

 

Prior to the adoption of SFAS123 (R), we provided the disclosures required under SFAS No. 123, “Accountingfor Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation — Transition and Disclosures.” SFAS 123(R) requires us to present proforma information for the comparative period prior to adoption as if we hadaccounted for all our employee stock options under the fair value method of theoriginal SFAS 123. The following table illustrates the effect on net loss and netloss per share if we had applied the fair value recognition provisions of SFAS123 to stock-based employee compensation to the prior-year period (inthousands, except per-share data):

 
| ** **                                                                                       | ** ** | **Three Months  Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                           | ** ** |
| Stock-based compensation in the form of  employee stock options, included in:                    |       |                               |       |
| Net loss as reported                                                                             |       | $                                  | (4,123     | ) |
| Selling, general and administrative                                                              |       | (5                                 | )          |
| Stock-based employee  compensation expense included in reported net loss                         |       | (235                               | )          |
|                                                                                             |       |                               |       |
| Total stock-based compensation expense determined under fair value based  methods for all awards |       | $                                  | (4,363     | ) |
|                                                                                             |       |                               |       |
| Basic and diluted net loss per common share                                                      |       |                               |       |
|                                                                                             |       |                               |       |
| As reported                                                                                      |       | $                                  | (0.18      | ) |
|                                                                                             |       |                               |       |
| Pro forma                                                                                        |       | $                                  | (0.19      | ) |

 

7

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

 

We elected to adopt themodified prospective application method as provided by SFAS 123(R), and we recorded $257,000 of stockcompensation expense on our unaudited condensed consolidated statement ofoperations for the three months ended March 31, 2006. We elected not to capitalize any stock-basedcompensation to inventory at January 1, 2006 when the provisions of SFAS123(R) were initially adopted. We utilized the Black-Scholes valuation model for estimating the fairvalue of the stock compensation granted both before and after the adoption ofSFAS 123(R). In accordance with the modified prospective method, ourcondensed consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS No. 123(R).The following table summarizes compensation costs related to our stock-basedcompensation plan (in thousands, except per-share data):

 
| ** **                                                                    | ** ** | **Three Months  Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                           | ** ** |
| Stock-based  compensation in the form of employee stock options, included in: |       |                               |       |
| Cost of revenue                                                               |       | $                                  | 28         |   |
| Selling, general and administrative                                           |       | 173                                |       |
| Research and development                                                      |       | 56                                 |       |
| Total stock-based compensation                                                |       | 257                                |       |
| Tax effect on stock-based compensation                                        |       | —                             |       |
| Net effect on net loss                                                        |       | $                                  | 257        |   |
|                                                                          |       |                               |       |
| Effect on basic and diluted net loss per  share                               |       | $                                  | (0.01      | ) |

 

AtMarch 31, 2006, the total compensation cost related to unvestedstock-based awards granted to employees under our stock option plan but not yetrecognized was approximately $1.2 million, net of estimated forfeitures of$158,000. This cost will be amortized on a straight-line basis over aweighted-average period of approximately 1.3 years and will be adjusted forsubsequent changes in estimated forfeitures.

 

Theamortization of stock compensation under SFAS 123(R) for the period after ourJanuary 1, 2006 adoption is based on the single-option approach.

 

We estimate the fair value ofstock options using a Black-Scholes valuation model, consistent with theprovisions of SFAS 123(R), SEC SAB No. 107 and our prior period pro formadisclosures of net loss, including stock-based compensation (determined under afair value method as prescribed by SFAS No. 123). The fair value of our stock options granted to employeesfor the three months ended March 31, 2006 and 2005 was estimated using thefollowing weighted-average assumptions:

 

| ** **                  | ** ** | **Three Months Ended   March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Expected term (in years)    |       | 5.0                                               |       | 5.0 |   |
| Volatility                  |       | 86.2                                              | %          | 95.4 | % |
| Expected dividend           |       | 0                                                 | %          | 0 | % |
| Risk-free interest rate     |       | 4.82                                              | %          | 4.20 | % |
| Estimated forfeitures       |       | 9.59                                              | %          | 0 | % |
| Weighted-average fair value |       | $                                                 | 1.53       |   | $ | 0.86 |   |
|                             |            |                                                   |            |  |  |  |  |

 

8

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The following table summarizesthe stock option transactions during the three months ended March 31, 2006(in thousands, except per share amounts):

 
| ** **                                                  | ** ** | **March 31, 2006**                | ** ** | **Aggregate  intrinsic  value**                                 | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------------------------|------------|
| **Shares**                                                  | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted  average  remaining  contractual  life  (in years)** |
| Options outstanding at January 1, 2006                      |       | 2,917                                  |       | $                                                               | 2.30       |   |   |   |   |   |
| Granted                                                     |       | 16                                     |       | 2.30                                                            |       |   |   |   |   |
| Exercised                                                   |       | (30                                    | )          | 2.21                                                            |       |   |   |   |   |
| Canceled                                                    |       | (68                                    | )          | 1.48                                                            |       |   |   |   |   |
|                                                        |       |                                   |       |                                                            |       |   |   |   |   |
| Options outstanding at March 31, 2006                  |       | 2,835                                  |       | $                                                               | 2.32       |   | 7.2 |   | $ | 5,613 |   |
|                                                        |       |                                   |       |                                                            |       |   |   |   |   |
| Options vested and expected to vest at  March 31, 2006 |       | 2,694                                  |       | $                                                               | 2.37       |   | 7.1 |   | $ | 5,261 |   |
| Options exercisable at March 31, 2006                  |       | 1,675                                  |       | $                                                               | 2.91       |   | 6.0 |   | $ | 2,813 |   |

 

The total intrinsic value ofoptions exercised for the three months ended March 31, 2006 was $66,000. Cashreceived from option exercises for the three months ended March 31, 2006 was$66,000. The total fair value of options vested for the three months endedMarch 31, 2006 was $509,000.

 

9

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

** **

Our cash, cash equivalents andinvestments are classified as follows (in thousands):

 
| ** **                                    | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Amortized  Cost**          | ** ** | **Gross  Unrealized  Gain**     | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** |
| **Classified  as:**                           | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash                                          |       | $                            | 5,812      |                            | $          | — |   | $ | — |   | $ | 5,812 |   | $ | 12,803 |   | $ | — |   | $ | — |   | $ | 12,803 |   |
| Cash equivalents:                             |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market fund                             |       | 3,301                        |       | —                          |       | — |   | 3,301 |   | 1,729 |   | — |   | — |   | 1,729 |   |
| Commercial paper                              |       | 3,740                        |       | —                          |       | — |   | 3,740 |   | 2,940 |   | — |   | — |   | 2,940 |   |
| Repurchase agreements                         |       | —                       |       | —                          |       | — |   | — |   | — |   | — |   | — |   | — |   |
|                                          |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cash  equivalents                       |       | 7,041                        |       | —                          |       | — |   | 7,041 |   | 4,669 |   | — |   | — |   | 4,669 |   |
| Total cash and  cash equivalents              |       | 12,853                       |       | —                          |       | — |   | 12,853 |   | 17,472 |   | — |   | — |   | 17,472 |   |
|                                          |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                  |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and  agency securities            |       | 4,473                        |       | —                          |       | (14 | ) | 4,459 |   | 4,460 |   | — |   | (12 | ) | 4,448 |   |
| Asset-backed  securities                      |       | 2,604                        |       | —                          |       | (9 | ) | 2,595 |   | 3,285 |   | — |   | (11 | ) | 3,274 |   |
| Corporate bonds                               |       | 3,941                        |       | —                          |       | (16 | ) | 3,925 |   | 2,504 |   | — |   | (13 | ) | 2,491 |   |
| Corporate equity  securities                  |       | 1,372                        |       | 4,262                           |       | — |   | 5,634 |   | 1,468 |   | 1,324 |   | — |   | 2,792 |   |
| Total investments                             |       | 12,390                       |       | 4,262                           |       | (39 | ) | 16,613 |   | 11,717 |   | 1,324 |   | (36 | ) | 13,005 |   |
| Total cash, cash  equivalents and investments |       | $                            | 25,243     |                            | $          | 4,262 |   | $ | (39 | ) | $ | 29,466 |   | $ | 29,189 |   | $ | 1,324 |   | $ | (36 | ) | $ | 30,477 |   |
|                                          |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Contractual  maturities on investments:**   | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Due within 1 year                             |       | $                            | 6,478      |                            |       |   |   |   | $ | 10,724 |   | $ | 8,384 |   |   |   |   |   | $ | 9,682 |   |
| Due after 1  through 5 years                  |       | 5,912                        |       |                            |       |   |   | 5,889 |   | 3,333 |   |   |   |   |   | 3,323 |   |
|                                          |       | $                            | 12,390     |                            |       |   |   |   | $ | 16,613 |   | $ | 11,717 |   |   |   |   |   | $ | 13,005 |   |

 

The investments include $7.5million recorded as restricted deposits on the condensed consolidated balancesheets as of March 31, 2006 and December 31, 2005.

 

We manage our investments as asingle portfolio of highly marketable securities that is intended to beavailable to meet our current cash requirements. For the three months ended March 31,2006, we had $376,000 gross realized gains on sales of our available-for-salesecurities. For the three months ended March 31, 2005, we had no gross realizedgains or losses on sales of our available-for-sale securities.

 

The gross unrealized lossesrelated to our portfolio of available-for-sale securities were primarily due toa decrease in the fair value of debt and equity securities as a result of anincrease in interest rates during 2005 and the first three months of 2006. Wehave determined that the gross unrealized losses on our available-for-salesecurities as of March 31, 2006 are temporary in nature. We reviewed ourinvestment portfolio to identify and evaluate investments that have indicationsof possible impairment. 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,

 

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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 March 31, 2006 (inthousands):

 
| ** **                        | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**                            | ** ** | **Fair  Value**                  | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| Short-term investments:           |       |                                                     |       |                                                     |       |                             |       |   |   |   |   |   |   |
| US Treasury and agency securities |       | $                                                        | 1,377      |                                                     | $          | (4                               | )          | $ | 3,082 |   | $ | (10 | ) | $ | 4,459 |   | $ | (14 | ) |
| Asset-backed securities           |       | 924                                                      |       | (2                                                       | )          | 1,671                            |       | (7 | ) | 2,595 |   | (9 | ) |
| Corporate bonds                   |       | 2,789                                                    |       | (12                                                      | )          | 1,136                            |       | (4 | ) | 3,925 |   | (16 | ) |
| Total in loss position            |       | $                                                        | 5,090      |                                                     | $          | (18                              | )          | $ | 5,889 |   | $ | (21 | ) | $ | 10,979 |   | $ | (39 | ) |

 

**Note 5. Inventories, Net**

 

The components of inventoriesare summarized below (in thousands):

 
| ** **         | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------|------------|---------------------|------------|------------------------|------------|
| Inventories,  net: |       |                |       |                   |       |
| Raw materials      |       | $                   | 6,212      |                   | $          | 6,667 |   |
| Work in process    |       | 8,789               |       | 9,141                  |       |
| Finished goods     |       | 801                 |       | 348                    |       |
|               |       | $                   | 15,802     |                   | $          | 16,156 |   |

 

**Note 6. Restructuring Charges**

 

Our restructuring accrual is asfollows (in thousands):

 
| **For the three month period  ended March 31, 2006**   | ** ** | **Restructuring  Accrual as of  December 31, 2005** | ** ** | **Additions/  Reversals** | ** ** | **Payments** | ** ** | **Restructuring Accrual as of March 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------|------------|--------------|------------|------------------------------------------------|------------|
| Future lease payments related to abandoned  facilities |       | $                                                   | 250        |                      | $          | —       |       | $                                              | (122       | ) | $ | 128 |   |
| Workforce reduction                                    |       | 215                                                 |       | (2                        | )          | (213         | )          | —                                         |       |
| Total                                                  |       | $                                                   | 465        |                      | $          | (2           | )          | $                                              | (335       | ) | $ | 128 |   |

 

In December 2005, we reducedthe workforce at our Fremont, California facility by approximately 15positions that are no longer required to support production and operations, orapproximately 29 percent. This measure was taken as part of our ongoingeffort to downsize our Fremont, California facility headcount.  Accordingly, we recorded a restructuringcharge of approximately $273,000 related to the reduction in force forseverance-related expenses, of which $215,000 was the balance as of December31, 2005. As of March 31, 2006 we completed the reduction in force.

 

As of March 31, 2006 the remaining restructuringaccrual for future lease payments related to abandoned U.S. facilities is $128,000,is expected to be paid out through 2006, and is included on the accompanyingcondensed consolidated balance sheet as accrued restructuring.

 

**Note7. Net Loss Per Share**

 

Basic net loss per common shareis calculated by dividing net loss available to common stockholders by theweighted average number of common shares outstanding during the period. Dilutednet loss per common and common equivalent

 

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shares include the dilutive effect of commonstock equivalents outstanding during the period calculated using the treasurystock method. Common stock equivalents consist of the shares issueable upon theexercise of stock options.

 

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

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Numerator:                                                                       |       |                              |       |   |   |
| Net loss                                                                         |       | $                                 | (2,203     | ) | $ | (4,123 | ) |
| Less: Preferred stock dividends                                                  |       | (44                               | )          | (44 | ) |
| Net loss available to common stockholders                                        |       | $                                 | (2,247     | ) | $ | (4,167 | ) |
| Denominator:                                                                     |       |                              |       |   |   |
| Denominator for basic net loss per share -  weighted average common shares       |       | 22,986                            |       | 23,147 |   |
| Effect of dilutive securities:                                                   |       |                              |       |   |   |
| Common stock options                                                             |       | —                            |       | — |   |
| Denominator for dilutive net loss per  common share                              |       | 22,986                            |       | 23,147 |   |
| Basic and diluted net loss per share                                             |       | $                                 | (0.10      | ) | $ | (0.18 | ) |
| Options excluded from diluted net loss per  share as the impact is anti-dilutive |       | 2,835                             |       | 2,534 |   |

 

**Note 8. Comprehensive Loss**

 

The components of comprehensiveloss are as follows (in thousands):

 
| ** **                                                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                                      |       |                              |       |   |   |
| Net loss                                                                  |       | $                                 | (2,203     | ) | $ | (4,123 | ) |
| Foreign  currency translation loss                                        |       | (129                              | )          | (144 | ) |
| Unrealized gain (loss) on available for  sale investments                 |       | 3,311                             |       | (1,221 | ) |
| Less: reclassification adjustment for  realized gain included in net loss |       | (376                              | )          | — |   |
| Comprehensive  gain (loss)                                                |       | $                                 | 603        |   | $ | (5,488 | ) |

 

**Note 9. Segment Information and ForeignOperations**

 

***SegmentInformation***

 

We operate in one segment forthe design, development, manufacture and distribution of high-performancecompound semiconductor substrates and sale of materials. In accordance withSFAS No. 131, *“Disclosures aboutSegments of an Enterprise and Related Information,”* (“SFAS No. 131”)our chief operating decision-maker has been identified as the Chief ExecutiveOfficer, who reviews operating results to make decisions about allocatingresources and assessing performance for the Company. All material operatingunits qualify for aggregation under SFAS No. 131 due to theiridentical customer base and similarities in economic characteristics, nature ofproducts and services, and procurement, manufacturing and distribution processes.Since we operate in one segment, all financial segment and product lineinformation required by SFAS No. 131 can be found in the condensedconsolidated financial statements.

 

***Geographical Information***

 

The following table representsrevenue amounts (in thousands) reported for products shipped to customers inthe corresponding geographic region:

 

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| ** **         | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------|------------|-----------------------------------|------------|
| ** **         | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Net  revenues:     |       |                              |       |   |   |
| North America*     |       | $                                 | 1,959      |   | $ | 972 |   |
| Europe             |       | 1,406                             |       | 1,782 |   |
| Japan              |       | 666                               |       | 240 |   |
| Taiwan             |       | 1,514                             |       | 1,660 |   |
| Asia Pacific       |       | 2,926                             |       | 1,980 |   |
| Consolidated total |       | $                                 | 8,471      |   | $ | 6,634 |   |

 

----

*      Primarily the United States

 

Long-lived assets consistprimarily of property, plant and equipment, and are attributed to thegeographic location in which they are located. Long-lived assets by geographicregion were as follows (in thousands):

 
| ** **          | ** ** | **As of**      | ** ** |
|---------------------|------------|---------------------|------------|
| ** **          | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
| Long-lived  assets: |       |                |       |   |   |
| North America       |       | $                   | 6,411      |   | $ | 6,547 |   |
| Asia Pacific        |       | 9,948               |       | 10,759 |   |
|                |       | $                   | 16,359     |   | $ | 17,306 |   |

 

***Significant Customers***

 

Two customers represented 14.3%and 12.1%, respectively, of revenues for the three month period ended March 31,2006. One customer represented 12.9% of revenues for the three month period endedMarch 31, 2005. Our top five customers represented 45.8% and 44.6% of revenuefor the three month periods ended March 31, 2006 and 2005, respectively.

 

**Note 10. Corporate Affiliates**

 

We have made strategicinvestments in private companies located in China in order to gain access toraw materials at a competitive cost that are critical to our substratebusiness. Our investments in these private corporate affiliates are summarizedbelow (in thousands):

 
| **Affiliate**                                  | ** ** | **Investment Balance as of** | ** ** | **Accounting  Method** | ** ** | **Ownership  Percentage** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|------------------------|------------|---------------------------|------------|
| **March 31,  2006**                       | ** ** | **December 31,  2005**       |
| Beijing Ji  Ya Semiconductor Material Co., Ltd |       | $                                 | 996        |                   | $          | 1,071                     |       | Consolidated |   | 46 | % |
| Nanjing Jin  Mei Gallium Co., Ltd              |       | 592                               |       | 616                    |       | Consolidated              |       | 83 |   |
| Beijing BoYu  Manufacturing Co., Ltd           |       | 410                               |       | 409                    |       | Consolidated              |       | 70 |   |
| Xilingol  Tongli Ge Co. Ltd                    |       | 838                               |       | 847                    |       | Equity                    |       | 25 |   |
| Emeishan Jia  Mei High Pure Metals Co., Ltd    |       | 606                               |       | 584                    |       | Equity                    |       | 25 |   |
|                                                |            |                                   |            |                        |            |                           |            |  |  |  |  |

 

The investment balances for thetwo affiliates accounted for under the equity method are included in otherassets in the condensed consolidated balance sheets. We own 25% of theownership interests in each of these affiliates. These two affiliates are notconsidered variable interest entities because:

 

•        bothaffiliates have sustainable businesses of their own;

 

•        our votingpower is proportionate to our ownership interests;

 

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

 

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occur, or both; and

 

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

 

Undistributed retained earningsrelating to our corporate affiliates were $2.9 million and $1.6 million as of March31, 2006 and 2005, respectively. Net income recorded from our corporateaffiliates were $269,000 and $88,000 for the three month periods ended March 31,2006 and 2005, respectively.

 

The minority interest for thoseaffiliates that are consolidated is included within “Other long-termliabilities” in the condensed consolidated balance sheets and within “Otherexpense (income)” on the condensed consolidated statements of operations.

 

**Note 11. Commitments and Contingencies**

 

***Legal Matters***

 

On October 15, 2004, apurported securities class action lawsuit was filed in the United States Courtfor the Northern District of California. City of Harper Woods EmployeesRetirement System v. AXT, Inc. et al., No. C 04 4362 MJJ.  The Court consolidated the case with asubsequent related case and appointed a lead plaintiff.  On April 5, 2005, the lead plaintiff filed aconsolidated complaint, captioned as Morgan v. AXT, Inc. et al., No. C 04 4362MJJ.  The lawsuit complaint names AXT,Inc. and our chief technology officer, as defendants, and is brought on behalfof a class of all purchasers of our securities from February 6, 2001 throughApril 27, 2004. The complaint alleges that we announced financial resultsduring this period that were false and misleading. No specific amount ofdamages is claimed.  We believe thatthere are meritorious defenses against this litigation and intend to vigorouslydefend it. On September 23, 2005, the Court granted our motion to dismiss thecomplaint, with leave to amend. Lead plaintiff filed an amended complaint,which we have moved to dismiss. However, due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

 

On June 1, 2005, a lawsuit wasfiled in the Superior Court of California, County of Alameda, *Zhao et. Al. vs. American Xtal Technology, et. al.*, No. R605215713.  The lawsuit complaint names asdefendants AXT, its chief technology officer, its former interim chiefexecutive officer, a former safety department employee and a supplier toAXT.  The lawsuit is brought on behalf oftwo former employees and their minor child. The complaint alleges personal injury, general negligence, intentionaltort, wage loss and other damages, including punitive damages, as a result of exposureto the child while in utero to high levels of gallium arsenide and methanol usedin the production of gallium arsenide wafers.

 

We believe that there aremeritorious defenses against this litigation and intend to vigorously defendit.  AXT’s commercial general liabilityinsurance carrier has agreed to fund AXT’s defense of the case, but hasreserved the right to deny coverage, in whole or in part, in the future underselected policy provisions and applicable law. There is $21 million in available limits under the policies in question.Due to the inherent uncertainties of litigation, we cannot accurately predictthe ultimate outcome of the litigation. Any unfavorable outcome of thelitigation could have an adverse impact on our business, financial conditionand results of operations.

 

***IndemnificationAgreements***

 

We enter into standardindemnification arrangements in the ordinary course of business. Pursuant tothese arrangements, we indemnify, hold harmless, and agree to reimburse theindemnified parties for losses suffered or incurred by the indemnified party,generally their business partners or customers, in connection with any U.S.patent, or any copyright or other intellectual property infringement claim byany third party with respect to our products. The term of these indemnificationagreements is generally perpetual anytime after the execution of the agreement.The maximum potential amount of future payments we could be required to makeunder these agreements is unlimited. We have never incurred costs to defendlawsuits or settle claims related to these indemnification agreements. As aresult, we believe the estimated fair value of these agreements is minimal.

 

We have entered intoindemnification agreements with our directors and officers that may require usto indemnify our directors and officers against liabilities that may arise byreason of their status or service as directors or officers, other thanliabilities arising from willful misconduct of a culpable nature; to advancetheir expenses incurred as a result of any proceeding against them as to whichthey could be indemnified; and to obtain directors’ and officers’ insurance if

 

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available on reasonable terms, which wecurrently have in place.

 

***Product Warranty***

 

We warrant our products for aspecific period of time, generally twelve months, against material defects. Weprovide for the estimated future costs of warranty obligations in cost of saleswhen the related revenue is recognized. The accrued warranty costs representthe best estimate at the time of sale of the total costs that we expect toincur to repair or replace product parts that fail while still under warranty.The amount of accrued estimated warranty costs are primarily based onhistorical experience as to product failures as well as current information onrepair costs. On a quarterly basis, we review the accrued balances and updatethese based on the historical warranty cost trends. The following tablereflects the change in our warranty accrual during the three months ended March31, 2006 and 2005 (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                                          |       |                             |       |   |   |
| Beginning  accrued warranty and related costs |       | $                                | 120        |   | $ | 135 |   |
| Charged to  cost of revenue                   |       | 105                              |       | — |   |
| Actual warranty  expenditures                 |       | (41                              | )          | — |   |
| Ending  accrued warranty and related costs    |       | $                                | 184        |   | $ | 135 |   |

 

***Sales Returns***

 

In March 2004, weincreased our reserve for repair and replacement costs by $745,000. As of March31, 2006, this reserve is zero since approximately $487,000 had been utilizedand approximately $258,000 had been reversed to revenue as we favorablyresolved an outstanding matter with a customer.

 

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

 

We incurred foreign currencytransaction exchange losses of $36,000 and $20,000 for the three month periodsended March 31, 2006, and 2005, respectively. These amounts are included inother income (expense), net on the condensed consolidated statements ofoperations.

 

**Note 13. Recent Accounting Pronouncements**

 

In November 2004, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 151 (“SFAS 151”), *Inventory Costs*,*an amendment of ARB No. 43, Chapter 4.* SFAS 151 amendsthe guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4,previously stated that “...under some circumstances, items such as idle facilityexpense, excessive spoilage, double freight, and rehandling costs may be soabnormal as to require treatment as current period charges....” SFAS 151 requiresthat those items be recognized as current period charges regardless of whetherthey meet the criterion of “so abnormal.” In addition, SFAS 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. The provisions of SFAS 151 areeffective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. The adoption of SFAS 151 did not have a material effect onour consolidated financial position, results of operations or cash flows.

 

In December 2004, the FASBissued SFAS No. 153 (“SFAS 153”), *“Exchangesof Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting forNonmonetary Transactions.”* SFAS 153 eliminates the exceptionfrom fair value measurement for nonmonetary exchanges of similar productiveassets in paragraph 21(b) of APB Opinion No. 29, “Accounting forNonmonetary Transactions,” and replaces it with an exception for exchanges thatdo not have commercial substance. SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. SFAS 153 iseffective for the fiscal periods beginning after June 15, 2005. Theadoption of SFAS 153 did not have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

InMay 2005, the FASB issued SFAS No. 154 (“SFAS 154”), “*AccountingChanges and Error Corrections*”, which will require entities thatvoluntarily make a change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS 154 supersedes APB No. 20 (“APB 20”), Accounting Changes,which previously required that most voluntary changes in accounting principlebe recognized by including in the current period’s net income the cumulativeeffect of changing to the new accounting principle. SFAS 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror. Another significant change in practice under SFAS 154 will be

 

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that ifan entity changes its method of depreciation, amortization, or depletion forlong-lived, non-financial assets, the change must be accounted for as a changein accounting estimate. Under APB 20, such a change would have been reported asa change in accounting principle. SFAS 154 applies to accounting changes anderror corrections that are made in fiscal years beginning after December 15,2005. The adoption of SFAS 154 did not have a material impact on our consolidatedfinancial position, results of operations, or cash flows.

 

InFebruary 2006, the FASB issued SFAS No. 155 (“SFAS 155”), “*Accountingfor Certain Hybrid Instruments – an amendment of FASB Statements No. 133 and140”.* SFAS 155 amends SFAS No. 133, “Accounting for derivativeInstruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*” (“SFAS 140”). SFAS 155 gives entitiesthe option of applying fair value accounting to certain hybrid financialinstruments in their entirety if they contain embedded derivatives that wouldotherwise require bifurcation under SFAS 133. SFAS 155 will be effective for usas of January 1, 2007. We are currently assessing the impact that SFAS 155 mayhave on our consolidated financial statements.

 

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

This Management’s Discussionand Analysis of Financial Condition and Results of Operations includes a numberof forward-looking statements made pursuant to the provisions of Section 21E ofthe Securities Exchange Act of 1934. These forward-looking statements are basedupon management’s current views with respect to future events and financialperformance, and are subject to certain risks and uncertainties that couldcause actual results to differ materially from historical results or thoseanticipated. Such risks and uncertainties include those set forth under “RisksRelated to our Business” below. Forward-looking statements may be identified bythe use of terms such as “anticipates,” “believes,” “estimates,” “expects,” “intends,”and similar expressions. Statements concerning our future or expected financialresults and condition, business strategy and plans or objectives for futureoperations are forward-looking statements.

 

These forward-lookingstatements are not guarantees of future performance. Readers are cautioned notto place undue relianceon these forward-looking statements, which speak only as of the date hereof.This discussion should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations included in ourAnnual Report onForm 10-K for the year ended December 31, 2005 and the condensed consolidatedfinancial statements included elsewhere in this report.

 

**Overview**

 

We design, develop, manufacture and distribute high-performancecompound and single element semiconductor substrates comprising galliumarsenide (GaAs), indium phosphide (InP) and germanium (Ge). Our substrateproducts are used primarily in lighting display applications, wirelesscommunications, and fiber optic communications. We believe our verticalgradient freeze, or VGF, technique for manufacturing semiconductor substratesprovides significant benefits over other methods and has enabled us to become aleading manufacturer of such substrates. We pioneered the commercial use of VGFtechnology to manufacture GaAs substrates and subsequently used VGF technologyto manufacture substrates from InP and Ge.

 

We also manufacture and sell raw materials related to our substratebusiness through five joint ventures located in China. These joint venturesproduce products including 99.99% pure gallium (4N Ga), high purity gallium,arsenic, germanium, germanium dioxide, paralytic boron nitride (pBN) crucibles,and boron oxide. AXT’s ownership interest in these entities ranges from 25percent to 83 percent. We consolidate the three ventures in which we own amajority interest and employ equity accounting for the two joint ventures inwhich we have a 25 percent interest. We purchase the materials produced bythese ventures for our use and sell other portions of their production to thirdparties.

 

Revenues from continuingoperations increased $1.8 million, or 27.7%, to $8.5 million for the threemonth period ended March 31, 2006 compared to $6.6 million for the same periodof fiscal 2005 primarily due to our improved quality and higher demands forsix-inch diameter wafers. As of March 31, 2006, we had available cash, cashequivalents and short-term investments of $22.0 million, excluding restricteddeposits.

 

***Discontinued Opto-Electronics Business***

 

In June 2003, we announcedthe discontinuation of our opto-electronics division, which we had establishedas part of our acquisition of Lyte Optronics, Inc. in May 1999. Thediscontinued opto-electronics division manufactured blue, cyan, and greenhigh-brightness light emitting diodes (HBLEDs) for the illumination markets,including full-color displays, wireless handset backlighting and trafficsignals, and also manufactured vertical cavity surface emitting lasers (VCSELs)and laser diodes for fiber optic communications and storage area networks.Accordingly, the results of operations of the opto-electronics divisionhave been segregated from continuing operations and are reported separately asdiscontinued operations in our consolidated statements of operations for allperiods presented. See Note 2 to our condensed consolidated financialstatements for details regarding the accounting for discontinued operations.

 

In September 2003, wecompleted the sale of substantially all of the assets of our opto-electronicsbusiness to Lumei Optoelectronics Corp. (Lumei) and Dalian Luming Science andTechnology Group, Co., Ltd. for the Chinese Renminbi (RMB) equivalent of $9.6million.

 

In June 2005, we completedthe sale of a building located in Monterey Park, California. This asset hadbeen classified as “assets held for sale” in the amount of $1.25 million on theconsolidated balance sheet as of December 31, 2004. We received netproceeds on the sale of the property of approximately $1.3 million andaccordingly recorded a gain on disposal of $53,000.

 

17

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***Restructuring Charges***

 

In December 2005, we furtherreduced the workforce at our Fremont, California facility byapproximately 15 positions that are no longer required to supportproduction and operations, or approximately 29 percent. This measure wastaken as part of our ongoing effort to downsize our Fremont,California facility headcount and we expect to save $0.9 million annually inpayroll and related expenses. Accordingly, we recorded a restructuring chargeof approximately $273,000 related to the reduction in force forseverance-related expenses, of which $215,000 was the balance as of December31, 2005. As of March 31, 2006 we completed the reduction in force.

 

As of March 31, 2006 the remainingrestructuring accrual for future lease payments related to abandoned U.S.facilities located in California that are no longer required to supportproduction is $128,000, is expected to be paid out through 2006, and isincluded on the accompanying condensed consolidated balance sheet as accruedrestructuring.

 

**CriticalAccounting Policies and Estimates**

 

We have prepared our condensedconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America. As such, we have had tomake estimates, assumptions and judgments that affect the amounts reported onour financial statements. These estimates, assumptions and judgments aboutfuture events and their effects on our results cannot be determined withcertainty, and are made based upon our historical experience and on otherassumptions that are believed to be reasonable under the circumstances. Theseestimates may change as new events occur or additional information is obtained,and we may periodically be faced with uncertainties, the outcomes of which arenot within our control and may not be known for a prolonged period of time. Thediscussion and analysis of our results of operations and financial conditionare based upon these condensed consolidated financial statements. We haveidentified the policies below as critical to our business operations andunderstanding of our financial condition and results of operations. A criticalaccounting policy is one that is both material to the presentation of ourfinancial statements and requires us to make difficult, subjective or complexjudgments that could have a material effect on our financial condition andresults of operations. They may require us to make assumptions about mattersthat are highly uncertain at the time of the estimate, and different estimatesthat we could have used, or changes in the estimate that are reasonably likelyto occur, may have a material impact on our financial condition or results ofoperations.

 

We believe that the followingare our critical accounting policies:

 

***Revenue Recognition***

 

We manufacture and sellhigh-performance compound semiconductor substrates and sell certain rawmaterials including gallium, germanium dioxide, and pBN crucibles. After weship our products, there are no remaining obligations or customer acceptancerequirements that would preclude recognition of the revenue earned on the sale.Our products are typically sold pursuant to a purchase order placed by ourcustomers, and our terms and conditions of sale do not require customeracceptance. We recognize revenue upon shipment and transfer of title ofproducts to our customers, which is 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 do not provide discounts or other incentives to customersexcept for one customer with whom we agreed in the fourth quarter of 2004to provide a certain amount of cumulative discounts on future product purchasesfrom us. We will recognize these discounts in future periods as a reduction inrevenue as products are sold to this customer.

 

We provide for future returnsbased on historical experience, current economic trends and changes in customerdemand at the time revenue is recognized. In the first quarter of 2004, werecorded a specific reserve for sales returns of $745,000 related to ourfailure to follow certain testing requirements and provision of testing dataand information to certain customers. This reserve was based on discussionswith some of the affected customers and review of specific shipments. As ofMarch 31, 2006, this reserve is zero since approximately $487,000 had beenutilized and approximately $258,000 had been reversed to revenue as wefavorably resolved an outstanding matter with a customer.

 

***Allowance for Doubtful Accounts***

 

We periodically review thelikelihood of collection on our accounts receivable balances and provide anallowance for doubtful accounts receivable primarily based upon the age ofthese accounts. We provide a 100% allowance for U.S. receivables in excess of90 days and for foreign receivables in excess of 120 days. We assess theprobability of collection based on a number of factors, including the length oftime a receivable balance has been outstanding, our past history with thecustomer and their credit worthiness.

 

As of March 31, 2006 andDecember 31, 2005, our accounts receivable balance was $5.9 million and $5.2million, respectively, which was net of an allowance for doubtful accounts of$0.6 million and $0.6 million, respectively. If actual uncollectible accounts differ substantially from ourestimates, revisions to the estimated allowance for doubtful accounts would berequired, which could have a material impact on our financial results for theperiod.

 

18

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***Warranty Reserve***

 

We maintain a warranty reservebased upon our claims experience during the prior twelve months. Warranty costsare accrued at the time revenue is recognized. As of March 31, 2006, andDecember 31, 2005 accrued product warranties totaled $184,000 and $120,000,respectively. If actual warranty costs differ substantially from our estimates,revisions to the estimated warranty liability would be required, which couldhave a material impact on our financial condition and results of operations.

 

***Inventory Valuation***

 

Inventories are stated at thelower of cost or market. Cost is determined using the weighted average costmethod. Our inventory consists of raw materials as well as finished goods andwork-in-process that include material, labor and manufacturing overhead costs.Given the nature of our substrate products, and the materials used in themanufacturing process, the wafers and ingots comprising work-in-process may beheld in inventory for up to two years and three years, respectively, as therisk of obsolescence for these materials is low. We routinely evaluate thelevels of our inventory in light of current market conditions in order toidentify excess and obsolete inventory and provide a valuation allowance forcertain inventories based upon the age and quality of the product and theprojections for sale of the completed products. As of March 31, 2006, andDecember 31, 2005 we had an inventory reserve of $16.2 million and $16.9million for excess and obsolete inventory, respectively. The majority of thisinventory has not been scrapped. If actual demand for our products were to besubstantially lower than estimated, additional inventory adjustments for excessor obsolete inventory might be required, which could have a material impact onour business, financial condition and results of operations.

 

***Impairment of Investments***

 

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

 

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

 

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

 

We evaluate the recoverabilityof property, equipment, and intangible assets in accordance with SFASNo. 144, *“Accounting for the Impairmentor Disposal of Long-Lived Assets.”* When events and circumstancesindicate that long-lived assets may be impaired, we compare the carrying valueof the long-lived assets to the projection of future undiscounted cash flowsattributable to such assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against incomeequal to the excess of the carrying value over the asset’s fair value.

 

***Employee Stock Options***

 

We grant options tosubstantially all management employees and believe that this program helps usto attract, motivate, and retain high quality employees, to the ultimatebenefit of our stockholders. Effective January 1, 2006, we adopted thefair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123 (revised 2004), “*Share-Based Payment*,” (“SFAS 123(R)”), using the modified-prospective transition method. Underthis transition method, stock-based compensation cost was recognized in thecondensed consolidated financial statements for all share based payments afterJanuary 1, 2006. Compensation cost recognized includes the estimated expensefor the portion of the vesting period after January 1, 2006 for share basedpayments prior to, but not vested as of January 1, 2006, based on the grantdate fair value estimated in accordance with the original provisions of SFAS123. Results for prior periods have not been restated, as provided for underthe modified-prospective method. See Note 3 to our condensedconsolidated financial statements.

 

19

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***Income Taxes***

 

We account for income taxes inaccordance with SFAS No. 109 (“SFAS 109”), *“Accounting for Income Taxes,”* which requires that deferredtax assets and liabilities be recognized using enacted tax rates for the effectof temporary differences between the book and tax bases of recorded assets andliabilities. SFAS 109 also requires that deferred tax assets be reduced bya valuation allowance if it is more likely than not that a portion of thedeferred tax asset will not be realized.

 

We provide for income taxesbased upon the geographic composition of worldwide earnings and tax regulationsgoverning each region, particularly China. The calculation of tax liabilitiesinvolves significant judgment in estimating the impact of uncertainties in theapplication of complex tax laws, particularly in foreign countries such as China.

 

**Results of Operations**

 

**Revenue**

 
| ** **    | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|---------------|------------|-----------------------------------|------------|--------------------------|------------|--------------|------------|
| **2006**      | ** ** | **2005**                          |
| ** **    | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **   | ** ** |
| GaAs          |       | $                                 | 6,755      |                     | $          | 5,193        |       | $ | 1,562 |   | 30.1 | % |
| InP           |       | 296                               |       | 137                      |       | 159          |       | 116.1 | % |
| Ge            |       | 36                                |       | 5                        |       | 31           |       | 620.0 | % |
| Raw Materials |       | 1,384                             |       | 1,296                    |       | 88           |       | 6.8 | % |
| Other         |       | —                            |       | 3                        |       | (3           | )          | NM |   |
| Total revenue |       | $                                 | 8,471      |                     | $          | 6,634        |       | $ | 1,837 |   | 27.7 | % |

----

NM = % notmeaningful

 

Revenues increased $1.8 million,or 27.7%, to $8.5 million for the three month period ended March 31, 2006compared with $6.6 million for the three month period ended March 31, 2005. TotalGaAs substrate revenue increased $1.6 million, or 30.1%, to $6.8 million forthe three month period ended March 31, 2006 compared with $5.2 million for thethree month period ended March 31, 2005.

 

Sales of 5 inch and 6 inchdiameter GaAs substrates were $2.8 million for the three month period ended March31, 2006 compared with $0.5 million for the three month period ended March 31,2005. The increase in larger diameter substrate revenue is due to an increasein orders from customers who have now qualified our China-grown products. Salesof 2 inch and 3 inch diameter GaAs substrates were $2.8 million for the threemonth period ended March 31, 2006 compared with $3.8 million for the three monthperiod ended March 31, 2005. The decrease in smaller diameter substrate revenueis due to the continuing pricing pressures causing average sales prices todecline, and overall lower demand from our wireless application customers.

 

InP substrate revenue increased$159,000, or 116.1%, to $296,000 for the three month period ended March 31,2006 compared with $137,000 for the three month period ended March 31, 2005.The increase in InP substrate revenue was due to an increase in orders fromcustomers who qualified our China-grown products.

 

Ge substrate revenue increased$31,000, or 620.0%, to $36,000 for the three month period ended March 31, 2006compared with $5,000 for the three month period ended March 31, 2005. Thegermanium market is still relatively small, but we are in the process ofqualifying our Ge substrates with some of our customers.

 

Raw material sales revenue increased$88,000, or 6.8%, to $1.4 million for the three month period ended March 31,2006 compared with $1.3 million for the three month period ended March 31, 2005.The increase in raw material sales revenue was due to sales of gallium to a newcustomer.

 

20

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***Revenue by Geographic Region***

 
| ** **                                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                                   | ** ** | **2005**                          | ** ** |
| ** **                                 | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **        | ** ** |
| North  America *                           |       | $                                 | 1,959      |                     | $          | 972               |       | $ | 987 |   | 101.5 | % |
| *% of total revenue*                       |       | 23                                | %          | 15                       | %          |              |       |   |   |
| Europe                                     |       | 1,406                             |       | 1,782                    |       | (376              | )          | (21.1 | )% |
| *% of total revenue*                       |       | 17                                | %          | 27                       | %          |              |       |   |   |
| Japan                                      |       | 666                               |       | 240                      |       | 426               |       | 177.5 | % |
| *% of total revenue*                       |       | 8                                 | %          | 4                        | %          |              |       |   |   |
| Taiwan                                     |       | 1,514                             |       | 1,660                    |       | (146              | )          | (8.8 | )% |
| *% of total revenue*                       |       | 18                                | %          | 25                       | %          |              |       |   |   |
| Asia Pacific  (excluding Japan and Taiwan) |       | 2,926                             |       | 1,980                    |       | 946               |       | 47.8 | % |
| *% of total revenue*                       |       | 34                                | %          | 29                       | %          |              |       |   |   |
| Total revenue                              |       | $                                 | 8,471      |                     | $          | 6,634             |       | $ | 1,837 |   | 27.7 | % |

 

----

*      Primarily the United States

 

The North America revenueincreased by $1.0 million or 101.5%, to $2.0 million for the three month periodended March 31, 2006 compared with $1.0 million for the three month periodended March 31, 2005. Our quality has improved as shown by customers who havequalified our China-grown products as sales to existing customers increased by$0.9 million, while we gained $0.1 million in sales to new customers.

 

The Europe revenue decreased by$376,000 or 21.1%, to $1.4 million for the three month period ended March 31,2006 compared with $1.8 million for the three month period ended March 31,2005. This decrease was predominantly from one customer in the United Kingdomthat we lost in the second half of 2005 due to quality problems in our product.This customer is slowly coming back as it has begun placing orders again in thefirst quarter of 2006.

 

The Japan revenue increased by$426,000 or 177.5%, to $666,000 for the three month period ended March 31, 2006compared with $240,000 for the three month period ended March 31, 2005. Rawmaterial sales to a new customer accounted for $288,000 of this increase, while$287,000 was from substrate sales to new customers who have qualified ourChina-grown products, offset by $149,000 of lost or reduced sales to existingcustomers.

 

The Taiwan revenue decreased by$146,000 or 8.8%, to $1.5 million for the three month period ended March 31,2006 compared with $1.7 million for the three month period ended March 31, 2005.The overall decrease is due to continuing pricing pressures causing averagesales prices to decline, and overall lower demand.

 

The Asia Pacific (excludingJapan and Taiwan) revenue increased by $0.9 million or 47.8% to $2.9 millionfor the three month period ended March 31, 2006 compared with $2.0 million forthe three month period ended March 31, 2005. This $0.9 million increase waspredominantly from one customer’s demand for the large diameter wafers. Ourquality has improved as shown by customers who have qualified our China-grownproducts.

 

***Gross Margin***

 
| ** **      | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|-----------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**        | ** ** | **2005**                          |
| ** **      | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **        | ** ** |
| Gross profit    |       | $                                 | 1,510      |                     | $          | 279               |       | $ | 1,231 |   | 441.2 | % |
| *Gross Margin%* |       | 17.8                              | %          | 4.2                      | %          |              |       |   |   |
|                 |            |                                   |            |                          |            |                   |            |  |  |  |  |  |

 

21

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*Gross margin.*Gross margin increased to 17.8% of total revenue forthe three month period ended March 31, 2006 compared with 4.2% of total revenuefor the three month period ended March 31, 2005. Gross margin in the threemonth period ended March 31, 2006 was positively impacted by sales ofapproximately $569,000 of gallium arsenide (GaAs) wafers which were previouslyfully reserved, and by approximately $53,000 as a result of a reversal of asales return reserve established in 2004 as we favorably resolved anoutstanding matter with a customer. In addition, we sold a greater amount oflarger diameter wafers which contributed larger gross margin dollars. Grossmargin was 4.2% of total revenue for the three months ended March 31, 2005primarily due to the product mix where we sold a greater amount of smallerdiameter wafers where there has been continuing pricing pressures causingaverage sales prices to decline which in turn contributes smaller gross margindollars. Gross margin in the three month period ended March 31, 2005 waspositively impacted by sales of approximately $152,000 of gallium arsenide(GaAs) wafers which were previously fully reserved.

 

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

 
| ** **                                    | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                                      | ** ** | **2005**                          |
| ** **                                    | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **        | ** ** |
| Selling,  general and administrative expenses |       | $                                 | 3,230      |                     | $          | 4,252             |       | $ | (1,022 | ) | (24.0 | )% |
| *% of total revenue*                          |       | 38.1                              | %          | 64.1                     | %          |              |       |   |   |
|                                               |            |                                   |            |                          |            |                   |            |  |  |  |  |  |

 

Selling, general andadministrative expenses decreased $1.0 million to $3.2 million for the threemonth period ended March 31, 2006 compared with $4.3 million for the threemonth period ended March 31, 2005. The decrease was primarily due to the March2005 expenses of $1.3 million for decommissioning our Fremont, Californiafacilities, and $0.1 million for recruiting fees partially offset by $0.2million for stock based compensation costs, and $0.1 million for travel andrelated costs.

 

***Research and Development***

 
| ** **                | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|---------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                  | ** ** | **2005**                          |
| ** **                | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **        |
| Research and  development |       | $                                 | 534        |                     | $          | 362               |       | $ | 172 |   | 47.5 | % |
| *% of total revenue*      |       | 6.3                               | %          | 5.5                      | %          |              |       |   |   |
|                           |            |                                   |            |                          |            |                   |            |  |  |  |  |  |

*** ***

Research and developmentexpenses increased $172,000, or 47.5%, to $534,000 for the three month periodended March 31, 2006 compared with $362,000 for the three month period ended March31, 2005, as a result of our appointing Dr. Morris Young as our Chief TechnologyOfficer to enhance our technology leadership, thereby causing the relatedcompensation costs to be included in research and development expense ratherthan general and administrative expense, and for stock based compensation costs.We believe that continued investment in product development is critical toattaining our strategic objectives of maintaining and enhancing our technologyleadership.

 

***Restructuring Charges***

 
| ** **             | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**               | ** ** | **2005**                          |
| ** **             | ** ** | **($ in thousands)**    | ** ** | ** **               | ** ** | ** **        | ** ** |
| Restructuring  charges |       | $                                 | (2         | )                        | $          | 125               |       | $ | (127 | ) | (101.6 | )% |
| *% of total revenue*   |       | (0.0                              | )%         | 1.9                      | %          |              |       |   |   |
|                        |            |                                   |            |                          |            |                   |            |  |  |  |  |  |

 

During the three month periodended March 31, 2006, the $2,000 was an adjustment to a prior accrual. Duringthe three month period ended March 31, 2005, we recorded restructuring chargesrelated to the reduction in work force effected in March 2005, and to leasecosts associated with facilities located in California that are no longerrequired to

 

22

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support production of $86,000and $39,000, respectively.

 

***InterestIncome, net***

*** ***
| ** **           | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|----------------------|------------|--------------------------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**             | ** ** | **2005**                                         |
| ** **           | ** ** | **($in thousands  )**                       | ** ** | ** **               | ** ** | ** **        | ** ** |
| Interest income, net |       | $                                                | 128        |                     | $          | 119               |       | $ | 9 |   | 7.6 | % |
| *% of total revenue* |       | 1.5                                              | %          | 1.8                      | %          |              |       |   |   |
|                      |            |                                                  |            |                          |            |                   |            |  |  |  |  |  |

*** ***

Interest income, net increased $9,000 to $128,000 for the three monthperiod ended March 31, 2006 compared with $119,000 for the three month periodended March 31, 2005 as a result of higher interest rates earned on ourinvestments, partially offset by higher interest rates on our debt on which wehave continued to pay down.

 

***Other Income andExpense, net***

*** ***
| ** **                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|----------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                   | ** ** | **2005**                                         |
| ** **                 | ** ** | **($ in thousands)**                   | ** ** | ** **               | ** ** | ** **        | ** ** |
| Other income (expense) net |       | $                                                | 238        |                     | $          | (105              | )          | $ | 343 |   | 326.7 | % |
| *% of total revenue*       |       | 2.8                                              | %          | (1.6                     | )%         |              |       |   |   |
|                            |            |                                                  |            |                          |            |                   |            |  |  |  |  |  |

*** ***

Other income was $238,000 for the three month period ended March 31,2006 due to a realized gain of $376,000 on the sale of investments, partiallyoffset by minority interests in our joint ventures. Other expense was $105,000for the three month period ended March 31, 2005 mainly due to foreign exchangelosses related to the Japanese yen and minority interests in our jointventures.

 

***Provisionfor Income Taxes***

*** ***
| ** **                 | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|----------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                   | ** ** | **2005**                                         |
| ** **                 | ** ** | **($ in thousands)**                   | ** ** | ** **               | ** ** | ** **        | ** ** |
| Provision for income taxes |       | $                                                | 318        |                     | $          | 35                |       | $ | 283 |   | 808.6 | % |
| *% of total revenue*       |       | 3.8                                              | %          | 0.5                      | %          |              |       |   |   |
|                            |            |                                                  |            |                          |            |                   |            |  |  |  |  |  |

*** ***

We provided for income taxes of $318,000 for our overseas businessesfor the three month period ended March 31, 2006 compared to $35,000 for thethree month period ended March 31, 2005. The reason for the increase is acombination of higher income from processing fees from rates and volume in ouroverseas businesses at higher tax rates.

 

***Gain from DiscontinuedOperations***

*** ***
| ** **                        | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase  (Decrease)** | ** ** | **% Change** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|-------------------|------------|
| **2006**                          | ** ** | **2005**                                         |
| ** **                        | ** ** | **($ in thousands)**                   | ** ** | ** **               | ** ** | ** **        | ** ** |
| Gain from discontinued operations |       | $                                                | 1          |                     | $          | 358               |       | $ | (357 | ) | (99.7 | %) |
| *% of total revenue*              |       | 0.0                                              | %          | 5.4                      | %          |              |       |   |   |
|                                   |            |                                                  |            |                          |            |                   |            |  |  |  |  |  |

 

In the three month period ended March 31, 2006, the $1,000 was interestincome on cash balances held in the discontinued operation. InFebruary 2005, we received $300,000 which was the remaining portion of thefirst $750,000 held in escrow due to us and accordingly we recorded a gain ondiscontinued operations for the three month period ended March 31, 2005 of$300,000. We also recorded a gain on discontinued operations of $58,000 inproperty tax refunds for the same period.

 

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**Liquidity and Capital Resources**

 

We consider cash and cash equivalents and short-term investments asliquid and available for use. Short-term investments are comprised ofgovernment bonds and high-grade commercial debt instruments. Also included inshort-term investments is our investment in common stock of FinisarCorporation. As of March 31, 2006, our principal sources of liquidity were$22.0 million in cash and cash equivalents and short-term investments,excluding restricted deposits.

 

Cash and cash equivalents and short-term investments decreased $1.0million to $22.0 millionas of March 31, 2006 compared with $23.0 million as of December 31, 2005.Included in this decrease is a $2.8 million increase in our investment inFinisar common stock from $2.4 million as of December 31, 2005 to $5.2 millionas of March 31, 2006. The sale of 100,000 shares of Finisar common stockbrought in additional cash of $371,000 in the three month period ended March31, 2006. We plan to sell additional Finisar stock for the remainder of 2006.

 

Net cash used by operating activities of $4.2 million for the threemonth period ended March 31, 2006 was comprised primarily of our net loss of$2.2 million, adjusted for non-cash items of depreciation of $0.8 million, andstock based compensation of $0.3 million, a realized gain on sale ofinvestments of $0.4 million, and by a net decrease of $2.7 million in assetsand liabilities. The net decrease in assets and liabilities resulted from a$1.1 million decrease in accrued liabilities, primarily for restructuring costsand decommissioning expenses, a $0.6 million decrease in accounts payable, a$1.1 million increase in prepaid expenses, mainly foreign taxes, and $0.7million increase in accounts receivable, net and partially offset by a decrease in netinventory and income taxes.

 

Net accounts receivable increased by $0.7 million, or 13.2%, to $5.9million as of March 31, 2006 compared with $5.2 million as of December 31,2005. The increase was primarily a result of our increased sales. Our dayssales outstanding is 63 days as of March 31, 2006 compared to 62 days as ofDecember 31, 2005.

 

Net cash used by investing activities of $0.2 million for the threemonth period ended March 31, 2006 was primarily for the purchase of investmentstotaling $3.7 million, partially offset by proceeds from sale of investments of$3.4 million.

 

We expect to invest approximately $4.1 million in capital projects forthe remainder of 2006. We believe that our existing and planned facilities andequipment are sufficient to fulfill current and expected future orders.

 

Net cash used in financing activities of $102,000 for the three monthperiod ended March 31, 2006 consisted of payments of $168,000 related tolong-term borrowings, partially offset by proceeds of $66,000 through our stockoption program.

 

Our main Fremont, California manufacturing facility is financed bylong-term borrowings, which were refinanced by taxable variable rate revenuebonds in 1998. These bonds mature in 2023 and bear interest at a variable ratethat was 4.92% as of March 31, 2006. The bonds are traded in the public market.Repayment of principal and interest under the bonds is supported by a letter ofcredit from our bank and is paid on a quarterly basis. We have the option toredeem the bonds in whole or in part during their term. As of March 31, 2006,$7.5 million was outstanding under these bonds.

 

As of March 31, 2006, the credit facility maintained by us with a bank included aletter of credit supporting repayment of our industrial bonds with anoutstanding amount of $7.5 million. We have pledged and placed certaininvestment securities with an affiliate of the bank as additional collateralfor this facility.

 

We believe that we have adequate cash and investments to meet our needsover the next 12 months. If our performance fails to improve, we will continueto use cash and may at some time be forced to seek additional capital. Therecan be no assurance that such additional capital will be available or, ifavailable it will be at terms acceptable to us. Cash from operations could beaffected by various risks and uncertainties, including, but not limited tothose set forth below under Item 1A “Risks Factors.”

 

Outstanding contractual obligations as of March 31, 2006 are summarizedas follows (in thousands):

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More than  5 years** | ** ** |
| Long-term debt                   |       | $                                         | 7,552      |   | $ | 450 |   | $ | 1,452 |   | $ | 900 |   | $ | 4,750 |   |
| Operating leases                 |       | 5,218                                     |       | 811 |   | 2,106 |   | 1,541 |   | 760 |   |
| Total                            |       | $                                         | 12,770     |   | $ | 1,261 |   | $ | 3,558 |   | $ | 2,441 |   | $ | 5,510 |   |

 

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 $0.3million and $0.4 million for the three month periods ended March 31, 2006 and2005, respectively.

 

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**RecentAccounting Pronouncements**

 

In November 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 151 (“SFAS 151”), *InventoryCosts*,*an amendment of ARBNo. 43, Chapter 4.* SFAS 151 amends the guidance in ARBNo. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “...undersome circumstances, items such as idle facility expense, excessive spoilage,double freight, and rehandling costs may be so abnormal as to require treatmentas current period charges....” SFAS 151 requires that those items be recognizedas current period charges regardless of whether they meet the criterion of “soabnormal.” In addition, SFAS 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. The provisions of SFAS 151 are effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. The adoptionof SFAS 151 did not have a material effect on our consolidated financialposition, results of operations or cash flows.

 

In December 2004, the FASB issued SFAS No. 153 (“SFAS153”), *“Exchanges of Nonmonetary Assets—AnAmendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.”*SFAS 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets inparagraph 21(b) of APB Opinion No. 29, “Accounting forNonmonetary Transactions,” and replaces it with an exception for exchanges thatdo not have commercial substance. SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. SFAS 153 iseffective for the fiscal periods beginning after June 15, 2005. Theadoption of SFAS 153 did not have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

InMay 2005, the FASB issued SFAS No. 154 (“SFAS 154”), “*AccountingChanges and Error Corrections*”, which will require entities thatvoluntarily make a change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS 154 supersedes APB No. 20 (“APB 20”), Accounting Changes,which previously required that most voluntary changes in accounting principlebe recognized by including in the current period’s net income the cumulativeeffect of changing to the new accounting principle. SFAS 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror. Another significant change in practice under SFAS 154 will be that if anentity changes its method of depreciation, amortization, or depletion forlong-lived, non-financial assets, the change must be accounted for as a changein accounting estimate. Under APB 20, such a change would have been reported asa change in accounting principle. SFAS 154 applies to accounting changes anderror corrections that are made in fiscal years beginning after December 15,2005. The adoption of SFAS 154 did not have a material impact on ourconsolidated financial position, results of operations, or cash flows.

 

InFebruary 2006, the FASB issued SFAS No. 155 (“SFAS 155”), “*Accountingfor Certain Hybrid Instruments – an amendment of FASB Statements No. 133 and140”.* SFAS 155 amends SFAS No. 133, “Accounting for derivativeInstruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*” (“SFAS 140”). SFAS 155 givesentities the option of applying fair value accounting to certain hybridfinancial instruments in their entirety if they contain embedded derivativesthat would otherwise require bifurcation under SFAS 133. SFAS 155 will beeffective for us as of January 1, 2007. We are currently assessing the impactthat SFAS 155 may have on our consolidated financial statements.

 

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

 

**Foreign Currency Exchange Rate Exposure**

 

We operate in theUnited States, manufacture in China, and the substantial majority of our salesto date have been made in U.S. dollars. Certain expenses from our Chinaoperations are incurred in the Chinese Renminbi. As a result, currencyfluctuations between the U.S. dollar and the Chinese Renminbi could causeforeign currency transaction gains or losses that we would recognize in theperiod incurred.

 

In July 2005,China uncoupled Renminbi from the U.S. dollar and will let it float in a narrowband against a basket of foreign currencies. The move revalued Renminbi by 2.1%against the U.S. dollar; however, it is uncertain what further adjustments willfollow. The Renminbi-U.S. dollar exchange rate could float, and the Renminbicould appreciate relative to the U.S. dollar.

 

We expect ourinternational revenues and expenses to continue to be denominated largely inU.S. dollars. We also believe that our China operations will likely expand inthe future as our business continues to grow. As a result, we anticipate thatwe may experience increased exposure to the risks of fluctuating currencies andmay choose to engage in

 

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currencyhedging activities to reduce these risks. However, we cannot be certain thatany such hedging activities will be effective, or available to us atcommercially reasonable rates.

 

**InterestRate Risk**

 

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

 
| **Instrument**                            | ** ** | **Balance as of  March 31, 2006** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Cash                                      |       | $                                                     | 5,812      |                        | 0.50       | %                                                     | $          | 29                                                                   |       | $                                                                     | 26         |   | $ | 32 |   |
| Cash equivalents                          |       | 7,041                                                 |       | 4.56                        |       | 321                                                   |       | 289                                                                  |       | 353                                                                   |       |
| Investment in debt and equity instruments |       | 16,613                                                |       | 4.70                        |       | 781                                                   |       | 703                                                                  |       | 859                                                                   |       |
| Long-term debt                            |       | (7,450                                                | )          | 4.92                        |       | (367                                                  | )          | (330                                                                 | )          | (403                                                                  | )          |
|                                      |       |                                                  |       |                        |       | $                                                     | 764        |                                                                 | $          | 688                                                                   |       | $ | 841 |   |
|                                           |            |                                                       |            |                             |            |                                                       |            |                                                                      |            |                                                                       |            |  |  |  |  |

 

**Equity Risk**

 

We also maintain minority investments in private and publicly tradedcompanies. These investments are reviewed for other than temporary declines invalue on a quarterly basis. Reasons for other than temporary declines in valueinclude whether the related company would have insufficient cash flow tooperate for the next twelve months, significant changes in the operatingperformance and changes in market conditions. For the three month period endedMarch 31, 2006, we recorded a $2.9 million unrealized gain in othercomprehensive income to write up our investment in one public U.S. company. Asof March 30, 2006, the minority investments we continue to hold amounted to$7.1 million.

 

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**ITEM 4*.*CONTROLSAND PROCEDURES**

 

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

 

(b) No changein our internal control over financial reporting was made during the quarterended March 31, 2006, that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**PART II OTHERINFORMATION**

 

**Item 1. Legal Proceedings**

 

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

 

On October 15, 2004, a purported securities class action lawsuitwas filed in the United States Court for the Northern District of California.City of Harper Woods Employees Retirement System v. AXT, Inc. et al.,No. C 04 4362 MJJ. The Court consolidated the case with a subsequentrelated case and appointed a lead plaintiff. On April 5, 2005, the leadplaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ. The lawsuit complaint names AXT, Inc. andour chief technology officer, as defendants, and is brought on behalf of aclass of all purchasers of our securities from February 6, 2001 throughApril 27, 2004. The complaint alleges that we announced financial resultsduring this period that were false and misleading. No specific amount ofdamages is claimed. On September 23, 2005, the Court granted our motion todismiss the complaint, with leave to amend*.***Lead plaintiff filed anamended complaint, which we have moved to dismiss**.We believe that there are meritorious defenses against this litigation andintend to vigorously defend it. However, due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

 

OnJune 1, 2005, a lawsuit was filed in the Superior Court of California,County of Alameda, *Zhao et. Al. vs. AmericanXtal Technology, et. al.*, No. R 605215713. The lawsuitcomplaint names as defendants AXT, its chief technology officer, its formerinterim chief executive officer, a former safety department employee and asupplier to AXT. The lawsuit is brought on behalf of two former employees andtheir minor child. The complaint alleges personal injury, general negligence,intentional tort, wage loss and other damages, including punitive damages, as aresult of exposure to the child while in utero to high levels of galliumarsenide and methanol used in the production of gallium arsenide wafers.

 

Webelieve that there are meritorious defenses against this litigation and intendto vigorously defend it. AXT’s commercial general liability insurance carrierhas agreed to fund AXT’s defense of the case, but has reserved the right todeny coverage, in whole or in part, in the future under selected policyprovisions and applicable law. There is $21 million in available limits underthe policies in question. Due to the inherent uncertainties of litigation, wecannot accurately predict the ultimate outcome of the litigation. Anyunfavorable outcome of the litigation could have an adverse impact on ourbusiness, financial condition and results of operations.

 

**Item 1A. Risk Factors**

 

We operate in arapidly changing environment that involves many risks, some of which are beyondour control. The following is a discussion that highlights some of these risks,which are substantially the same as included in our Annual Report onForm 10-K for the year ended December 31, 2005. Additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial may also impair our business, operations or financial results.

 

**RisksRelated to Our Business**

** **

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

*** ***

As we are nowmanufacturing only in China, if the shift of our substrate manufacturingoperations to China is to be successful, we will need our customers to qualifyproducts manufactured in China. If we are unable to continue to achievequalifications for these products, our China facility will be underutilized,our investments in China will not be recouped and we will be unable to lowerour costs by moving to China. We may lose sales of our products to competitorswho are not manufacturing in China, or whose operations in China have alreadybeen qualified by customers. If customers do not fully qualify our Chinaproduction, we may lose additional customers and fail to achieve revenuegrowth.

 

Furthermore, somecustomers reduced their orders from us until our surface quality is as good andconsistent as that offered by competitors. As a result, some customersallocated their requirements for compound semiconductor substrates across morecompetitors and although our quality is improving, resulting in increasedsales, we believe that we have lost revenue and market share as a result ofthese customer decisions, which we may be unable to recover. If we are unableto recover and retain our market share, we may be unable to grow our business.

 

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

*** ***

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

 

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

 

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

*** ***

Therequirements adopted by the Securities and Exchange Commission, or SEC, inresponse to the passage of the Sarbanes-Oxley Act of 2002 will require annualreview and evaluation of our internal control systems, and an attestation ofthese systems by our independent registered public accounting firm beginningwith our fiscal year ending December 31, 2007. This may be due earlierbeginning with our fiscal year ending December 31, 2006 if our marketcapitalization increases above $75 million on the determining date onJune 30, 2006. We are currently reviewing our internal control proceduresand considering further documentation of such procedures that may be necessary.We are currently evaluating the extent to which any of our joint ventures mayalso be required to comply, if at all. We can give no assurances that oursystems will satisfy the new requirements of the Securities and ExchangeCommission, or if required, that any of the systems of our joint ventures willmeet such requirements, or that we will receive a favorable review andattestation by our independent registered public accounting firm.

 

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

 

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

 

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

*** ***

We are subjectto federal, state and local environmental and safety laws and regulations inall of our operating locations, including laws and regulations of China,including, but not limited to, regulations related to the development,manufacture and use of our products, the operation of our facilities, and theuse of our real property. These laws, rules and regulations govern theuse, storage, discharge and disposal of hazardous chemicals duringmanufacturing, research and development, and sales demonstrations. If we failto comply with applicable regulations, we could be subject to substantialliability for clean-up efforts, personal injury and fines or suspension orcessation of our operations, and/or the suspension or termination ofdevelopment, manufacture or use of certain of our products, or may affect theoperation of our facilities or use of our real property, each of which couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

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

 

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

 

Litigation isinherently uncertain and while we would expect to defend ourselves vigorously,it is possible that our business, financial condition, results of operations orcash flows could be affected in any particular period by such litigation nowpending, and any additional litigation if brought against us.

 

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

*** ***

In June 2005,a complaint was filed against us and a current and former officer, allegingpersonal injury, general negligence, intentional tort, wage loss and otherdamages, including punitive damages, as a result of exposure of plaintiffs, whoare former employees of AXT, including a minor child in utero, to high levelsof gallium arsenide in gallium arsenide wafers, and methanol. In addition, weare defendants in an ongoing securities litigation matter. Litigation isinherently uncertain and while we would expect to defend ourselves vigorously,it is possible that our business, financial condition, results of operations orcash flows could be affected in any particular period by such litigation nowpending, and any additional litigation if brought against us. In addition,response to such litigation could divert management’s attention from ourbusiness and operations, causing our business and financial results to suffer. Wecould incur defense or settlement costs in excess of the insurance coveringsuch litigation matters, or such litigation could result in significantjudgments against us, in excess of our insurance limits.

*** ***

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

*** ***

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

 

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

*** ***

A small numberof substrate customers have historically accounted for a substantial portion ofour total revenue. Our top five customers represented 45.8%, and 44.6% ofrevenue for the three months ended March 31, 2006, and 2005, respectively.We expect that a significant portion of our future revenue will continue to bederived from a limited number of substrate customers. Our customers are not obligatedto purchase a specified quantity of our products or to provide us with bindingforecasts of product purchases. In addition, our customers may reduce, delay orcancel orders at any time without any significant penalty, and during the pastyear, we have experienced slower bookings, significant push outs andcancellation of orders from some customers. If we lose a major customer or if acustomer cancels, reduces or delays orders, our revenue would decline. Inaddition, customers that have accounted for significant revenue in the past maynot continue to generate revenue for us in any future period. Any delay inscheduled shipments of our products could cause revenue to fall below ourexpectations and the expectations of market analysts or investors, causing ourstock price to decline.

 

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

*** ***

During thefirst quarter of 2004, we determined that we had not followed requirements fortesting of products and provision of testing data and information relating tocustomer requirements. We notified affected customers concerning our findings,however, there can be no assurance that we will not incur customer claims orother liabilities or obligations in connection with this matter, nor, if we receiveany such claims, that we will not have to restate results from prior

 

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periods. In addition, revenuein future periods may be adversely impacted if customers decide not to orderfrom us as a result of this disclosure. We experienced several cancellations offuture orders by customers pending further information regarding enhancementsto our product testing and quality control systems. In addition, some customersare requiring additional qualification of our China operations before placingfuture orders with us. We cannot be sure that we will not receive additionalcancellations of orders by other customers, or fail to win expected futureorders from customers, as a result of our disclosure of our investigationconclusions, or that our customers will qualify our China operations and placefuture orders with us.

 

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

*** ***

We haveinvested in five joint venture operations in China that produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium,germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. Wepurchase the materials produced by these ventures for our use and sell otherportions of their production to third parties. Our ownership interest in theseentities ranges from 25 percent to 83 percent. We consolidate the threeventures in which we own a majority interest and employ equity accounting forthe two joint ventures in which we have a 25 percent interest. Several of theseventures occupy facilities within larger facilities owned and/or operated byone of the other venture partners. Several of these venture partners areengaged in other manufacturing activities at or near the same facility. In somefacilities, we share access to certain functions, including water, treatment ofhazardous waste or air quality treatment. If any of our joint venture partnersin any of these five ventures experience problems with their operations,disruptions of our joint venture operations could result, having a materialadverse effect on the financial condition and results of operation of our jointventures, and correspondingly on our financial condition or results ofoperations.

 

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

 

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

 

Since all ofour joint venture activity is expected to occur in China, these activitiescould subject us to a number of risks associated with conducting operationsinternationally, including:

 

•        difficultiesin managing geographically disparate operations;

 

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

 

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

 

•        politicaland economic instability, civil unrest or war;

 

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•        terroristactivities that impact international commerce;

 

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

 

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

 

•        nationalizationof foreign owned assets, including intellectual property.

 

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

*** ***

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

 

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

*** ***

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

 

The industryhas in the past experienced periods of oversupply that result in significantlyreduced demand and prices for compound semiconductor devices and components,including our products, both as a result of general economic changes andovercapacity. When these periods occur, our operating results and financialcondition are adversely affected, and create pressure on our revenue, grossmargins and net income (loss). Inventory buildups in telecommunicationsproducts and slower than expected sales of computer equipment resulted inovercapacity and led to reduced sales by our customers, and therefore reducedpurchases of our products. During periods of weak demand such as thoseexperienced over the past years, customers typically reduce purchases, delaydelivery of products and/or cancel orders of component parts such as ourproducts.

 

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

 

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

 

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

*** ***

We must manageour inventory of component parts, work-in-process, and finished goodseffectively to meet

 

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changing customer requirements,while keeping inventory costs down and improving gross margins. Some of ourproducts and supplies have in the past and may in the future become obsoletewhile in inventory due to changing customer specifications, or become excessinventory due to decreased demand for our products and an inability to sell theinventory within a foreseeable period. Furthermore, if current costs ofproduction increase or sales prices drop below the standard prices at which wevalue inventory, we may need to take a charge for a reduction in inventoryvalues. We have in the past, including during 2004, had to take inventoryvaluation and impairment charges. Any future unexpected changes indemand or increases in costs of production that cause us to takeadditional charges for un-saleable, obsolete or excess inventory, or toreduce inventory values, could adversely affect our results of operations.

 

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

*** ***

Our operatingresults can vary significantly based upon the impact of changes in globaleconomic conditions on our customers. The revenue growth and profitability ofour business depends on the overall demand for our substrates, and we areparticularly dependant on the market conditions for the wireless, solid-stateillumination, fiber optics and telecommunications industries. Because our salesare primarily to major corporate customers whose businesses fluctuate withgeneral economic and business conditions, a softening of demand for productsthat use our substrates, caused by a weakening economy may result in decreasedrevenues. Customers may find themselves facing excess inventory from earlierpurchases, and may defer or reconsider purchasing products due to the downturnin their business and in the general economy.

 

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

*** ***

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

 

•             impuritiesin the materials used;

 

•             contaminationof the manufacturing environment;

 

•             substratebreakage;

 

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

 

•             performanceof personnel involved in the manufacturing process.

 

If our yieldsdecrease, our revenue could decline if we are unable to produce needed producton time while our manufacturing costs remain fixed, or could increase. We haveexperienced product shipment delays and difficulties in achieving acceptableyields on both new and older products, and delays and poor yields haveadversely affected our operating results. We may experience similar problems inthe future and we cannot predict when they may occur or their severity. Inparticular, many of our manufacturing processes are new and are still beingrefined, which can result in lower yields.

 

If there isdeliberate sabotage of our products making it unfit for use by our customers,our products would be rejected resulting in compensation costs paid to ourcustomers, and possible disqualification, and could lead to revenue loss andmarket share loss.

 

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

*** ***

Our successdepends on our ability to offer new products and product features thatincorporate leading technology and respond to technological advances. Inaddition, our new products must meet customer needs and compete effectively onquality, price and performance. The life cycles of our products are difficultto predict because the markets for our products are characterized by rapidtechnological change, changing customer needs and evolving industry standards.If our competitors introduce products employing new technologies or performancecharacteristics, our existing products could become obsolete and unmarketable.During the past two years, we have seen our competitors selling more substratesmanufactured using a crystal growth technology similar to ours, which haseroded our technological differentiation. Other companies, including Triquent,are actively developing substrate materials that could be used to

 

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manufacture devices that couldprovide the same high-performance, low-power capabilities as GaAs- andInP-based devices at competitive prices. If these substrate materials orVGF-derived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

 

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

 

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

*** ***

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

 

•             greaterexperience in the business;

 

•             moremanufacturing experience;

 

•             extensiveintellectual property;

 

•             broader namerecognition; and

 

•             significantlygreater financial, technical and marketing resources.

 

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

 

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

 

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

*** ***

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

 

•             thecompetition our customers face in their particular industries;

 

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

 

•             thefinancial and other resources of our customers; and

 

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

 

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

 

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

*** ***

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

 

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

*** ***

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

 

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

*** ***

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

 

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

*** ***

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

 

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

*** ***

Werely on a combination of patents, copyrights, trademark and trade secret laws,non-disclosure agreements and other intellectual property protection methods toprotect our proprietary technology. However, we believe that, due to the rapidpace of technological innovation in the markets for our products, our ability toestablish and maintain a position of

 

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technology leadershipalso depends on the skills of our development personnel.

 

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

 

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

 

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

 

Forexample, we have been in the past been involved in litigation with SumitomoElectric Industries, Ltd. (“SEI”) in Japan as well as interference actions inthe United States. We and SEI approved a settlement of this litigation duringthe fourth quarter of 2004 and the litigation was withdrawn and we abandonedthe interference proceeding. We incurred an initial charge of approximately$1.4 million and will have to pay ongoing royalties to SEI on certain of ourproducts.

 

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

*** ***

Ourrevenue growth depends in part on the expansion of our international sales andoperations. International sales represented 81% and 79% of our total revenuefor the years ended December 31, 2005 and 2004, respectively, and 77% ofour total revenue for the three month period ended March 31, 2006. We expectthat sales to customers outside the U.S. will continue to represent asignificant portion of our revenue, particularly sales to customers in Asia.

 

Currently,an increasing percentage of our sales are to customers headquartered in Asia.Certain manufacturing facilities and suppliers are also located outside theU.S. Managing our global operations presents challenges, including periodicregional economic downturns, trade balance issues, varying business conditionsand demands, political instability, variations in enforcement of intellectualproperty and contract rights in different jurisdictions, differences in the abilityto develop relationships with suppliers and other local businesses, changes inU.S. and international laws and regulations including U.S. exportrestrictions, fluctuations in interest and currency exchange rates, the abilityto provide sufficient levels of technical support in different locations,cultural differences, shipping delays and terrorist acts or acts of war, amongother risks. Many of these challenges are present in China, which represents alarge potential market for semiconductor equipment and where we anticipatesignificant opportunity for growth. Global uncertainties with respect to:(i) economic growth rates in various countries; (ii) sustainabilityof demand for electronics products; (iii) capital spending by semiconductormanufacturers; (iv) price weakness for certain semiconductor devices; and(v) political instability in regions where we have operations may alsoaffect our business, financial condition and results of operations.

 

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

 

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

 

•             unexpectedchanges in regulatory requirements;

 

•             longerperiods to collect accounts receivable;

 

•             changes inexport license requirements;

 

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•             politicaland economic instability;

 

•             unexpectedchanges in diplomatic and trade relationships; and

 

•             foreignexchange rate fluctuations.

 

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

 

Also, denominating somesales in Japanese yen subjects us to fluctuations in the exchange rates betweenthe U.S. dollar and the Japanese yen. The functional currencies of our Chinesesubsidiaries are the local currencies. We incur transaction gains or lossesresulting from consolidation of expenses incurred in local currencies for thesesubsidiaries, as well as in translation of the assets and liabilities of theseassets at each balance sheet date. If we do not effectively manage the risksassociated with international sales, our revenue, cash flows and financialcondition could be adversely affected.

 

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

*** ***

TheChinese government faced a power crunch over the summer of 2004 and reportedthat power demand in 24 provinces outstripped supply in peak periods during thefirst four months of 2004. Instability in electrical supply caused sporadicoutages among residential and commercial consumers. As a result, the Chinesegovernment implemented tough measures in 2004 to ease the energy shortage.Provinces imposed power brownouts during 2004 to reduce electricity demand andsome companies in Beijing were ordered to give their employees a week off toease the pressure on power supply. The plants, most of which are state-owned,were closed and reopened on a staggered schedule to reduce power consumptionduring the capital’s hottest months during 2004. As a result we closed most ofour operations for a week in late July 2004 in conformance with thispolicy. Although shortages requiring closure of facilities did not occurduring summer 2005, if we are required to make additional temporary closures ofour Beijing and joint venture operations at any time during 2006, we may beunable to manufacture our products, and would then be unable to meet customerorders except from inventory on hand. As a result, we could lose sales,adversely impacting our revenues, and our relationships with our customerscould suffer, impacting our ability to generate future sales. In addition, ifpower is shut off at our Beijing operations at any time, either voluntarily oras a result of unplanned brownouts, during certain phases of our manufacturingprocess including our crystal growth phase, the work in process may be ruinedand rendered unusable, causing us to incur expense that will not be covered byrevenue, and negatively impacting our cost of goods sold and gross margins. Weare attempting to partially mitigate the potential effects of power outages bybuilding inventory in anticipation of power outages during the summer. Thisinventory build is prepared to accommodate forecast demand rather specificcustomer orders. If the inventory we build is not ordered by customers, we mayhave to scrap these products and incur a cost which will reduce our grossmargins.

 

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

*** ***

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

 

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

*** ***

Weanticipate that our existing cash resources will fund any anticipated operatinglosses, purchases of capital equipment and provide adequate working capital forthe next twelve months. However, our liquidity is affected by many

 

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

 

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

*** ***

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

 

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

 

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

 

InJuly 2005, the People’s Republic of China agreed to a shift in Chinesecurrency policy and established a 2% revaluation of the renminbi, and the renminbi will now be referencedto a basket of currencies, with a daily trading band of +/-0.3%. Depending on market conditions andthe state of the Chinese economy, it is possible that China will make moreadjustments in the future. Over the next five to ten years, China may move to amanaged float system, with opportunistic interventions. This reservediversification may negatively impact the United States dollar and U.S.interest rates, which could in turn negatively impact the Company’s operatingresults and financial condition. A significant percentage of our sales are madeto customers located outside of the United States, particularly Asia. Oursales are denominated in U.S. dollars, except for sales to our Japanese andsome Taiwanese customers, which are denominated in Japanese yen. Thus,increases in the value of the U.S. dollar could increase the price of ourproducts in non-U.S. markets and make our products more expensive thancompetitors’ products in these markets. The functional currencies of ourChinese subsidiaries, including our joint ventures, are the local currency;since most of our operations are conducted in China, many of our costs areincurred in Chinese currency, which subjects us to fluctuations in the exchangerates between the U.S. dollar and the Chinese renminbi. We incur transactiongains or losses resulting from consolidation of expenses incurred in localcurrencies for these subsidiaries, as well as in translation of the assets andliabilities of these assets at each balance sheet date. These risks may beincreased by the fluctuation and revaluation of the Chinese renminbi. If we donot effectively manage the risks associated with this currency risk, ourrevenue, cash flows and financial condition could be adversely affected.

 

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

*** ***

The majorityof our substrate manufacturing activities are conducted in China. In addition,we source key raw materials, including gallium, from our joint ventures andother suppliers in China. The 2003 SARS outbreak was most notable in China anda small number of cases were reported in 2004. One employee at our LEDproduction facility in China contracted SARS in late April 2003 promptingus to close the facility for ten days. There was no significant impact to ourability to fill customer orders. If there were to be another outbreak of SARSor a different contagious disease, such as Avian Flu, and if our employeescontracted the disease, we may be required to temporarily close ourmanufacturing operations. Similarly, if one of our key suppliers is required toclose for an extended period, we may not have enough raw material inventory tocontinue manufacturing operations. In addition, while we possess managementskills among our China staff that enable us to maintain our manufacturingoperations with minimal on-site supervision from our US-based staff, ourbusiness could also be harmed if travel to or from Asia and the United Statesis restricted or inadvisable, as it was during parts of 2003. None of oursubstrate competitors is as dependent on manufacturing facilities

 

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in China as we are. If ourmanufacturing operations were closed for a significant period, we could loserevenue and market share during that period which would depress our financialperformance and could be difficult to recapture. Finally, if one of our keycustomers is required to close for an extended period, we may not be able toship product to them, our revenue would decline and our financial performancewould suffer.

 

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

*** ***

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

 

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

*** ***

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

 

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

*** ***

We have notover the past years been able to sustain growth, and may not be able to returnto historic growth levels in the current economic environment. Our net loss in2002 was the largest in our history and our losses continued during 2003, 2004,2005 and for the three month period ended March 31, 2006.

 

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

 

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

 

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

 

•             fluctuationsin demand for our products;

 

•             expansion ofour manufacturing capacity;

 

•             expansion ofour operations in China;

 

•             limitedavailability and increased cost of raw materials;

 

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

 

•             fluctuationof our manufacturing yields;

 

•             decreases inthe prices of our competitors’ products;

 

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

 

39

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

 

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

 

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

 

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

*** ***

Our stockprice has fluctuated significantly since we began trading on the NASDAQNational Market. For the year ended December 31, 2005, the high and lowclosing sales prices of our common stock were $2.47 and $1.08, respectively,and for the three months ended March 31, 2006, the high and low closing salesprices of our common stock were $3.87 and $1.98, respectively. A number offactors could cause the price of our common stock to continue to fluctuatesubstantially, including:

 

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

 

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

 

•             announcementsof technological innovations by us or our competitors;

 

•             new productintroduction by us or our competitors;

 

•             largecustomer orders or order cancellations; and

 

•             theoperating and stock price performance of comparable companies.

 

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

 

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

*** ***

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

 

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

 

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

 

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

 

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

 

•             the abilityof our board to alter our bylaws;

 

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

 

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

 

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

 

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

 

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

 

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

 

None

 

**Item 3. Defaults uponSenior Securities**

 

None

 

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

 

None

 

**Item 5. Other Information**

 

None

 

**Item 6. Exhibits**

 

**a.Exhibits**

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

 

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

 

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(1) Incorporated by reference to the exhibitof the same number filed with the SEC with our Annual Report on Form 10-K forthe year ended December 31, 1998.

 

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

 

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

 

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

 

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

 

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**SIGNATURES**

 

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

 
|                 | AXT, INC. |
|----------------------|-----------|
|                 |      |   |
| Dated: May  12, 2006 | By:       | /s/ Philip  C. S. Yin |
|                 |      | Philip C. S.  Yin |
|                 |      | Chief  Executive Officer |
|                 |      | (Principal  Executive Officer) |
|                 |      |   |
|                 |      | /s/ Wilson  W. Cheung |
|                 |      | Wilson W.  Cheung |
|                 |      | Chief  Financial Officer |
|                 |      | (Principal  Financial and Accounting Officer) |

 

43

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**EXHIBIT INDEX**

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

 

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(1)          Incorporated by reference to the exhibit asof the same number as filed with the SEC in our Annual Report on Form 10-K forthe year ended December 31, 1998.

 

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

 

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

 

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

 

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

 

44

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